Emerging markets pose challenge for Private Equity

Written by Niharika Naveen

The career path for many a Stern graduate has been a few years in Investment Banking followed by a “break” into the hallowed world of alternative finance such as Private Equity and Hedge Funds. While this has been the route for many generations of bright eyed analysts and graduates, the world in which private equity came of age, with stable macroeconomic trends and reliable growth, is fast changing. The increasing use of alternative sources of finance such as private equity (that in the past have been well known but underutilized) has been accompanied by a parallel trend: the flow of capital has increasingly shifted to emerging economies in the face of slowing growth and saturated markets in developed countries.

The basic operating principal of private equity is that investment capital from high net worth individuals and institutions is used to buy all the equity of an undervalued company and take it private, then fix the issues that cause it to be undervalued and exit the investment to generate market-beating returns. Private equity differs from traditional stock market finance since managers are relieved from the daily pressures of stock market volatility and communicating their strategy and actions to thousands of shareholders. Instead, in a private equity deal, like-minded investors can align their interests towards a longer-term horizon, typically spanning five to seven years.  In recent years following the global economic crisis, Private Equity firms have increasingly begun to invest in Emerging Markets that promise stellar growth and opportunity.

While this source of financing remains constant over time and geography, the actual process of structuring and executing a deal varies widely, and especially in emerging markets, as the private equity world is coming to realize.  Even though emerging markets are regarded as a homogenous group, it is crucial to recognize that each emerging market presents its own challenges; every country has different standards of corporate governance, entrepreneurial climates and regulatory support as well as political stability. For example, Brazil and India (two of the BRICs) have recently elected new premiers: while India elected Narendra Modi, a market oriented leader with a huge mandate to replace the policy paralysis of the incumbent, Brazil re-elected Dilma Rousseff, a socialist President who’s party has been in power since 2002 and who only narrowly won against Aecio Neves, her right wing challenger supported by the business community in Brazil. Their widely different political climate shows how investing in these markets, with despite their explosive growth rates and promising demographics, is often underlined with uncertainty and structural weakness that arise unexpectedly. In such a context, Private Equity investors must reach beyond their traditional capabilities and analyze risk factors to engineer deals with a clear entry as well as exit strategy.

The macroeconomic influences now matter more than ever. In a world where political and economic stability is no longer the norm, factors such as currency movements, monetary policy, technological trends and demographics can no longer fade into the background. Instead, they play a vital role in the outcome of even the most promising transaction that champions a winning company in a growing industry. The two most important macroeconomic decisions become the timing of deals and their sensitivity to business cycles as well as assessing disruptive competitive, technological or other important shifts that could potentially affect their portfolio company’s industry.

In an emerging market, the challenge of assessing an investment’s competitive and microeconomic environment is magnified by the lack of reliable resources. Entrepreneurs seeking investment capital in emerging markets have much better knowledge regarding their industry – that this creates an information asymmetry. In order to deal with this, building a proprietary deal network with strong industry sector knowledge and focus is of utmost importance. As Deepak Sachdeva, a partner at the India focussed private equity advisory Star-Lane comments: “Before venturing into an emerging market, you really have to consider your parameters for investing and ask yourself: What are you bringing to the table? Is it just money? Or are you a source of expertise on the industry, or the local environment.”  These factors can often be the game-changers in the outcome of a private equity investment. Early warning systems for potential problems and deal breakers have to work along with strong due diligence. This will ultimately pressure-test the investment thesis and provide an operating blueprint that will guide the management teams throughout the time the fund owns an asset.

Thus, the investment thesis in an emerging market must rely on a growth focus in specific sectors and identifying low-risk “cut-and-paste” deals. One such as example is FlipKart, the Indian version of Amazon.com, which adapts successful Western ideas to their its specific emerging market climate. Deal sourcing teams in emerging markets have to support the information gathering and be more varied with more in-depth industry knowledge. Sometimes, this might include the right individuals with enough institutional memory to know the informal factors that influence how a company is treated by the market and regulators and how to best navigate the pervasive red tape in many of these economies.