Briefing: Investor Capital in Emerging Markets

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1 Briefing: Investor Capital in Emerging Markets Table of Contents / Introductory Note 2 Expert Takeaways: Investor Capital in Emerging Markets 3 An executive summary of the Privcap series featuring three experts Q&A With Philip Bass, Ernst & Young 7 Sponsored by Q3 2012

2 INTRODUCTORY NOTE / Investors Want More Emerging Markets The numbers tell the story: emerging markets are in full bloom. The amount of private equity devoted to emerging markets has doubled since And a recent survey by the Emerging Markets Private Equity Association shows that three-quarters of investors plan to increase their allocations to emerging markets over the next two years. Several factors are driving this trend. Growth in emerging markets is accelerating, as the middle class in these markets rapidly expands. LPs are now well aware that emerging markets hold high potential for success, often much higher potential than established Western markets. And today s more sophisticated LPs are more comfortable sending their money to the far corners of the world. As you ll learn from the expert contributors to this Privcap Briefing, investment in emerging markets is a complex proposition with an array of challenges unique to each country. Venturing into these markets and bringing back returns demands exacting risk assessment, careful selection and nurturing of local GPs, and meticulously constructed terms to assure self-protection. I hope this report is of interest, whether you re a private equity professional or a limited partner who wants to learn more about the vast opportunity emerging markets hold for investors. I know you ll be enlightened by the thoughts of the three experts in this Privcap discussion: David Marchick, managing director at the Carlyle Group, Maureen Downey, principal at Pantheon Ventures, and Peter Furci, partner at Debevoise & Plimpton. Enjoy the Briefing, David Snow CEO, Privcap Contributors David M. Marchick Managing Director The Carlyle Group Maureen Downey Principal Pantheon Ventures Peter Furci Partner Debevoise & Plimtpon Moderator / David Snow CEO Privcap Privcap Briefing Investor Capital in Emerging Markets Q / 2

EXPERT TAKEAWAYS / Investor Capital in Emerging Markets Key Findings An executive summary of the Privcap thought-leadership series featuring three emerging markets experts 1 More investment will flow

3 EXPERT TAKEAWAYS / Investor Capital in Emerging Markets Key Findings An executive summary of the Privcap thought-leadership series featuring three emerging markets experts 1 More investment will flow to emerging markets 2 Assessing risk requires careful scrutiny 3 It s crucial to choose the right GPs 4 Use terms and conditions specific to emerging markets risks 5 Big capital from emerging markets will change the world Investors have a growing appetite for exposure to emerging markets. LPs expect strong returns and they are looking for seasoned GPs who can deliver these. But investing in emerging markets is a complex process fraught with questions. What s the right way to allocate private equity in these markets? What are the risks and how should they be understood? Below are five key takeaways from the Privcap expert-discussion series Private Equity in the Emerging Markets, featuring David Marchick, managing director at the Carlyle Group, Maureen Downey, principal at Pantheon Ventures, and Peter Furci, partner at Debevoise & Plimpton. Left to Right: David Marchick, Managing Director, The Carlyle Group; Maureen Downey, Principal, Pantheon Ventures; Peter Furci, Partner, Debevoise & Plimtpon; and David Snow, CEO, Privcap. 1 More investment will flow to emerging markets Emerging markets are an increasingly popular destination for investment. The amount of money in PE portfolios contributed to emerging markets has doubled since And a recent survey by the Emerging Markets Private Equity Association showed three-quarters of investors expect to boost their allocations to emerging markets over the next two years. The headroom is definitely there, Marchick said. Emerging market stock markets account for about 17 percent of global equity markets but Western LPs Western, large institutional investors only have about 5 percent exposure. So it s a growing market, there s Privcap Briefing Investor Capital in Emerging Markets Q / 3

EXPERT TAKEAWAYS / Local LPs Go Global It s not just foreign money pouring into emerging markets. Local LPs are also jumping on the bandwagon and allocating capital to home-grown private equity firms.

4 EXPERT TAKEAWAYS / Local LPs Go Global It s not just foreign money pouring into emerging markets. Local LPs are also jumping on the bandwagon and allocating capital to home-grown private equity firms. Peter Furci still under-allocation and most of the major firms are increasing their presence in emerging markets. LPs are drawn to these markets because they recognize that this is where the growth is now. Whether you re talking about Asia or India or Latin America, you have this incredible growth that s taking place in the middle class, Downey said. People becoming wealthier, being able to purchase more goods is really going to be the big driver. When we think, what makes emerging markets attractive, it s really this rise in the middle class. Another factor in the pace of capital flow to emerging markets is the increasing sophistication of investors. They re now comfortable sending their money to the far corners of the world, Furci said. When we negotiate with investors, they re not just asking about the team and the track record and the usual boilerplate-type provisions. They really want to understand the country dynamics, the types of investments, exit horizons, what are the liquidity opportunities. You re dealing with people who are much more savvy. This is a hugely important trend, says Peter Furci, partner at Debevoise & Plimpton. What you see in China, for example, is the growth of RMB funds, which actually permit local investors to invest in China using local currency. That has been a huge phenomenon in China and it s something we think will be of increasing importance. It s not just China where local investors are embracing private equity, but countries like Brazil as well. Brazil has a long private equity tradition, notes Furci. The Brazilian pension plans have invested in private equity for many years and continue to be a very important source of capital. Perhaps the most interesting development is that many emerging market investors are now moving beyond their own borders and are looking to put their money to work in other developing economies. In some of the recent Latin American fund raises we worked on, we saw very significant investments from China, Singapore, and Middle Eastern sovereign wealth and other investors, in addition to large Western pension plans, says Furci. So we think the global movement of capital is going to be a hugely important trend for private equity. 2 Assessing risk requires careful scrutiny While the growth of the middle class in emerging markets enhances stability and pressures governments to get their acts together, as Marchick put it, the strengthening middle class across emerging markets does not mean risk is spread evenly. Any investment must be done with careful due diligence, from the macro to the micro level. Privcap Briefing Investor Capital in Emerging Markets Q / 4

5 EXPERT TAKEAWAYS / PE Outperforms Public Markets Some investors prefer to access the emerging economies though the public markets. But by ignoring private equity, they could be missing out on some of the fastest growing companies and limiting their rate of return. If you look at the companies on the emerging market exchanges that you can invest in, many of them are financial, commodityoriented, or oil-related, says Maureen Downey, principal at Pantheon Ventures. They don't actually represent the fastest growing segments of the economy like, for instance, consumer or retail. Pantheon recently conducted an analysis of the Bovespa, Brazil s Sao Paulo Stock Exchange. It found that highest growth areas of the Brazilian economy were best accessed through private equity, not the public markets. There are probably five companies (on the Bovespa) that make up 50 percent of the market capitalization, notes Downey. Within those companies, there's not 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. She adds that there are only about 470 companies on the Bovespa, but there are upwards of 50,000 private companies that are really in need of capital. That, to me, is a very compelling argument for the case for private equity in emerging markets over public. Maureen Downey You have to look at each region on a case-by-case basis, Furci said. For example, Brazil, from a political and fiscal point of view, is a very attractive jurisdiction. So is India. It s a democracy disorderly at times but one with established laws and institutions. And while China may lack transparency, it has a government dead-set on making sure investments keep coming and growth continues. On the other side of the coin is the Middle East/North Africa. The region was considered the next phase in private equity but the risk needle has jumped since the Arab spring. Downey brought up a recent study showing that, with the exception of Hong Kong, the countries with the best ability to pay i.e. revenues flowing out and the lowest debt per person are emerging market countries, while those with the worst ability to pay are developed nations. There s this perception that emerging markets are always so much more risky. I wouldn t say they re more risky. I think there are just different risks. And then there s the deal. Each is a different puzzle and partners must solve the question of how they can add value. Many companies in developing countries, they don t need capital, they need access to expertise, Marchick said. What private equity can do is find ways to create a delta, in terms of adding real value, adding Privcap Briefing Investor Capital in Emerging Markets Q / 5

EXPERT TAKEAWAYS / Declining Role of Development Agencies Development agencies were once the main source of capital for private companies in emerging economies.

6 EXPERT TAKEAWAYS / Declining Role of Development Agencies Development agencies were once the main source of capital for private companies in emerging economies. But now that private equity is on the rise, the role of development agencies is diminishing, especially in Africa. David Marchick operational expertise, adding management strength and helping them become global companies. 3 It s crucial to choose the right GPs Selecting a GP team is the most critical task in alternative investing and it s far more difficult when GPs are across borders, in foreign cultures, in economies that don t have a deep history of private equity. Investors must get out the microscope and find GPs who are stable, because in fast-growing markets free-agency can be a problem. They must decide if GPs are adding real value or just riding an upward tide by looking at where GPs have bought companies, what they ve done with them and where they ve sold them. There are a number of ways a firm can address the GP question. It can import experts from the home office. It can deploy a Western-trained team of GPs with roots in the target country. Or it can recruit locals who know their region s business community inside and out. Marchick said the Carlyle Group has gone through all those stages. When we first set up in China, we brought a successful investor from the United States, moved him to Hong Kong and said, Recruit a team. That evolved to having a local national that was educated in the United States, that may have trained with one of the large investment banks, and then went back to China to As a country matures and moves up the economic development continuum, development agencies play a lesser and lesser role, says David Marchick, managing director at the Carlyle Group Development agencies have graduated from investing in South Africa. They are close to graduating in a country like Nigeria, which has a fast-growing middle class and very significant amounts of private sector investments. For the most part, development agencies in Afri ca are focused on the smaller, less developed countries that have a harder time attracting outside capital. Here, development agencies want to use their money as a catalyst to attract other private sector investors. They know they can t fill the need that a country has in terms of the amount of investment, but they are trying to use their wallet and their leverage to attract many times the amount of money they can invest themselves. invest. Today our fundamental approach is to find locals in the markets that know the culture, know the language, that can operate within those cultures and understand the nuances. A lot of firms now do the same. But this may change as the global market changes, Furci said. There s a premium on being connected in the jurisdiction, knowing your way around. I think, though, that as Privcap Briefing Investor Capital in Emerging Markets Q / 6

7 EXPERT TAKEAWAYS / global markets become more and more integrated, in particular as Latin America becomes more interrelated with China, with India, the need for local private equity teams who are also sophisticated globally is going to be increasingly important. Deal size matters as well. Downey pointed out that GPs may be successful in small funds but overwhelmed by larger challenges. They may not have the skills, frankly, to add value to a company where you have to make a $150 million investment, because they don t have the international contacts, she said. 4 Use terms and conditions specific to emerging markets risks When investors entrust capital to emerging markets, it s important that they install protections against local risks. Currency fluctuations are always near the top of that list, Furci said. For example, in a number of the Brazil funds we did see currency-specific protections and inflation-specific protections, where investors came in and said, Look, an 8-percent hurdle rate, which is kind of the standard in global funds, that may not be appropriate for a country that has consistently high inflation or at least higher inflation than in the developed world. Therefore we want the hurdle rate to be inflation-adjusted. Downey said she often sees terms related to financing, being able to, for instance, use up to one-quarter of the fund to bridge a deal and then not have that count to the waterfall, because financing is more challenging to arrange in particular countries. And she added that key-man provisions are important in emerging markets, because talent is thinner on the ground. We pay particular attention to the allocation of the economics, not only within the ownership of the GP but also within the carry, because we really don t want those VPs and principals to leave. 5 Big capital from emerging markets will change the world Emerging markets investment is not a one-way pipe. There is an accelerating trend of institutions in developing nations allocating capital to other emerging markets and to the West. The investments are large now and will get much larger in the years ahead. The amount of capital available in a lot of developing countries is just staggering, Marchick said, and the level of their outward foreign direct investment is way behind the level of development of their economies. He pointed to China. It s the second-largest economy in the world and the second-largest exporter. But it ranks 17th or 18th in the amount of outward investment, below Denmark and Sweden. So the amount of capital that China can and should be investing abroad is a staggering amount, and they need to catch up and they will catch up. The sheer numbers will drive Chinese companies and Chinese institutions to invest abroad. Where will it go? Downey said many investors in emerging markets are attracted to education. They want access to knowledge, training. I would say that is across the board for all of these emerging market LP investors they re looking for education. As far as favored nations, she said investors are a more interested now in the U.S. than in Europe, for obvious reasons. One of my clients refers to Europe as the submerging markets, Furci said. But in all seriousness there is a perception that, even though the growth rates are fairly low, there is a distressed opportunity [in Europe] and we are seeing more funds being raised to pursue distressed opportunities in Europe and more capital from emerging markets pursuing those. Privcap Briefing Investor Capital in Emerging Markets Q / 7

8 Ernst & Young is the sponsor of this program and of the Privcap series, Private Equity in the Emerging Markets. Expert Q&A with Philip Bass Global Private Equity Markets Leader Ernst & Young Ernst & Young s new Global Private Equity Watch report finds that GPs have been very entrepreneurial in adapting to new opportunities. Can you elaborate? Why are the largest private equity firms expanding into the emerging markets? How does Ernst & Young help connect private equity firms with opportunities in the emerging markets? Over the next 10 years, what is your prediction for the magnitude of the impact that emerging markets will have on the private equity industry? > In putting together the PE watch this year, we took a look at private equity behavior over the last 12 months and looked at what was happening in today's market. One of the things we noticed was that PEs were behaving much like the clients that they were investing in very entrepreneurial, adapting to the environment, adapting their operating model to the current system. > So we talk about companies diversifying, going public, diversifying into different businesses, diversifying into different markets, so really a completely different ball game. > When you take a look at the mature markets, the developed markets, you're really looking at reduced GDP growth across the landscape. When private equity firms are looking at their portfolio and their investment strategy, they're looking to diversify. That's where the rapidly growth markets come in, so markets like Brazil, China, India, with higher GDP growth, really become much more attractive. > We have resources around the globe and around the world. So as different funds set up offices, we can introduce them, we can help them set up the office, we can introduce them to our local contacts, our local team, and really help them get started. So it should be a much easier transition than it is. > One of the keys to private equity is having resources on the ground. If you're going to invest in Brazil, you have to be in Brazil. It's connecting them with our local resources, helping them get started, helping them develop their investment strategy, and then moving forward together. > Emerging markets will continue to be an increasingly big part of the overall portfolio for private equity. I think we'll continue to see investment again, the attraction and the GDP growth, the rising middle class in many cases. > For more information, please contact Philip Bass at philip.bass@ey.com

Thought-Leadership for the Private Capital Market Series / Private Equity in the Emerging Markets Watch this groundbreaking three-part series in its entirety at www.privcap.

10 Thought-Leadership for the Private Capital Market Series / Private Equity in the Emerging Markets Watch this groundbreaking three-part series in its entirety at Click here to view Emerging in the Portfolio Click here to view Assessing the GP Team Click here to view Emerging LPs This series is part of the ongoing Private Equity in the Emerging Markets group of programs, sponsored by Ernst & Young. Privcap content you may also enjoy: The Brazilian Opportunity Private Equity in India Optimistic on the Middle East Emerging Momentum About Privcap Private capital has a new channel for thought leadership: Privcap. Privcap is a producer of, and destination for, high-quality content for participants in the global private capital markets. Through videos, podcasts, articles and supporting content, Privcap delivers valuable context for private capital investment, allowing investors to make better decisions and achieve greater success in the private capital asset classes. Privcap s digital content is universally accessible to all who register, and highly navigable. Our goal is to produce the kinds of quality exchanges of intelligence that market participants expect from seminars and conferences, and to make these available online in a compelling and evergreen digital format. Our signature video programs feature talk-show style, panel conversations and interviews. To learn more about how to use and benefit from Privcap content, and access our exciting forward calendar, log on to Contacts Editorial David Snow / dsnow@privcap.com Sponsorships and Sales Gill Torren / gtorren@privcap.com

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