In frontier markets, private equity is often the first source of investment for business. However, as Joseph Mariathasan reports, there are pitfalls as well as the opportunities

Private equity in emerging markets can be a challenge. Should it be regarded purely in financial terms, or as a spur to broader economic development? In the case of frontier markets, that issue becomes even more pertinent.

For CDC, the UK government-owned development agency, the answer is clear: financial returns and economic development go hand in hand.

"It is amazing that many people think that there is a trade-off between profitability and development," says CDC COO Shonaid Jemmett-Page. "If you put capital in and create profitable businesses, that creates employment and tax revenues and so it stimulates development. What you need to ensure is that the framework is there to ensure good corporate governance and ethical business practices."

In countries without a stock market, private equity can provide the first source of capital for developing businesses: "All you need are entrepreneurs, a reasonably functioning legal system and the vestiges of a banking system," she explains. Ethiopia is a case in point. With IMF GDP growth rates estimated at around 8% per annum for the next few years, Ethiopia, like many other African economies, is expanding at speeds previously only associated with the Asian tiger economies - despite environmental disasters, a Marxist-influenced government that has been wary of foreign investment, and the lack of a functioning stock market.

"The challenge in frontier markets is to find a country at that inflexion point when the risks you take, political, regulatory economic, etc, are calculable," argues Miriam Schmitter, managing director of Cambridge Associates.

The term ‘frontier market' encompasses a wide variety of opportunities where often the only commonality is GDP growth rates way in excess of those seen in the developed world, and even most emerging markets. Which ones are the ‘real' frontier markets seems very much in the eyes of the beholder.

From 2011 CDC only invests in sub-Saharan Africa and South Asia: a UK government
stipulation to focus on the world's poorest countries. Regions such as Latin America and Central Asia and China are considered to have reached levels of prosperity that no longer justify the use of CDC's capital as a developmental agency. Sri Lanka is considered a frontier market by most investors, yet for CDC, Sri Lanka's per capita GDP is too high for its mandate. For Simon Faure, investment director at PPM Managers, Russia and Latin American countries - even Brazil - are frontier markets for private equity.

What is clear is that private equity investment in frontier markets requires a detailed, case-by-case analysis and a very deep appreciation of the local environment. "We like private equity firms that have people on the ground," says Jemmett-Page. "There is no substitute for local knowledge - which means we tend to favour local firms."

Private equity investments in frontier markets are often in family-owned businesses. They have to be handled delicately.

"As companies grow and require outside investors, they need to take care of the rights and the needs of their minority shareholders by having, for example, some independent board members," says Jemmett-Page. "Corporate governance can be a major issue if a founder or senior family member has the view, ‘I own this show, I run this show just as I want, and if I want to make my son the head of sales then I will'."

Then again, these tensions exist in family-run businesses in Europe. In a place like Ethiopia, the challenge is to find and develop an entrepreneurial class where there is still a lack of education and a poor legal framework. To take an extreme example, countries such as the Democratic Republic of Congo find that despite their abundant mineral wealth, nervousness around the strength of legal contracts leaves mining companies reluctant to operate there. CDC is investing in an Ethiopia fund, but it is not clear whether investors with different developmental objectives would be willing to follow.

Faure outlines a key issue that makes many of the frontier markets less attractive. Private equity in emerging markets is usually unleveraged. That means a company must grow at 25-30% annually to produce returns comparable to those of leveraged developed-market private equity. But growing that fast can be a challenge when a company is constricted by a lack of infrastructure and management expertise.

"For private equity to give decent returns in most markets you need a critical mass in terms of the size of the economy and the size of the middle class," he argues. "You also need reasonable-sized domestic champions. In western Europe you can find great companies in countries such as the Netherlands, Sweden and Switzerland as they have to be good to be able to sell outside their home country as well as domestically. In emerging markets, there is less of that and we are not keen to invest in wholly export-driven businesses in emerging markets."

For Adveq, such problems mean ruling out most frontier markets. "I personally am interested in frontier markets," says chairman Bruno Raschle, "but they are not suitable for our institutional clients. On a risk-adjusted basis, I don't think that you can continuously generate the required return - the risk premium is not there. Countries like India and China with major technologies look better."

It is not that there are not great businesses in these countries. There are opportunities such as telecoms in Bangladesh or the metals and mining sector in Mongolia, for example. But investors have to accept that they will be exposed not only to the risks associated with those businesses and their sectors, but also to political risks in countries that do not have the institutional framework associated with western democracies - and the fact that governments tend to play a more important role than they do in the core emerging markets.

"Often there are a set of sectors that foreigners are not allowed in which need to be opened up," says Jemmet-Page. "Key sectors are banking, telecoms and infrastructure."

From CDC's viewpoint, these sectors are extremely developmental and CDC is advising countries such as Ethiopia to open them up to foreign investment.

But ensuring political stability and harmony within diverse communities in frontier markets has often been the first of a number of challenges that need to be solved to convince the likes of Adveq to invest. For frontier markets with high growth rates, such as Sri Lanka, that have already opened up their economies, overcoming that hurdle may be the only obstacle that private equity investors should really focus on.
 

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