“New breed of private equity investor”

November 28, 2012 | 4 min read

An increasing number of investors are broadening their portfolio beyond traditional markets. There was a time when many capital investors looked upon the territory beyond developed economies as a land unknown—fraught with risk. Development Financial Institutions (DFIs) such as such as International Finance Corporation (IFC), the Dutch FMO Entrepreneurial Development Bank, CDC in the UK, various regional development banks and others, have been instrumental in building the Private Equity (PE) industry in frontier and emerging markets. Many of these institutions have used public funding to do so and have put a strong focus on environmental, social and governance (ESG) practices. Sarona Asset Management, believes that the ESG conditions attached to DFIs’ capital have played an important role in shaping a more sustainable private equity investment approach which is now accessible through a new group of intermediaries ready to attract private capital.

Appetite for capital

The Institute of International Finance estimates that worldwide, $910 billion flowed from private investors into emerging markets in 2011 compared to $580 in 2009^[1]. Although the renewed Euro Area crisis is expected to play a role in the willingness and ability of investors and lenders in the region to supply financing to emerging economies, there are various reasons which will sustain the growth in appeal of these new markets. First and obviously, the majority of people in developing countries are seeking to better their own and their families’ living conditions. A growing entrepreneurial drive has improved business conditions which, in turn, have led to the growth of middle classes who have a stronger demand for goods and services that can be produced and/or distributed locally.

The number of Small/Medium Enterprises (SMEs) is increasing, and there exists a significant demand for capital to sustain this growth. The opportunity for growth and returns is considerable: emerging markets have outperformed and are expected to outperform developed markets for the foreseeable future. While theInternational Monetary Fund predicts growth rates of between minus and plus 1% in developed economies, the average expected growth for emerging countries over coming years is projected to be around 6%. The SME sector is an important component of this GDP growth.

Risks and opportunities

Traditionally, one has heard the frequently voiced objection that SMEs carry great risk. Yet, the most recent crisis within developed capital markets has demonstrated this is not necessarily the case. For example, let us look at the Debt to Equity Ratio. Excessive debt levels have been associated with high volatility and increased credit risk. The International Finance Corporation (IFC) examined 604 companies in its emerging markets portfolio (excluding financial institutions) and found that the median Debt to Equity Ratio was 0.33 while the average was 0.74. This is a far cry from European and USA ratios that have recently run around 3.

Another consideration for many investors is that emerging capital markets can be labelled “inefficient” in the financial sense: they lack transparency, financial liquidity and reliable access to information. These factors are compounded by significant structural blockages that inhibit the flow of capital. While a potential downside, these conditions also create opportunities for knowledgeable and experienced investors who can put money to work with the expectation of achieving returns in excess of those available in efficient markets. “PE Impact Investing” is a new name for a timeless activity: deploying patient capital —the average holding period is 5-7 years—to promising companies and nurturing them to improve their operations and increase revenues for the longer term.

Competitive outperformance

Many studies show that private equity investments outperform public equity markets. A common prejudice is that this outperformance is attributable to the higher risk that private equity investors take—making private equity unattractive during difficult macroeconomic environments. However, excess returns are not always linked to additional risk. The success lies in the business model of private equity investors. Due to the alignment of interests in the structure of PE deals and the focus on ESG practices (which numerous studies show can also be linked to higher returns), the premium returns of PE benefit all stakeholders.

The widely held expectation is that a high quality, well-diversified PE portfolio should be able to outperform a listed market index such as the S&P500 or the MSCI Emerging Market index by 300-500 basis points on an annual basis. Recent research by Partners Group^[2] into its own portfolio of companies, shows that the volatility of a private equity (buy-out in this case) portfolio is lower than corresponding market indices in Europe and North America. Since 2000, private equity investments have outperformed the respective public equity indices by 5% in North America and 9% in Europe per year.

Exits from aid

For investors seeking financial returns as well as social/environmental positive impact, the opportunities in emerging markets are significant. On a local level, providing capital to grow more and better companies leads to more jobs and opportunities for local suppliers and possibly more local buyers. This, in turn, has the potential to generate greater tax revenues, which holds the promise of supporting the delivery of better national services. Increased financial empowerment also positions citizens to demand greater government accountability, while more jobs generate greater income and increased spending power— all of which translates into families better able to educate their children, receive greater access to superior healthcare, and so on.

There is a large, well-priced opportunity to focus on “impactful” sectors such as education, healthcare, affordable housing, clean energy, and enabling technologies; sectors that can, and are, already changing the lives of millions both directly and indirectly. On an international level, the opportunity lies in the possibility of reducing the instability reflected in the global gap between those who have and those who have-not, between North and South, between the resource-rich socially poor and the western economies. In addition, thoughtful private equity investing has the potential of reducing developing nation dependence on aid and charity, particularly important at a time when mainstream donors are reducing grant flows. Emerging markets, where so many people are increasingly willing and able to create “real” value to their economies, represent the most recognizable and realistic opportunity to combine financial returns while making a positive difference to communities and the environment.

Video on Sarona Asset Management’s investment strategy

In the following video, Vivina Berla explains in more detail the investment strategy of Sarona Asset Management in developing markets.

http://www.youtube.com/watch?v=my3Kq5q2Bns

References

Suttle, Phil, Robin Koepke, and Emre Tiftik. “2012 January Capital Flows to Emerging Market Economies.” Institute of International Finance (January 24, 2012).
Partners Group Research Flash. “ Understanding private equity's outperformance in difficult times.” (January, 2012).

This article may be reproduced according to our terms of use with attribution (and link, if online) to www.tias.edu. To be cited as:“‘New breed of private equity investor’ yields successful returns and social impact“Berla, V., and G. Pries, November 30, 2012.

This article is based on the Issue Brief, “Private Equity in Emerging Markets: Exits From Aid, Steps Toward Independence“, jointly authored by Gerhard Pries, Managing Partner and CEO, and Vivina Berla, Senior Partner and Managing Director Europe of Sarona Asset Management.

ImpactAssets_IssueBriefs_6
Sarona Asset Management ImpactAssets issue brief
ImpactAssets