A bridge too far?
Institutional investors who view private equity generally as high risk may see investing in private equity in emerging markets as a bridge too far. The experience of the 1990s would only confirm this view as results have been disappointing in both absolute terms and also relative to private equity funds in the US and Europe. This disenchantment led to 2002 being the worst year for fund raising for emerging markets in Latin America and Asia since 1993. Investor appetite however, is in the process of changing dramatically as reports appear to indicate that 2003 has seen record levels of new investment in Asia.
The arguments for investment in emerging markets can be attractive; severe capital shortages giving rise to low valuations and increasing numbers of companies seeking capital; and a demographic profile dramatically different from developed nations with a younger and growing population fuelling higher growth rates in their economies. Europe in particular, faces the issue that to support its aging population, it needs to export savings to countries with higher growth rates.
Whilst the major emerging markets all have stock exchanges that enable both local and foreign investors to gain exposure to listed companies, there is also a case to be made for foreign institutional investment in emerging market private equity. Key issues include; whether a regional or country basis should be chosen or a global sectoral one choosing locally dominant companies that are capable of incorporating global best practices; How to overcome the problems of low quality of information, weaknesses of legal systems and the inability of domestic equity markets to provide an IPO exit route.
In practice, there are strong cases for both global sectoral funds as well as regional and country specific funds depending on the sectors chosen and the investment strategy. CDC Capital Partners for example, as well as running regional funds, has organised its portfolio of power investments into one vehicle using its specialist expertise to buy cheap assets from retreating American multi-nationals.
The reasons for the years of disenchantment with emerging market private equity private equity are clear enough. According to IMF statistics, foreign direct investment in Asia and Latin America both grew at a compound rate of 19% from 1992 to 1998 whilst Roger Leeds and Julie Sutherland from John Hopkins University estimate that between 1992 and 1997 the value of new private equity in Latin America grew from just over $100m (E78m) to over $5bn. In emerging markets of Asia, 500 funds raised more than $450bn between 1992 and 1999. However, the evidence so far is that the returns from investments made in the 1990s have not generally been commensurate with the risks. Leeds and Sutherland quote a survey of 227 Latin American private equity investments made between 1995 and 2000 where only 15 had been exited and in Asia, divestments in 1998 and 1999 averaged $2.5bn per year compared to the $35bn invested between 1992 and 1999. Private equity is of course, a long term investment and most funds in Europe and the US have a 10 year life and do not begin to generate positive returns until half way through the life. However, the disappointing experience had been enough to reduce funds raised in 2002 for Latin America to the lowest level since 1993 when private equity first took off in the region according to Leeds and Sutherland.
The change in sentiment seen in 2003 reflects the fact that long-term investors seeking higher returns are being won over by the arguments put forward by managers. Many, such as Jonathon Bond at CDC Capital Partners argue that certain emerging markets have matured with established track records of exits. Jean Salata, the managing director of Baring Private Equity Partners Asia concurs with this view and argues that whilst early investors in Asian private equity have been disappointed, there has been a sea change at both macro and micro levels. On the macro, important developments include deregulation, improved disclosure and transparency, privatisation in countries such as China and India, banking sector reform, and global trade growth. On the micro, the most impressive development has been the emergence of a new breed of Asian entrepreneur and in China and India, a whole new category of private sector businesses. These entrepreneurs are hungry for success, world class in terms of capability, and very different from the family businesses that dominated Asian private equity investments historically. He also argues that there is a myth that exits are tough in Asia, with exits possible in multiple forms and markets including ADR issues in the US, IPOs in Asia and trade sales to both US and Asian buyers.
Perhaps China best illustrates the opportunities that make emerging market private equity worth taking seriously. The last decade has seen a rapid move to replace the “rule of man” by the “rule of law” and whilst growth rates of 8% pa have been disputed the fact remains that the economy has managed to grow at a tremendous rate for a long period amidst claims that the size of the economy will overtake the US within the next 20 years. Its domestic stock exchanges in Shanghai and Shenzen service a rapidly growing fund management industry which the government is encouraging to develop in sophistication through setting up joint ventures with foreign companies and these should provide avenues for IPO exits in the coming years.
To undertake private equity investment successfully in China requires some key attributes. Successfully identifying good investments requires a network of contacts with: local enterprise managers in various industries; Chinese officials in industrial supervisory bodies or foreign investment administrations; local investment banks/securities houses; and overseas financial institutions doing business in China, who are aware of projects with good potential prepared to use outside capital. At the project negotiation stage, deal structuring and negotiating require hands-on expertise, and great care is necessary to ensure the rights of the investor are perfectly protected in the joint venture contract and articles of association. A strong office network on the ground in China, staffed by a team of experienced investment managers, is therefore essential. This is also critical for managing the investments. Problems in the past were discovered far too late because the investors were lacking the capacity to get close enough to the Chinese management to understand what they are really doing. Only if there is a genuine commonality of interest between both partners, and the foreign partner is able to advise and monitor the investment, will such risks be avoided. This again requires experienced investment managers working on the ground.
The growth of the domestic stock exchanges means that the exit routes through the IPO market looks far more viable in the future. Trade sales are also popular and have enabled some foreign companies to get a foothold in China quickly without having hassles to negotiate their own joint ventures. The difficulty here is that most foreign strategic investors of this kind wish to acquire majority stakes in Chinese businesses so that they can run them in the same way as the rest of their business, and many purely financial investments are in minority stakes.
David Mahon, the managing director of Mahon China Investment Management firm, points out that if foreign private equity investors in China look at the performances of their peers in the foreign invested service and industrial sectors they will see that a large majority are profitable. He quotes a recent American Chamber of Commerce study where four out of five respondents said that in 2001 – 2002 their revenues improved. Forty four per cent reported substantial increases in profits and 65% of all respondents said that they were profitable. Most of the higher performers are those selling to China’s domestic economy rather than producing in China for export. Instead of focusing on complex and unstable pre-listing investment strategies or following the trend of acquiring non performing loans, foreign financial investors should be seeking businesses to which they can add strategic value and investment and over which they have some measure of control.
Baring’s Salata summarises the current opportunities in emerging market private equity by pointing out that, in contrast to the excess of private equity funds chasing limited opportunities in the developed markets, there is less money now in emerging markets chasing more companies with better management and good earnings growth. As a result, he, like his competitors in the emerging market arena, would argue that investments being undertaken now will re-establish emerging market private equity as a high return asset class worth considering.