Arguably, private equity is not for the risk-averse no matter where it is practised. Many can just about get comfortable with it when it is practised within the relative comfort and security of a well-developed market environment. But as soon as the safety net of legal, fiscal, operational and political stability is removed from the investment process, private equity starts to look too much like a high-risk approach for some.
This is why private equity investment in emerging markets, where the rule of law is less deeply entrenched than in other parts of the world, is absolutely not for everyone. And most investors consider it strictly off limits. But there are exceptions.
Even during the dark days of the mid 1990s, when the dramatic financial crises shaking Asia, Russia and Mexico caused investors to run scared, a small group of institutions stuck to their convictions and continued strategies of programmatically investing in local private equity funds. One such institution is the International Finance Corporation (IFC).
Sustainable private sector investment
Established in 1956 as a member of the World Bank, the group is based in Washington, D.C., and operates a large network of local offices across the world's less developed regions. According to the IFC's charter, its mission is to promote sustainable private sector investment in developing countries in order to reduce poverty and improve people's lives. To achieve this, it makes loans and equity investments in some of the poorest countries in the world.
IFC's origins as an investor in private equity funds date back to the 1970s. At that time, private equity as a source of funding had not entered the financial mainstream anywhere, not even in the US. In some of the markets that IFC moved in, it was virtually unknown.
For almost 25 years, the group used its considerable financial muscle to provide capital to fledgling private equity groups and other types of investment managers on a wholly opportunistic basis. Potential investments were vetted on a deal-by-deal basis, and were handled by different divisions within this multi-headed organisation. An underlying strategic framework was not formulated until 2001, which was a turning point in the corporation's approach to private equity. Teresa Barger, Director of Private Equity and Investment Funds, has spent the two years since then building IFC's collection of private equity fund investments into a centrally managed fund of funds programme.
Barger arrived at IFC in 1986 after working for consultants McKinsey & Co. One of her first assignments was to look after a $2m investment IFC had just made in Sadicar, a first-time private equity fund investing in Argentina. In many ways the project was representative of IFC's fundamental motivation for doing private equity, then as well as now. As Barger recalls: ?We were neophytes to the business, but this asset class was also absolutely unheard of in Argentina. Some interesting mistakes were being made, and the returns were awful. But the project did work in the sense that we helped create a good team that could then participate in the creation of the industry in Argentina. Its successor today, the HSBC Tower Fund 2, is doing some very interesting things in the market.?
The idea of pioneering private equity in new markets remains fundamental to IFC's motivation. Although there are obviously fewer spots on the global private equity map today that are still entirely uncharted territory, there remains much to do in many parts of the world. Barger and the IFC see it as a central part of their mission to help the private equity concept establish itself in local markets, ensuring that it is practised by professional managers capable of attracting domestic and international capital and putting it to work in ways that benefit them, their investors, their portfolio companies and their host countries' economies.
Not just another limited partner
IFC's developmental goals mean that it measures its own effectiveness in more than just financial terms. Returns are important, which is why Barger insists that IFC should as a matter of policy continue to invest in successful managers' second and third time funds. In the 1990s, IFC had often turned down such funds on the basis that their managers could stand on their own feet and were no longer dependant on the IFC's support. That principle no longer applies.
IFC's scorecard also rewards projects that have high developmental impact, that help advance a country's private equity investment infrastructure and drive innovation. Barger explains: ?We can't just be another limited partner. IFC's rules stipulate that we have a unique role in every project. We're not there to compete directly with private sector investors in emerging markets, but to catalyse other investors into the market, and to give comfort to those that are not as knowledgeable about investing in emerging countries.? Critically, there is also a mandate to help professionalise the local private equity industry, which she and her team care immensely about.
However, to do this effectively, IFC decided in 2001 it needed to professionalise its own private equity activities first. At that time, its interests in the asset class were looked after by 12 different groups within the corporation who between them were managing a total of 100 fund investments ? which all added up to $1bn. ?When our management realised that we did not have a nexus of expertise on this product area, they started to become concerned that people who didn't really know the product were booking these assets,? Barger says with just a hint of understatement.
Having spent the previous 15 years at IFC sporadically working on private equity projects while devoting most of her time to financial markets transactions and capital market development, she agreed to a brief to turn the existing platform into what was ? and still is ? intended to evolve into ?the best private equity fund of funds manager for the emerging markets.?
What followed was a largescale campaign to clean up IFC's portfolio. The energy and good humour that Barger possesses must have helped her ? and her team ? a great deal to get the job done. She clearly is proud of what has been achieved. There is much to talk about, and she talks about it passionately, but never overbearingly. There is a lightness of touch, coupled with a strong sense of purpose ? as well as a conviction that what she and her colleagues are doing is right, because there is in fact a right way of doing it.
Restructuring IFC's private equity business must nevertheless have been a daunting task. This was, after all, about reforming a multitude of business relationships in parts of the world where best private equity investment practice was not particularly well established. Barger's tales of what this entailed provide fascinating insight into the realities of running a fund management business that engages with less developed markets.
?When I took over the portfolio two years ago, probably half the managers did not really understand what it meant to be a fiduciary for our money,? she says. ?We had funds where half the corpus was kept in cash, which was a complete absurdity. The managers didn't even understand that there was a problem with that, that it was going to lower their IRR. They didn't understand that because they didn't care about it. We don't want managers that don't care about their IRR.?
One particular problem that needed to be dealt with was a legacy of the late 1990s. At that time, in the aftermath of the big emerging markets crises, many general partners at funds within the IFC portfolio realised that their funds were not going to reach carry. When the market dynamic changed, some of these managers started to concentrate on their fee income instead.
As a result, ailing investments were often held at cost, especially when poorly drafted fund documentation didn't require the managers to write them down. ?We even had funds where the partnership agreement entitled the GP to charge fees on the original, committed amount even if it hadn't been fully invested. So even after the investment period, one was still paying two per cent on a $100m fund, even if the manager had only managed to get $50m in the ground! These managers were in one business, and in one business only: the fee collection business. And that really poisoned the atmosphere and made a lot of LPs totally gun shy.?
This was why professionalising how the asset class was evolving in emerging markets became such an important concern for Barger and her team.
?The hobbyists should not be in this business. PE is a slow and painful way to make money in our markets. It's one of the most exciting endeavours one can undertake, because you really are in that important business of creating valuable companies, but it is not an easy thing to do.? With some emphasis she declares: ?I can say now that I think everyone in my portfolio now understands what fiduciary duty is.?
In some cases IFC took steps to wind down partnerships and terminate manager relationships. Other situations were resolved in more constructive ways. Interests needed to be realigned, investment agreements had to be rewritten ? sometimes in favour of the investors, sometimes in order to keep the manager motivated. Says Barger: ?We've been very serious about working out the problems. We renegotiated a lot of contracts. I'm particularly happy with that, because many people in private equity say, ?when you are in a ten-year contract, there is nothing you can do, why don't you just give up?? We didn't give up.?
As a result of this refusal to let go of even the messiest situations, Barger says IFC came to deal with, and get used to, deeper problems than many of its more mainstream FoF peers operating in Western Europe and North America. ?They don't struggle with issues like the vesting of carry, because it's very rare for them to fire a manager in midstream and hire another another one. It's not so rare for us.?
Needless to say that these negotiations weren't always amicable. But there have been exceptions: ?I also have my ?garden of delights?: a Hungary fund we invested in was not going to make its IRR target. The managers wound it up themselves, willing to forgo the fees, and ended up with a 9 per cent net IRR to investors. We like people who do that, but you don't find this kind of behaviour too often, neither in emerging markets nor elsewhere.?
During the restructuring of the portfolio, IFC deliberately slowed the pace of new investment, wanting to ensure that Barger's new department was fully up and running before making new commitments.
How well the existing portfolio is performing at this point is not clear. On average, IFC's funds are five years old which, according to Barger, is young by emerging markets standards. She is therefore wary of committing to final target return figures: ?The J-curve doesn't go above the 0 per cent IRR line until after year five. So we are right at the dangerous part of the J-curve. I find it very hard to predict where our portfolio is going to go.?
In an effort to get a clearer picture, IFC is working with other international finance institutions on a project co-ordinated by Cambridge Associates to develop appropriate performance benchmarks for private equity investors in emerging markets.
The restructuring of the IFC portfolio also entailed the adoption of a new set of investment principles. Abandoning the opportunistic approach of old, IFC's private equity investment strategy today is based on top down asset allocation principles ? how much capital should be invested in which regions, and in what type of private equity product ? and a strong emphasis on manager selection. Barger's group will only proceed with plans to invest in a country or region provided it can identify managers who fit its selection criteria. The group reviews approximately 200 investment proposals per year and aims to fund around eight, but there are no annual volume targets.
?That's why we're there?
Barger says current deal flow is attractive. Opportunities exist for example in Latin American countries such as Brasil, Argentina and Chile. To help promising fund managers to get off the ground, IFC requires other international investors, as well as domestic institutions, to overcome their scepticism towards private equity in the region. This is not easy as much of this scepticism took root after a number of US private equity managers that moved into the region in the 1990s failed spectacularly.
This basic challenge of persuading others LPs to participate is the same in other regions. Fundraising is still excruciatingly difficult business for most emerging markets managers. Says Barger: ?We went through a tough pioneering period in the 90s. Now what we have is tough LPs.? Not that she thinks that's a bad thing: ?I hope IFC is in the vanguard of tough LPs. We want to be tough but fair.?
She says the learning curve for IFC has been steep, and that the learning still continues. ?I tell you, I have seen huge changes in this industry in the last two years. We will certainly continue to make mistakes, I've got great humility about that. But at least I know that we've taken in very systematically everything we have learned.? To pass on some of this knowledge about investing in emerging markets, IFC organises investor workshops and provides detailed documentation on its website.
Doing this work requires more than a little idealism. IFC's staff do not participate in the carried interest, although a small bonus scheme has been instigated recently. Barger describes herself and her team as ?classic international civil servants? motivated by professionalism, the desire to do a good job, and the goal of developing the private sector in developing countries. There is an appealing richness and diversity about IFC's work, she says, that is determined in part by the vagaries of international markets, and in part by the complexities of each country's legal, regulatory, political and cultural frameworks.
Many of the countries that IFC invests in suffer from bad governance, exploitation, and markedly uneven distribution of wealth, countries where there is no guarantee that funds provided will ultimately benefit the intended recipients. Does this not worry her?
Far from it. It's the reason for doing the job in the first place: ?I'm hugely bothered by corruption, be it governmental or on the part of companies. But investing in private companies can be a good thing for pushing forward good governance even where there is a level of corruption and chaos in an economy. We invest in countries with less than perfect regimes, because that's why we're there. It's the substance of what we do. You have to start somewhere, and when the private sector gets developed, it becomes a lobbying organisation for better application of the rule of law.?