Apr 22 2014, 6:51pm CDT | by Forbes
After surveying another year of disappointing results from their emerging market investments in 2013, many private equity (PE) investors that had enthusiastically piled into the big developing economies of Brazil, Russia, India and China (the BRICs) are rethinking their emerging market strategies.
As we discuss in Bain & Company’s 2014 Global Private Equity Report, the problem PE faces in emerging markets is stark: General partners (GPs) are failing to deliver on the job their limited partners (LPs) hire them to do—to generate market-beating returns. Indeed, returns of emerging market PE funds have been trending lower for nearly a decade. Even the best performers’ results have dropped steadily from their vintage peak.
These are not the results that LPs signed on for when they shifted their attention to the fast-growing emerging BRIC economies from the deteriorating conditions for PE in the advanced economics after 2008. Emerging market funds raised since the financial crisis have underperformed their developed market counterparts. Although these vintages are still very immature and have booked few realizations of gains, their interim results are disappointing.
The emerging market behemoths, China and India, have disappointed most of all. With too much money chasing too few deals amid the expectation that double-digit GDP growth rates would endure, some PE firms rushed to close deals without adequately preparing for the risks of a prolonged slowdown.
Recent disappointment, however, has not caused PE investors to lose confidence in emerging markets’ prospects. Drawn by the allure of diversification, GDP growth and rising middle-class incomes, many LPs are planning to boost their exposure to the emerging markets. In a 2013 global survey of LPs, conducted by EMPEA, the emerging market private equity association, one-third of LPs indicated that they plan to increase the share of their PE allocation in emerging markets. However, the pace of new commitments will likely slow in light of the big infusions of capital into emerging market-focused funds from 2010 through 2012, the huge pile of dry powder still waiting to be deployed, and the struggle
GPs have faced trying to unwind portfolio holdings and return capital to LPs.
Absorbing the lessons of what has not worked well in China and India, GPs and LPs are broadening their horizons beyond the BRICs to seek diversification in markets that will offer the next wave of growth, including Sub-Saharan Africa, Southeast Asia and Latin America (excluding Brazil). Both investment deal value and targeted new fund-raising reflect the increasing importance of these rising markets (see Figure).
GPs are also embracing a more hands-on investment model. Most are no longer willing to settle for the purchase of passive minority stakes in companies whose entrepreneur owners are reluctant to cede control. Instead, they are increasingly likely to hold out for deals where they can exert influence over the assets they acquire.
As PE expands its geographic reach and deepens its activist approach to portfolio management, GPs will need to develop distinctive ways to create value in order to succeed. Five skills are paramount:
Will GPs that adapt their investment models to match today’s more tempered realities ultimately be able to crack the code for emerging market success? Certainly, there is a deep need for the role PE firms can play in spurring their growth while rewarding their investors. What remains to be seen is whether a repeatable model for success in emerging markets can put that capital to work productively.
Read the full report: Global Private Equity Report 2014
Written by Hugh MacArthur, Graham Elton, Bill Halloran and Suvir Varma, leaders of Bain & Company’s Private Equity Group.
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