April 1, 2012
Interviewed by: David Snow
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Emerging in the Portfolio

It is hard to find investors today who don’t want increased exposure to the emerging markets. But what’s the right way to allocate to emerging markets private equity?

Privcap’s “Emerging in the Portfolio” is the first of three expert discussions exploring how institutional investors are assessing emerging markets private capital opportunities and structuring programs to capture expected growth in these economies. Our panel includes David Marchick of The Carlyle Group, Maureen Downey of Pantheon Ventures, and Peter Furci of Debevoise & Plimpton.

It is hard to find investors today who don’t want increased exposure to the emerging markets. But what’s the right way to allocate to emerging markets private equity?

Privcap’s “Emerging in the Portfolio” is the first of three expert discussions exploring how institutional investors are assessing emerging markets private capital opportunities and structuring programs to capture expected growth in these economies. Our panel includes David Marchick of The Carlyle Group, Maureen Downey of Pantheon Ventures, and Peter Furci of Debevoise & Plimpton.

David Snow, Privcap: We are joined today by David Marchick of The Carlyle Group, Maureen Downey with Pantheon Ventures, and Peter Furci of Debevoise & Plimpton. Welcome, everyone, to Privcap today. Thank you for joining us.

We are talking about the emerging markets, but specifically the roll that emerging markets has played in institutional portfolios, and in our case, it’s the private equity side of the emerging markets. I’m fascinated to hear from all of you, what you’ve been seeing recently, and certainly being able to compare that with 10 years ago when emerging markets was not such a big topic.

So starting with David. Right now, emerging markets are on everyone’s minds, and everyone wants emerging markets in the portfolio in, it seems, greater and greater doses. But this wasn’t always the case, right? Can you talk about how things were 10 years ago, and sort of the degree to which investors wanted emerging markets in their portfolio, and why you think that things have changed?

David Marchick, Carlyle Group: Sure. 10 years ago, private equity was really very, very new in emerging markets. Very few firms were present in China, in India, in other emerging markets. Over the last 10, 12 years, there’s been a significant increase in the exposure for private equity firms. That’s really been driven by LPs. LPs have wanted more exposure for emerging markets. Emerging markets are growing much faster than the developed world.

This year, for example, emerging markets will probably contribute about 40% of global growth compared to overall GDP. Investors tend to still be underallocated. I’ll give you one data point. Overall, emerging market stock markets account for about 17% of global equity markets, but Western LPs– Western, large, institutional investors– only have about 5% exposure. So it’s a growing market, there’s still underallocation, and most of the major firms are increasing their presence in emerging markets.

Snow: How do you see the emerging markets demand from investors evolving? How has it evolved recently?

Maureen Downey, Pantheon Ventures: I looked at a recent study and it looked at– in terms of the amount of money that was contributed to emerging markets out of a PE portfolio, was about 8% in 2006, and by 2010, that’s gone up to about 16%, so it’s doubled. I think what’s largely driving that is one, the desire for LPs to have growth in their portfolio. The fact that, as David mentioned, there’s just a tremendous amount of growth in the emerging markets. Largely, that’s really driven by the rise in the middle class. And people can see that.

Whether you’re talking about Asia, or India, or Latin America, you have this incredible growth that’s taking place in the middle class. As these consumers become wealthier, they continue to consume. That’s really driving, I think, the attraction in the emerging markets. So people are seeing that now, and I think it’s definitely put into greater perspective, just given the slow growth that we’re seeing now in the developed markets.

Snow: Peter, you’re someone who’s been involved in a lot of fundraising and a lot of deals in the emerging markets. What do you see as being particularly striking about the interest from investors today, versus maybe 10 years ago?

Peter Furci, Debevoise & Plimpton: One of the things is that investors are much more sophisticated than they used to be. We’re typically on the sponsor side, and when we negotiate with investors, they’re coming in and they’re not just asking about the team, and the track record, and the usual boilerplate-type provisions. But they really want to understand the country dynamics, they want to understand the types of investments, exit horizons, what are the liquidity opportunities? So you’re dealing with people who are much more savvy about the particular markets, and how those market dynamics are to influence the terms of the investment.

Snow: Maureen, you mentioned the growth of the middle class as being a driver, something that’s gotten the attention of investors. Is that one among several common theses for why investors want or think they want more emerging markets in the portfolio? So, what is the analysis behind, “Gee, I think we need more of this.”

Downey: I think the rise of the middle class is, frankly, the biggest driver in the growth in emerging markets. As individual consumers become wealthier, they want to consume more. This kind of disparage between supply and demand, and the convergence, is what’s really propelling the growth. We don’t see that abating anytime soon. Because if you look at– right now, I think in India, 6% of the population is in the middle class, technically. I think by 2025, they estimate that will be 46%. So that is an eight-fold time increase. I mean, that’s essentially, more or less– if you look at the population in India being 1.3 billion– that’s about 400 million people coming into the middle class. That’s a huge number of consumers. And that’s just India.

So we think that these people becoming wealthier, being able to purchase more goods, is really going to be the big driver. So, I don’t see that stopping and I also see that many of these people, when they come into the middle class, will also move into cities. And that’s another big factor, urbanization. So when we think, basically, what makes emerging markets attractive, it’s really this rise in the middle class.

Snow: David, as you speak to investors from your perch at The Carlyle Group, is that what you’re hearing? What kinds of reasons are you hearing for why they’re interested in moving into certain markets that perhaps some of these investors have not previously been in, or at least been in in a significant way?

Marchick: Well, they want attractive returns. If the emerging markets are growing faster, then they start at a higher level in terms of potential returns. Private equity investors try to find companies that are growing even faster than GDP. If a good private equity firm can find a company that’s growing twice or three times as fast as GDP, and GDP in China or India is growing twice or three times the pace of the US or Europe, then an investment has a good chance of doing well.

As was mentioned, the growth of the middle class not only creates a very strong consumer-driven demand, it also creates stability in these countries. It’s stabilizing. It anchors institutions. It creates pressure for more institutionalization and greater entrepreneurship in those countries. We’re seeing this across the board in emerging markets. Not only in China, India, but Brazil, and other parts of Latin America, and now even Africa, where sub-Saharan Africa is a very, very attractive, fast-growing market. It’s growing faster than any region except for India and China. You’re seeing the middle class grow, and that’s brought stability, fewer conflicts, and greater pressure on governments to essentially get their acts together.

Snow: I’m glad you mentioned stability, because I think– even today, but certainly 10 years ago– maybe the next term you would hear after someone said the term emerging markets was risk. So, a lot of investors would say, “Well, gee. Those sound like risky markets. We should probably be paid– or we should expect much higher returns, in exchange for our venturing into some of these regions.” What’s the right way to think about risk in today’s more developed set of emerging markets, from an investor’s point of view?

Furci: Well, I think first of all, you can’t really generalize about risk in emerging markets as a totality. I think you have to look at each region on a case-by-case basis. If you take Brazil, for example, there is a country where the challenges are very well known. The absence of infrastructure, the need to alleviate some of the high costs of doing business there. But from a general political and fiscal stability point of view, it’s a very attractive jurisdiction in which to invest.

India, same thing. You’re dealing with a democracy. It’s a bit of a disorderly democracy at times, but it is clearly a democracy. It does have established laws and institutions. China, a little bit of a different story. I think it may not get the highest marks on transparency. At the same time, you have a government that is very committed to making sure that investments are made and that growth continues. In some sense, even though there’s some worry that that economy could slow down at times, because their investment model may not be fully sustainable, I think people are less worried about country risk.

When you get into things like Middle East/North Africa, obviously prior to the Arab Spring, I think Middle East/North Africa was considered to be definitely the next phase of private equity, along with sub-Saharan. I think that there’s been a sense that people are a little bit more skittish about it. The reality is you can’t really know what’s going to happen in some of these jurisdictions, and you have to be prepared to take a bit of that risk. But I think for the places that have had the most private equity penetration, it’s really more about economic fundamentals, and less about political and those types of risks.

Downey: I think risks are very different across each region, and I think they’re different from, say, developed markets. So when you construct a portfolio of investments through the global emerging markets, I think that collection of different risks gives you, I think, sufficient diversification.

It’s really interesting, I saw a study done not so long ago, where they put on a graph all the different countries. On one axis was your ability to pay, which was obviously the revenues coming from the country, but also the country’s flexibility in terms of political system. Then on the bottom axis was, essentially, the debt per person. It was interesting to note that, with the exception of Hong Kong, the countries that had the best ability to pay and the lowest level of debt were the emerging market countries. The countries with the worst ability to pay were actually most of the developed market, larger developed market countries.

So I think there’s this perception that emerging markets are always so much more risky. I wouldn’t say they’re more risky, I think there’s just different risks. When you look at the debt per person, or even the debt as a function of GDP, it’s actually quite a bit lower in emerging market countries. There’s just different risks. There’s a risk that you have infrastructure. People assume that there’s going to be all this great growth in emerging markets. Well, yes, that could be the case, but you also have to assume that there will be sufficient investment in infrastructure so that growth can continue.

One of the big issues in Brazil, that’s noted besides the infrastructure issue, is education. You have to be able to hire people to run these private companies, and I think that’s been a concern. But if you look at that relative to, say, Eastern Europe, there, Eastern Europe has benefited from 20 years of infrastructure investment from Western Europe. Maybe the growth isn’t as strong as it is, say, in China, or India, or Brazil, but you also have a really high education component in Eastern Europe. So I think that you just have to understand the different risks in each region.

Marchick: The only thing I would add is you have to look at it on a deal-by-deal, transaction-by-transaction basis. So you start with the premise that you have faster growing environments than in the Western world. But then, in particular deals, you have to ask, well, what is it that we’re going to do to add value? How can we create a better company? How can we help them professionalize? How can we help strengthen their finance function?

In China, the biggest challenges are brands, access to international markets, their financial function, the sophistication of their CFO, the sophistication of their accounting staff, corporate governance. If you can help create value in those areas, then you’re actually potentially facing a situation with lower risk than in the Western world or in developed countries, because you can identify the delta of where you can add value.

Many countries, and many companies in developing countries, they don’t need capital. They need access to expertise. There are plenty of sources of capital from banks or other forms of financial institutions. What private equity can do is find ways to create a delta, in terms of adding real value, adding operational expertise, adding management strength, and helping them become global companies.

Downey: Another point I’d also raise, and I think it was touched upon earlier– when you want to access this emerging market growth, you can do it in the public markets. But as you mentioned, the public markets actually don’t represent a lot, in terms of overall market capitalization. I think even more importantly, if you look at the companies that you can invest in in the emerging market exchanges, many of them are financial, commodity-oriented, or oil-related. They don’t actually represent the fastest growing segments of the economy, like for instance, consumer or retail.

So we actually did an analysis, where we said, “OK. Let’s take a look at the Bovespa, let’s take a look at the sector breakdown as a percentage, and then let’s take a look at the GDP of the country.” You see there’s a really big mismatch. So if you want to access, sometimes, the highest growth areas of economies, you’re better off doing it through private equity than you are actually doing it on the exchanges.

In addition to that, let’s use the Bovespa for example. There’s probably five companies that make up 50% of the market capitalization. Within those companies, there’s not very much liquidity or turnover. So when someone asks me, well, I’ll just do the emerging markets through the public markets, I’m like, wait a minute. You may not get access to the sectors that are actually growing the highest. Two, you may be able to only invest in a handful of companies that are more commodity-oriented. Then I would say also, there’s what, 470 companies on the Bovespa, but there’s probably 30,000, 40,000, 50,000 companies that are private in Brazil, that are really in need of capital, because they’re still at the stage to have nascent capital markets. So I think that, to me, is a very compelling argument for the case for private equity in emerging markets over public.

Furci: I think that that’s made very clear about your point about the Bovespa. If you look at Petrobras, which is just such a huge weighting in the Bovespa. You know, there are real questions about whether it can really achieve the profit margins that it should if it were a completely privately-operated company. It’s really very much subject to the whims of the Brazilian government at times–

Downey: Which owns 62% of it.

Furci: Right and by contrast, private equity has a very strong interest in the oil and gas supply chain around Petrobras. Because if you say, well, look. If it’s going to cost $300 billion over the next two to three years to start to build up the deep water opportunity, it’s really that fragmented supply chain that presents the most opportunities, not an investment in Petrobras itself.

Downey: I absolutely agree with you.

Snow: Big topic, which is the way to allocate to private equity, emerging markets private equity. It’s one thing to say, yes, I would like to enjoy the growth of the middle class in the emerging markets, but it’s another thing to look at your institutional portfolio, and then look within your private equity allocation and say, OK, therefore it needs to be X%. Perhaps starting with Maureen as a professional allocator, what is the right way for an investor to think about getting emerging markets into the private equity portfolio?

Downey: Sure. We do come up with what we would call a thematic view of the macro landscape, globally, every two to three years. On that basis we say where we think there will be more opportunities. We break it down really between Europe, US, and I would say Asia and the other emerging markets. Right now, I think we’re targeting about a 20% allocation in a private equity portfolio to the emerging markets, which would include Asia.

Then once you take a look then, within the emerging market allocation, we look across the different regions. China, Southeast Asia, India, LatAm, Central-Eastern Europe, as well as Africa, too, because I do agree that Africa presents a really interesting opportunity. Then it’s a combination of saying, OK, where do we see there to be talented GPs? Are they going to be fundraising in the next one to three years? Then, secondly, where do we see some of the very attractive macro conditions?

I’ll give an example of an area where we think there are many attractive GPs there, but we didn’t actually pursue, for instance, an investment– is Turkey. There are many very attractive aspects of Turkey, but one of the issues that Turkey is facing right now is their current account issue. So that would be a thing where we’ve looked at the country, we liked it quite a bit, but we decided not to make an investment, even though there are some very attractive GPs there.

So it’s the combination of finding– one, what do we think are the macroeconomic themes across the emerging markets? Then trying to marry them with what we think or what we see as attractive managers of fundraising within that period.

Snow: Well, it gets tricky, right? Because even if someone invested in a Carlyle European fund, a substantial portion of the revenue within that portfolio could be as a result of the growth in the emerging markets, right? So then that kind of adds a lot of nuance to how you think about getting into the emerging markets, right?

Downey: Well, we look at that, frankly– when we make investments, both on the primary side and on the secondary side, we make a number of investments in Australia, because we like the fact that Australia reflects a lot of the growth in China. I would also say, there are a number of companies that we’ve invested in that have a lot of exposure to the emerging markets through funds that may be located in Europe, or maybe even in the US, and this is something that we definitely take into account.

Furci: I think it’s also fair to say that emerging market targets have exposure to other emerging markets. For example, an investment in agribusiness in Brazil, where the primary customer may be located in China, you really have dual country exposure in an investment like that.

Downey: One other thing I think that’s important, though, when you’re constructing an emerging market portfolio is to look at the stage mix. That’s a little bit more– I would say it’s a little bit less complex in emerging markets, because you don’t have the diversity. For instance, if you were investing in the US, where you have everything from seed stage to large buy-out, but in some of the more developed emerging markets– say, China or India– you do have the ability to pick large buyout, growth, late stage venture. That composition, and how you construct your portfolio between the different types of managers investing in different stages– sectors, it’s a little bit less so. But I think that’s also an important thing. So not only are you looking at across regions, but you’re also looking at different types of managers within a particular region.

Snow: One final question, and maybe we could start with Peter on this. But to what extent, when investors are thinking of investing in an emerging market’s fund, are they still spending a lot of time on due diligence into the political regime of the country or the region, the macroeconomic trends, things that are beyond the control of the managers of the private equity fund?

Furci: I think most investors are coming to those funds already being generally familiar with the overall situation, in that they’re really looking for a top quality management team that’s going to enable them to access that market with which they’ve already developed some threshold level of comfort and familiarity.

The one thing I will say is that investors who familiarize themselves with some of the key issues– like, for example, in some of the Brazil fundraisings we did, investors came to the table already having some– I don’t want to say concerns, but at least thoughts about currency movements and inflation. That influenced a number of the negotiations that we had with those investors. So it’s not so much that they need to get up to speed on the macroeconomic picture– they’re showing up with some thoughts in mind– but that their thoughts on those issues definitely influence the fund negotiations.

Snow: One quick question for David, since you mentioned that Carlyle is now forming a serious team in Africa, and that’s your newest geographic region. Are you getting the kinds of questions about Africa that maybe you would have gotten about India 10 years ago? Like, well, gee, what countries? And is anyone going to get kidnapped? Questions that are more, someone who’s never thought about investing in Africa is now thinking about it with your firm.

Marchick: It really matters where the investors are coming from. If they’re coming from the region, we tend not to get those questions, because people in the region are familiar with, essentially, the Renaissance that’s taken place in Africa, with a lower number of conflicts, with the democratization of many countries, with the stability of the middle class. In the West, I would say in the United States, you’re still getting a lot of questions about, well, how do you differentiate between particular countries? Which countries may have conflicts? Which countries present the most attractive opportunities? And how are you going to allocate?

Investors do want a mix of larger countries, smaller countries, Western Africa, Eastern Africa, local companies, and Pan-African countries. And a good firm, a good team will be able to provide all those opportunities for investors.

Downey: One final thing I’d say is that we have a lot of investors, in particular in Northern Europe, who are very focused on ESG risk. So it’s something that we spend a lot of time on. One, thinking about when we make our investments, but also working with the GPs to institute more robust monitoring, so that we’re able to report back to our investors who take it very, very seriously– sometimes more seriously than actually the returns. And so I think that’s another component that plays a big factor.

Snow: Well, this is a fascinating topic. We will be talking about it further, but I think for now we should pause. So thank you very much for being on Privcap today.

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