Searching high and wide

In 2005, optimism over the future of emerging markets private equity reached a new high. Figures from the Emerging Markets Private Equity Association (EMPEA) revealed that funds raised by general partners in developing countries soared 300 percent from just short of $5 billion (€3.9 billion) in 2004 to over $20 billion last year. While the recipients of this capital are the immediate beneficiaries, they're not the only ones relishing the trend. Buoyed by the thought that a portion of these funds' investments may eventually end up being recycled, secondaries investors too have reason to feel encouraged.

Paul Capital Partners, the San Francisco-based funds of funds and secondaries investor, is one firm that has big ambitions for the emerging markets secondaries space. David de Weese, a general partner, says that until around 18 months ago, the firm had an exposure to emerging markets of “typically between three and five percent” of total assets under management. Since then it has been “substantially increasing” its exposure, and is planning, he says, to commit between 20-25 percent of Paul Capital Partners IX, the new global secondaries fund it is currently raising, to emerging markets. (The firm's previous global fund closed on $960 million in October 2004.)

While these figures are arresting enough, the strategy may also cater for even more investor appetite through a side vehicle that de Weese stresses is only under consideration rather than being a confirmed feature of the fund at this stage.

One of the most important factors in developing the strategy, in de Weese's view, is the issue of pricing (of which more later). “Our problem, and that of most secondaries players looking at the space, is that, in order to price assets accurately, you need to have locals experienced in doing business in emerging markets,” he says. Paul Capital's proposed solution – and an indication of the strength of the firm's commitment – is to launch a recruiting spree that de Weese says will take place over the next six to eight months. These new hires, he says, will help populate one or two new offices in Asia, one in Latin America and possibly one in Central and Eastern Europe – a region which will initially be covered from the firm's existing London office.

Paul Capital is not the only established Western secondaries group beginning to take emerging markets more seriously. New York-based AIG Capital Partners has an existing secondaries operation in developed markets, which notably acquired a portfolio of private equity assets from Dresdner Bank for around €1.1 billion in March 2005. It also has an established direct investment business in emerging markets, with around 90 professionals based in 18 countries around the world. Scott Foushee, a managing director at AIG, says that by combining the strengths of the two platforms, the firm will have a solid depth of resource with which to target emerging markets secondaries. Declining to discuss details of the planned strategy, Foushee does not elaborate on whether AIG will raise a dedicated emerging markets secondary fund.

AlpInvest Partners, the Dutch pension fund manager, is another organisation starting to look at secondaries opportunities in emerging markets. The group has a global secondaries team which, from a standing start four years ago, put around $1 billion to work last year – including making its first imprint in emerging markets.

In July 2005, AlpInvest teamed up with Lexington Partners of the US to acquire a $1.2 billion portfolio of private equity assets from Dayton Power and Light, the Ohio-based electricity group. According to Tjarko Hektor, AlpInvest's New York-based head of secondaries, around 5-6 percent of these assets were based in emerging markets. He says the firm is now looking to buy emerging markets assets “on our own”.

WEIGHING THE NUMBERS
Given the examples above, it is clear that at least some global secondaries investors see an emerging markets strategy as viable – which begs the question as to how they have formed that conclusion.

Our general philosophy is to buy quality assets, invest in successful GPs and pay a full and fair price rather than to try and determine an appropriate discount for lower quality positions managed by people whose track records are unclear

David De Weese

One rather obvious answer is that they have simply done their homework. De Weese cites figures suggesting that around $86 billion was committed to emerging markets private equity funds between 1992 and 2002 – around 10 percent of the cash raised for the asset class globally during that period. This, he says, represents a “significant inventory”, even allowing for the fact that many investments made in emerging markets from that era have subsequently been written off. On top of this, there is the fundraising boom of the last two years potentially creating a “new wave of attractive product” as well. Adding the two together equals a credible market opportunity as far as de Weese is concerned.

AIG's Foushee concurs that the numbers look increasingly attractive. He says that, in developed markets, the ratio of direct investments that end up being acquired by secondaries funds is around five percent of the total. In emerging markets, meanwhile, the equivalent figure stands at “a fraction of one percent”. However, over the next few years, he sees that gap closing significantly.

Amid this optimism, there are dissenting voices. Stefan Hepp, CEO of Swiss gatekeeper SCM Strategic Capital Management, says that emerging markets secondaries is “by definition a small segment” and adds that he is “hard pressed to see that a dedicated vehicle would be viable”. For the time being, Hepp feels that the only significant activity in the space will be in the form of emerging markets assets forming a minority component of a large deal. “CalPERS might conceivably sell off a global portfolio that has a batch of Asian interests in it,” is a theoretical example he volunteers.

Not that many secondaries firms would disagree strongly with Hepp's assessment of the current state of play. “What's driving people towards emerging markets is less about what's happening now and more about what they can see happening down the road,” says Stephen Sloan, managing director at Dallas-based secondaries advisory firm Cogent Partners. Speaking specifically of Asia, he adds: “If the region grows as people believe it will, institutions will want to increase their allocations because they want to be diversified on a global basis and they see Asia as a great opportunity where they are currently underallocated. But at the moment they're focusing on building relationships and familiarising themselves with the terrain.”

FORCED MIGRATION?
Some observers suggest that eagerness to explore opportunities in emerging markets stems from increasing competition in developed markets. According to this argument, the strong performance delivered by secondaries funds in recent years has boosted the flow of capital into the market, resulting in upward pressure on pricing. This has in turn persuaded investors to consider new strategies, including expansion into emerging markets.

But not everyone buys into this line of reasoning. For instance, AlpInvest's Hektor dismisses any suggestion that secondaries funds are under pressure to find assets they can purchase in Europe and North America. “There has never been so much supply in global secondaries as there is now,” he insists. “We are swamped with opportunities. It's what fits with your investment strategy that dictates what you do rather than a lack of opportunity.”

It is tempting though to think of secondaries investors in developed markets seeking refuge from high prices in emerging markets. Given that returns on private equity investments in Asia and Latin America have historically been poor, discounts available on mature assets from these regions surfacing in the secondary market would likely have been significant (as ever in the secondary market, hard data to prove this assumption is difficult to obtain). To some, this no doubt represents a tempting if risky alternative to the cut and thrust of the highly competitive mainstream arena.

However, there are signs of change on the horizon as high quality assets for which full prices can be demanded begin to appear on radar screens. The most high profile example of this was seen in February this year, when London-based global secondaries firm Coller Capital forked out $35 million to acquire partial stakes from a number of investors in India Advantage Fund I, a 2002-vintage private equity vehicle managed by Bangalore – and Mumbai-based ICICI Venture Funds.

As well as being the first major secondaries transaction in India, it was also understood to have been a profitable deal for the sellers, who reportedly achieved a 40 percent IRR on the transaction. Says Coller partner Daniel Dupont: “ICICI was in a position where some of its investors wanted create to liquidity from some high quality assets in the previous fund so that they could invest in the same firm's new fund.” Dupont says that although the opportunity came out of the blue, Coller had been a regular visitor to India over the prior two years, during which it had developed a good relationship with ICICI.

Anecdotally, it appears that this is the type of deal – rather than the discount variety – that is doing most to turn heads toward the emerging markets. Says AlpInvest's Hektor: “We're not bottom fishers, we're more than willing to pay up for the right assets. What we have seen to date in emerging markets is predominantly funds that have got caught in bubbles and blown up. These kinds of situation require a very significant discount and we're not a buyer of them. But there are good GPs in emerging markets and that's why we want to be active there.”

Adds de Weese: “Our general philosophy is to buy quality assets, invest in successful GPs and pay a full and fair price rather than to try and determine an appropriate discount for lower quality positions managed by people whose track records are unclear.”

PATIENCE A VIRTUE
But while funds are eager to express their willingness to do such deals, at least two major obstacles remain when it comes to execution. One is that deal flow is still very thin and may remain so for a while yet. There is considerable optimism regarding the size of funds raised in Asia over the last few years and the quality of the recipients, but investments would not normally find their way into the secondaries market until quite late in a fund's typical 10-12 year lifecycle.

The second key issue is the ability to price assets accurately in markets which, according to Stefan Hepp, can be “a bit of a data desert”. In order to do so, secondaries buyers need to have some confidence in their ability to predict future cash flows and the likelihood of achieving exits. “More people are getting familiar with these regions and have better views on what's happening,” says Sloan at Cogent. “If you don't understand pricing and risk issues, discounts will be heavier. But if you're active in the market, your ability to price assets will be much improved.” This helps explain why the likes of AIG and Paul Capital see having a local presence as essential.

But even being “on the ground” does not guarantee accurate pricing in volatile markets. Says Foushee: “Pricing is getting clearer in emerging markets. The centre of global growth is shifting in their direction and some of the volatility has been dampened. But recent months, in which stock market corrections have occurred widely in emerging markets, have been proof that the volatility has not gone away. People have to bear in mind that the last two years of a steadily rising growth curve may not always hold steady.”

The leading luminaries of the secondaries market will not dismiss such cautious considerations as they plan how to best hone their emerging markets strategies. Nonetheless, as money continues to pour into Asia in particular, there is a sense that some bold moves are required to capitalise on a looming opportunity.