December 1, 2011
Interviewed by: David Snow
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Emerging Markets Value Creation

“The best way to gain exposure to the emerging markets is by direct investment, by private investment,” according to veteran emerging markets investor David Creighton, one of three experts in a Privcap conversation about value creation in the emerging markets. Moderated by Privcap’s David Snow, the first of a three-part series includes Jeff Bunder of EY; David Creighton of Cordiant Capital; and Rob Petty of Clearwater Capital Partners.

“The best way to gain exposure to the emerging markets is by direct investment, by private investment,” according to veteran emerging markets investor David Creighton, one of three experts in a Privcap conversation about value creation in the emerging markets. Moderated by Privcap’s David Snow, the first of a three-part series includes Jeff Bunder of EY; David Creighton of Cordiant Capital; and Rob Petty of Clearwater Capital Partners.

David Snow, Privcap: Hello and welcome to Privcap.  I’m David Snow, founder of Privcap.  Privcap brings you smart conversations about private capital.

Today, we have a very important topic: Value Creation in the Emerging Markets Private Equity.  Today’s conversation will give you an overview of the value creation strategies in emerging markets, what tools are available to general partners, and what challenges do they face.

We are joined by a panel of experts.  We have with us Jeff Bunder from Ernst & Young, David Creighton President and CEO of Cordiant Capital, Robert Petty Co-founder and Managing Partner of Clearwater Capital Partners.

This program is sponsored by EY.

First of all, welcome.  Thank you for joining us at Privcap today.  We’re talking about creating value in the emerging markets.  Now, private equity is a difficult business no matter where you go, but in the developing economies and in the emerging markets there are some added layers of complexity.  So starting with Rob, you’re based in Hong Kong and you invest across Asia.  Private equity is hard.  What is additionally complex or additionally difficult about investing in an emerging markets context?

Robert Petty: Asia is a big place and the first thing I would say is that part of it is emerging and frankly part of it is emerged.  One of the interesting dichotomies or dimensions of that is thinking about, say, India and China’s, two obvious examples.  Even within those economies there are emerged parts and there are emerging parts.  That’s more clear when you step into the Vietnams and the Indonesians of the world of emerging markets.  I think it’s also just to recognize and step back and think about language, law, currency.

Those three things you can’t simplify in investing.  But you have to address each one of those three elements as you address investing in emerging, or even if they’re emerged, capital-controlled economies- the currency part, the law- what is the bankruptcy code, what is the process, and then the language- all that it takes to due diligence, to use one simple example.  How do you actually practice that in the local language?  So, you’re absolutely right.  It’s harder, but that’s part of the opportunity.  It makes it competitively interesting when fewer people can actually do that and practice that as we’ve all built teams to address that.  But it also means it’s what is really hard about it.  It’s why you have teams that, in our case 75 people large, across these economies.  It takes people to be able to sort of tackle those three components, as I try to simplify, what it means to go into emerging markets.

Snow: David, your firm Cordiant has investments and has people around the world, so you really invest across the emerging markets.  What have you found to be a commonality as far as the added layer of complexity or the added layer of difficulty in making private equity work in an emerging markets context?

David Creighton, Cordiant Capital: Well, perhaps along the lines of what Rob was just saying, foreign exchange is obviously the big one.  And oddly enough, in all my experience in sitting through investment committee meetings and looking at proposals, while we tear apart individual companies that we’re considering investing in and looking for that sort of half point of IRR and so on.  The foreign exchange numbers are sort of, well, this is what the authorities are expecting over the next 5 or 10 years, so we’re just going to plug that in.  When, in fact, the volatility of that number is substantially higher than the rest of the value drivers that you’re considering.  So, I continue to focus on foreign exchange as being one of the key things

With that in mind, with those countries where we see foreign exchange as being a particular issue from a devaluation perspective, we will look at businesses that will be able to generate some sort of a link to hard currency so that you’re insulating that major risk.  But that’s not always the case.  Looking across all of the emerging markets, probably the main reason that we’re involved in this business is because it is so fascinating.  You’ve got such a broad range of mentalities and styles.  And I think that’s one of the real impediments that Western investors have of going into the emerging markets because it is just so vast.  There are different religions and different ways of doing business and some people work on Fridays and some people don’t and all of these different things that a lot of people just can’t get their heads wrapped around.  But this is what makes this whole business fascinating.  It’s what keeps us involved and allows us to differentiate between what we are doing versus what is happening in say, North America or Western Europe.

Snow: Jeff your firm Ernst & Young has private equity clients in the developed markets as well as in the emerging markets.  What are some of the added challenges that you find that your clients face in the emerging markets as they try to add value to their portfolio companies?

Jeffrey Bunder, Ernst & Young: I think from the outset a lot of these investments are minority interest.  You’re sort of automatically coming into a situation where not only does your client not have control, but it’s pretty clear from the amount of work you can do in diligence, that it’s in their favor, if you will.  And it’s pretty clear from the outside that you have to work alongside management.  So in other situations, maybe in a developed situation where it is intermediated with an investment bank and it is controlled situation you can certainly get more aggressive in terms of getting information and drilling down from a diligence standpoint.  It’s much more challenging in emerging markets where this represents a minority interest and a partner.  And our clients are sensitive to that from the outset.  So that doesn’t mean that we don’t do our work and we have local teams there that know the culture and know how to do business on the ground.  But clearly, you’re seemingly at a disadvantage from the outset in terms of doing the amount of diligence you would like to do or the amount of diligence we do in a developed market situation.

Best Practices Meets Emerging Markets

Snow: Rob or David, picking up on what Jeff said, on the one hand there are more minority investments in emerging markets as far as private equity is concerned and on the other hand there may be less familiarity with private equity as someone who might sit on your board or be an investor.  So that’s sort of a double challenge.  How do you deal with that?

Petty: I would just sort of temper that statement and say that absolutely there are challenges, but I think that Asia, as the most emerged of the emerging economies, really has a not insubstantial track record today of really addressing corporate governance.  And we shouldn’t forget that.  I think often coming from the Western world, we assume what best practices are and I think there are actually some outstanding practices in some of these economies.  It doesn’t mean there aren’t troubles.  It doesn’t mean it isn’t difficult.  Certainly there are things to improve and we spend our time on that, but I would just go across Asia quickly and simplistically say that every single country in Asia changed their bankruptcy code after the Asian financial crisis in 1997.  So that’s 12 years of new bankruptcy codes.

A good lawyer will tell you, ‘What’s on practice and what’s on paper?’  You can go through many of these jurisdictions and actually find some pretty darn good practices.  The second component, which is probably the most compelling component, to think about this and to answer your question- if you’re sitting on a board, there are robust public equity markets in Asia that are now not just invested by foreign capital but have been invested by domestic capital.  So if you look at India, you look at Hong Kong, to use two simple examples, those domestic equity markets’ board members are not just Western asset managers any longer, but they’re locals.  Therefore, we are all aligned as fellow shareholders of this business to build the business.  Now, that’s the good news.

But, we’re not blind to the fact that actually executing and making sure you have that alignment is an important component of what we do.  And one of the first things we’ll do is make sure it’s a deal killer if we can’t walk in the door and make sure we’re going to get a big foreign.  E&Y is at the top of the list in terms of who we’re actually bringing in.  You’ve got to make sure you’re playing by the best of class rules.  You expect those standards and you demand those standards.

And to take the other obvious example, you work with the family who is management and teach them to be owners.  And it is a simplistic example of what we do, but very often we have multiple family members on a public company board and it’s about making sure that the family takes the step back and learns the differentiation between what it is to be an owner and what it is to be a manager and sitting on the board.  Those are some of the things we think about when we look at those investments.

Snow: David, is that your experience or does it range as far as the amount of attention you need to give to companies based on which economy they are in or the level of development in that economy?

Creighton: First of all, a lot of the opportunity is in engaging with families and dealing with succession planning and these sorts of things.  In Brazil, where you have an excellent stock market and you’ve also got a number of multigenerational family businesses that are huge.  I’ve sat down with some that have never had an audit.  And they’re sort of sitting here as the third generation and it’s a cash machine, but they all recognize the fact that maybe the economy is changing from primarily a debt business, a debt economy into an equity economy.  You’ve got the stock market and there are valuations and stuff like that.  So there is an opportunity for these guys to be able to tidy themselves up, get an audit, scrub themselves down, pull away some of the non-arm’s length relationships that are embedded within the company, and then bring it to the market.  So that’s a real opportunity.

But interestingly also, as much as that is an opportunity, it is also a massive challenge.  I don’t know, Rob, what you’re experience has been, but sitting down with family businesses and talking to them as I just have about the opportunity and they say, “This is it. This is what makes sense.”  They talk amongst themselves and they say, “We’d like to do this.”  Getting them to actually follow through, we find, can sometimes be a challenge because that company is their life.  That is their family.  And when you come in and starting saying, “Well, okay these are the things you have to do.”  All of a sudden, there tends to be some reluctance.   And it’s very difficult, but you just have to be considerate of that when you’re going into it because it’s just a pattern that we’ve seen over and over again.

The Benefits of the PE Model

Snow:  I’ve heard an argument that I think is very interesting and I’d like to ask you all about it.  Maybe we can start with Jeff.  In the emerging markets, the private equity form ownership, the private equity form of corporate governance is even more appropriate than in the developed markets where you have the super structure of regulation and of best practice around public ownership, whereas in the emerging markets there are so many benefits from the closely held form of ownership.  I’m wondering, Jeff, if you agree with that or if you’ve seen that shown to be true.

Bunder:  Yes.  I think that we typically, in the developed countries, if a family-owned business or the like needs to raise capital, they go out and it’s a pretty easy exercise, relatively, depending on the business.  I think in the emerging markets it is much more of a challenge.  I think to your point, private equity can bring value along with capital and what we see is in some situations is that families are interested in taking the next step.  That may be just institutionalizing the company- putting in the finance team, putting some financial discipline or rigor around financial reporting or internal controls.  Or it could be creating a more developed sales force, more focus, to bring value in that way.  I think you look at it and say that private equity, you can use the term ‘activist,’ not managing the business but are certainly there with a broad base of experience to be able to sort of help a company as it looks to grows to the next level or expand geographically.   I think private equity’s got a nice model in place to be able to do that with a time frame that is often consistent with some of the families or private businesses in terms of where they want to evolve to and potentially realize some value.

Snow: David or Rob, do you agree that private equity is particularly well suited for emerging markets or the recently emerged markets?

Creighton: Absolutely.  It’s all about engagement and as much as we agree that in certain countries the public markets are transparent and have certain governance structures that you can count on, by and large, I think the best way to gain exposure to the emerging markets is by direct investment, private investment.  That’s a real problem because a lot of people, when they start thinking about going into the emerging markets, they’ll go into the public markets.  They just figure that the Lagos stock exchange has the same requirements of its listed companies as the SEC or some of the others, but they don’t.  Let’s be honest.  That’s where you can run into some real troubles.

Where you have direct engagement, where you are working with management, whether it is through sitting on the board or covenants, what have you, you’re very much involved in the day-to-day activity.  With some controls of the business, there you are able to drive some returns.  And what you’re also doing is you understand what the risks are and you can manage those risks a lot better than you can in the public markets.

Petty: Maybe another way to think about this, and I would agree with my colleagues here, that private equity totally makes sense in these businesses.  And maybe one common theme, certainly across Asia where we’re doing our investing, is in the scale of the business.  What are we really talking about?  We’re talking about a massively, rapidly growing economy and growing businesses that really need transitional capital before they are really ready to be public companies.  And we’ve seen, as you rightly said David, that companies that have gone public that really weren’t perhaps ready for primetime.  Private equity has, in successful cases, done that family transition step of teaching the finance department, as I always highlight, what it takes to be a quarterly reporter.  What does it take to sit down and prepare for your board- not just the legal documents and many of these jurisdictions you get the legally required, to use India as an example, what are the legal requirements of the board.  What is your financial reporting like?  Again, the well-used euphemism, data- I don’t want data.  I want information.

And the businesses and the CFOs, the departments, and the reporting departments, really are just inexperienced in that.  Not that they can’t do it.  That transition period, call it the 4 to 8 year evolution, to then become a public company, transition from a family, from a manager to an owner, finance department from data to information, when done well.  And it’s hard.  It’s hard to be a minority and it’s hard to sort of do that positive influence.  That is the goal and the success stories.

Needless to say, there are difficulties, as you said.  And the way we try to address those difficulties is more through debt.  So we’ll structure our investments to be able to make the most of our returns through debt interest payments, so there’s a contractual component to it.  Then as the enterprise value and they pay down your debt, then you’re making equity kickers and that perhaps aligns us a little bit more with that cash flow motivation.  Again, private equity entirely makes sense for that transition of what are probably younger companies in most of these markets.

Tools for Effecting Change

Snow: David, you said something earlier interesting, which is actually investing privately in the emerging markets can be argued to be a more attractive way to participate in the growth in emerging markets.  But from an investor’s prospective, from an LPs perspective, now it really matters who you’re investing with.  So imagining yourself as LPs or giving advice to LPs, what should you look for in private equity firms that would demonstrate an ability to actually go into some of these businesses, many of which are family owned, many of which maybe haven’t had external owners before, and bring the tools out that can actually effect change as opposed to mere window dressing?  As an investor, what would you look for?  Maybe starting with David.

Creighton: It’s a very simple answer, but it’s track record and experience.  You can drill down on that.  It’s empathy and it’s having stubbed your toe and number of times and learning from that.  But it’s really the ability to get in there, roll up your sleeves, understand what the risks are, be able to manage those risks, and to be able to walk away if you feel as though you can’t.  One of the challenges that you have in private equity in particular and some of the hotter markets is people are going to raise money from their LPs and they’re finding that they’re in competition to get deals in their books.  All of a sudden the dynamic completely changes where you’ve got pressure from the LPs to invest and you’ve got this deepening J-Curve effect that’s going on.  So you just need to able to go out and get assets in the book.  And to be perfectly honest, humans are pretty lazy.

So if they are looking at a particular deal and they’re in competition and there are some big names that are also in there bidding at the same time, then they will kind of say, ‘Well, if they are looking at the same businesses, they’ve done their due diligence, they’re even bigger than we are, so we are, therefore, comfortable with it and we are, therefore, going to try to beat them.’  And there is this dynamic that happens, which I think is actually sort of a negative spiral.  Which is why, going into the big economies, you really want to be able to generate your own deals.  You don’t want to be sitting there just doing things at auction because you’re just going to find yourself in that difficult situation.

Snow: Rob, looking at things from the LPs perspective, what should be in the toolkit of a GP who’s in economies ranging from not developed to recently developed?

Petty: I think David did a good job of saying it could be relatively simple, but it’s actually hard to find teams that have done it.  It is team and track record, really.  I would go back to those three tools that we always think about.  How do you address local law?  How do you address local languages?  How do you address local currency?  And that means, essentially, do you have two to four to six people in that jurisdiction who have done it?  And then you start building that out.  So it does take I would say, from an LPs perspective, scale to business, scale of a GP level business and real time of wins and losses- good old lessons learned.  There’s a reason LPs ask that question all the time because there really are lessons learned.  I think that’s easy to say and probably hard to create in emerging markets where you actually need to have multiple teams and yet you need to pull those teams together across multiple geographies.  Team and track record.

Snow: You can’t just fly in from New York and stay for a couple days and fly back and get the job done?

Petty:  I think the fly-in and fly-out team thesis has been proven and disproven.  I think that there’s been a decade now of disproving that thesis with the exception of the large, global businesses that happen to be based somewhere.

Snow: Jeff, what to you distinguishes a private equity firm that is able to go into an economy that is perhaps not as developed and bring about change and be able to bring more than capital to an investment thesis?

Bunder: What’s interesting is, it’s almost like the developed markets, in terms of the bigger funds, have evolved to become pretty specialized shops, particularly around operations. So there’s quite a bit of focus about operational improvement.  I don’t think that’s transferable to the emerging markets.  I think you’ll still have some basics that have to get covered, so you almost have to shift it back to how can we help this company get around producing financial statements.  Or at least identifying where the data source is then using that data to then provide reporting and financial information, so you can make key decisions.  I think the growth part is sort of there.  So I think from a developed standpoint, there is a lot of focus on operationally improving the business because the growth is largely not in the developed economies.

You have to do things better, you have to be more efficient- that’s the way you’re going to capitalize, possibly expanding that developed business into the emerging markets.  But from a pure investment into the emerging markets, you tend to look at it as a growth story.  How do we take a company that doesn’t have a tradition of corporate governance and financial discipline?  How do we take that to a medium level from a PE perspective that meets the needs of the PE firm to help manage the business?  I think there are different skills required and as we talked about, you need local teams to be able to do that.  This isn’t about receiving email, the actual spreadsheets, go through it, then flying down to have a meeting and come back.  This is hands-on coaching and training and getting people accustomed to how you manage a business for the next level, of the evolution of the business.

Snow:  Well, this is a fascinating conversation.  We are going to pause here.  Gentlemen, thank you very much.

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