Private Equity Heads the Bill

For institutional investors with a long horizon, private equity, especially in emerging markets, can deliver high returns with low risk.

By Catherine Bolgar / 30 July 2013 / for the Dow Jones advertising department

Amid the prevailing low interest rates and mixed stock market performance, how can asset managers deliver returns?

The dilemma is even more pressing for institutional investors such as pension funds that have to keep up with fixed obligations for payouts. For institutional investors with a long horizon, private equity, especially in emerging markets, can deliver high returns with low risk. Returns on emerging market private equity have surpassed those on U.S. private equity over 10 years and have topped both U.S. and European private equity over five and three years, according to the International Finance Corp. a member of the World Bank in Washington.

Emerging market private equity is doing quite well compared to both public markets and private markets, says David Wilton, chief investment officer, private equity, at the IFC. It’s not the high-risk asset class it might have been in 2000. Over the past 10 years it really has matured a lot.

One reason for the good performance is that private equity can better tap into economic growth in emerging markets than can public equities. China has been growing at 7% to 10% since forever and the stock market goes up and down all over the place, says Tim Jenkinson, professor of finance at Oxford University in the U.K. Emerging stock markets are still small and listed companies tend to be concentrated in a few sectors, such as resources, financial services and telecommunications, that fail to capture the growth of the consumer class in those economies.

If you want exposure to fast-growing consumer sectors, then the place you’re going to find that is in private equity more than in public markets, Mr. Wilton says. The IFC’s analysis shows its consumer and industrial exposure is 49% in emerging market private equity, vs. 22% in the MSCI Emerging Markets index. [* ]

Obviously, institutional investors face lots of portfolio diversification issues, says Robert Harris, professor of business administration at the University of Virginia in Charlottesville. I think private equity is a class they need to consider in all markets, not just their home markets.

The world of private equity investors includes development finance institutions, pension funds, endowments, sovereign wealth funds, family offices and long-term saving institutions, as well as high net worth individuals.

The opportunities are growing fast. In 2000, the IFC looked at the countries that had enough deal flow to support private equity funds. It found only the BRICs (Brazil, Russia, India and China) plus South Africa, Mr. Wilton says. Now there are 20-30 countries that have enough deal flow. There’s a big increase in the quality of the offering. We can get closer to the deal.

In addition, since 2000, globalization has blossomed, along with greater freedom of trade flows and of capital flows. People in these countries for the first time could expand offshore and might have wanted help with that, Mr. Wilton says. Some might have wanted to invest to bring their companies up to standards of international competitiveness, or to sell off noncore businesses. It’s all led to better deal flow and better alignment between private equity people, he says.

One reason emerging market private equity performs so well is that it has very little leverage. An IFC study in 2009 found the average debt-to-equity ratio of the companies in the funds IFC invested in was 0.7, compared to about four for U.S. or European companies at that time.

Emerging markets are far less leveraged than developed markets. If you’re unleveraged, you can take more macroeconomic cyclical shocks, Mr. Wilton says.

However, buyout funds―one of the many themes available for private equity funds―do tend to be highly leveraged. Yet, U.S. buyout funds have outperformed the Standard & Poor’s 500 by three to four percentage points a year, notes Dr. Jenkinson. People worry that these returns are going to be very cyclical, he says. However, funds that were raised just before the financial crisis in 2008 had post-crisis returns that don’t look too bad compared to public markets.

The key to success? Good managers. The funds are good at managing companies that are highly leveraged, Dr. Jenkinson says. They manage to negotiate flexible loans from banks so the companies are less likely to default. And then, leverage works like a dream in an upturn.

The IFC also found that funds’ quality depended mostly on managers’ skills―first-time or frontier-focused funds could outperform funds with more experience or with safer focus if the managers were good. The internal rate of return from 2000 to June 30, 2011, was 18.3% for all the IFC’s funds, and 24% for its first-time funds. [* ]

Half of the IFC’s PE funds are first-time funds, Mr. Wilton says. They’re largely local guys who either have been successful entrepreneurs and are branching out into private equity or else they have worked overseas and come back to their home countries.

Rehan Atiq is an example of a global, successful entrepreneur and investor. Mr. Atiq is co-chairman of Region Holdings, a U.S.-based business with investments in India, which was born as a family office in Qatar. Region Holding is a consolidated platform for owning and operating a diversified portfolio of businesses in India, a very strong emerging market, he says.

With offices in Hyderabad, Boston and Doha, Region Holdings is investing $150 million, including $50 million of its own funds, between 2010 and 2016, Mr. Atiq says. It isn’t traditional private equity. We bring in other investors as co-shareholders. We felt the paradigm has shifted where investors are looking at alternative platforms to make direct investments in markets like India. For an investor in the U.S. or Western Europe, it isn’t easy to get access to platforms in India.

The Persian Gulf is another region with growing private equity opportunities. Some of the region’s sovereign wealth funds have a development strategy, in which they wish to encourage employment, contribution to gross domestic product or intellectual property, as well as to reap returns, according to the Middle East Asset Management Study 2013 published by Invesco Ltd. the asset management giant. Year-on-year private equity allocations for Gulf sovereign wealth funds have grown to 13% for 2013 from 5% in 2011.

Development funds started in private equity funds but many have evolved toward co-investment or direct investment models, the report says. They are looking for 14% returns per annum, says Nick Tolchard, head of Invesco Middle East, in Dubai. They have more control as well and can be active investors. Private equity is the only model that will achieve the desire to do local development as well as to get the returns they’re looking for.

Even large, internationally invested sovereign wealth funds (as opposed to development-focused funds) are looking to do more private equity, but there’s a limit to the amount of supply, Mr. Tolchard says.

Indeed, demand outstrips supply in both number and size of funds in emerging markets. While some large funds are being developed, many still are too small.

The Emerging Markets Private Equity Association counts 611 emerging markets funds for 2007-2012, with only 61 emerging market private equity funds―12% of the total―over $1 billion. By contrast, nearly a third are under $100 million.

Very large investors want to deploy serious amounts of capital, but they don’t want to own 20% of a fund, Dr. Jenkinson says. They only want to write big tickets. If they can write a $200 million ticket, that’s OK, but they don’t want to do 10 tickets of $25 million.

One way around this is a fund of funds, which also allows an investor to spread investments over a broader range of funds and to outsource some of the due diligence to the fund manager. However, fees are even steeper than the already-high fees of straight private equity funds.

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