by Costanza Bassano and Davide Di Biase
An emerging market economy (EME) is defined as an economy with low to medium per capita income, which will gradually converge to that of developed countries. Currently, the most prominent regions covering EMEs are Latin America (Brazil, Chile, Colombia, Mexico), Southeast Asia (China, India, Malaysia, Thailand), some countries of Eastern Europe (Hungary, Poland, Russia) and South Africa.
One of the key characteristics distinguishing investments in EMEs from those in developed markets is the higher risk associated with them. This holds true for every type of investment, PE included, as illustrated by the graph below.
Figure 1. Private Equity Risk/Return: Emerging Markets VS North America and Europe Focused Funds (Vintage 2005 onwards)
Investments in emerging markets allow private equity funds to diversify and tap into unspoiled, growing industries promising appealing returns. In an environment where firms are trying to set themselves apart from the rest, emerging markets represent an interesting investment proposition for investors.
The tendency is to avoid single-country strategies in emerging markets, which from time to time experience high volatility or become overcrowded. Taking a global approach allows to mitigate some of the risks associated with a downturn or overheating in a single market or region through real-time opportunistic country selection.
Besides, it is interesting to assess the attractiveness of EMEs relative to other geographies, and among them, the single countries which present the best opportunities for PE firms.
Figure 2. Regions and Markets that Investors View as Presenting the Best Opportunities
Figure 3. Countries and Regions within Emerging Markets that Investors View as Presenting the Best Opportunities
Europe and North America still represent the geographical focus of investments for PE firms. Of all EMEs, Emerging Asia (Indonesia among others) is considered to be the most attractive in terms of investment opportunities, followed by China and India. Conversely, regions that have been characterized by significant geopolitical risk (Middle East, Central & Eastern Europe and Russia) as well as economic instability (Brazil) were the ones least favored.
Recent years have seen significant volatility in developed capital markets together with a roller coaster ride of returns. In fact, some firms are also reluctant to allocate more capital to developed markets due to political instability in the US, and the unknown consequences of Brexit. In contrast, investors in emerging markets have experienced lower volatility with more consistent financial performance.
As a matter of fact, EMEs have long become the driver of global economic growth. Around 70% of global growth comes from emerging markets and 40% of that comes from China and India alone.
Historically, private equity portfolios have been focused on North America and Europe. However, because of the aforementioned developments, over the last decade there has been a significant increase in assets under management for private equity business in emerging markets.
Figure 4. Emerging Markets-Focused Private Equity Assets under Management, 2005 – 2016
Moreover, from a GPs point of view, it would be of extreme importance to understand which investors are more likely to invest in such markets, in order to ultimately shape the capital raising strategy. Foundations and endowment plans (categorized under ‘Other’ in the figure below) as well as pension funds (both public and private sector) are the dominant investors in developed markets. However, in emerging markets, the most prevalent LPs are banks, corporate investors and investment companies. This is due to the fact that pension funds are less compatible with the riskier investments in EMEs, hence preferring developed market economies.
Figure 5. Private Equity Investors by Type: Emerging Markets- VS Developed Markets- Based Investors
WHAT ARE THE DRIVERS OF THE INCREASING ATTRACTIVENESS OF EMEs?
Looking at the last two decades, three main drivers drew the attention of PE firms towards emerging markets:
Improved quality of management teams → the recent expansion of multinationals and professional services firms into these markets, along with their excellent training programs, resulted in an improvement of management teams, which now operate in accordance with global standards. This means that management teams are now more reliable and therefore more likely to attract private equity investments.
Favorable social variables → the expansion of the consumer class across global emerging markets creates a strong foundation for investments. Urbanization trends within emerging markets furthermore accelerate consumer spending. The average income of people in cities is up to three times higher than that of those living in rural areas, leading to growing demand for new products and services. In addition, the demographic profile of many emerging markets is likely to result in greater consumer spending, as they benefit from younger populations compared to developed markets. These younger populations have more disposable income and are eager to raise their standards of living, both of which drives consumption. This provides an interesting insight when considering the growth drivers of PE investments, leading to a positive outlook when valuing revenues and EBITDA increases.
Macroeconomics trends → monetary and structural reforms implemented in response to past crises – such as floating exchange rates, fiscal restraint and trade liberalization – have stabilized emerging market economies over the last two decades. The resulting improvement of economic variables has led to stronger and more stable investment flows, as investors are now more willing than ever to invest in EMEs.
The recent deal which saw KKR acquire a minority stake (12%) in Indosari is only the latest of a series of deals in EMEs, which demonstrate a positive attitude towards these markets. KKR, one of the largest PE funds with over $168 billion of assets under management, is now stepping up investments in Asia while reducing its US equity exposure from 19% to 17%. As outlined before, KKR stated that macroeconomic health, including balanced deficits, stable currencies and accelerating infrastructures are among the drivers of its strategy. Once again, macroeconomic and social factors are opening up new avenues in EMEs.
Summing up, emerging markets are coming to light and are increasingly attracting the attention of PE funds. However, it is also true that within EMEs, there is an heterogeneous investment picture. Some countries (Indonesia, India and China rather than Latin America and Eastern European countries) are going through a positive transition (politically, socially and demographically) which makes them appealing to investors (KKR’s trust in Indonesia makes the point). This fuels a beneficial dynamic which is likely to further strengthen these economies.
Authors: Costanza Bassano and Davide Di Biase
Editor Responsible: Carmelo Spallino