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 new study from IESE Business School and The Boston Consulting Group (BCG).
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 is based on an analysis of the International Finance Corporation's (IFC) data set on emerging-market private-equity funds. The IFC data set, which covers 176 such funds, is the largest of its kind and reveals that emerging markets’ share of deals has increased steadily from 5% in 1998 to 30% in 2009, when the United States and Europe accounted for 34% and 38% of deals, respectively. Over the same period, emerging markets’ share of deal volumes more than quadrupled to 21%. Moreover, there are strong signs that investors plan to step up their involvement in these markets.
Increasingly high returns have been a key driver behind this shift toward emerging markets, notes BCG. During the 1990s, returns averaged just 5.3% but since 2000 they have more than tripled to 17.3%. 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.”
Some of the most promising markets according to the BCG analysis are 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% 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% 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.
“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.”
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