EMERGING MARKETS: Adjusting, slowly

If anyone out there still believed in the notion that emerging markets are ‘decoupled’ from developed ones, the events of the last year or so will presumably have disabused them of it.

It’s true that in the years after the onset of the financial crisis, most emerging markets proved to be more resilient (or bounced back faster) than many expected. But it is becoming increasingly clear that many of these economies are not immune to the developed world’s problems – particularly the chaos in the Eurozone, which is such an important trading partner for so many of them. The likes of China, India and Brazil are all likely to see lower growth than expected in 2012, bringing its own domestic challenges for their respective authorities.

The private equity picture in emerging markets is not particularly cheery either. Deal volume was down by one-third year-on-year in the first half of 2012, according to Emerging Markets Private Equity Association figures – from just under $15 billion to just under $10 billion, including a noticeable decline in the number of ‘big ticket’ deals ($100 million-plus).

One of the issues is financing. As private debt fund manager Cordiant Capital pointed out recently, figures from the Bank of International Settlements show that bank lending to emerging markets businesses fell 21 percent in the 12 months through June 2012 – from $334.2 billion in 2010-11 to $263.5 billion in 2011-12 (The Middle East and Africa were particularly hard hit, with loan volumes tumbling over 40 percent).

The European banks have always been big lenders to emerging market companies, so their well-attested (and ongoing) problems are inevitably having a knock-on effect; some are trying desperately to shrink their balance sheets, others are under instruction from politicians to focus their lending on domestic companies.


The good news is that most of these markets are still growing at a much faster pace than the largely stagnant developed world. Many are becoming more open to private equity investment. And their managers are getting more experienced and better-resourced. That’s why many LPs are keen to increase their allocations to emerging markets.

“Emerging markets like Latin America and Africa are growing, so they’re actually a very defensive play in the current environment,” says Brian Lim, Hong Kong-based head of emerging markets investments at Pantheon.

Judging by the fundraising figures, this hasn’t necessarily happened this year. After a bumper couple of years for emerging markets funds – total capital raised jumped 121 percent year-on-year in 2010, and then a further 16 percent in 2011 – there were clear signs of a slowdown in 2012, with the full-year total likely to be the lowest since 2009 (see chart).

Of course, that’s not necessarily a reflection of the attractiveness of emerging markets: fundraising is down across the board, as some investors have cut back their private equity allocations and others adopt a more cautious approach. Which makes it all the more useful that the development of emerging markets is starting to unearth some new sources of LP capital – particularly the big pensions funds of Latin America.

Most emerging markets managers will tell you that the short-term noise around particular markets – China’s ‘hard landing’, India’s inflation problem, Brazil’s tax burden etc – should not be a barrier to investment.

“By definition private equity means you invest in very long cycles,” says Carlos Héneiné, who’s co-head of emerging markets for European LP Quilvest Private Equity. “Of course you need to take short-term factors into account; but ultimately, when you do private equity fund selection you’re investing in the people running the fund and in their judgment; not the cycle of an economy. So as long as there’s nothing that makes the country completely uncompetitive, we tend to focus on the long-term trends – like consumers getting wealthier and spending more money.”

By far the most important factor, he suggests, is price. “The real issue in terms of risk/reward is whether there’s too much money in a particular country/sector– and thus whether you can buy companies without overpaying. If you can do transactions that are reasonably priced, it’s easier to cope with error or delay or macro-related problems.”

This highlights a key issue for emerging markets managers: the possibility that as investors pour into a particular country (and the herd mentality is a well-attested phenomenon) there ends up being too much money chasing too few deals.

Brazil is currently a case in point, following a record fundraising period.

“There are signs of overheating at the large end of the market in Brazil,” admits Lim. “The four or five biggest funds have raised a lot of money lately, plus you have the large global funds. And the pressure is being felt on big ticket deals; price inflation is already happening.

Héneiné agrees: “The large end of the market [is] very competitive and expensive – and if you combine that with a slowing economy, it starts looking a bit discouraging, because you have lots of money chasing very few opportunities.”


The other (related) issue facing many LPs is finding the right risk/return profile.

Although emerging markets are relatively less risky than they once were, given the parlous state of many developed economies, most investors would still expect to receive some sort of premium for the additional risk involved. But as a country’s private equity market gets more crowded and more competitive, valuations rise and it becomes increasingly hard to generate those outsized returns.

Héneiné says Quilvest focuses on two core factors when evaluating emerging market managers: the team’s experience level, and how developed the private equity industry is in that particular country.

“If you want to make your life easy, you could stick to established teams – say a Fund III and upwards – in the more established countries, i.e. developed Asia and the BRICs. But then it’s not easy to make good returns.” As managers get bigger and raise more money, they typically do fewer proprietary deals and can be “less disciplined about entry price”, he says. “So it becomes very hard to do more than [a] 2x return at a portfolio company level.”

The trouble is, he argues, you can get this sort of return in the US mid-market, with less risk. So investors looking for better returns from their emerging markets portfolio (as arguably they should be) may need to look beyond the obvious – like first- or second-time funds, perhaps with a sector or thematic focus, or less well-trodden markets, like Peru or Indonesia or Vietnam.

Of course, sensible portfolio management might entail having a range of funds with different return profiles. “We are willing to look at a fund that will do 2x or 2.2x at a company level – if there’s a higher degree of certainty,” says Héneiné. “But if your whole portfolio looks like that, you’d look pretty silly as an emerging markets manager. So you need to combine that with other funds that can produce 4x returns or even higher.”

Indeed, it’s increasingly hard to talk about emerging markets in toto, given how much diversity there is within this catch-all title. But one thing’s for sure: at a time when growth is at a premium around the globe, these markets cannot be ignored.