As the world faces a range of challenges, from the war in Ukraine and the resulting energy and food shocks, to inflation and market corrections, should investors’ risk perceptions around emerging markets be shifting?
As we started emerging from the COVID-19 pandemic, many will have hoped for a period of calm and normality. Yet the past year has been anything but.
And while private equity, with its long investment horizons has some capacity to smooth out more turbulent times, it’s clear that the industry will not emerge unscathed.
Against this backdrop, many LPs admit that they are starting to rethink how they allocate their capital. Private equity in its various forms is likely to be a net beneficiary, but allocations within the asset class are highly likely to change. So how will this affect emerging markets (EMs)?
While we have seen a steady increase in EMs fundraising over the past decade, it hasn’t kept the pace of that in developed markets.
“Ten years ago, 15% of private capital fundraising went to emerging markets,” says Daniel Schoneveld, Principal at Hamilton Lane. “Today, it’s just around 10%.”
The reason for this is the benign environment for GPs in developed markets. “Contrary to what we all thought post-GFC – that emerging markets were the best place to be because of the growth prospects – developed markets outperformed across all metrics,” says Schoneveld. “European and US LPs took the view that there was no point in taking the risk when GPs closer to home were performing so well, the markets were big and more liquid than emerging markets and the talent pool bigger. But now there are macro risks ahead and these may well impact performance.”
Turkven Private Equity’s Chairman, Neil Harper, agrees. “It’s fair to say that investor interest in emerging markets private markets has been somewhat subdued over recent years,” he says. “That’s largely because people have taken a limited, but fact-based opinion from the rear-view mirror.
Developed markets have done so well that if they’d put all their private capital in the US, they’d have outperformed almost any other allocation. That’s true in a backward-looking sense; it’s now far less so in a forward-looking sense.”
And this change, according to Menno Derks, Managing Director of Private Equity at Sarona Asset Management, is causing a shift in investor sentiment. “Some investors are now thinking that maybe they shouldn’t invest all of their money in the US and Europe,” he says.
“From a risk diversification perspective, they are starting to look at markets that are far away from the issues we are seeing today.”
If this is the case, many LPs will have to get past some of the most common negative perceptions of EMs – surveys show that many LPs are put off by the potential lack of control because of the predominance of minority investments, weak governance, single country risk, lack of exits and currency risk. As an Gulf-focused GP says: “Emerging markets private equity has an image problem.”
Depending on which market(s) LPs are assessing, some of these concerns may be at least partly valid; others rather less so. Here, seasoned investors offer their view of what LPs will find if they take a closer look and of why some EM investments may come through the current situation in better shape than those in developed markets.
Companies and fund managers have ready-made strategies for dealing with disruption. Supply chain issues are one of the big problems for businesses today – yet far less for those in some EMs. “As a private equity investor, we’ve seen very little supply chain disruption in our portfolio companies because operating a business in Africa requires significant planning,” says Alam. “Our companies are used to stockpiling six to 12 months ahead. Companies are also not entirely dependent on China; rather, China is more dependent on African nations for commodities.”
GPs and portfolio company managers are battle-hardened.
The turbulence stemming from the war in Ukraine and soaring inflation may be spooking developed markets GPs and management teams, but those in EMs are experienced in dealing with challenging situations. “There is a definite perception versus reality gap,” says Runa Alam, co-founder and CEO of Development Partners International. “When LPs hop onto a plane and come on the ground, they meet CEOs and companies in our markets. The feedback we often get is that our CEOs are just as, if not more sophisticated, than in developed markets – they are used to dealing with crises and significant events.” Or, as Eghosa Omoigui, Founder and Managing General Partner of EchoVC Partners, puts it: “No great sailor was ever built on calm seas.”
GP ESG processes are more ingrained. EM GPs were the early adopters of ESG management and so tend to be more mature in their processes. “When I started investing in emerging markets 12 years ago, I was surprised how much more GPs were attuned to doing the right thing than in developed markets,” says Vivina Berla, Founder and CEO of Vimine Holding. “That’s because these markets were seeded by development finance institutions – it’s part of their mandate to do things according to ESG criteria because they are investing taxpayers’ money on behalf of governments with a mission to develop economies. If GPs want to raise capital from DFIs, they have long had to sign a detailed code of conduct.”
Lived experience in managing through inflation. High inflation is nothing new for many fund managers and their companies in EMs. “Many countries in Central and Eastern Europe are accustomed to rising inflation because of their past,” says Alexander Bebov, Managing Partner of BAC Securities. “The region may well fare better than markets not used to this.” Indeed, many central banks in emerging markets acted far more quickly than their developed market counterparts – and so the pain may be felt for a shorter period. “Latin American countries are far more advanced on addressing the inflation problem,” says Luis Fernando Lopes, Partner and Chief Economist and Strategist for Patria Investimentos. “The peak of consumer inflation has now passed and production prices are now trending down sharply.” Further, because high inflation usually means high interest rates, debt exposures tend to be low. As his colleague, Noberto Jannuzzi, Partner at the firm, says: “We don’t leverage because interest rates are always volatile in our markets – we focus instead on value creation levers.”
Emerging markets exposure can boost impact allocations. While positive impact outcomes are far from guaranteed in EMs, the potential per dollar invested is usually greater than in developed markets. “Impact needs to be embedded in emerging market strategies,” says Derks. “There are so many challenges in emerging markets, you need to have meaningful and measurable outcomes.” Indeed, impact investing is leading some LPs to start looking at emerging markets for the first time. “Impact can open the doors to emerging markets for LPs,” says Marina Leytes, Senior Vice President, 57 Stars. “I’ve talked to institutional investors that wouldn’t generally allocate to emerging markets, but that are considering doing so through their impact allocations – it can be a first step for many.”
And lastly, a final piece of advice from Schoneveld for investors considering EMs: “Don’t put emerging markets into one bucket. There is no comparison between China to a small frontier market, for example. There is a huge difference, with some more developed than others, which will impact investors from risk-return perspective.”
