Emerging markets are generating increasingly high returns for private equity investors and could soon account for the lion’s share of deals, according to a study from IESE Business School and The Boston Consulting Group.
However, the most attractive markets are not necessarily the ones that have captured the headlines in the past, and the key success factors for investors differ significantly from those that have worked in developed countries.
The study, which is based on an analysis of the largest data set of its kind, reveals that emerging markets’ share of deals has increased steadily from five per cent in 1998 to 30 per cent in 2009, when the US and Europe accounted for 34 per cent and 38 per cent of deals, respectively.
Over the same period, emerging markets’ share of deal volumes more than quadrupled to 21 per cent.
Moreover, there are strong signs that investors plan to step up their involvement in these markets. Approximately one-fifth of global dry powder, equivalent to about USD231bn or seven times annual deal volume (based on a five-year average), is earmarked for these markets, spanning all investment stages.
Increasingly high returns have been a key driver behind this shift toward emerging markets. During the 1990s, returns averaged just 5.3 per cent but since 2000 they have more than tripled to 17.3 per cent. Other factors that are pushing and pulling investors toward these markets include the widening gap between emerging- and developed-market GDP growth rates, and more attractive socioeconomic environments in emerging markets.
"The economic scale of a market is obviously critical for private equity but socioeconomic factors such as the market’s degree of openness, legal protection for investors, and the liquidity of its local stock exchange is equally important if investors are to realize the market’s full potential," says Professor Heinrich Liechtenstein of IESE Business School, one of the leaders of the study. "The most attractive markets for private equity are not necessarily the biggest economies."
The study assessed the relative attractiveness of markets, taking into account both GDP and a country’s socioeconomic environment, based on IESE’s Global Venture Capital and Private Equity Country Attractiveness Index. Some of the most promising markets according to this analysis were Brazil, India, Malaysia, Poland, South Africa, and Turkey, while certain countries such as Russia and Argentina appear to offer less potential due to their weaker socioeconomic environments. Although China’s socioeconomic environment is not especially strong, its sheer size is likely to make it a major destination for private equity investors.
To succeed in emerging markets, however, private equity firms will have to apply different business models than those that have worked so successfully in the past in developed markets. For example, the research by IESE and BCG found that minority stakes in businesses not only account for 86 per cent of all transactions in emerging markets but also produce three times the returns of majority stakes, which are the norm in developed markets. Investments in businesses that are focused on domestic markets also produce 18 per cent higher returns than investments in internationally oriented companies do.
In addition, the winners in private equity in emerging markets create value through operational improvements, rather than leverage, and have a strong local presence. On average, the returns of domestic and international funds with local offices are more than five times higher than international funds without local offices.
"The overriding conclusion of the study is that emerging markets have come of age for private-equity investors," says Heino Meerkatt, a senior partner and managing director at BCG, and one of the leaders of the study. "Our findings also signal a new age for private equity, with a new center of gravity and different rules, plus potentially very different players in the future, including the possibility of local firms in emerging markets emerging as tomorrow’s giants. Given the important role that private equity has played in developed-world stock markets in recent years, its shift to emerging markets has potentially much wider implications."
