Emerging & Frontier Equities: The private market complement
Mark Mobius outlines why private equity is different in emerging markets from in developed – but also different from your existing public emerging markets exposure
Emerging markets (EMs) today represent approximately 30% of global market capitalisation, and their attractiveness stems mainly from their rapid economic growth which, on average, has been five times faster than that of developed nations. Per capita gross domestic product (GDP) in many emerging markets has been increasing at a rapid pace, giving rise to a middle class demanding more consumer goods and services. In addition, EMs have low debt-to-GDP ratios, as well as foreign reserves that often surpass those of developed countries. Many emerging markets are blessed with favourable demographic trends and substantially younger populations.
As long-term investors in emerging markets, we are today seeing a wealth of untapped private equity opportunities in emerging economies, especially among small to medium-sized companies. This is largely due to expanding and dynamic economies, which tend to contain a higher proportion of smaller, faster-growing businesses than developed, mature economies. This article will explore the investment opportunity that emerging market private equity represents for the long-term investor.
A new take
The type of private equity approach prevalent in emerging markets differs significantly from that common in most developed markets. Leveraged buyouts, which are more common in developed markets, are less common in emerging markets due to a combination of factors, namely the relative immaturity of debt markets, lack of available bank capital, prohibition of majority foreign ownership and a strong culture of family ownership. Indeed, given the advantages conferred by local knowledge and local relationships, loss of the previous management could potentially be damaging for these companies.
Instead, opportunity frequently comes from small to medium-sized, rapidly growing businesses looking for ‘expansion’ capital or financial expertise to take the business to a new level of development. The bulk of potential investments tend to lie among smaller companies that display high-growth characteristics. This means that the private equity investor is investing at the time of highest growth potential for the company. This potential is further accelerated by the
rapid economic growth paths of many emerging market economies. In addition, emerging market industries also tend to be fragmented into many small businesses, which may offer private equity investors the opportunity to participate in industry consolidation.
The use of private investment in public equity, or ‘PIPE’ investments, is more common in emerging markets, particularly India, than in developed countries. Often, the free floats and stockmarket turnover of smaller listed companies are less significant, making it difficult to accumulate significant positions through public markets. For example, in India, out of approximately 5,000 listed businesses on the country’s two main stock exchanges, as few as 500 achieve monthly stock turnover above $1m and together represent about 90% of the overall market capitalisation. In these circumstances, PIPE investments provide an attractive way to gain exposure to a class of small and medium-sized, illiquid, yet growing, companies. Not only can investors build significant minority stakes but they can also have added shareholder rights accorded in the private equity deal negotiation. Such shareholder rights could provide a measure of downside protection for investments that might otherwise be deemed too risky.
Unlisted companies are less subject to short-term market swings than listed companies, and so are not exposed to extremes of investor sentiment in the same way. In addition, the closed-end nature of the investments provides an element of freedom from a short-term outlook which means that the private equity fund manager generally cannot be pushed into inappropriate investment decisions by the threat of sudden and large asset flows either in or out. This can have tangible benefits for long-term returns.
Investing in unlisted companies and becoming involved as a shareholder at board level provides much greater potential to influence company decisions and behaviour. Private equity investors are often closely involved in determining the strategic direction of a company and improving corporate governance policies, not only in their role as board members, but also contractually. Being on the inside brings the investor significant depth of knowledge and understanding about a company.
No one asset category does well all the time and adding a private equity element to an investment portfolio is an effective way to diversify. Private equity can complement a portfolio by providing a longer-term, more illiquid component. Furthermore, studies have shown that bear market weakness tends to be less severe for private equity, so this limited downside tends to smooth overall returns from portfolios containing both private equity and publicly quoted assets.
In our view, the most interesting private equity opportunities are currently to be found in China, South East Asia (particularly Vietnam) and Brazil. Broadly speaking, consumer-related industries and those in healthcare, industrials and light infrastructure present particularly attractive opportunities due to the nature of emerging market economies, but the individual opportunities depend largely on the level of development within countries, and the industries on which economic development is centred. For example, investment needs differ widely between Singapore and Brazil or between Indonesia and India. Brazil is focusing heavily on the construction of new roads and transport links, whereas, in India, we are seeing rapid expansion of the healthcare and pharmaceuticals industry. In Indonesia, there is a fast-growing consumer population.
Private equity penetration in emerging markets is still considerably lower than in developed markets, despite recent increases in activity, especially in Asia. This low penetration has created abundant opportunities for the private equity investor.
The main risks in investing in private equity in emerging markets include exit liquidity risk, corporate governance issues, and political and foreign exchange risks. The latter three are present with many emerging markets investments in other asset classes and are not specific to private equity.
Exit liquidity can be effectively mitigated through deal structuring, and investor value added to ensure a successful IPO or trade sale. Structuring helps provide liquidity in both successful and struggling investments, the latter via downside protection such as put options or convertible bonds.
In the capital market arena, improving shareholder protection has reduced the risks relative to developed markets but there is still work to be done. In order to minimise corporate governance risk, thorough due diligence on the company and management team prior to investment is key. It is also critical to ensure international legal jurisdiction in order to give the highest likelihood of enforcing the law if ever required. Foreign exchange risk can be mitigated by targeting either export or import focused companies to counter depreciation or appreciation of local currency.
Unlisted companies are exposed to macro-economic and political risk to much the same degree as listed companies. However, the impact can arguably be greater because of a lack of regular reporting and transparency in private companies. However, on the plus side, investing in these companies and becoming involved as a shareholder at board level provides much greater potential to influence company decisions and behaviour, thus significantly reducing the exposure to this type of risk.
It is also important to remember that a private equity position is usually less liquid than an equivalent investment in public equity, and also that management fees charged on committed capital are higher than for typical investments in a mutual fund or index.
To summarise, we believe that private equity investment is a growing area of interest for investors and it has a key role to play in enhancing access to the strong economic growth characteristics, favourable demographics and relatively secure public finances offered by public investment in emerging and frontier markets.
Furthermore, the low level of private equity penetration in emerging markets relative to developed markets means that there is a wealth of untapped opportunities. Private equity has much to offer the long-term investor as a complement to a traditional emerging market portfolio of public equities and hence we believe it merits attention.
Mark Mobius is executive chairman of the Templeton Emerging Markets Group