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Navigating the PE Industry's Push into Emerging Markets

The assets held by private equity funds focused on investments in emerging markets have increased dramatically over the last decade, and attorneys interested in capitalizing on the industry's quest to find value in uncommon places need to be aware of the trends and risks involved.

The idea of private equity firms investing in markets outside of North America and Europe is not new, but in recent years, the practice has picked up considerably. The assets held by PE funds focused on investments in emerging markets has ballooned in the last 10 years, from $93 billion in 2006 to roughly $564 billion as of the end of September 2016, according to a report put out this month by research firm Preqin.

That private equity players would eventually begin to show a proclivity for investing in emerging markets shouldn't come as a surprise, considering that the general ethos of the industry is finding unrealized value in companies. Now that it has been firmly cemented as a part of the business world in North America and much of Europe for a while, it's only natural that private equity would start exploring the untapped opportunities around the globe.

"There is an odd confluence of so much cash looking for projects and so many projects ready to go in emerging markets that PE has found a way to operate outside of their traditional comfort zone," said John Beardsworth, head of Hunton & Williams LLP's business practice group.

Emerging markets, as defined by Preqin, include all countries in Africa, Central and Eastern Europe, Central America and South America. It also includes all of Asia, except for Hong Kong, Japan and Singapore, and the Middle East, minus Israel. Investing in any of those regions requires knowledgeable legal counsel capable of guiding clients through multiple unique sets of obstacles.

"The private equity industry in emerging markets faces a set of challenges that can at times be quite different from those facing the more developed markets of Europe and North America," said Christopher Elvin, head of private equity products at Preqin.

According to Elvin, those challenges include slowing growth and rising debt in China, political and economic upheaval in Brazil, Venezuela and Argentina, and instability in Eastern Europe and the Middle East. Those issues "put pressure on private equity operators," he said.

Meanwhile, corruption may be more difficult to detect in many emerging markets, according to Beardsworth.

"The biggest challenge is corruption and navigating locally in ways that avoid direct and, more important, indirect corruption," he said.

Other challenges involved in private equity transactions in emerging markets include the availability of hard currency at market rates, as well as inflexible public procurement laws in cases involving infrastructure projects with government-owned off-takers.

None of the above hurdles are insurmountable, however. Elvin said the existence of such issues "underlines the success of the asset class to have doubled in size over the past six years."

Preqin data shows that the average net internal rate of return for emerging markets-focused investments is only slightly below that seen for North America- and Europe-focused vehicles. Meanwhile, emerging markets-focused funds distributed more capital back to investors than was called up for the first time ever in 2015, a trend that continued through the first three quarters of last year.

"Robust performance and recent net capital flows to investors have proved that emerging markets-focused vehicles can offer real returns on investment," Elvin said.

Asia is at the forefront of investors' minds, according to a Preqin survey of more than 200 private equity investors taken at the end of 2016, and China and India are specifically touted as presenting the best opportunities.

One of the key drivers to increased activity in China is the social mobility and urbanization of the country, which has "given rise to a growing middle class and increased purchasing power among Chinese consumers," according to Jeffrey Kaplan, a corporate partner at Kirkland & Ellis LLP.

"In recent years, as China's economy has developed, local markets there have become more receptive to private equity investments," he said.

India, meanwhile, is among the fastest-growing economies in the world and is "viewed as relatively politically stable and having a deep pool of talented entrepreneurs in an emerging market," according to Kaplan.

Africa, which, according to Preqin, is home to almost 300 emerging markets-based private equity fund managers, is another place that has attracted a significantly increased amount of private equity attention, Beardsworth noted.

"Africa has really caught on because the needs are great and the returns are higher, at least in infrastructure, compared to North America or Europe," he said.

A global economy that only continues to expand is evidence that the progression of private equity's interest in emerging markets will continue. So is the fact that PE investors have historically been willing to take risks, a trait private equity fund managers and limited partners share.

"I have a sense that many emerging market investors have a bit of an adventurer streak in them," Beardsworth said.

When it comes to emerging markets-focused PE funds, the most prevalent investors are banks, corporate investors and investment companies, according to Preqin, but the complete list includes all the same players that typically invest in private equity vehicles.

The private equity world's push into emerging markets is still developing, but where opportunities exist, potential PE clients will emerge and will require legal advisers "who have previously successfully navigated the land mines in any particular market," Beardsworth said.