“A tree is known by its fruit; a man by his deeds”, cannot be more true if private capital investments were personified today. Many portfolios must thank private assets, particularly private credit for its karma that benefited institutional investors caught in a never-ending lower for longer environment, post the financial crisis. Investors, faced with funding shortfalls and elusive spending targets, amidst choppy, QE-driven global equity markets, took refuge in private assets (mainly buyout, venture, direct- lending, real estate, and some infrastructure, and natural resources) harboring growth, yield and smooth (leveraged) returns, avoiding marked-to-market fluctuations.
Private equity, specifically a select group of household names in buyout, were primary beneficiaries of this influx of capital. In fact, 60% reached their fund-raising goals in record time- 12 months vs. average 16 months for all PE- even though buyout returns in the current cycle have fallen to 2 x (for reasons below) from 3 x levels recorded before the global financial crisis (Bain Private Equity Report 2019). The story is no different in venture capital where a few VCs were consistently able to raise $1 billion+ funds. The desperate hunt for yield saw private credit triple its assets over the past decade to $770 billion in 2018 (Preqin). All said, ~$8 trillion (Preqin) of fund-raising across private assets since 2005 finds private markets today awash in capital with a pressing need to put large amounts of money to work.
Endowed with rising dry powder, or uncalled capital, that hit a record high of $2 trillion in December 2018 (Preqin) across all private market assets, the pace of deal activity picked up since 2014. Leverage came easy from both banks and private creditors to the point that 7x EBITDA made up 40% of LBOs above max of 6x (set by regulators post crisis) for 60% of LBOs in 2018 (Bain Private Equity Report 2019). To add to a torrent of capital chasing deals, competition from corporate buyers seeking growth through acquisitions (faced with weak organic growth prospects) also heated up. Rising multiples in public markets and bigger targets to deploy war chests further fueled the private equity frenzy driving valuations or entry multiples to record levels i.e 11x EBITDA (Preqin). This has provided a rich opportunity to sell assets-trade sale and sponsor to sponsor sale- for premium prices due to rising fears of a recession, and an attempt to cash out timely and realize good IRRs (massaged further by subscription-lines and dividend recaps.) to inspire a new fund-raise. Venture capital is experiencing a similar fate and private credit has suffered both declining yields and lax underwriting standards where many investors are bracing for a shakeout/consolidation.
The irony is that many large respectable LPs’ karma of committing to private assets with a developed markets bias continues to rub on to the privileged few large private asset managers (across the spectrum). The chosen few continue to return to market with bigger-than-ever funds hoping that they can miraculously find compelling opportunities in developed markets, uphold underwriting (and covenant) standards, resist the temptation to overpay for assets and find lucky exits. However, some of them are sensing that opportunities in DM are getting tapped out, and therefore pivoting to EM seeking access to opportunities through local partnerships. The key to such affiliations that bears watching, is the nature of sub advisory or partnership agreements specifically in terms of longevity, transparency, shared-economics, and above all, autonomy granted to local managers to make timely and judicious calls. Many relationships are merely access to co-investments in outsized “benign” deals that would justify the expansive war chests of large managers and be justifiable to their investment committees. A few large traditional managers have also diversified into alternatives by acquiring some local private asset shops that might evoke questions around cultural fit (traditional vs. alternative), and contagion from parent’s size afflicting capacity- constrained local opportunities.
In contrast, some Canadian majors- CDPQ, CPP, OMERS, etc. and other similar profile investors from Europe, have gathered their own convictions in these local EM managers by striking direct partnerships buying into their networks, expertise and process (with adequate oversight without sacrificing local managers’ autonomy). Some have gone a step further in setting up offices on the ground in EM hubs- Hong Kong, Singapore, etc. As avid researchers in the emerging markets, we can surely relate to those LPs making a beeline to emerging and frontier markets. What is guiding them is their quest for local managers’ unique know-how (alpha) to exploit niche opportunities that fly below the radar of investors in developed markets.
Local investors can tap into their well-entrenched relationships within their local business ecosystems to source opportunities. Building personal trust is a prerequisite to doing business effectively and sustaining a presence in any EM region. Local investors also exercise their deep sector expertise in understanding business cycles, and the credit cycle within each sector. Being local, allows them to understand the operational aspects of their portfolio companies (e.g. how to obtain various operating permits) and extend their teams to create value through their operational hands-on involvement. Supplementing in-house efforts, strong and credible local partners are often engaged to successfully develop projects alongside a carefully selected team of local advisers who have relevant project finance expertise. Since executive talent might be scarce, local investors also lend themselves to strategic decision-making to drive and grow the businesses of their portfolio companies.
Many portfolio companies might not even have formal business plans so the need for an extensive due diligence and constant monitoring is crucial and the ability to work with promoters through thick and thin (stressed situations) is important. This takes root even at the deal structuring phase where, an investor needs to adopt a very open mind to understand and relate to an entrepreneur’s financial needs, psychology, circumstances and even cultural background. This lends itself to structuring term-sheets customized to each business-owner situation aligned with sponsors’ interests. Therefore, managers often adopt flexible capital (and fund mandates) to invest into each situation. SMEs generally dislike instant dilution of equity and are probably more amenable to straight debt or convertible debt or PIK structures. This is quite difficult for an asset manager with a rigid private equity or private debt fund. A local manager with boots-on-the ground with total autonomy to flex as the situation dictates is much better-positioned than a team parachuted from NY or London managing local affiliations/partners.
Local networks of managers cannot be emphasized enough especially when it comes to leveraging the insights of qualified lawyers with local jurisdictional expertise. 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. Networks remain equally important when it comes to exits as in Africa where 60% are done through proprietary networks with almost half in the form of trade sales to strategic buyers including cross-border deals (AVCA).
Establishing channel-checks on sponsors is an important and valuable activity of local managers considering that governance is often an issue. Local managers maintain a tight leash on the flow of funds into and out of a business ensuring that it does not get diverted for bribery, tax evasion and political donations. Thus, many managers avoid sponsors with political connections to circumvent conflicts much that such ties also help to get ahead of policy-making, nepotism and state-capture (as observed with Guptas influencing the decision-making of Jacob Zuma, former President of South Africa). For many large asset managers not only are such governance issues an investment nightmare, these might not even pass muster (due to reputational risk) with their investment committees far removed from the local scene to fathom the inherent risks and mitigants thus missing out totally on what could other wise be risk-adjusted attractive opportunities.
So, 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. Local know-how to drive value creation through margin expansion and acquiring market share 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 overseas investor.
With global growth concerns mounting, LPs renewing their commitments to private capital seeking growth and yield, need to gauge if their household favorites can overcome current challenges of overcrowding, excessive valuations, and leverage to replicate their old successes in a new investment paradigm re-defined by secular changes across global economics, politics, business and capital markets. Much will also depend on how these industry doyens can use their heft, balance sheets and global presence to penetrate emerging markets adopting a mind-set, and execution as local as possible to parallel local investors, yet exercise best western-world practices (that many domestic managers also employ quite impressively leveraging their global pedigrees). However, deploying their bloated AUMs into small EM niches will probably remain a challenge (that had quite a few large PE houses pull out of EM) even though deal sizes and target raises are likely to increase to compensate for restricted domestic capital sources that often prove more expensive than overseas financing.
Therefore, for progressive-minded LPs, the karmic choice is between a) investing in “comfort managers” in DM pivoting toward EM with restricted/acquired local know-how; and b) overcoming internal governance issues to invest directly with on-the-ground investors possessing local know-how to extract premiums for complexities, inefficiencies and illiquidity. The former is like buying a multinational company (e.g. Coca Cola, Procter & Gamble, etc.) stock to gain indirect EM exposure, while the latter is like investing directly in Alibaba in China or a Reliance in India.
As newer and complex private markets open further for overseas investors, ÊMA remains intellectually curious to learn about the execution capabilities of domestic managers positioned to tap into these markets equipped with local knowledge, expertise and networks. ÊMA continues to conduct independent investment audit/due diligence on various such EM private equity/credit managers who can deftly and timely tap into on-the-ground opportunities, adding good karma to LPs’ portfolios. Stay tuned.
Kamal Suppal, CFA
Chief Investment Auditor
March 28, 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.