Pop quiz: how could you have achieved a 26% return in 2010 or an 11% annualized return over the past 10 years, from 2000 – 2010? By investing in PE & VC in emerging markets!
Unfortunately for you, it’s not as simple as just finding a mysterious “emerging markets PE fund” and investing your life savings there – unless you’re fine losing your entire net worth in the process.
You can earn a lot if you invest the right way, but emerging markets are trickier to get a handle on than the traditional, developed markets of the US and Western Europe.
Here’s what you’ll need to know to invest successfully:
- Emerging markets: What they are and why we hear about them all the time.
- Why PE firms are racing to emerging markets: What makes them so attractive?
- How PE in emerging markets is different from PE in developed markets.
- Where the money is going – Hot markets and key industries.
- Risks – Yes, emerging markets may not be able to generate incredible returns forever…
Emerging Markets … What Are They Exactly?
So you probably want to hear all about the hot markets, the different strategies and the outstanding returns, but first we need to understand what emerging markets are and what makes them attractive to investors.
“Emerging Markets” is one of those buzzwords we hear all the time, but what really makes a market “emerging”? Different people have different opinions on the question and there are many different classifications such as the FTSE List, the Dow Jones List, MSCI List, the S&P List, etc.
For the fastest growing and most promising emerging markets, we use several acronyms. Let’s have a look at a few:
- The BRICs: By far the most famous acronym of them all. Invented by Goldman Sachs, it stands for Brazil, Russia, India and China, which many believe are the most dynamic and promising emerging markets. These four countries represent over 40% of the world’s population and 25% of the total land. As we’ll see later, this is where most PE activity is taking place.
- The Next Eleven: Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey, and Vietnam.
- The CIVETS: Colombia, Indonesia, Vietnam, Egypt, Turkey, South Africa.
Why Are PE Firms Racing to Invest in Emerging Markets?
The total private equity investment in emerging markets in 2010 reached USD $28.8 billion (13% of the global total) compared to only USD $2.0 billion in 2002 (2.5% of the global total).
In short, PE investors are flocking to emerging markets because of… MONEY!
As of 2010, according to the Emerging Markets Private Equity Association (EMPEA), the annualized returns (pooled end-to-end) for emerging markets PE and VC stood at 26.6% (1 year), 7.3% (3 years), 15.9% (5 years) and 11% (10 years).
That compares to… much lower numbers overall in the US:
- 1-Year Returns (PE, VC): 19.9%; 13.5%
- 3-Year Returns (PE, VC): 2.8%; (0.3%)
- 5-Year Returns (PE, VC): 9.5%; 5.7%
- 10-Year Returns (PE, VC): 9.7%; (2.0%)
These “developed market” numbers seem quite pathetic in comparison – but if we compared them against the numbers for emerging markets in Asia only, they would look even worse.
More specifically, emerging markets are attractive to investors because of the incredible economic growth and development taking place there, which should translate into higher returns.
Because emerging countries are in transition, their economy usually grows 2-3 times faster than developed economies.
For example, China’s GDP has increased by on average 10% per year over the past 30 years.
Emerging markets typically undergo economic and political reforms to achieve greater liberalization, privatization and openness to international trade & foreign investment, which also supports that growth.
What that translates into for investors: you don’t have to be a rock-star business owner in these markets to do well.
You just need to sell something to the rapidly growing middle class and take advantage of the rapid growth there, and you’ll do well – just ask Jim Breyer.
Are Emerging Markets Taking Over the World?
Emerging markets now play a key role in the world and drive global growth. Twenty years ago, emerging markets represented 20% of the global GDP; today, they represent 40%.
In addition, emerging markets are home to 80% of the world’s population, account for 80% of mobile phone subscriptions and 46% of retail sales, and they consume over 50% of most major commodities.
So this is why top VC firms such as Accel Partners now have more Partners in China than in the US – emerging markets have the majority of the world’s population and will account for the majority of its growth going forward.
How is PE in Emerging Markets Different?
Because PE investors in emerging markets are looking for growth, most of the funds are growth capital funds – in other words, they don’t focus as much on “financial engineering” (adding leverage to deals to attain high returns) but instead focus on finding great companies that need capital to expand.
Infrastructure funds are also common, especially in India. Buyout funds do exists, but they are less prevalent than in developed markets and you rarely see highly leveraged buyouts.
For this reason, funds and deals tend to be smaller than in developed markets.
Deals are done on the basis of top–line revenue growth, improved efficiency, and attractive industries, not on leverage and financial engineering.
Plenty of PE Investment Opportunities
Emerging markets have a large and young population, with an increasing number joining the middle class every year.
The income level increases drive savings and consumption, which creates great opportunities in the consumer and financial services industries.
In terms of infrastructure, several emerging countries, including Brazil and India, have insufficient or crumbling infrastructure which is a weakness from the country’s perspective – but an opportunity from a PE investor’s perspective.
Several emerging countries, including China and India, are manufacturing countries and their economy relies heavily on exports due to the low cost and abundance of labor force. This creates investment opportunities in the manufacturing sector.
With communications & technology, if you look at the internet penetration rate, for example, you can see that it has increased in most emerging markets, but is still extremely low as a proportion of the total population – which also creates great opportunities for investors.
Also, several emerging markets (e.g. South Africa, Russia, China and Brazil) are resource-rich, which also attracts PE investment.
Hot and Bubbly – The Most Sought–After Markets
In 2010, $28.8 billion was invested in emerging markets in over 800 deals. But where is all that money going?
Here’s the full breakdown for 2010 (as a % of total PE investment in emerging markets):
- Emerging Asia (including China and India): 64%
- Latin America & Caribbean (including Brazil): 23%
- Central and Eastern Europe & Commonwealth of Independent States (CEE & CIS): 8%
- Middle-East North Africa (MENA): 3%
- Sub-Saharan Africa: 2%
Approximately 70% of the $28.8 billion went to the top-three markets: China ($9.2B), India ($6.2B), and Brazil ($4.6B).
In addition to Brazil, India and China, a large proportion of the growth comes from emerging Asia (excluding India and China) and Latin America (excluding Brazil).
Interestingly, Russia has not yet been able to attract investors and accounts for only around 5% of total PE investment in emerging markets because of the country’s less attractive risk/return profile.
As a matter of fact, GDP growth is low in Russia compared to other emerging countries (4% in 2010, -7.8% in 2009, 5.2% in 2008), and the business environment is not very attractive due to corruption, bureaucracy and weak rule of law.
Where the Money is Going – Leading Industries
Overall, the top 4 industries for PE investment in emerging markets in 2010 were Industrials & Manufacturing (16% of total deals), Technology (15%), Consumer (12%) and Energy & Natural Resources (12%).
Of course, the attractiveness of industries depends on the country you’re in. Here are the top industries for the top markets in 2010:
- LATAM (ex- Brazil): Energy & Natural Resources, Agribusiness, Banking & Financial Services.
- Brazil: Energy and Natural Resources, Industrial & Manufacturing, Infrastructure.
- India: Industrials & Manufacturing, Technology, Banking & Financial Services, Services, Infrastructure.
- Asia (ex–China & India): Technology, Energy & Resources, Industrial & Manufacturing, Consumer.
- China: Industrial & Manufacturing, Consumer, Technology.
Overall, manufacturing investments are the most common deal type in China, India, and Central & Eastern Europe.
In the Middle East, Russia and Asia (ex- China & India), technology deals account for the largest proportion of investments – and even in China and India, technology deals are not far behind manufacturing.
Finally, energy & natural resources rank first in Latin America, including Brazil, which makes sense given the richness of resources in the region.
See: more on Latin America investment banking.
Wait, Aren’t There Any Risks?
Higher potential returns in emerging markets also means higher risk, but many people forget there is no such thing as a free lunch and only see the bright side.
Returns for PE in emerging markets before the early 2000s were not nearly as good as they currently are, and the future is anything but certain.
Political instability is always a concern in emerging markets. In the most extreme case, your portfolio company could be expropriated or nationalized.
A less extreme case would involve conflicts, manifestations, coup d’états, etc. which still make it a much harder environment to operate in.
In the short to medium term, most emerging countries face the risk of overheating and inflation, which affects corporate earnings and lowers real returns.
If you invest in a country where the inflation rate is 10% and your investment generates a 15% annual return, your real return is only 5% – and inflation rates of 5 to 10% or more are the norm in emerging markets.
So those returns above look a lot less impressive once you adjust them for inflation across the board.
Also, entry valuations are a key concern. Because of high growth assumptions, optimism and high competition for good deals, entry valuations in PE are very high in some emerging markets – particularly in China and India, and to a lesser extent in Brazil.
The key concern is whether emerging markets can sustain their current level of growth: For how long can China grow at 10% per year?
Currency risk is another factor sometimes overlooked by investors, but the devaluation of a local currency can easily wipe out an investor’s return in USD/EUR/GBP terms.
Finally, keep in mind that PE investors are more vulnerable because their investment is illiquid since the life of the fund is usually 10 years. So if, as an LP, you invest in a PE fund in a specific country and a terrible crisis occurs, you cannot exit like someone investing in the stock market could.
To Be Continued…
You have now learned the basics of PE in emerging markets, and why some of the mind-boggling returns you always hear about aren’t so impressive once you adjust them for inflation, risk, and other factors.
Stay tuned for the next article on “emerging markets PE,” where we’ll have the chance to chat with a PE Portfolio Manager that has close to 10 years of experience working in Latin American private equity.
Source of Figures: EMPEA, The Economist.