Limited partners are continuing their rush to build exposure to emerging markets, judging by comments in the hallways and onstage at our Emerging Markets Investors Forum in New York in March.
However, the risks associated with emerging markets investment have been brought into sharp relief in the last month, with major political upheavals in the Middle East and North Africa leading to regime changes in countries like Egypt, Tunisia and armed conflict in Libya. The impact on private equity is as yet difficult to determine.
In an informal poll, delegates at the event in New York, perhaps inspired by the events in MENA, ranked “political risk” as being of the greatest concern when making emerging markets investments.
However, not everyone agreed that political risk should be the foremost concern. Private equity funds rarely fail because of political catastrophe, according to Kevin Albert, managing director with fund of funds Pantheon, who said LPs should be more worried about currency fluctuations, which can render a once-attractive fund into something that simply “churns dollars”.
Ranked second among the concerns of the delegates – who comprised a mixture of LPs and GPs – was “manager risk”. Some speakers argued that this should be the foremost concern. “You have managers who are just getting their feet wet raising sums that are too big,” said Mike McCabe, partner with private equity advisor StepStone Group, who added that the flood of capital into certain emerging markets like China or Brazil was elevating the risk of GPs paying too much for assets.
A theme raised time and again at the conference was the fear that LPs could be making a costly mistake in trying to push their way into what are now over-saturated markets. Three of the BRIC countries – Brazil, India and China – have attracted a great deal of attention from limited partners in recent years. And some say “MIST” – Mexico, Indonesia, South Korea and Turkey – will be the next tier of emerging market countries to attract investors en masse also.
LPs often develop a “herd mentality”, according to one LP who was considering an allocation to Brazil. Investors will watch what other institutions are doing; as they see more and more LPs crowding into a market in search of outsized performance, the fear of missing out takes over. The problem is, as more capital pours into a market, second and third tier managers will materialise and capture some of that capital flow, regardless of whether they have the skills to deliver.
“You see the same story in a lot of places,” Josh Lerner, a private equity scholar and Harvard Business School professor, said late last year during a discussion about a PEI white paper on LP attitudes toward MENA private equity. “Limited partners move, by and large, in packs, where the decisions are sort of self-reinforcing. In a lot of cases it’s not based on where the best returns are but the areas seen as more fashionable for investing. In general, there’s a lot of caution and a lot of fear outside of a few markets that are perceived as safe – if they are or not is another question. For example, there are a lot of questions about China as a private equity market, but it’s … fashionable for private equity investing so you have a lot of LPs rushing in.”
Rushing in can mean settling for GPs who aren’t best-in-breed, delegates at the Emerging Markets Forum cautioned. One LP advisor felt that risk could be mitigated if investors re-think how they allocate to emerging markets. LPs for the most part tend to treat private equity like the public markets, saying, ‘I want to be in secondaries today, Brazil Tuesday and the US mid-market on Wednesday’,” the advisor said.
A better practice would be to think in terms of year ranges, he went on. Rather than thinking of committing a certain amount in one year, an LP would be better off to consider spending a certain amount over a five-year period, and only if the right opportunities arise.
Adopting that approach could make LPs less prone to following the herd and making decisions predicated on a fear of missing out, or a need to spend an allocation.
And if an LP does miss out on a great fund as it tries to avoid the herd and make cautious commitments to the most deserving GPs? Well, as another delegate at the conference said, “I’ve never regretted not being in a fund.”