Comment: Emerging markets offer unprecedented opportunities for 2008 vintages
Shamillia Sivathambu of Argo Capital Management argues that the difficult global economic environment, which is forcing even healthy companies into desperate measures to raise capital, offers especially good opportunities in emerging markets for the current vintage of private equity funds and the investors with the vision to back them.
The market's short-term volatility and investors' flight to safety have resulted in indiscriminate losses across all asset classes. The age-old premise of negative correlation between differing asset classes doesn't hold any water in today's market.
As a result, investors acting on emotion rather than fundamentals are finding it difficult to see the wood from the trees and are happy to forgo any upside in return for some kind of respite from the storm. Not surprisingly, yields on two-, 10- and 30-year US Treasury debt are trading at 50-year lows. Given such a backdrop, why then are a record number of new private equity funds currently out on the road?
According to a recent survey from Private Equity Intelligence, there are now 1,600 funds on the road, an increase of 24 per cent from January this year, and the average fund size is up 20 per cent from a year ago to USD760m. Additionally, out of 200 limited partners surveyed by Preqin, just 9 per cent said they would not invest in new funds.
Given the level of uncertainty in the current market, these numbers are encouraging and only go to show that LPs and general partners alike are very bullish about return prospects for 2008-10 vintages. Much of this enthusiasm is backed by past results.
Historically, deals completed during periods of market downturns have often been among the best performing vintages. Unable to raise capital through conventional channels such as bank borrowing or public securities issues in times of market uncertainty, companies have little choice but to turn to private equity investors to refinance their debt. Not only are there a greater number of potential private equity deals in periods of economic slowdown, but valuations are a lot lower.
However, the current market turmoil goes one step further. With the market completely decoupling technicals and fundamentals, sellers are being forced to give up their equity at distressed prices despite strong potential for growth.
The need for fresh capital injection to meet pressing financial commitments in the short term is creating a wave of forced selling. For example, companies with little leverage and low debt ratios operating in sectors with high barriers to entry are being forced to sell low irrespective of their fundamentals, simply to meet maturing obligations or stave off a covenant breach or default.
Such scenarios are especially pervasive in emerging markets where debt tenors are quite short. Given how emerging markets have been less exposed to the sub-prime contagion and have not extended themselves the way companies in the West have, the potential to tap deals with strong growth at distressed prices in the current climate is arguably stronger in emerging economies than in the US and parts of Europe.
An affluent middle-class, a rising number of highly skilled managers, low labour costs, increasing intra-regional trade and lower household and corporate sector leverage are some of the factors that make the emerging market pipeline so compelling. Many companies in these regions also benefit from the catch-up effect, which gives them greater growth rates than their Western counterparts.
In addition, as private equity is still relatively new to emerging markets, there is less competition for deals, while deeper capital markets and better legal framework are awarding greater transparency and credence to shareholder rights. In many emerging Europe markets the application of European Union law either in the lead-up to accession or actual EU membership is also adding to their appeal.
By taking advantage of the compelling number of distressed prices in emerging markets growth companies, investors that deploy capital to new funds now can expect prospective returns to be higher than the median expected gross internal rate of return over the next five years, the 15-20 per cent range, according to analysts' projections. In addition, given the low entry prices and substantial growth potential of current deals, unlike the leveraged buyout market, emerging markets-focused private equity funds can achieve high returns without heavily relying on leverage.
Experience in emerging markets overrides private equity investing experience
Private equity investing requires a strong network of legal advisers, while a reputation for winning over management is also advantageous. However, a GP's skill-set is further tested when the investment remit is extended beyond the home market and into emerging regions.
When considering emerging economies, a track record in emerging markets investing is far more important than one in private equity investing, not least because emerging markets throws up a number of challenges for the unprepared. However, only a few houses have experience in both.
The onset of new opportunities is great news for the strategy, but in the interest of generating risk-adjusted returns, investors should seek out experienced managers with strong local contacts and on-the-ground investment teams. Access to investment banks and brokers to source deal flow as well as co-investors in the form of local private equity funds, entrepreneurs and financial investors, adds to a fund's appeal. A good grasp of local markets and their respective peculiarities is equally crucial and will allow the GP to identify overlooked opportunities while remaining fully conversant with the associated risks.
GPs with a strong track record in emerging markets and a local network of contacts are better placed to originate attractive off-market deals. For those with an eye on generating risk-adjusted returns, companies with little or no leverage, operating in defensive or anti-cyclical sectors with high barriers to entry and good management teams are likely to generate far superior returns than the industry average.
Companies operating in fragmented industries with distressed valuations but rapid growth potential offer multiple and relatively quick exit options. Small and mid-sized companies, which tend to be sidelined by larger funds, are often the ones most in need of private funding. If the entry point is disciplined and strategically timed, it can take just two or three years for these companies to achieve critical mass and produce an opportunity for GPs to successfully exit the investment through a trade sale, secondary buyout or IPO.
The advantage of chasing smaller deals in a less competitive market also gives a savvy GP more room to negotiate better terms. Of course an owner's willingness to give up more upside is heightened by current market conditions and the large number of distressed sellers it is inadvertently producing.
Overall, it is clear that for the discerning GP the financial crisis is bringing about new opportunities for private equity investment and LPs that adapt their investment approach to take advantage of these could profit handsomely over a relatively short timeframe.
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