"Emerging markets" is a catch-all term that tends to suggest outsized risks and the potential for outsized investment returns. But for private equity (PE) firms, this broad term masks the wide-ranging differences between distinctive markets. Large emerging countries like China and India are very different from smaller ones like Bolivia and Paraguay.

So how do PE firms that specialize in emerging markets find opportunities that justify the risks? It's not an exact science, according to speakers who participated in a panel discussion on emerging markets at the 2013 Wharton Private Equity & Venture Capital Conference, but the most appealing markets do share some characteristics, like a growing middle class and business-friendly government.

Some countries, such as Brazil, Russia, China and India (which are also known as the BRICs), are obviously further along in the process of emerging than others, and have a track record of profitable PE investments as an indicator of their market's potential, said Ralph Keitel, principal investment officer of the International Finance Corp. (IFC), the private sector arm of the World Bank Group that invests in PE funds. The IFC invests $12 billion to $15 billion a year, and has a dual goal of earning investment returns and aiding economic development in emerging markets.

Understanding a country's pros and cons takes a "granular" examination, he added, because a single country may be relatively well developed in some geographical regions, "whereas 500 miles to the north or south, people are living in abject poverty." China is a prime example, he pointed out, with vast differences between the developed coastal cities and the poor rural inland areas. It would be a mistake to assume that all of China presents great PE opportunities.

Emerging markets that appeal to PE firms do tend to share some other features as well, said Enrique Bascur, managing partner of Citigroup Venture Capital International (CVCI). "The one thing that they have in common is a higher than average growth rate," he noted. But a high growth rate is not enough if the country's economy is small, he added. That is why countries like Brazil, Mexico, Chile, Peru and Columbia are attractive, but Bolivia and Paraguay are not.

Health Care Opportunities in Emerging Markets

Stephen M. Sammut, a Wharton lecturer and partner at Burrill & Company, a venture capital firm focused on the life sciences and health care, said his firm looks for markets that offer "growth and consolidation of the middle class." They also look for markets where "it is clear that the government policies are moving toward seeing health as a human right." A good market has a culture that encourages innovation and offers a favorable legal environment that provides basics such as contract enforcement, he noted.

Burrill also looks for countries that already have an established foundation in health care, he said. For example, India has a thriving generic medication industry eager to do research, and the government has made it easier for medical research firms to conduct drug trials, Sammut noted.

Keitel said the IFC prefers to invest in a business that, instead of doing what its competitors are doing, can move to the next level. Some markets, for instance, have companies that provide raw materials for medications, and the IFC tries to help them develop the expertise to produce finished products. A firm in one country might produce a drug, while a firm in another makes the syringe needed to administer it. "That would be an example of how we see various parts of East Asia work together," he said.

Different Markets, Different Strategies

The key to PE success in emerging markets is the ability to adapt, according to Keitel. Investors must be able to adapt to wide variations that distinguish one market from another. "Cookie-cutting in emerging markets is not a good strategy," he said. "We believe all business is local. We want to back [general partners] who have a very deep understanding of the market, who understand the culture, who have networks there."

For example, it takes very different strategies to invest successfully in Central America, where the capital markets are undeveloped, compared to South Africa, which has well-established capital markets and a fairly well-developed PE industry, said Keitel.

Business cultures also differ from one region to another, he added. In China and India, the PE firm often takes a minority stake because, for the target company's founder, "retaining control is a very important issue." It's more common for PE firms to take a controlling stake when they operate in Latin America, he noted.

On-the-Ground Presence is Optional

While it is important to have a deep understanding of local markets, this doesn't necessarily mean a PE firm must set up an office in every country in which it operates, said Bascur. "You can have an office there and not be local … or be outside and understand it perfectly well," he explained. CVCI prefers to set up hub offices that serve multiple countries, he noted. These offices have the size, or "critical mass," that allows them to work more effectively compared to a multitude of small offices with skimpy resources. Typically, the hub is staffed by people from the various countries it serves, added Bascur.

While a country at the early stages of emerging might seem like virgin territory that is ripe with opportunity, it can be useful to have company in the PE space, Sammut observed, noting that indigenous PE funds are now forming in some emerging markets. "In my view, that's been a very positive trend," he said.

Much is often made of the risks of investing in emerging markets. There can be unstable currencies and governments, shaky legal systems, corruption and even warfare. But a closer look often reveals a difference between "perceived risk and real risk," Keitel said. Revolutions in Cairo and Tunis made headlines around the world, but had little effect on PE firms' operations in those cities, he pointed out.

A PE Home Run

The panel's moderator, Timothy J. Hartnett, leader of the U.S. private equity sector at PwC, an auditing and consulting firm, asked for examples of home runs in emerging markets.

Bascur provided one stand-out example: in the early 2000s, CVCI was approached by investment bankers seeking a buyer for a family-owned salt mine in Chile. In the wake of the Internet boom, this seemed like an out-of-the-ordinary opportunity that was about as low-tech as a business can get.

"This salt mine happened to be in the most economical place in the world to produce pure salt," he recalled. The salt lay on the surface only about 10 miles from the ocean, in a place where it almost never rains. Because this salt was so cheap to produce, CVCI saw a chance to capture a large share of the U.S. market for road salt for municipalities, airports and other big users.

The salt mine was purchased for $100 million, and CVCI then bought a Brazilian distribution company to help get the salt to market. After a few years, the operation had captured about 50% of the U.S. road salt market, and the firm was sold for $500 million.

This case was a classic example of an emerging market PE strategy that brought together firms in different emerging markets to serve customers in developed ones, he said.