November 9, 2015
Interviewed by: David Snow
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Myth Busting Emerging Markets PE

Harvard Business School Professor Josh Lerner discusses findings from new research into the performance of private equity in the emerging markets. Among them: minority stakes do not necessarily spell a disadvantage; PE affords better access than many public markets; and a good number of “global growth markets” will reach 2015 U.S. GDP levels within our lifetime.

Harvard Business School Professor Josh Lerner discusses findings from new research into the performance of private equity in the emerging markets. Among them: minority stakes do not necessarily spell a disadvantage; PE affords better access than many public markets; and a good number of “global growth markets” will reach 2015 U.S. GDP levels within our lifetime.

Myth-Busting Emerging Markets PE
With Professor Josh Lerner of Harvard Business School

David Snow, Privcap: Today, we’re joined by Josh Lerner of Harvard Business School. Josh, welcome to Privcap today. Thanks for being here.

Josh Lerner, Harvard Business School: Thanks for the invitation.

Snow: You are a long-time observer and student of the private equity asset class and you have done many different research papers that are very influential in this asset class. But you’ve been, naturally, busy lately on another topic, which is private equity in the emerging markets. I’d love to ask you about a few of your findings.

Why don’t we talk about where you felt further clarity was needed in the emerging markets? What mysteries were lingering over private equity in the emerging markets that justified this research report?

Lerner: I think when you look at the institutional investor, the limitedpartner community today, you see a spectrum. At one end, you have some people who are exceedingly sophisticated and knowledgeable about doing emerging-market investing. But, on the other hand, you see a large number of investors who may have a lot of money but are relatively new to the whole field of investing in emerging economies.

Particularly, I think it’s fair to say that among that set of investors, you see—probably induced by a lack of familiarity—a number of myths or misconceptions out there about the characteristics of here. And the kinds of topics that come up are what is, for instance, the ability to get out of these investments—a perception that there’s a bit of a Hotel California aspect where you can check in but never check out. [There are] concerns about the structures of these investments, particularly the heavy reliance on minority equity stakes, and certainly a sense, in many cases, that private equity in these emerging economies may be more trouble than it’s worth.

Snow: Why don’t we start with an interesting chart that you’ve put together that really sets the stage for what is at stake when talking about investing in the emerging markets?

Lerner: We wanted to really emphasize one of the crucial points…out there, which is why there is a potential for this class of investments to be attractive ones. And, certainly, when you reach down and drill down to it, one of the really critical things is the rate of growth in these economies. Now, we know these rates of growth have slowed in recent years, but we said, “Let’s look over the last few years—including some good years and some notsogood years”—and asked the question of “When are these economies going to catch up with the rate of GDP per capita that we see today in the U.S.?”

Essentially, what we did is look over the last five years. We looked at the rate at which those economies were growing, and then just extrapolated out and said, “How long will it take these economies to catch up with a level of wealth—the GDP per capita—we see in the U.S. today? And the answer was that it varies. Certainly, on the one extreme, we see South Korea, which in a matter of a dozen years—assuming the growth we’ve seen in the last five years continues—is likely to have caught up with today’s level of growth in the U.S. On the other end, we can look at a market like Colombia, where we’re talking more about a matter of several decades.

But the striking thing is that when we look going forward, not necessarily tomorrow or the year after, but when you look in the years and decades afterward, given the historical trends we’re seeing, we’re going to see some very dramatic accretion of wealth in these places.

Snow: One of the major findings of your research, and there were a number, but a really interesting one was that private equity affords access in the emerging markets to industries and types of companies that you just can’t get through the national public markets. Which is interesting, because I guess many investors probably feel that, “Gee, if I just put my money in an index fund that tracks the stock market,” that seems like a more liquid and comparable way to put money to work in that economy.

Lerner: When we drill down into the emerging economies, we see that it actually is quite a different picture. In particular, there seem to be two dimensions along which differences occur.

The first is size. When we look at the public markets, we see that in many countries—like Argentina and Colombia, for instance—the top few companies dominate the market capitalization. That’s really a few very large companies that dominate the public markets. Private equity is a much broader array of mid-sized companies, so there’s one differential in terms of size.

The other thing in is terms of the sector. When we look at many of the public-market indexes in emerging economies, we see them being dominated by very capital-intensive industries—natural resources, large banks and the like. When we turn to private equity, and we can look at this in a variety of ways from both consultants’ compilations as well as…the exits by private equity groups, we see a very different picture. It’s dominated in large part by industries geared toward, for instance, the consumer market, where many people feel there’s going to be spectacular growth over the next few decades as we see more and more people crossing over into the middle class.

So, you see a differentiation, not just in terms of the size of firm, but also the industry mix. In particular, it’s fair to say that, in many cases, it seems that private equity funds have focused in sectors that do look like particularly exciting ones.

Snow: This leads us to another interesting finding of your research, which is [that] it sounds like private equity is a great way to access the growth of the emerging markets. In fact, [it’s] possibly even a superior way, but isn’t emerging-markets investing characterized mainly by minority investments? And aren’t those bad things because you don’t have control and the risks are higher?

Lerner: It’s a great question. Again, I think it’s fair to say that if we put on things with our U.S. lens—historically, at least—private equity groups did control investment here and their portfolios were dominated by companies in which they had very large stakes and could really call the shots on the investments. So, it’s natural to ask the question about emerging-market private equity, where so many of the investments are minority transactions. Isn’t it the case that they’re missing many of the benefits of the kind of investment style we seeing in the U.S. and Western Europe?

But, when you actually get into the data, one sees a somewhat different story. Certainly, whether you look at the track record of very seasoned emerging-market investors like the international finance corporation, or you look at the exits of private equity investments more generally, it appears that minority investments do as well as majority investments. It seems that, despite not having the controlling stake that we might think is almost a requirement for successful private equity investing, it turns out that groups can still do very well.

I think we can offer various explanations for it. Certainly, one possibility is that, given the attitudes of entrepreneurs, there is a greater willingness of investors to sell minority stakes. So that if you come in demanding a majority stake, there is a bit of an adverse selection problem at work. But, whatever the reason, one sees a very consistent pattern where it seems that, in emerging economies, both majority and minority stakes can yield attractive returns.

Snow: I think investors are obviously attracted to private equity in the emerging markets where they see the opportunity to outperform similar investments in the west in more developed private equity markets. How have returns done in emerging-markets private equity relative to where LPs could otherwise put their capital to work in the west?

Lerner: I think this certainly gets at one of the big challenges, which is that if you look at the historical data over the last decade, for instance, you clearly would have had higher returns investing in the U.S. or Western European markets than you would in most of the emerging economies. On the other hand, it’s a bit more complex than that, because there are really two additional considerations one might want to throw in which might muddy the waters in terms of this comparison.

First, you have the issue that if we look at public stock markets, it’s also the case that the public markets—particularly in the U.S.—have really outperformed. And, if you pose the calculation as, “Let’s not look at the absolute returns, but at the returns relative to that in the public stock markets,” it can actually look quite different. In many respects, emerging-market private equity may be the more attractive of the two.

The second thing that at least gives some food for thought, if nothing else, is that in some sense, when we look at the history of private equity returns in most developed economies—the U.S. and much of UK, much of Western Europe—we see that there was a long period in the wilderness where returns were relatively disappointing. And it took a while for both the general partners and the limited partners to reach the level of sophistication where it seems they got the machine humming and the returns to be attractive.

One of the interesting questions to ask is—as you look at returns from emerging economies over the last decade, should we be comparing it to those of the U.S. during the 2000s? Or, maybe we should be comparing it to the U.S. over the 1970s, when it was still a very immature industry. I think we certainly see one pattern in terms of absolute returns that we have to acknowledge. On the other end, how you interpret what that means for the future is still very much an open question.

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