Emerging Markets: (Still) The Future of Private Equity?

October 22, 2024, 17:20

Emerging markets have promised major long-term investment opportunities for decades, but private equity allocations remain below their economic weight. The maturation of private capital markets suggests this could change.

TL;DR
  • Despite making $93.6 billion of investments in emerging markets last year, private equity remains significantly underexposed to EMs considering the size of their GDP.

In 1981, International Finance Corporation employee Antoine van Agtmael pitched an idea for a listed company investment fund focused on the developing world.

The idea was good, but the name wasn’t. ‘Third World Equity Fund’, van Agtmael later admitted, implied backwardness, poverty, and stagnation.

His proposed alternative, ‘emerging markets’ (EM), was steeped in promise. It caught on, and so did the idea that there were major long-term investment opportunities outside the established rich countries, including for private equity (PE).

What is the state of PE investment in emerging markets?

According to the Global Private Capital Association (GPCA), total deal value in Latin America, Africa, the Middle East, Central and Eastern Europe, and the Asia Pacific region (excluding Japan, South Korea, Australia and New Zealand) was $93.6bn in 2023.

That’s equivalent to 21.3 percent of the $438bn global total given by Bain’s Global Private Equity Report – a large figure, but far below EMs’ collective 54 percent share of global GDP.

Clearly, no two EMs are the same, and neither are their investment profiles. Taiwan generally retains the ‘emerging’ classification despite a GDP per capita of $34,400 – 150 times higher than fellow EM Burundi, and 4 percent higher than Japan.

Nonetheless, there are patterns. Most EMs have a higher proportion of venture capital (VC) and growth investments than developed nations, relative to other forms of PE such as buyouts and real estate. In Africa, for example, VC constituted 38 percent of total deal value in 2023.

EM investment is also highly concentrated, with China ($34.3bn deal value in 2023) and India ($27.5bn) overwhelming the biggest destinations. For context, PE investment in Latin America reached $15.5bn last year, Southeast Asia $7.1bn and Africa $5bn.

Is it increasing?

The 40-year trajectory of PE investment in emerging markets shows remarkable, but not linear, growth.

In the wake of the global financial crisis, the proportion of global PE fundraising focused on EMs jumped from 15 percent to 40 percent as capital went in search of returns. The pattern then reversed as quantitative easing inflated asset prices in developed markets, with EM assets underperforming by comparison. As one Morgan Stanley research paper put it in 2021, EMs “had fallen off the radar, after the worst decade for stock market returns since records began in the 1930s.”

Like their peers holding listed stocks and bonds, PE firms adjusted their allocations accordingly and by 2017 EM-focused fundraising had dropped back to 23 percent of the global total.

The story changed during the pandemic, largely due to China avoiding the worst effects of the lockdowns that hamstrung Western economies, before retracting again in 2022-3.

That setback was very much in the context of a global retreat for PE, as the inflationary crisis hit returns and delayed exits, reducing the pool of capital to reinvest, just as higher bond yields and surging returns from listed tech companies diverted new funds from PE. In Asia Pacific, fundraising was between $250bn and $300bn annually between 2018 and 2021, but by 2023, it had fallen to a decade-low of $100bn.

China’s investment decline was particularly steep, following slowing economic growth and trade disputes with the West. According to Bain, Chinese PE deal value fell 58 percent in 2023 from the previous five-year average, and its share of Asia Pacific deal value fell from 43 percent to 28 percent. India, with GDP growth of 7 percent, fared notably better through the downswing in relative terms, with exit value rising.

Globally, there are signs of a PE recovery, with EY data showing second-quarter deal value rising 50 percent year-over-year to $159bn, though thus far it has been US-centered.

What are the opportunities for PE in emerging markets?

The investment case for EMs rests firstly on higher long-term economic growth rates, creating opportunities for companies operating domestically.

Between 2000 and 2021, Brazil’s GDP grew by a factor of 2.5, India’s by a factor of 6.7, while China’s increased nearly fourteen-fold. Though growth may have slowed, it remains high: the IMF projects EM economies to expand by 4.2 percent in 2024, compared with 1.7 percent for developed countries.

A second basis for EM bullishness is internationally competitive players emerging in high-growth sectors.

In India, for example, PEs have focused on the country’s sophisticated tech and IT scene, which hit 37 percent of its 2022 deal volume. The largest deal was EQT’s acquisition of IGT Solutions for $813m, followed by Apax’s purchase of IBS Software Services for $450m.

These have run in parallel to investment in burgeoning sectors tied to economic growth like retail and consumer, and financial services, such as the $1.1bn EQT-led acquisition of student finance company HDFC Credila in 2023.

Across EMs more widely, other resilient sectors for PE investment have been in the energy transition (up 76 percent from pre-pandemic averages, according to GPCA), telecoms and digital infrastructure (up 42 percent), and healthcare (level). Notable deals last year included CVC Capital’s $223m buyout of Philippine healthcare provider The Medical City, and Meridiam and ENGIE’s purchase of South Africa’s BTE Renewables for $1bn.

What is holding it back?

Several barriers exist. EMs are typically more exposed to macroeconomic volatility, such as extreme foreign exchange movements and bouts of inflation. Higher corruption, and lower standards of governance and transparency, complicate due diligence in the absence of experienced partners on the ground. Regulatory restrictions can also affect what foreign investors can buy and on what terms.

Then there’s the inherent risk: emerging markets’ promise is predicated on long-term growth, but it is uncertain how many will escape the ‘middle-income trap’ to reach European or US levels of development.

These challenges are compounded by underdeveloped private capital markets, with fewer experienced PE firms on the ground to add value to portfolio companies: according to Preqin, only 16 percent of private equity investors were themselves based in emerging markets as of 2018. Some global firms have since invested in dedicated offices in China or India, but it’s less common elsewhere.

There are signs of change here, however. When Ares Management invested $100m into Brazilian PE house Vinci Partners last year, its CEO Michael Arougheti argued that Latin American markets were beginning to shift from public to private capital, just as previously happened in Europe and then Asia.

The activity of home-grown PE firms like Vinci or India’s Kedaara Capital is increasing, partly in response to an increasing local population of high-net-worth families interested in investing in PE as limited partners.

In some countries, sovereign wealth funds have also started co-investing with global PE houses, bringing local nous that would have been lacking otherwise. The Indonesia Investment Authority, for instance, has attracted around $1.5bn from global funds into such co-investments, since forming in 2020.

Navigating challenges in EMs are best done by experienced partners working on the ground, who are truly attuned to the local point of view. Major PE firms like EQT are cultivating highly localized teams to better unlock opportunities there.

Ultimately, the maturation of PE itself in emerging markets, as well as macroeconomic progress, will determine how much it grows, and how fast.

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