Stephen Davidoff has an excellent overview in DealBook of the potential obstacles that US private equity firms should worry about as they increasingly look abroad.
They are:
– Carried interest taxes are higher, especially in Europe
– More regulations to get around
– Worries about rule of law
– Foreign ownership restrictions that require teaming up with local vehicle
– Currency restrictions and the tendency of foreign governments to “to steer the best investments to local heroes.”
Do read the whole thing for detail.
For our part, we’ll take this opportunity to recapitulate a few thoughts of our own, from back when we were blogging in humbler digs, on additional concerns that apply specifically to emerging markets:
– Returns are constrained by the less accepted use of leverage. Private equity in emerging markets mostly follows a growth capital business model.
There are several reasons for this: it’s a young asset class, less than ten years old in China and other places, and until the crisis it was perceived as riskier; many of these countries don’t have local bond markets sufficiently developed to support long term debt issuance; there is heavy state involvement in the domestic financial sectors; plus some cultural and historical factors.
This has obviously served the asset class well through the crisis — unlike in the US where debt-laden portfolio companies defaulted in spades and banks were left with a big leverage overhang. But private equity firms seeking to capitalise on EM opportunities will have to manage a clear break from their traditional way they’ve made money.
– We lack reliable information on returns in EM private equity:
There are two sources: Cambridge Associates, which aggregates fund return data that is voluntarily submitted by private equity managers; and the IFC, which keeps tabs on the funds in which it co-invests with other private equity managers.
But Cambridge only has data from about 300 funds that manage a collective $100 billion.* That represents only a fraction of the estimated several thousand EM PE funds, and the IRR numbers will also be skewed by the self-selection bias of the sample. …
The IFC aggregates the return data from the even smaller pool of about 100 funds in which it has co-invested. It also has a unique investment approach, which is to get into a market early (or first) to help spur its growth and encourage more private-sector funds to invest. Once that happens, the IFC pursues new markets to jumpstart. Consequently it probably invests in different places from the funds aggregated by Cambridge, and the two arrive at different conclusions. I have no idea which is the more accurate. …
(If you’re still interested despite these problems, the Cambridge data shows that EM PE underperformed developed markets for the last ten years, though outperformed during the crisis. The IFC data shows that EM PE slightly outperformed for the last ten years. Check slide 22 of this presentation for more detail. Caveat lector.)
* As of 1H2010 — the sample has probably grown since then. (By the way, these efforts by Cambridge and the IFC are certainly better than nothing. It’s just that more time is needed before these numbers are comprehensive enough to be meaningful.)
– These markets are already crowded with buyers. The idea of increasing emerging market exposure isn’t exactly a contrarian stance, and hasn’t been for rather a long time.
And US private equity firms aren’t just facing competition in these markets from each other, or even just from local acquirers in individual countries, but (increasingly) also from EM acquirers who are venturing abroad of their own.
– Growth in the emerging market countries that private equity managers would be most interested experienced only minor setbacks during the crisis, and given how many firms are scurrying to invest, how likely is it that target valuations are all that attractive?
Have we missed any?
Look, the attraction of these markets is understandable. Not only are the growth prospects of target companies obviously better in emerging markets, but bigger pools of capital — like the pension schemes of Latin America — will continue to emerge and make themselves available to the asset class. According to latest stats from EMPEA, both fundraising and investment figures have continued to rebound steadily.
Certainly the biggest Western private equity firms carry both big reputations and big treasure chests to these markets — and whatever revenues they ultimately generate from their share in these markets will be considerable.
But there’s also a lot for them to worry about, and it won’t be easy.
Related links:
Cross-border M&A and EM flows – FT Alphaville
The rush to EM – FT Alphaville
Of bond markets and imbalances – FT Alphaville
Table du jour, EM GDP edition – FT Alphaville