Rewarding Risk: Why Private Equity Needs to Venture Beyond BRICS

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The world is never short of crises. Whether it is another incursion of the radical Islamic group ISIS into a new city or an escalation of the conflict in Gaza, the globe can be a dangerous place. Investing in emerging markets especially during tumultuous times is not for the faint of heart. But for the forward-thinking investment firm that goes in with its eyes — and wallets — open, the rewards can be plentiful.

Of course, private capital has long treaded this risk-reward relationship in emerging markets. But fresh thinking out of the recent U.S. Global Growth Markets Forum in New York, put on by The Abraaj Group, makes the case that these markets are undergoing a structural shift that cannot be ignored by investors seeking robust returns for the long term.

“What’s going on in emerging markets, and the growth that is emanating from most of them, is a structural issue, it’s a transformational issue, and this is not a one-off event,” said a former World Bank official who spoke at the event. “It is dramatically and fundamentally shaping globalization of the world economy and it has enormous implications.”

Emerging markets, he contended, will be the engine of growth for the world economy well into the future, a status previously conferred on developed nations. Already, these markets are outpacing advanced economies: Annual, real GDP growth in the 120 countries classified as emerging markets has been growing two to three times faster.

And opportunities are not limited to the well-trodden BRICS — Brazil, Russia, India, China, South Africa — but also much of Latin America, sub-Saharan Africa and Southeast Asia. “Focusing the discussion only about BRICS is missing the boat big time,” the official said.

However, outdated assumptions are fueling investor trepidation about venturing deeply into these other markets. For instance, Africa weathered the recent global financial crisis better than most other regions because of hard-won reforms in many sub-Saharan nations in the prior two decades — a belief that on the surface may sound counter-intuitive.

While investors from developed countries hesitate about going in, China and India — themselves emerging markets — are forging ahead. Indeed, they exemplify a recent trend that speaks to the structural shift in emerging markets: the virtual explosion in trade and investment within these economies. The old status quo of capital flows emanating from developed nations to emerging markets is eroding.

Consider this: 15 years ago, the trade and investment activity among emerging nations composed only 3% of world trade. Today, it is 25%. Indeed, a third of foreign investment coming out of an emerging market goes into another emerging market.

If U.S. corporations do not move more quickly, a forum presenter said, they will be ceding first-mover advantage to countries such as China and India. But this is where private equity can step in and become a first mover as well to take advantage of emerging market opportunities.

The opportunities are significant as emerging markets see the rise of the middle, or consumer, class. For instance, in the last 30 years, 300 million Chinese entered the middle class, another speaker said. Focusing on regions with a growing middle class is the right long-term strategy, he added. Buyers also are becoming more sophisticated, as increased affluence is giving them more discerning tastes. “Sophistication of purchasing decisions is really accelerating far faster than we believe,” the former World Bank official said.

Further, some innovations are being created in emerging markets and then flowing to developed nations — upending the traditional cycle that starts with technologies being created in advanced economies and flowing to secondary and emerging nations much later on. Now, innovations are starting from emerging markets — due to necessity, as there typically is inadequate legacy infrastructure — and flowing to the West. For instance, mobile money was invented in Kenya years before Apple or Google brought it to the U.S. This is also a sign of a structural shift taking place that could yield plenty of opportunities for private capital.

But investors should take the right approach in entering these markets, one forum participant warned. There is a lesson to be learned from the Chinese, who are using cross-sectoral investments to build goodwill and gain influence. For example, a Chinese bank could provide loans to an African nation and, in addition, build a school, railway and port in that country. U.S. companies and private equity firms tend not to consider this approach.

“What’s going on in emerging markets, and the growth that is emanating from most of them, is a structural issue, it’s a transformational issue, and this is not a one-off event.” –Former World Bank Official

Separating Useful News from Noise

When a crisis strikes an emerging market, capital tends to flee. But a veteran journalist at the conference said such thinking can be premature. “There’s a lot more fear and hysteria in the markets about geopolitics than the actual situations merit,” he said. “There’s a media industry interested in playing off crises, and a public that’s easily spooked.” The bottom line? “The situation will change less than the discussion about it would indicate,” he said.

So, look beyond the daily headlines, another speaker said. Instead, revisit the investment themes that attracted capital in the first place, such as growing consumer needs of a fast-growing population. If those remain unchanged, then stay put. “Focus on the right thing in the news that will affect underlying trends,” one speaker said.

For example, a private equity firm partner said his firm kept its investment in a medical diagnostics business in Egypt even after the Arab Spring because of continuing robust demand for health care services. The business eventually went public and listed on the London Stock Exchange. “Even in political turmoil, if you take a long-term view, there will be sectors that will fundamentally grow,” he said.

Another example is Tunisia. The birthplace of the Arab Spring, the country saw major declines in its stock market and currency as investors fled during the turmoil. But a look at fundamentals shows that GDP was still growing through the uprising, with consumption trends even stronger.

One private equity firm largely stayed put with its investments in Tunisia: Gallus, a chicken producer; Unimed and Opalia, both drugmakers; PEC, a plastics company and Moulin D’Or, a muffin manufacturer. It bought Unimed two weeks after the Arab Spring, and about two years later, it sold Opalia to an Italian company for a 32% return.

Indeed, one speaker noted, it is important not to make the mistake of mixing macroeconomic indicators with microeconomic outcomes, as the example of Tunisia shows. To separate the two, it is critical to have a nuanced understanding of the emerging market instead of painting the entire region with a broad brush. Venezuela might get a lot of negative press, but it is not representative of the economic potential of the whole region. Investments also are selective: one investor focused on only half a dozen sectors in 14 out of 54 African countries.

Often, one is more likely to lose money in an emerging market due to a counterparty not being able to deliver on the potential market opportunity, instead of a change in government or macroeconomic issues. “Counterparty risk is the biggest risk in our investment process,” one speaker said. “Obviously, there’s also commercial risk, operational risk – those types of risks we’re built to take.”

Currency risks also pose an issue, but a forum speaker suggested that investors should focus on the net return. For example, if an investor bought into a company that is growing at 20% a year, she could potentially still get a 15% return after taking a foreign exchange hit. So what is the right return? It is around 25% to 30%, the speaker said, assuming the company’s EBITDA (earnings before interest, taxes, depreciation and amortization) is growing at a compound annual growth rate in the 20% range.

“Even in political turmoil, if you take a long-term view, there will be sectors that will fundamentally grow.” –Private Equity Firm Partner

There is not much investors can do about corruption in an emerging market. However, it has proven to have a limited impact on returns, one speaker said. His firm carefully chooses where to invest. “We don’t invest in all 54 countries in Africa but focus on four where there is a democratic process, the government is pro-business and where they want the political environment to get better,” he said.

Case Study: Health Care

Health care is a necessary service everywhere in the world, but expenditures are growing three times faster in emerging markets than in developed nations. Moreover, urbanization is leading to an increase in diseases such as cancer and diabetes. But how can private capital take advantage of opportunities in the health care market when a country does not have enough doctors or hospital beds while demand keeps increasing? Developed nations have up to 10 times more doctors and eight times more hospital beds.

One private equity firm’s strategy starts with buying a cornerstone asset, such as the best hospital in the city. It will tend to have specialists that, in turn, will attract more doctors as the new infusion of capital finances an expansion. Also, the firm brings in managerial talent and clinical innovation. But it is critical to put in an ecosystem that the locals can afford, starting with lowering the cost of building a facility by being more efficient. “If you’re at the top end of the market, your cost structure won’t survive,” one speaker said.

If there are not enough specialists, such as cardiac doctors, then junior doctors, cardiac nurses and community workers can be trained to triage the system and work with the poor. In India, for example, high-quality dialysis run by community workers are producing Western outcomes at $20 per session.

Such detailed involvement means that it is critical for investors to know the market well. “It is important to have boots on the ground, people embedded in those countries who speak the language and know the culture,” one speaker said. “Over 50% of business ventures fail because they cannot communicate across cultures.”

Understand what is important in the minds of the local consumer – is it quality? Is it value? Also, be mindful of local practices. In China, for example, it was not part of the culture for people to use a drive-thru window to order food. So they were pulling up on their bicycles, one speaker pointed out. “These are details, but sometimes we take those for granted,” she said. “Those are the secret ingredients for success.”

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