Emerging economies now capture a larger share of global private equity activity than ever before and the markets are quickly maturing as investors take more controlling stakes in companies.
Statistics from the Emerging Markets Private Equity Association (EMPEA) showed that the emerging markets share of global private equity fundraising has risen from 5% in 2004 to 20% as of June 2009 and from 7% to 24% of global private equity investment totals during the same period.
However, capital commitments decreased. Research by the association found that a total of 84 emerging market funds raised US$16 billion (€10.7 billion) through to June 2009, which was down 55% from a half-year high of $36 billion raised by 132 funds in 2008 and a departure from the record-breaking $66.5 billion raised in 2008.
Despite the lower sums of money being invested, the situation in emerging economies is still better than what can be seen in the West.
“We are not seeing the sort of capital flight from emerging markets that followed past crises,” says Sarah Alexander, president of EMPEA. “In fact, emerging markets continue to account for a larger share of the global private equity markets, consistent with their contribution to global GDP and GDP growth”.
Erwin Roex, partner at Coller Capital, says: “Money is coming back slower, but the valuation change of the investments has certainly been a lot less pronounced than is the case in mature markets. One of the reasons for this is that most emerging markets do not use leverage”.
In the developed world, private equity investment rode on the back of extreme levels of leverage. This is not the case in the emerging markets and experts believe that there is no real danger of the asset class degenerating into the overleveraged depths witnessed in developed economies.
Leverage Worry
“Research on traditional private equity deals in Europe and the US has concluded that 70% of the alpha is coming from leverage,” says Jerome Booth, head of research at Ashmore Investment Management, “and that may well be an understatement”.
Such outrageous levels of leverage have not yet been seen in the private equity deals transacted in emerging economies, but one cannot help but wonder whether high leverage could creep in over time.
Most experts do not believe that this is a danger, not only because the private equity markets in these regions are still not mature but also because the lack of leverage has been one of the characteristics of the industry within emerging markets.
However, as economic circumstances develop, this function of the market may change as well.
Roex of Coller Capital says: “Leverage has not been used for a number of very good reasons, one of which is inflation. Another reason is that the cost of debt was prohibitive, particularly if you are a private equity investor”.
He says that this could change. Roex speaks of Brazil as an example: “There is modest leverage coming into deals because interest rates have been cut. So now, you can attract senior debt at a cost of somewhere between 11% to 13%, which in some instances makes you put on modest leverage”.
But although the markets are changing, Roex says that having the leverage levels seen in the West in emerging markets is completely unthinkable for now.
Taking Control
There are certain characteristics of the private equity world in emerging markets that make it distinct from what has been seen in the West – this is mainly because these markets are still evolving.
One main difference is that, historically, a majority of the private equity deals in emerging economies have been for minority stakes in businesses.
The reason for this is two-fold. First of all, many of these companies are often family-run and would generally like to keep it that way. Secondly, private equity investment in these regions tends to be for growth capital. Therefore, private equity firms in these markets are usually looking to expand and grow the business of the target company rather than to buy it out and look for a swift exit.
Roex of Coller Capital says: “The opportunities are definitely there and private equity in emerging markets is becoming a more important part of the way businesses are being financed”.
But the trend for buying minority stakes in firms is slowly changing as the emerging markets private equity industry becomes more mature.
Janusz Heath, managing director and head of the asset management division at Capital Dynamics, says: “The first investments that take place are expansion finance and then as the private equity aspect of the market matures and gets more comfortable with what private equity brings to the table, then that moves into a buyout market”.
And it seems this has already started to happen.
Adiba Ighodaro, director at Actis, an emerging markets private equity firm, says: “We have been at the forefront of executing control transactions in India, which has been a more recent phenomenon”.
The fabric of the entrepreneurship has not changed; the target firms are still mostly family-owned. Ighodaro says that trying to buy controlling stakes in such companies puts an even greater emphasis on the importance of relationships. “To be successful in doing that (acquiring a controlling stake) within a family business, the family needs to be comfortable and needs to feel that we are a firm they can partner with,” she says.
In one of its most recent deals, Actis invested $244 million, the single largest shareholding, in Egypt’s Commercial International Bank. This was the largest private equity deal in Africa in 2009.
Another significant emerging markets deal was between US-based firm Global Environment Fund (GEF) and Greenko, one of India’s largest independent power producers focused exclusively on renewable energy generation. GEF invested $46.3 million in the Indian company, giving it a 30% stake.
Heath of Capital Dynamics says that the increase in control transactions is no surprise, after all, the private equity markets in the US and Europe went through a similar cycle. He says: “The trends you have seen in those markets are going to be repeated and broadly, there is no reason to believe that they will not”.
Although in Asia, there is a tendency to try and hold onto businesses for future generations, Heath says: “We are seeing more buyouts, although it is a trickle at this stage. There are one or two managers, particularly in China, who say they only do control transactions, but they are a huge minority at the moment”.
Jim Seymour, managing director at EMP Global, says: “The absolute equity ownership of shares, which would provide control, is much more difficult in emerging markets. There is a slight trend in that direction, but generally, the large buyouts you see in the US and Europe are still much rarer in emerging economies”.
Heath counters: “I think we will be pleasantly surprised by the speed at which a buyout market will emerge from the emerging markets”. He says that looking at the evolution of the market in other regions, this should happen over the next ten years.
An interesting observation is that even in smaller deals, the element of control is becoming more apparent. Seymour at EMP Global says that in some cases, “there might be a minority equity shareholding but with conditions that enable the private equity investor to have control over certain elements, such as hiring and firing of the CEO and CFO, capital budget expenditures and any add-on acquisitions.”
He says that the Asia crisis in the late 1990s was one of the drivers for private equity investors seeking more control. “Before the crisis, investing in emerging markets was about buying a minority interest and riding the growth curve of the GDP. Investors, therefore, had no way of managing their way through that crisis. This is why now they are seeking more control over the future of the companies they target”.
Price Pressure
Experts say that although the pace has slowed somewhat over the last 18 months, more private equity investors are wanting to do business in emerging economies.
Rainer Ender, managing director of Adveq, says: “As the emerging markets have held up pretty well in the downturn, the capital inflow into these regions is not low – but it has reduced nonetheless”.
The fact that more players are wanting a piece of the action has a direct impact on the prices demanded by the target companies as well as their attitude towards foreign investors.
Ighodaro of Actis says: “As more competing funds come into the market, private equity becomes less of a “gentleman’s club” type investment… You are beginning to see auctions and people being very hard-nosed about where they can get the best deal”.
Seymour of EMP Global says: “There is certainly more price pressure… The company owners in emerging markets are more aware of what global private equity is and therefore, are much more attuned with the fact that there could be other offers out there”.
He says that therefore, owners are now more receptive to other bidders and therefore, are able to get better prices. It goes without saying that this development puts private equity managers under pressure as competition becomes stiffer.
Ron O’Hanley, CEO of BNY Mellon Asset Management, says: “Most emerging markets are enjoying strong recoveries and significant new cash flow. These markets and the underlying economies have proven to be resilient and are attracting investors globally. This investor interest demand eventually will make the underlying deals expensive and harder to do”.
But Ighodaro of Actis says strong relationships can be an investor’s saving grace. “If you look at some of the recent investments in our portfolio, there have been instances where our offer was not the highest one on the table. It was more a question of the family or the managers, being comfortable with us. Our global platform provides us with the opportunity to combine strong relationships with deep sector expertise; this is proving to be a powerful competitive advantage”.
Seymour says: “It is a natural development of the market. As the markets are slowly becoming more efficient and more competitive, the challenge for the private equity investors is to demonstrate why they are the best for that owner or the best firm to which to sell the company and that may go beyond price”.
Ender says: “In order to win (an auction or a bid) without offering the highest price, you must offer something else – that is, contribution to the company’s development and your experience to support the growth of the company”.
Anuj Chande, partner at Grant Thornton and head of the South Asia Group, says that increased competition does not go across the board, but he adds: “If the company is the right proposition, then there is a lot of competition. For example, we closed a deal in the telecoms/infrastructure space a few months ago where we had five private equity players producing term sheets within a week for the same opportunity”.
Chande focuses on the Indian market and he says: “There are certain sectors where there is additional competition, for example, education, health and infrastructure. The reason behind this goes back to the fundamentals of the country. Education is only now beginning to open up to foreign investment… so it is a combination of regulation and the fundamental market opportunity”.
Deal prices collapsed alongside the markets, but they are recovering rapidly and in this tough environment, O’Hanley at BNY Mellon says: “The better investors will be the ones that will succeed”.
Roex says: “Competition is growing and as a result, prices are going up. So going forward, it could be fair to say that it will be more difficult to generate really good returns by buying cheap”.
But competition has not increased in all parts of the emerging markets. There are some deals where there is no auction process and the structure of this part of the industry has not changed much.
Booth at Ashmore says: “If, as an entrepreneur, you have got something very sensitive to do to your company, you do not want a bidding process”. He explains that in the vast majority of its deals, Ashmore was not competing with any other investors. “It is because they (the target companies) want something that is discreet,” he says.
This article first appeared in www.funds-europe.com (Issue 82, Dec 2009/Jan 2010).
