For private equity and venture capital investors, emerging markets (EM) have long felt like the Wild West. Many question the model’s success in countries where regulation is low and leverage is hard to come by. Sovereign wealth funds, family offices and other institutions traditionally seek a geographically diversified portfolio- often in developed markets. For many, the perceived risk in emerging markets is just too high. For limited partners (LPs) based in the Middle East and Africa, the story is similar: LPs would rather seek security in the tried and tested private equity markets of Europe and North America. But in doing so, they are neglecting opportunities available much closer to home. By consistently looking towards developed markets, investors are missing the chance to capitalize on several emerging market advantages: demographic change, middle class consumption, and sector diversification are just a few. To better understand the opportunities, we need to look closer at what drives private equity and venture capital in so-called “emerging” markets.
1. Local knowledge is the name of the game As is the case in developed markets, successful fund managers need extensive networks and a deep understanding of deal making in a local context. Many investors in New York or London are disconnected from these markets and are hence reluctant to put capital in unfamiliar and sometimes untested geographies. However, sector diversification and financial market development are becoming familiar themes. Development finance institutions like the IFC in the US and CDC Group in the UK are paving the way for this systematic growth- private investors should follow. Investors who become familiar with local markets will have an early mover advantage and should explore opportunities for local networking and knowledge sharing in emerging markets.
2. Growing returns with less risk The risk in many emerging markets has decreased over time, as economic liberalization grows and regulation becomes standardized. Nevertheless, progress has been slow and the lack of full open markets has put pressure on growth capital as the key to successful private equity deals. For many EM managers, revenue growth is essential and leverage remains a luxury. Investors accustomed to highly leveraged deals should find comfort in the fact that growth relies more on fundamental performance rather than financial engineering. As financial systems develop and leverage comes into play, the sources of growth will change and private equity is sure to grow. Today’s investors should remain conscious and creative about the ways to facilitate returns in emerging markets.
3. A self-fulfilling growth cycle Institutions considering emerging market private equity have the opportunity to invest early, beating the rush of competition in many countries. Unlike Europe and the US, emerging markets still possess major inefficiencies, making the selection of local partners a crucial part of any process. Local General Partners (GPs) in turn, invest in projects that contribute to economic diversification, growth and job creation. The ultimate outcome is a more developed, and less risky ecosystem for international investors. For fund managers with environmental, social and governance (ESG) considerations, economic development is as much a goal as risk-adjusted returns. Private equity in these markets provides an opportunity for investors of all types to meet these interdependent goals of return and economic development.
So, with that said, how can MENA business owners and fund managers convince investors to look their way? There is strong evidence to support investment:
1. Consider the returns Firstly, while many consider emerging markets to be undeveloped, returns in such regions are anything but. David Wilton, the former head of private equity at the IFC, proved this by generating returns that would be attractive to any developed market investor (17% IRR on funds from 2000-09). The IFC team boasted a consistent and successful track record investing in emerging market fund managers that many would have ignored as too risky.
2. Short-term goals A second way to attract investment is by highlighting the short-term benefits to MENA investors. History has shown that private markets move faster in creating economic growth than public markets. To put this into practice, GPs should promote deals where invested capital trickles down to local economies and promotes development.
3. Focus on the big picture Finally, managers need to make local investing tangible for investors across the globe. Fund managers should involve investors in co-investment opportunities, which provide visible examples of how improving company operations can lead to larger deal exits.
The ability to identify emerging trends and capitalize on high growth opportunities is attractive in today’s environment where yield is scarce and good ideas are hard to find. For MENA investors, local markets provide an opportunity for faster economic diversification at home. Many regional investors can manage an added degree of risk in the short-term in favor of long-term performance. For large institutions, investment mandates increasingly require a balance between long-term financial performance and short-term economic opportunity. Emerging markets provide an opportunity to achieve both.