Views from the Field: Reflecting on 2015 and the Outlook for EM Private Capital in 2016
After a tumultuous year characterized by declining commodity prices, a slowdown in China and currency volatility in many emerging markets, EMPEA asked several of our members to reflect on challenges and opportunities for the coming year. They provided views on a wide range of topics, identifying important trends and lessons learned for emerging markets private capital, as well as key opportunities for the asset class in 2016.
The Limited Partner's View
Roberta Brzezinski, Managing Principal, Growth Markets, Caisse de dépôt et placement du Québec (CDPQ)
The View on China’s Slowdown
Johannes Schoeter, Partner, China New Enterprise Investment
Mingpo Cai, President and Managing Partner, Cathay Capital Private Equity
The View on Family Offices and Opportunities in Africa
Hendrik F. Jordaan, President and CEO, One Thousand & One Voices
The View on ESG
Steven R. Okun, Public Affairs Director, KKR Asia Pacific
The View on Currency Volatility and Opportunities in Latin America
Sebastian Popik, Managing Partner, Aqua Capital
The View on Direct Secondaries in Emerging Asia
Harjit Bhatia, Executive Chairman, Asia Growth Capital Advisors
The View on Private Credit
David Mathewson, Partner, Delphos Capital
The View on India
Mukul Gulati, Managing Director, Zephyr Peacock Management India
The View on Turkey
Baris Oney, Managing Partner, Globalturk Capital
The View on Sri Lanka
Senaka Kakiriwaragodage, Managing Director, NDB Zephyr Partners (Emerald Sri Lanka Fund)
The Limited Partner’s View
Roberta Brzezinski, Managing Principal, Growth Markets, Caisse de dépôt et placement du Québec (CDPQ)
CDPQ’s activities are consistent with the Canadian pension fund model off disintermediation. Thus, while we are continuing with fund commitments, we are very focused on direct investing in both developed markets and emerging markets. Within emerging markets, our current emphasis is to allocate resources to several key markets in Latin America and Asia and focus on direct private equity and infrastructure opportunities within those markets, rather than broad fund commitments. One recent deal we completed in Mexico exemplifies this approach: in September 2015, CDPQ announced a CAD1.43 billion commitment to a new partnership with a group of five Mexican pension funds, or afores, who jointly committed CAD1.38 billion to co-invest in infrastructure projects in Mexico.
In 2015, Mexico and the other emerging markets of Latin America and Asia on which we focus admittedly had a somewhat difficult year in terms of currency depreciation and volatility in the public markets. However, these short-term movements have not dissuaded us from our broader strategy, which is to meaningfully increase our exposure to emerging markets, particularly to illiquid investments. Whether it takes the form of direct investments or funds, we are undeterred, and view the market corrections as an opportunity rather than a crisis. As an institutional investor, we have the luxury—or built-in advantage—of not facing immediate liquidity pressures and can patiently deploy capital.
Looking to 2016, we expect to continue to emphasize depth and specialization, rather than breadth, in our portfolio. In particular, we are looking to consumer-facing industries that are still supported by strong secular dynamics domestically. Because of our size, it is difficult for us to invest in small and mid-sized opportunities, so we tend to target high-growth mature market leaders in various emerging market countries. By partnering with larger companies, which in turn then invest in some earlier-stage opportunities, we gain indirect exposure to that space as well.
The View on China’s Slowdown
Johannes Schoeter, Partner, China New Enterprise Investment
Turmoil in the Chinese stock market and the subsequent suspension of initial public offerings (IPOs) added pressure in 2015 on exit efforts by private equity (PE) funds. A bigger challenge for the portfolio companies of PE funds this year, however, has been the contraction in credit from banks, which are suffering from heavy bad debt loads following imprudent lending during the 2009 financial stimulus. On the positive side, China-focused PE funds with adequate dry powder saw plenty of opportunities from small and medium enterprises in need of financing.
Apart from these macro themes, an important development in 2015 was the New Third Board’s emergence as both an added exit channel and a competitor for investment opportunities for PE funds. The New Third Board is a disclosure-based listing venue in China with a shorter listing process and no lock-up period, although efforts are still under way to improve its trading liquidity. The advantage of the New Third Board is that it provides alternative exit routes for PE funds that are frustrated by the IPO route. Similarly, the New Third Board has proven to be an effective venue for high-quality SMEs to raise capital at attractive valuations (20-30x during fundraising, and over 40x average price-earnings ratio for the entire Board). This has created serious competition for PE funds. Going forward, PE fund managers’ ability to provide value to investment targets will become crucial in securing deals.
A second impactful development this year has been the increasing exposure of Chinese equity markets to companies structured as variable interest entities (VIEs), as well as to VIEs reversion to listing in China. Examples of domestic listing opportunities for returning VIEs include the Strategic Emerging Industries Board planned in Shanghai and a less stringent tier under ChiNext. With the influx of VIEs, traditional PE funds’ ability to structure offshore deals will become less of a differentiating factor in the future.
While the overall economy in China has markedly softened during 2015, looking to the year ahead we remain confident that opportunities abound in high growth sectors such as healthcare, education, financial services, advanced manufacturing, environmental protection and consumer products. As a fund manager, we also try to be constantly mindful of both the opportunities and the perils brought forth by fast emerging trends, such as the impact of e-commerce on the pricing and distribution of fast-moving consumer goods.
Mingpo Cai, President and Managing Partner, Cathay Capital Private Equity
The year 2015 was not short of disruptions affecting the private equity industry in China, echoing the shock waves that impacted the Chinese economy at large. Yet, from the stock market plunge and the slowdown in manufacturing activity to the inclusion of the renminbi in the International Monetary Fund's Special Drawing Rights basket, these disruptions offer many opportunities to private equity professionals who understand that these are also welcomed adjustments to China’s role in the global economy. The resulting re-balancing of such a large economy, even though closely managed by the Chinese government, cannot be expected to happen without “bumps”.
Central to China’s shifting economic landscape is its middle class, which is expected to grow from 200 million people in 2012 to 630 million people by 2022, and this population’s appetite for the products and services available to their counterparts in Western countries.[1] The consumption increases and services upgrades sought after by China’s middle class create tremendous cross-border business potential for Western and Chinese companies alike. The new paradigm here is one where China is becoming the top international end-market to Western companies. Conversely, developed economies are a source for best practices that Chinese companies can use to strengthen their market positions back home.
Cathay Capital Private Equity, a firm I co-founded in 2006, has been actively investing in lower and middle market companies in the West and China, assisting our portfolio companies—mostly smaller size companies with limited international resources and experience—in unlocking this cross-border value. With 44 investments since 2008, we believe that China remains an important piece of a direct or indirect private equity strategy based on a differentiated China thesis rather than a China “macro-play”.
[1]McKinsey & Company, Preparing For China’s Middle Class Challenge, March 31, 2014
The View on Family Offices and Opportunities in Africa
Hendrik F. Jordaan, President and CEO, One Thousand & One Voices
Tumultuous times—particularly in emerging markets—give many investors pause. Tumultuous times cause many investors—particularly those with short-term mindsets—to retreat. Defying these trends, in 2015 family offices from around the globe leveraged their longer-term mindsets and other competitive advantages to seize opportunities that others missed. Perhaps there is no place on earth where these trends played out more clearly than Africa, the continent with the most compelling demographic trends on the planet.
At One Thousand & One Voices, we also witnessed an unequivocal desire for family offices to cross-leverage their brands, industry insights, relationships and goodwill for higher investment returns. “Families partnering with families” is an age-old concept but, in 2015, we witnessed it grow. More and more family offices realized that strength in numbers exists—particularly when such strength is drawn from a group of aligned families representing multiple industries and diverse geographies around the globe. 2015 saw family offices source and execute private equity investments that institutional investors simply could not do.
One Thousand & One Voices’ model, which deploys longer-term capital to family-owned businesses and utilizes the relational capital and intellectual capital of influential families on an industry-by-industry and geography-by-geography basis, overcomes many of the challenges presented in today’s Africa. Tremendous opportunity still exists, and with patience and value-creation initiatives family offices are uniquely positioned to benefit from investing in Africa.
The View on ESG
Steven R. Okun, Public Affairs Director, KKR Asia Pacific
Over the past few years, there has been a growing recognition that incorporating Environmental, Social and Governance (ESG) considerations into the development of an investor’s investment thesis, in both due diligence and the investment itself, has led to better business practices, enhanced consumer trust, enhanced community relationships and oftentimes improved financial results.
ESG is effective in emerging markets when it is not mandated in a top-down approach. ESG does not work when firms “tick the boxes” instead of integrating it into their investment theses. The “tick the box” approach often leads to a superficial review of ESG factors in due diligence, which is then accompanied by a cursory report stating foregone conclusions. Viewing ESG as an opportunity to positively impact the bottom line—and not solely as an exercise in which investors look for reasons not to do a deal—is what will make ESG principles effective and sustainable in any market.
The Green Solutions Platform (GSP), launched by KKR in December 2015, is an example of this. The GSP seeks to drive business and environmental value by working with and highlighting the work of participating companies across a wide variety of focus areas. The program includes companies from emerging and developed markets that focus on eco-efficiency improvements, advancing eco-innovation and offering solutions to environmental problems as core to their business mandate. Looking forward into 2016, this increasing industry focus on ESG and local sustainability is a trend that will continue.
The View on Currency Volatility and Opportunities in Latin America
Sebastian Popik, Managing Partner, Aqua Capital
The scope of currency devaluations experienced by many countries in Latin America as the super commodity cycle came to an end was very pronounced—more so than analysts in the region expected. As a result, currency devaluations, coupled with a Brazilian recession also beyond expectations, made 2015 a challenging year for private equity in Latin America. One positive result, however, from this macroeconomic downturn has been that deal pipelines are rich—in fact, the opportunity set currently available in Latin America is likely the best of the past decade. Yet it still takes operational excellence to capitalize on these opportunities and navigate the challenging environment. In this sense, 2015 was a year for top performers to stand out.
A well-constructed portfolio—one that not only addresses the fund’s intended investment strategy, but also offers intrinsic diversification through exposure to different economic segments and vintage years—is key to top performance. Hedging currency exposure is another important consideration, and in this regards we have found that seller financing is often the best strategy to dilute vintage year FX exposure and boost internal rates of return and multiples on invested capital. Looking towards 2016, GPs with robust portfolios that incorporate these strategies will be better equipped to endure cyclicality, in addition to fulfilling LP expectations.
The View on Direct Secondaries in Emerging Asia
Harjit Bhatia, Executive Chairman, Asia Growth Capital Advisors
By and large, capital markets were shut down in many major emerging economies in 2015, the most notable example being China. This added to the pressure on general partners to exit investments and return capital to limited partners (LPs)—especially for long-held portfolio companies from the 2007 through 2009 vintage years. However, the most successful managers kept their focus on creating value at the portfolio company level and pursued alternative exit routes, including secondary direct options, which are not dependent on the public markets. For companies that are otherwise performing well, but unable to pursue traditional exit options like an IPO, secondary investors offer a potential win-win solution. Owners do not have to sell a company in distress, but merely at a slight discount to net asset value, as secondary investors can then prepare for a public market or strategic exit down the line.
Looking forward to 2016, market volatility will likely be lower than in the last two years as the U.S. economy is settling down to a reasonable growth level and the Federal Reserve is removing the lingering uncertainty of a potential interest rate hike, which has been weighing heavily on currencies in emerging markets. While the majority of good secondary direct opportunities will continue to emerge from China and India, Southeast Asia may present additional new opportunities in the next two years as the market experiences a correction. A couple of years ago, many managers invested aggressively in markets like Indonesia and Malaysia, but in some cases they made the same mistakes most people make in frontier markets and overpaid. In addition, most of the Southeast Asian markets have experienced severe currency depreciation and are dependent on commodities for growth. These factors will combine to create attractive buying opportunities.
While the direct secondaries market in Emerging Asia is not yet as deep as in the U.S. or Europe, a large number of Emerging Asia-focused funds were raised and invested between 2006 and 2008, and they are coming towards the end of their lives. Thus, we naturally expect fund managers, prodded by LPs, to become more active in seeking accelerated disposal of portfolios through secondary direct sales to meet fund life constraints. Once LPs start getting distributions from their older vintage commitments, they may return in bigger numbers to start committing new money to emerging markets.
The View on Private Credit
David Mathewson, Partner, Delphos Capital
Interest in small- and medium-sized investment opportunities continued to increase in 2015. The current transition in many developing markets—driven by commodity market dislocations, weakness in export-oriented economies, the impact of decelerating Chinese demand and more—has encouraged investors to be more open to exploring fund investments and direct investments in small- and medium-sized businesses that diversify local economies and meet the growing needs of local consumers. In addition to equity, investors are also evaluating opportunities to provide senior secured debt to quality companies in various markets. Medium-term debt is difficult to source in many countries and spreads are high, providing opportunities for investors to earn attractive yields on capital lent to lightly-leveraged, high quality growth companies.
For 2016, we expect to see continued growth in capital flows to direct lending vehicles, including vehicles providing trade finance and other specialized debt products. Commitments to private credit vehicles are booming in developed markets and we expect “spill-over” of some of these flows into major developing markets, particularly for medium-term specialized lending facilities. International development finance institutions are also keenly interested in backing new initiatives that provide credit in innovative ways to emerging market corporate borrowers, especially small- and medium-size companies. In addition, we expect that investor emphasis on impact measurement and monitoring will continue to increase in 2016, driving better evaluation and reporting tools and data. Given the growing market demand from a wide range of institutional investors, we expect to see a number of impact-oriented credit vehicles and/or direct investment opportunities come to market over the course of the next year.
The View on India
Mukul Gulati, Managing Director, Zephyr Peacock Management India
In 2015 we saw a significant increase in private equity (PE) investments in India. One of the key underlying trends was an increase in early-stage venture capital activity. Global and local venture investors, attracted by the potential of the third largest internet market in the world, poured large amounts of capital into Indian internet businesses. While the growth of online retail in India was impressive, the industry was characterized by intense competition and significant operating losses. A major shakeout is inevitable and consolidation in the online retail market will likely begin in 2016.
The exit environment in India improved in 2015, mainly due to a robust initial public offering (IPO) market. The IPO market revived in 2015 after a dry spell lasting over four years. Inbound M&A also picked up, but the amount of M&A activity is nowhere near what it should be for an economy of India’s size and growth rates. We expect that M&A activity will increase over the next few years as the ease of doing business improves in the country.
Global PE funds also increased their investment activities in India in 2015. Large, well-run businesses in India now have a range of financing options, including loans from commercial banks, private equity and the stock market. Unfortunately, small- and medium-sized enterprises (SMEs) continue to struggle to raise financing from banks and private equity, partly due to the limited number of growth capital PE funds in India.
The supply of SME growth equity capital in India will improve over time, but it remains a difficult segment for investors due to the lack of high quality management teams. Providers of growth capital, whether they are control or minority investors, will need to bring significant operating skills and industry specialization in order to generate attractive returns. We expect to see an increase in mid-market buyouts and the ongoing emergence of industry specialist PE funds.
The View on Turkey
Baris Oney, Managing Partner, Globalturk Capital
After two parliamentary elections in Turkey this year, the Justice and Development Party (AKP) was finally able to establish a strong single party government against all expectations. This election frenzy caused investments to slow, especially over the previous five months. However, despite the slowdown, the number of private equity investments in 2015 increased compared to 2014. We expect this trend to continue, not only because many investments that were postponed due to political uncertainty are now expected to go through, but also because the government has a plan to reinitiate its structural and macro reforms to boost the economy.
The biggest challenge in the next few years will be exits, as private equity investors in Turkey look for new exit opportunities. We expect to see many exits in the coming years through trade sales since many companies are too small for initial public offerings (IPOs). This will create a good environment for strategic sales, as well as for private equity investors seeking secondary acquisitions. However, in terms of returns, private equity investors depend on external factors such as the strong U.S. dollar. The Turkish lira has lost almost 30% of its value in the last 12 months against the dollar, making currency depreciation an obstacle to earning good returns.
Another challenge is that for many general partners (GPs) operating in Turkey, their investment ticket sizes are above the market’s requirements. Therefore, competition gets fierce when a good opportunity arises. However, the real private equity need in Turkey exists for hundreds of thousands of small- and medium-sized enterprises (SMEs). There is a clear mismatch in the market between the size of private equity funds and the size of businesses that need capital. Turkey needs more GPs who are willing to take the time to invest in SMEs rather than in large companies.
Finally, while big international institutions like International Finance Corporation and European Bank for Reconstruction and Development have been keen on investing in Turkey in recent years, other private investors have been hesitant. There are, however, a number of GPs currently fundraising and a number of other investors that may renew their interest in Turkey. With this in mind, in 2016 I believe that Turkey will be top of mind for investors seriously considering making commitments to emerging markets private equity.
The View on Sri Lanka
Senaka Kakiriwaragodage, Managing Director, NDB Zephyr Partners (Emerald Sri Lanka Fund)
In 2015, we were privileged to launch Emerald Sri Lanka Fund, the largest private equity fund dedicated to Sri Lanka, and we are hopeful the fund will be able to bridge a long-felt equity financing gap for Sri Lankan businesses. However, we experienced a slowdown in deal flow during the first nine months of the year as the country went through presidential and parliamentary elections, resulting in a new regime coming to power on the island.
Most Sri Lankan entrepreneurs took a cautious approach at the beginning of the year and held back on major projects requiring significant capital expenditure, waiting for clarity on the political outlook and policy directions. In the aftermath of the elections, the second of which was in August, we are experiencing a healthy increase in deal activity. However, we believe we need to further invest our time and effort in educating entrepreneurs on private equity as a financing option and, particularly, the value addition we can bring to companies during their growth phase. Taking a cue from the global markets, particularly from our neighboring giant India, exit strategies need to be worked out upfront as Sri Lanka is small and its capital markets are relatively underdeveloped.
As the domestic market is limited—Sri Lanka’s population is approximately 21 million—opportunities for scaling up business that receive investment need to be closely studied. However, we are bullish about the opportunities that will be available in the coming year in sectors such as consumer, education, healthcare, financial services, leisure and IT services. Looking forward, there are dynamic entrepreneurs willing to capture the opportunities presented in this peaceful and politically stable country, and we are optimistic about the growth opportunities present in the Sri Lankan market.