More private equity investors are delving into emerging markets, but significant hurdles remain to finding sustained outperformance, according to consultants and pension fund executives.
Unlike public equities, where the trend to invest overseas has resulted in sizable shifts into emerging markets, private equity strategies still are largely dominated by investments in developed countries, particularly the U.S. But more institutions are beginning to globalize their private equity portfolios, dedicating more capital to emerging and frontier markets.
The amount of money raised for emerging markets private equity strategies increased 64% to $39 billion in 2011 from 2010, although that's still below the pre-crisis level in 2008, when $66.5 billion was raised.
However, as a percentage of the total capital committed to private equity globally, emerging markets private equity accounted for 15% in 2011, up from 11% in 2008, according to the Emerging Markets Private Equity Association, Washington.
“Hunger for growth” is a large driver behind the interest in emerging markets private equity, said Miriam Schmitter, managing director and head of non-U.S. private equity research at Cambridge Associates LLC in London.
Among institutions that are looking to make new commitments to emerging markets private equity funds are the $235.2 billion California Public Employees' Retirement System, Sacramento; the 579 billion Danish krone ($103 billion) ATP, Hilleroed, Denmark; the $24 billion Texas Permanent School Fund, Austin; the $14 billion New Zealand Superannuation Fund, Auckland; and the $3.3 billion Fire & Police Pension Association of Colorado, Greenwood Village.
At ATP Private Equity Partners, the private equity fund-of-funds subsidiary of ATP with about e7 billion ($9.2 billion) in assets, emerging markets account for 10% of the target allocation for the latest fund launched in 2011, compared with 5% in the previous fundraising in 2007.
“In 2005, we decided that we needed to build our relations and understanding in emerging markets; otherwise, we might be left behind, as they were definitely gaining significance globally,” said Susanne Forsingdal, partner at ATP PEP based in New York.
Sovereign wealth funds have also become more aggressive investors in emerging markets private equity, said Alex Jones, senior analyst at Preqin, a London-based alternative investment research firm.
“Emerging markets are a big part (of the portfolio) for sovereign wealth funds looking at investing in private equity, not least because there are a significant number of such institutions based in (those) areas,” Mr. Jones added. In addition, SWFs “can be less risk-averse than other institutional investors in private equity because they are not worried by liabilities.”
While it's crucial for investors to have a meaningful allocation in emerging markets, “public markets are often very concentrated to handfuls of large companies that don't necessarily capture the potential of the local economy,” Ms. Schmitter added. Cambridge's own analysis revealed “little correlation” between gross domestic product growth and public equity market returns, she said.
A secondary reason for a higher emerging markets private equity allocation is diversification, said Tom Keck, chief investment officer at private equity consultant StepStone Group LLC, La Jolla, Calif.
“In addition, emerging market private equity is less efficient than developed market private equity,” Mr. Keck added. “There's essentially more alpha.”
Private equity investments in emerging markets are also perceived to be riskier “and therefore the risk/reward equation is more favorable,” said Mark Mobius, Singapore-based executive chairman of Templeton Emerging Markets Group, a division of Franklin Templeton (BEN) Investments (BEN). “Such investments, because of the false perception, can obtain higher returns.” The group manages a total of $45 billion in all emerging markets assets, including private equity.
In the year ended Sept. 30, 2011, Cambridge's Emerging Markets Venture Capital & Private Equity index returned 9.48%, compared with a return of -15.89% for the MSCI Emerging Markets index during the same time period.
The Cambridge index returned an annualized 11.9% and 12.11%, respectively, for the three- and five-year periods, compared with 6.59% and 5.17%, respectively, for the MSCI EMI for the same periods. However, the index underperformed the MSCI benchmark for the 10-year period by 5.8 percentage points.
“There are definitely concerns over the risk/return characteristics” of emerging markets private equity, Mr. Keck said. “We're focused on managers that are value-oriented and can mitigate operational risk. ... We want to get higher returns while mitigating the extra risk.”
As more institutional money flows into emerging markets private equity, specialist managers. as well as household names, are benefiting.
Abraaj Capital, for example, was launched in 2002 and now has about $6 billion in assets under management, with growth coming from a broad pool of investors that includes sovereign wealth funds, pension funds and endowments.
“Investor capacity is moving beyond the traditional BRIC stories to (countries such as) Indonesia, Malaysia, Mexico and Colombia,” said Mohamed Semary, partner at Abraaj Capital in Dubai.
Earlier this year, Abraaj announced an agreement to acquire Aureos Capital, a private equity firm with about $1.3 billion in assets under management operating in Asia, Africa and Latin America. When the deal is completed, the combined firm will have about $7.3 billion in AUM with investments across about 30 countries.
Mark Richards, partner and head of the financial services team at Actis in London, said the opportunity set has broadened in emerging markets private equity. “In part, this is because the industry is maturing,” Mr. Richards said. “We're doing slightly larger deals of around $100 million today, compared to about $30 million a few years ago.”
Actis, an emerging markets private equity firm largely focusing on Asia, Africa and Latin America, has about $5 billion in AUM, more than half of which was raised in its latest fund launched in 2008. “Institutional interest has risen exponentially,” Mr. Richards said.
At the Colorado Fire & Police Pension Association, emerging markets private equity has become more prominent on the pension fund's radar screen, said CIO Scott Simon.
About 4% of the private equity portfolio is allocated to developing economies, but officials would like the long-term target allocation to be closer to 13%, or the proportion to emerging markets within the MSCI All Country World index. “We want it to be meaningful enough, but not overwhelm the portfolio,” Mr. Simon said.
When compared to the “good opportunities in the U.S., a market that's more well-known to us, it's harder to get comfortable investing in emerging markets,” he said.
At ATP, one of the biggest challenges is “finding managers who are experienced with good track records,” Ms. Forsingdal said. “We wanted to avoid making commitments to emerging managers in emerging markets.”
For example, ATP does not have a dedicated commitment to China, “simply because we haven't been able to find a manager with a long enough track record,” Ms. Forsingdal said. “Some managers do have several funds behind them, but the people who are making investment decisions now are not the same” as in the previous funds.
So far, ATP has committed to emerging markets private equity funds managed by Advent International Corp., Innova Capital, Mid Europa Partners, Turkven Private Equity, Linzor Capital Partners LP, Victoria Capital Partners, India Value Fund Advisors and Archer Capital.