Capital’s flight to quality

Emerging market private equity is showing signs of coming of age, with early entrants tested over the past 10 years showing the battle scars and more recently the exit multiples to prove it.

Returns from Asia, Africa, Eastern Europe, the Middle East and Latin Ameri-ca for 2014, from both private equity and venture capital, outstripped developed markets (excluding the US), according to research from Cambridge Associates. The CA index for developed markets rose 

3.5 percent over the year compared with its emerging markets index that climbed 14.3 percent, helped by vibrant Asian M&A and initial public offerings.

In a fund-raising cycle undercut by devaluing currencies, plummeting oil prices and contagious stock market volatility in China, track record is key. Those general partners who can show returns have had a much easier time collecting capital from investors than first time funds.

Only 28 debut funds focused on emerging markets managed to close in 2014, raising a total of just $2.8 billion, according to the Emerging Markets Private Equity Association (EMPEA), the lowest number since it started collecting data in 2006. The figures sit within an overall decline in emerging market fund closings.

“There’s been a flight to quality,” says Brian Lim of recent fundraisings in Asia. Lim chairs the firm’s emerging markets investment committee. “Some funds have managed fast and strong fund raisings in a more challenging back drop.”

These include Everstone Capital Partners III which is focused on Indian opportunities and announced its final close in September at its $730 million hard-cap. And elsewhere in emerging markets, the picture is the same. The Abraaj Group has managed to close funds totalling almost $1.4 billion in the past five months to invest in North and sub-Saharan Africa.

Since the beginning of the year, funds focused on emerging markets have raised $25.8 billion in total, according to PEI Research & Analytics. But limited partner appetite for emerging markets remains constrained, given risks including government instability and currency volatility, as well as untried managers. LPs without a strategic imperative of a development finance institution to put money into such funds, still do so only to diversify.

“LPs say they have appetite and then the money they invest in a fund is less than their target amount,” says William Barrett, partner at Paris-based placement agent Reach Capital. He notes that internal rates of return between emerging market funds and US GPs is the same. “You don’t get the risk reward.”

And there is another barrier. The Alternative Investment Fund Management Directive has begun to curb the number of local funds targeting European investors. “The entry hurdle is such that many [emerging market GPs] drop the European market and fundraise in Asia and the US,” Barrett says.

However, for European LPs actively allocating to emerging markets, including funds of funds and pension funds, Asia tops the list.

Despite recent stock market plunges, China remains a draw for international investors, and funds previously dominated by foreign LPs have started to show a greater mix of local and international investors, says Lim. He expects cross-border investment to increase.

“There’s been a lot of negativity around China, but we would argue that there are still strong opportunities for investment and many of these are coming at adjusted prices,” Lim says.

In Asia, he adds that there are opportunities across the buyout and mid-markets due to lack of alternative sources of capital, including erratic equity markets, restricted bank debt, and price dislocations.

So-called “defensive” sectors, such as healthcare and education-related businesses, as well as consumer-driven remain attractive. L Capital Asia II, a $1 billion vehicle sponsored by LVMH Moët Hennessy Louis Vuitton and targeted at big name brands, has been able to deploy 70 percent of its capital a year on from its final close. Funds are also testing new waters in up-, mid- and downstream oil and gas investing.

In India too, the consumer story is strong. Faith in the economic reform agenda promised by prime minster Narendra Modi, as well as moderating inflation and improvements in the current account, have meant the market is poised to turn a corner despite a fluctuating currency back at around 65 rupees to the dollar.

Exit opportunities are opening, cash is piling up and deal flow appears to be improving – the likes of the India Value Fund V, which held a final close on $700 million in April, has already managed to invest $170 million.

“Just because they’re mega-funds doesn’t mean they won’t find opportunities,” Lim says, speaking generally.

This certainty is not reflected in Africa. Despite the number of $1 billion-plus funds raised this year, such as Helios Fund III and the TPG-Satya Capital platform in market, a question mark hangs over the number of big ticket deals the continent can provide, and the reasonableness of valuations. The availability of exit opportunities at required multiples is also far from assured.

One response has been to slide down the deal scale and specialise. Apis Partners is targeting $250 million in its first growth fund focused solely on financial services. The fund will invest in Africa and Asia, with a bias to the former, and is targeting deal tickets of $25 million.

Apis Partners co-managing partner Udayan Goyal believes the opportunity to deploy capital in this space is greater than for $100 million buys. “The pool of companies is bigger,” he says, adding that “all sectors depend on financial services. For us it is a proxy for a macro play”.

One of Apis Growth Fund I’s investors is the Netherlands Development Finance Company (FMO).

“We are still looking into new funds,” says Jaap Reinking, director of private equity at FMO. “We prefer to be first mover in a fund or country and we are still trying to find co-investments. We are more attracted to local fund managers but it is more difficult to find co-investment opportunities as deals are small.”

For “difficult” markets such in West Africa, Congo, Ethiopia and Pakistan, FMO opts for dedicated fund managers.

From an investor perspective, other challenging markets include Latin America. “Because of the currency slide, there is hardly any liquidity for exits and you have to be careful raising new funds and in the investor space it is a little quiet,” Reiking says.

In Brazil, economic recession, a devaluing real and a government in gridlock have private equity professionals focused on the long term. Fundraising has slowed to $550 million raised so far this year, according to PEI Research & Analytics. GPs are adopting a wait and see approach regarding exits. In the meantime, attention has shifted to alternative markets of Peru and Colombia.

Closer to home, FMO is considering investing in an Eastern European fund. Markets like Romania, Poland and the Baltics are managing to differentiate themselves from Russia, which is facing a storm of currency, commodity price and global-political headwinds.

Looking forward, even FMO, a committed emerging markets investor with a risk appetite to match, is unsure what the future holds.

“I’m curious to see what happens next year,” says Reiking, referring to the impact of deteriorating currency valuations and the slide in the oil price. “Some will benefit and some won’t.”