EM: Let’s Not Miss the Trees for the Forest…

…probably flies in the face of conventional wisdom. It also probably defies traditional investing philosophy of mapping out macro factors (e.g. economic indicators, political stability, currency, interest rates, etc.) on which thrived the EM gurus of yester-years making country bets or further still, EMD hard vs. local currency calls, now anyone’s guess. With globalization upended and localization gaining ground, it is imperative to focus on the trees in the EM forest, as also echoed by us earlier in our March 2019 post “Private Assets: EM Local for A Better Portfolio Karma”. Our suggestion (probably radical for some traditional minds) is born of the need to generate tangible returns in a risk-controlled manner in a new investing era beset with challenges to produce meaningful returns bar artificial life support (aka QE) from global central banks. Harvesting each tree individually could be more fruitful rather than blindly chasing EM forests in the hope of participating in economic growth or diversification, yet again old fangled ideas. As for participating in economic growth, empirical evidence is to the contrary as attested by many examples from Brazil to China where country bets would have paid off in hindsight despite a lackluster economic picture and vice-versa. In the perverse climate that prevails, equity and bond markets in fact rejoice dimming economic prospects on the gleaming hope of monetary easing in EM (encouraged by the Fed and now probably even by the Christine Lagarde-led ECB). A “lower-for-ever” yield engenders risk-taking by throwing caution to the wind as one may observe in leveraged loans and DM direct lending not far from investment grade credit where ~45% is teetering on junk status.

Should investors sole focus remain on the degree (25 bps vs. 50 bps vs. no cut at all) of monetary easing led by the Fed? Or worse still, should they take on unwarranted risk for little, if any, compensation? We would vehemently argue neither, if investors opened their minds to tending green shoots and harvesting trees that go largely unnoticed in the EM forest or avoided altogether on misplaced concerns of a forest fire (e.g. firing of Turkey’s Central bank governor or resignation by Mexico’s finance minister), little realizing that there is money to be made even when EM is ablaze.

Trapped in EM public markets, most investors remain largely confined to index names, as attested by the euphoria around the recent China A share inclusion in MSCI EM. While non-index, less liquid names offer a viable opportunity for those willing to invest with EM local stock pickers i.e. boutique hedge funds, the illiquidity risk might fetch even better/visible premiums in idiosyncratic middle-market names that dominate the private market landscape across EM. These are essentially small and medium enterprises, many family-owned and controlled and many led by innovative entrepreneurs, operating in niches geared toward improving, contributing and solving for local economies away from the riffraff of global issues. In Africa alone, the mid cap market comprises 400+ companies with revenue over $1 billion; 700 companies with revenues over $500 million aggregating $1.4 trillion in annual revenues in 2015 (Source: McKinsey). Asoko Insight, an Africa private company platform has mapped ~20,000 companies across Africa each with annual revenues up to $100 million. Research from Asoko also shows 645 family-owned businesses in East Africa with 60% operating in the industrial, agriculture and materials sector. The picture in India and other parts of Asia as well as LATAM is similar where consumer-facing companies are proliferating.

As in India, many family-owned businesses face both succession issues as well as flat-lining growth where new professional talent and operational know-how can potentially take businesses in newer directions, open new doors and unlock hidden potential. Recognizing this, the earlier resistance to diluting control is gradually giving way to accepting control buyouts by local private equity shops that can help take businesses to greater heights and provide exit options for promoters. This is a marked shift away from just a growth capital mind-set in the mid-market space observed in specialty manufacturing, financials, consumer, healthcare, etc. However, LATAM and Africa still seem more amenable to offering minority stakes for growth capital. Regardless, the absence of large established businesses in many markets presents an opportunity to help smaller companies in fragmented industries grow into industry leaders and regional champions especially in healthcare, IT and consumer discretionary sectors. This suggests that a targeted sector-focused approach is probably a better way for value creation through operational improvements and greater market share rather than an employing a leveraged play rampant in DM (7x EBITDA for 60% of LBOs in 2018 Bain Private Equity Report 2019). Local know-how to drive value creation for portfolio companies is more important to portfolio companies in EM than unsustainable multiple expansion driving buyout values or sponsor to sponsor sales in DM. With intra-regional differences in culture, language, politics, etc. it’s equally important to keep together teams that are spread out across various locations within a region, a tall order for an EM investor operating remotely from London or NY.

For those reluctant to give up control or prize their equity and don’t want to be sold short, taking urgent, discreet and flexible credit from private sources is a more acceptable option. With greater availability of institutional capital both domestic and overseas, countries across EM e.g. Kenya, Ghana, Indonesia, etc. have been trying to become more creditor-friendly by improving their protections for covenants and instituting more robust enforcement rights especially if they follow British common law. For private lenders, it affords not only better downside protection through artful structuring (covenants, collateral and default triggers) but both greater alignment of interests in the speed and priority of paybacks as well as equity kickers to top a tangible, visible and predictable stream of contractual income. Little wonder, that some US pension plans (e.g. AzPSRS) are recategorizing their fixed income bucket as “contractual income” to capture more of it. For context, where senior direct lending in DM is trending 6-7% net annualized IRRs, EM secured private credit could potentially offer unlevered low to mid teen IRRs. While DM faces serious origination issues amidst a glut of capital (due to a flood of yield-seeking LP capital into DM direct lenders) damping returns and compromising underwriting standards, EM enjoys a plethora of sponsor-less lending (vs. more sponsored transactions in DM) opportunities from SMEs deprived of financing from traditional banking channels. In real estate, private debt backs both infrastructure and affordable housing projects in major urban centers.

Banks aside, even local shadow lenders e.g. India and China that filled-in for them with life-blood credit to middle market companies, have come under pressure in recent times. When funding sources e.g. bond issuance or borrow from mutual funds or other financial institutions, etc. for these non-bank finance companies dry up it could cause stress for many corporate borrowers reliant on them who could face either lack of funding or a spike in borrowing rates. This is exacerbated if these non-banks borrow short term and lend long term as it necessitates a constant supply of short term funding. To make matters worse if their vulnerabilities are exploited with defaults and failures, it freezes liquidity in the system hurting end borrowers. We saw this play out recently with Baoshang Bank, a shadow lender in China and the first Chinese bank taken over by the regulators since 1998, for serious credit risk as part of the “financial supply-side reform” campaign to de-risk small banks. With a haircut on interbank liabilities and the implicit guarantee on corporate deposits (above $7 million) removed, it caused contagion risk in the broader financial system, which saw money market rates surge and made other nonbanks refuse corporate bonds as collateral for advancing credit to others for trust loans, entrusted loans and acceptances that represent 11% of Total Social Finance as at end of 2018 (Source: China Manager). This created stress for downstream corporate borrowers. Similarly, India witnessed a default by Infrastructure Leasing and Financial Services, a non-bank finance company, one among many that cropped up in the aftermath of the global financial crisis when mainstream banks curtailed their lending that now account for 17% of lending to the commercial sector (Source: Société Générale). Stress in the financial system creates special situation opportunities (as perverse as a slowing economy for public market investors banking on continued QE) like providing rescue financing and restructuring loans for stressed borrowers. Further still, stressed pools of loans from non-bank finance companies add to the pools of non-performing loans at state banks enlarging the opportunity set potentially offering high teen IRRs, with premiums of 300-500 bps over stress/distress situations in DM.

On the other end of the spectrum, tech innovation is sweeping across EM sectors like agriculture, logistics, manufacturing, and of course consumer, powered by young entrepreneurs endowed with both vision and talent. While B2C (marketplace, ecommerce, etc.) opportunities abound on the strength of mobile/smartphone penetration, the astute EM VC investor is cautious of consumer spend, scale, competition and most importantly, path to profitability (a missing tenet from VC backed IPO companies in DM that hope more for growth and market share). They therefore, remain equally open to B2B opportunities in fintech (e.g. insurance, payments), health-tech, Saas, etc. Local seed investors, generalist and specialist sector early stage (Series A/B) funds nurture such budding enterprises to scale for trade sales, strategic exits to corporate VCs or larger global players (e.g. Softbank etc.) targeting 3-3.5X gross MOIC. Their sensitivity to exits is apt considering that EM has until recently seen very few/delayed exits.

As highlighted in one of our previous posts, “Venturing for Growth into EM”, local EM governments have realized that companies backed by PE/VC funds have shown better performance vis-a-vis other companies, in terms of high-quality governance, consistent performance and growth, job creation and taxes. As an example, the Indian government recognizes the benefits of sticky PE/VC capital, to deliver on its “Make in India” dream, and has announced policy reforms to support the growth of Alternative Investment Funds (AIFs) onshore in India as the preferred vehicle for private capital pooling. As a result, it has implemented important policies to regulate AIFs which include, exemption from IPO lock-ups, relief from capital gains (as further extended beyond venture capital to private equity funds in India’s 2019 Budget) and classification of domestic owned/controlled AIFs with foreign capital as domestic capital (completely removing FDI and pricing regulations). Similarly, Kenya, South Africa, and Nigeria state pensions have upped their PE allocation to 15% of their assets which should see a significant inflow from local pensions’ $380 billion aggregate pool toward creating an African PE ecosystem (AVCA). Most recently, Hong Kong is considering taxing carried interest as a capital gain rather than income, a move against the grain of most established private equity hubs. Little wonder, abundance of venture capital has led to a boom in entrepreneurship, with more than 5,000 company founders across Asia receiving funding last year.

As argued in many previous posts, unless a manager has boots-on-the-ground in EM with a well-entrenched deal sourcing/origination network, cultural familiarity and can offer more than just capital in terms of broad industry insights, talent management, digital disruption management, and governance, it’s likely that they will face headwinds. Within EM-based managers, execution skills remain key which necessarily implies that manager selection is paramount.

 It is encouraging to note in some recent surveys including the EMPEA 2019 Global Limited Partners Survey that some institutional LPs have begun realizing that harvesting trees (as discussed above) within vast EM forests is a greater pursuit to generate meaningful returns. However, they have also candidly admitted that “limited staff resources for evaluating and investing in such opportunities” remains the number one obstacle to allocating a greater proportion of their EM portfolio to middle-market opportunities. With a greater number of mid-sized ($100-500 million) EM funds especially from Asia, coming to market in recent times, the task to distinguish one from another becomes much more challenging  for LPs as also for EM GPs seeking to differentiate themselves with regards to their opportunity sets, strategy execution, business operations and fund management best practices.

In this regard, ÊMA continues to offer independent investment audit/due diligence for LPs and GPs alike, on various such EM private equity/credit/venture capital managers who can deftly and timely harvest such individual trees within EM forests to the benefit of LPs’ portfolios. Stay tuned.

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

July 11, 2019

The above content is intended for sophisticated audiences as in institutional investors or accredited investors. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.