Protection, due diligence, control

For investors looking for exposure to emerging markets, investing in private rather than public markets is often the better option, argues Actis’ Jonathan Bond.

That China will overtake the US as the world’s largest economy by the middle of the century is an oft-cited prediction. One might argue about the timing, but the general conclusion is widely accepted. What is less frequently commented on is the shift in global economic power that will take place over the next 50 years.
Goldman Sachs predicts that by 2025 Brazil, Russia, India and China (the BRICs) could be half the size of the G6 economies (US, Japan, UK, Germany, France and Italy) in dollar terms. By 2039, the BRIC economies could – assuming “reasonably successful development” – be larger than the G6, with only the US and Japan hanging on to their spots at the top table of global economic power. While this shift will take place steadily over the period, it will be most dramatic in the first 30 years.

Emerging economies such as India, China, Egypt and Nigeria also have huge internal markets. India, for example, has a middle class population of 350 million people – equal to the combined total populations of the US and the UK. Per capita GDP in the BRIC countries may be starting from a low base, but is expected to grow dramatically over the next 50 years. Domestic markets – from consumer goods to financial services, leisure and healthcare – offer a huge opportunity.

Of course, this is not to say there are no risks. For emerging markets to fulfil their potential, they need to ensure the right conditions for growth. In our experience, the main requirements are: a strong democracy, the emergence of effective governments and stable political institutions, greater liberalisation and high levels of education.

But are emerging markets worth the risks? We believe they can be, particularly if you manage the risks effectively. F&C Management, which has £120bn of assets under management, certainly thinks so. The firm started a March 2004 report with the words, “Emerging markets are the growth opportunities of the future.” Among the positive factors the report cited were: accelerating domestic growth based on positive demographic trends; a reflationary environment, with flexible exchange rates and low interest rates; stronger commodity prices; resurgent foreign direct investment; reduced debt levels leading to higher returns on equity; and improved corporate governance.

Risk and reward

Emerging markets do entail greater risks as a result of political and/or economic instability, inflationary and exchange rate fluctuations, adverse repatriation laws and fiscal measures. But many Western companies and investors overestimate these risks. A recent McKinsey report analysed returns and noted that while individual risks in each country might be high, they have low correlations with each other and the overall performance of a geographically diversified emerging markets portfolio is stable and comparable to those in Europe and the US over the past 15 years.

Geographic diversification is an important pillar of our strategy at Actis.  The firm, which has $2.7 billion of funds under management, is most active in Africa, China, Malaysia and South Asia.

In developed markets, investors are naturally drawn to listed equities. A large population of companies across diverse sectors gives investors access to a full spread of opportunities and reduces market volatility. The size and populations of investors mean there is ample liquidity.

But these factors do not necessarily apply to emerging markets, particularly in Africa. Choice is limited by the small population of listed companies, generally with a heavy weighting on resource companies. Variable regulatory standards, poor liquidity and often low standards of corporate governance exacerbate the problems.

Private equity is often a better option. The relatively long hold periods of private equity investments insulate investors from the vagaries of what are often volatile markets. Due diligence is also of critical importance in markets where financial reporting standards may lag behind those in the developed world. The nature of the private equity investment process allows investors to conduct extensive due diligence that is not an option when investing in public markets. Similarly, investors can negotiate structures that provide them with significant protection.

Perhaps the most important factor, however, is the ability to control – or at the very least exert significant influence over – investments. As well as giving the private equity firm the ability to draw on its experiences in other markets (both developed and developing) when setting strategy, it also allows investors to introduce best practice and effective corporate governance. The importance of this cannot be understated.

Governance in emerging markets

A raft of academic studies shows that companies with effective corporate governance perform better. For example, a study by Harvard University’s Paul Gompers and Andrew Metrick at the Wharton School, found that “firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures and fewer corporate acquisitions.”

In emerging markets, there are additional benefits to be gained from adopting best corporate practice. Adopting high standards can lessen the risk of industrial action and business interruption, aiding business growth and making the business a more attractive acquisition target for a multinational. Also, domestic pressure on multinationals has forced them to be more diligent in checking the practices of their suppliers, which of course creates opportunities for properly managed businesses. For example, Nike, GAP, Adidas, Unilever, Monsanto and Bayer have all attracted criticism in recent years for employing, either directly or indirectly, child labour.

F&C says emerging markets are the growth opportunities of the future. However, we firmly believe that they are also the opportunities of the present. And investing via private equity is the ideal way to take advantage of those opportunities.

Jonathan Bond is a managing partner at Actis with responsibility for investor development. The firm has been investing in emerging markets for over 55 years through its origins as part of CDC Capital Partners. In addition to its London headquarters, the firm has 17 offices in Abidjan, Bangalore, Beijing, Cairo, Dar es Salaam, Delhi, Jakarta, Johannesburg, Karachi, Kuala Lumpur, Lagos, Lusaka, Mumbai, Nairobi, San José, Santa Cruz and Singapore. The group invests in SMEs and power through its Aureos and Globeleq arms. To find out more visit