In June, Kohlberg Kravis Roberts announced its first ever African transaction: a $200 million investment in Ethiopian rose business Afriflora. It was a deal that seemed emblematic of the growing interest in Africa, with its favourable demographics and attractive growth rates. At a time when other emerging markets have lost some of their lustre, global funds like KKR have been committing more resource to Africa, while a sizeable number of local managers are out on the fundraising trail (one LP told Private Equity International that he was looking at “between 40 and 50” managers, just at the smaller-cap end of the market).
But does it make sense for investors to be committing more capital to emerging markets? Not if past performance is anything to go by, according to a new research paper (for eFront’s PEVARA database) by Cyril Demaria, a Switzerland-based asset manager and academic.
Demaria starts from the premise that investors do expect a return premium from emerging markets, to compensate for the additional risk. To be more specific: a recent survey by the Emerging Markets Private Equity Association found that 57 percent of LPs expected an average return of 16 percent – compared to an average of 12 percent for developed markets.
However, according to Demaria’s calculations, most of them have been disappointed. Across the nine years he studied, the top-quartile emerging market managers only beat that 16 percent threshold twice. Even if you consistently backed the top 5 percent – a big ask over any extended period of time – you would still have only have hit the benchmark two-thirds of the time. In fact, pooled emerging market returns delivered that 400bps premium to developed markets in just one of the nine years; in seven of them, they actually lagged developed market returns. In other words: investors weren’t just getting a smaller-than-expected premium; they were getting a discount.
So why have these markets under-delivered? One possibility, suggests Demaria, is that too much capital flowed in too quickly. “Local economies might have absorbed this excess by financing less attractive opportunities – [i.e.] inflated valuations and/or less promising assets,” he explains. Another possibility is that emerging market returns are actually more closely correlated to developed market returns than they might seem, probably because of what he calls “valuation contagion” – i.e. shrinking multiples in developed markets change the overall comparable set and thus affect emerging markets too.
It’s worth stressing that making sensible comparisons of private equity performance is tricky enough at the best of times, and particularly so in emerging markets, where the data can be patchy and inconsistent. Equally, it’s likely that up-and-coming regions like Africa won’t have featured heavily in historical performance data; it’s possible the dynamics there could turn out to be very different. Past performance isn’t always a reliable indicator of future performance, after all.
Still, it’s not the only worrying data point for emerging market investors. At the end of last year, Goldman Sachs and Capital IQ reported that FX volatility in emerging markets has been rising even as revenue growth from emerging markets has been falling – to the extent that since 2012, the former has actually been higher than the latter. This led Goldman to predict “the strong possibility of significant underperformance and heightened volatility [in emerging markets] over the next five to 10 years”.
None of which is reason for investors to shun emerging markets altogether; they still serve a valuable diversification purpose, if nothing else. But it should give some pause for thought about the likely risk/return profile.