The case for frontier markets

With developed nations mired in financial crisis and emerging markets like Brazil, India and China now firmly emerged, canny investors should look to frontier territories, writes Robert Tomei, chairman and chief executive of private equity group Advanced Capital.

Since the category was coined in 1992, frontier markets have shown much promise without ever quite moving into the investment mainstream. The term is used to refer to a subset of countries within the broader field of emerging markets, which share some key characteristics: they are investable, but have a relatively low market capitalisation and liquidity compared to more developed emerging markets (most notably the BRIC nations).

While there is no definitive list of countries which fit these conditions, most attempts to list frontier markets produce a list of around 20 to 40 countries, spread across Eastern Europe, Africa, Asia and South America. Among the most commonly listed in Asia are Pakistan, Qatar and Vietnam; in Africa, Kenya, Tunisia and Mauritius; and from Europe, Ukraine, Romania and Estonia.

For many, the natural alternative to developed world investment has been to look at the BRIC (Brazil, Russia, India and China) economies. However, so many investors are looking to benefit from the opportunities on offer here that it is increasingly hard to find competitive returns which can justify the level of risk which investment in these markets necessarily entails.

By contrast, the lower profile of opportunities in frontier markets means investments can be identified offering rates of return more in line with the level of risk entailed. With local investment expertise on your side, it is possible to pick out the best opportunities, which will not have the price premium facing investors competing over opportunities in the BRICs. In addition, while the frontier has traditionally been seen as a relatively risky arena, these countries’ insulation from the present global economic stagnation makes them look increasingly attractive.
As the growth of the BRICs intensifies competition for global resources, those frontier markets which have access to relatively under-exploited deposits of raw materials are set to benefit from prices which are likely to remain high for some time.

However, looking at the companies which have had the most success over the second half of the twentieth century, it has tended to be manufacturing-led economies (such as South Korea and China) which have made the greatest strides over the long term. Fortunately, many frontier economies have huge potential for a move into manufacturing, both for export but also for domestic consumption, thanks to the emergence of a hungry and growing middle class.

In addition to the purely economic opportunities, supporting factors such as the political environments on the frontier are also fast-improving. In countries like Vietnam, Indonesia, Sri Lanka and South Africa, political stability is growing year by year. It is also possible to mitigate against lingering political instability through the use of insurance; many credible private equity managers take out political risk insurance to protect against political tail-risk.

To mitigate against any lack of transparency, ensuring that accountability is being enforced at the investment fund level is also key. The focus has to be on selecting high quality managers who rigorously comply with international regulations and enforce accounting standards – and backing up these requirements with a stringent vetting process which includes background checks. In addition to picking the best and most trustworthy managers, we would demand a high level of ongoing transparency; the leading funds use international accounting majors to audit the books of their portfolio companies.

Of course, any attempt to address such a varied range of countries can only offer the broadest of overviews. Opportunities and risks vary greatly within the bloc, and making a success of frontier investing means requires a focus on the specific context of each investment. However, it is quite clear that throughout these young, dynamic and growing countries, there are huge opportunities to be uncovered, and strong returns to be made. 

Robert Tomei is chairman and chief executive of Advanced Capital