Looking to a far horizon
Lynn Strongin Dodds finds that emerging markets still offer private equity and infrastructure opportunities.
The sub-prime crisis may have temporarily put the brakes on private equity deals in the developed world but opportunities abound in emerging markets. Infrastructure projects tend to grab most of the headlines but financial services, manufacturing, healthcare and retail also feature prominently. While the returns look alluring, the risks are also higher and investors are advised to be vigilant.
There is no doubt that money has been pouring into the emerging markets, with 2007 on target to be a record breaking year, according to Sarah Alexander, president of US-based industry body the Emerging Markets Private Equity Association. Its recent statistics reveal that 107 funds raised a total of $21.2bn (€14.9bn) by end-June, which is well over half of the $33.2bn raised during all 2006. The momentum continued into July and August with about $7.7bn estimated to have been raised.
Breaking it down geographically, Asia was the most popular destination, accounting for $11.6bn in the first half of 2007 compared with $19.4bn raised in all last year. China and India pulled in $4bn while pan-Asian funds raised $7bn. Southeast Asia funds garnered $646m through June 2007 while there was and still is a flurry of activity in the $1bn space. Kohlberg Kravis Roberts recently closed a $4bn Asia buyout fund while CVC Capital Partners is on target to build a fund that could reach $5bn.
Central and eastern Europe and Russia and the Commonwealth of Independent States (CIS) were next on the list, raking in $3.6bn in the first half. Noteworthy closures included Baring Vostok's $1.45bn Russia/CIS fund as well as Alpha Capital Partners' $200m buyout fund and $320m real estate fund. The group's main focus is on controlling stakes in medium-sized enterprises with $30m to $500m in annual sales turnover in oil and energy, branded consumer products, telecommunications, media, services, and technology sectors.
Latin America funds raised a total of $1.4bn in the first six months, with Brazil alone accounting for $1.2bn. Activity also gained pace in the Middle East with eight funds focused on the region collecting $1.8bn in the first six months. Investments range from telecommunications, financial services, biotechnology and life science, oil and gas, and industrial opportunities.
Meanwhile, Africa is becoming more than just a dot on the private equity radar screen. Last year, African fund managers raised $2.35bn which was a significant jump from 2005's $1bn. In the first half of 2007, an additional $1.6bn was added to the coffers. South Africa remains the main destination, but Nigeria and North Africa are also attracting investments, particularly in the telecommunication, mining and natural resources arena.
Despite these impressive figures, emerging market private equity is likely to remain a small portion of an institutional investor's overall private equity portfolio. "The allocation will depend on the overall set up of the institution and they have to decide whether private equity is the ideal way to gain exposure to emerging markets," says Thomas Kubr, managing director and chief executive of Capital Dynamics, an asset management firm that specialises in private equity. "I think a 10% investment in a global private equity fund is not a bad idea."
EMPEA statistics show that emerging market private equity accounts for only 4.4% of public and corporate pension funds holdings and 7.1% of funds of funds. Endowments, foundations and family offices are the biggest participants with 13.2%. This is not surprising given that the US dominates the private equity scene. During the halcyon year of 2006, 454 funds collected a staggering $237bn followed by Europe, with 217 funds with $95bn, according to UK-based data provider Private Equity Intelligence.
While each emerging country has its own risk profile and deal flow, the common thread is that these investments can provide investors with another accessible route into some of the world's fastest-growing countries. "An investment in the Russian index, for example, translates into about a 70% exposure to the oil and gas, and natural resource sectors because that is what the bulk of the market represents." says Kestutis Sasnauskas, partner and managing director of East Capital, an eastern Europe specialist with around €5.1bn in assets under management in both public and private equity. "The only way to get real exposure to the country's economy is through a private equity fund."
In addition, emerging market private equity provides portfolios with must-have diversification plus enhanced performance. According to figures from US based consultancy Cambridge Associates, emerging markets venture capital and private equity funds enjoyed a 26.8% return in 2006, which may seem paltry compared with western European's dazzling 63.98% for the year, but was still higher than the S&P 500's 15.8%.
While there is a great deal of hype, this is not the first time that private equity funds have ventured into the emerging markets, according to Sarah Alexander, president of EMPEA. Several funds tested the waters in Asia and Latin America during the 1990s but got burnt during the region's financial crises later that decade.
The difference this time around is that the regions are economically stronger with better regulation and controls in place. Equally important, and of particular appeal to investors in the current crunch environment, is that most transactions are smaller and typically unleveraged.
"Private equity in the emerging markets is a different ballgame," notes Alexander. "In the developed world, activity is mainly focused on venture capital and buyouts, and many deals today are highly leveraged. In emerging markets, you don't have early-stage venture backing an idea. The only countries where we are seeing a little leverage being done in the buyout markets are South Africa and Brazil. For the most part, especially in Asia, funds are providing capital for growing companies."
Private equity funds are also falling over themselves to provide capital for infrastructure projects, either via a straight equity injection into the company leading a project or through a public to private partnership. India, China, emerging Europe, the Middle East and to a lesser extent Africa are in a race to build roads, railways, airports, ports, water facilities, telecommunication networks, and oil and gas facilities to catch up to their developed peers. According to the World Bank, Asia's infrastructure spend is forecast to be over $212bn while Merrill Lynch predicts infrastructure spending in emerging Europe, the Middle East and Africa to top $575bn.
"Governments are taking a broader view of the mechanisms for financing infrastructure projects and are expanding the categories of traditional public sector infrastructure that are now able to be privately financed," says Jonathan Simpson, partner and head of European projects at international law firm Paul Hastings. "We have seen in many developed countries, and now increasingly in emerging markets, initial projects such as motorways, rail and airports lead into social infrastructure projects including schools, prisons and hospitals."
Simpson also notes that private equity's appetite for such projects depends on their underlying nature: "For example, pure market revenue/cash generating projects, such as oil and gas pipelines and electricity plants, typically prove most attractive for private equity funds while government payment streams projects, such as the $5bn motorway private-to-public partnership projects in Slovakia, are less appealing but are still proving highly attractive in the market."
Not surprisingly, different private equity firms adopt their own strategies. For example, Global Infrastructure Partners, a $4bn infrastructure private equity fund, pursues a selective approach. According to Matthew Harris, a partner, this means focusing on a narrow group of countries - China, India, Brazil and Mexico - and certain sectors such as energy, transport and water - including power generation and transmission, gas storage and pipelines, water assets, airports, air traffic control, ports and railways. The firm's most recent deal has been a 25% stake in Chennai Container Terminal Private, one of the biggest ports in India.
"From a business perspective our criteria are the same as in the developed world," Harris notes. "We look at investments that are impacted by global supply and demand issues. However, the transaction execution methodology is more established in the US and Europe and this is not the case, for example, in countries such as China or India. This is why it is crucial to build strong local partnerships. It not only helps identify and navigate the risks but it also helps originate deal flow. Many of the deals are done on a negotiated basis and you need the relationships to find them."
Sasnauskas also believes it is important to have people on the ground who know the language and understand the nuances of the business culture. "When buying a business, we look for strong local entrepreneurs but the biggest challenge is to find people with the right skills set and a track record," he says. "This is especially the case outside the major cities. We take minority stakes in companies but we are not passive investors. We sit on the board and work very closely with the management teams to develop the business."
The other big challenges include varying accounting practices plus working with fickle governments. "Given the nature of emerging markets the due diligence required should be much more rigorous than in the developed world," Simpson explains. "For example, investors do not always get the degree of comfort that they would have investing in their home markets as there have been a number of notable cases where emerging market governments have changed their minds and have elected to pull out of contracts or not honour their contractual commitments. It is important to look at the strength of any contractual agreement entered into in an emerging market to see whether there is protection if such an event occurs."
He adds: If we talk about emerging Europe, I think the landscape is now becoming much more positive for certainty of investment. Many countries have just joined or are aspiring to join the EU and aren't easily prepared to walk away from contracts for they fear damaging their investment reputation."