Growth-happy plans eye emerging-markets P-E

More private-equity investors are delving into emerging markets, but significant hurdles remain in the effort to find sustained outperformance, according to consultants and pension fund executives.

Unlike public equities, where the trend toward overseas investment has resulted in sizable shifts into emerging markets, private-equity strategies still are largely dominated by investments in developed countries, particularly the United States. But more institutions are beginning to globalize their private-equity portfolios, dedicating more capital to emerging and frontier markets.

The amount of money raised for emerging-markets private-equity strategies increased 64% to $39 billion last year from 2010, though that total still is below the pre-crisis level in 2008, when $66.5 billion was raised.

However, emerging-markets private equity accounted for 15% of the total capital committed to private equity globally last year, up from 11% in 2008, according to the Emerging Markets Private Equity Association.

“Hunger for growth” is a large driver behind the interest in emerging-markets private equity, said Miriam Schmitter, managing director and head of non-U.S. private-equity research at Cambridge Associates LLC.

Among institutions that are looking to make new commitments to emerging-markets private-equity funds are the $235.2 billion California Public Employees' Retirement System, Denmark's $103 billion ATP, the $24 billion Texas Permanent School Fund, the $14 billion New Zealand Superannuation Fund and the $3.3 billion Fire & Police Pension Association of Colorado.

At ATP Private Equity Partners, the fund-of-private-equity-funds subsidiary of ATP, which has about $9.2 billion in assets, emerging markets account for 10% of the target allocation for the latest fund, launched last year, compared with 5% in the previous fundraising in 2007.

“In 2005, we decided that we needed to build our relations and understanding in emerging markets; otherwise, we might be left behind, as they were definitely gaining significance globally,” said Susanne Forsingdal, a partner at ATP PEP.

Sovereign-wealth funds also have become more aggressive investors in emerging-markets private equity, said Alex Jones, a senior analyst at Preqin, an alternative-investments research firm.

“Emerging markets are a big part [of the portfolio] for sovereign-wealth funds looking at investing in private equity, not least because there are a significant number of such institutions based in [those] areas,” he said.

In addition, sovereign-wealth funds “can be less risk-averse than other institutional investors in private equity because they are not worried by liabilities,” Mr. Jones said.

Although it is crucial for investors to have a meaningful allocation in emerging markets, “public markets are often very concentrated to handfuls of large companies that don't necessarily capture the potential of the local economy,” Ms. Schmitter said.

Cambridge's own analysis revealed “little correlation” between gross domestic product growth and public-equity-market returns, she said.

A secondary reason for a higher emerging-markets private-equity allocation is diversification, said Tom Keck, chief investment officer at private-equity consultant StepStone Group LLC.

“In addition, emerging-markets private equity is less efficient than developed-markets private equity,” he said. “There's essentially more alpha.”

PERCEIVED AS RISKIER

Private-equity investments in emerging markets are also perceived to be riskier, “and therefore, the risk/reward equation is more favorable,” said Mark Mobius, chairman of Templeton Emerging Markets Group, a division of Franklin Templeton Investments. “Such investments, because of the false perception, can obtain higher returns.”

The group manages a total of $45 billion in emerging-markets assets, including private equity.

In the 12-month period ended Sept. 30, Cambridge's Emerging Markets Venture Capital & Private Equity Index returned 9.48%, compared with a return of -15.89% for the MSCI Emerging Markets Index.

The Cambridge index returned an annualized 11.9% and 12.11%, respectively, for the three- and five-year periods, compared with 6.59% and 5.17%, respectively, for the MSCI EMI. However, the index underperformed the MSCI benchmark for the 10-year period by 5.8 percentage points.

“There are definitely concerns over the risk/return characteristics” of emerging-markets private equity, Mr. Keck said.

“We're focused on managers that are value-oriented and can mitigate operational risk … We want to get higher returns while mitigating the extra risk,” he said.

As more institutional money flows into emerging-markets private equity, specialist managers, as well as household names, are benefiting.

Abraaj Capital Ltd., for example, was launched in 2002 and now has about $6 billion in assets under management, with growth coming from a broad pool of investors, including sovereign-wealth funds, pension funds and endowments.

“Investor capacity is moving beyond the traditional BRIC stories to [countries such as] Indonesia, Malaysia, Mexico and Colombia,” said Mohamed Semary, a partner at Abraaj Capital, referring to Brazil, Russia, India and China.

This year, Abraaj announced an agreement to acquire Aureos Capital Ltd., a private-equity firm with about $1.3 billion in assets under management operating in Africa, Asia and Latin America. When the deal is completed, the combined firm will have about $7.3 billion in assets under management, with investments across about 30 countries.

Opportunities have broadened in emerging-markets private equity, said Mark Richards, a partner and head of the financial services team at Actis LLP.

“In part, this is because the industry is maturing,” he said. “We're doing slightly larger deals of around $100 million today, compared to about $30 million a few years ago.”

Actis, an emerging-markets private-equity firm focusing largely on Africa, Asia and Latin America, has about $5 billion in assets under management, more than half of which was raised in its latest fund, launched in 2008.

“Institutional interest has risen exponentially,” Mr. Richards said.

At the Fire & Police Pension Association of Colorado, emerging-markets private equity has become more prominent on the pension fund's radar screen, said chief investment officer Scott Simon.

CHANGING TARGET

About 4% of the private-equity portfolio is allocated to developing economies, but officials would like the long-term target allocation to be closer to 13%, or the proportion to emerging markets within the MSCI All Country World Index.

“We want it to be meaningful enough but not overwhelm the portfolio,” Mr. Simon said.

When compared with the “good opportunities in the U.S., a market that's more well-known to us, it's harder to get comfortable investing in emerging markets,” he said.

At ATP, one of the biggest challenges is “finding managers who are experienced, with good track records,” Ms. Forsingdal said. “We wanted to avoid making commitments to emerging managers in emerging markets.”

For example, ATP doesn't have a dedicated commitment to China, “simply because we haven't been able to find a manager with a long-enough track record,” Ms. Forsingdal said.

“Some managers do have several funds behind them, but the people who are making investment decisions now are not the same” as in the previous funds, she said.

So far, ATP has committed to emerging-markets private-equity funds managed by Advent International Corp., Archer Capital PTY Ltd., India Value Fund Advisors, Innova Capital, Linzor Capital Partners LP, Mid Europa Partners LLP, Turkven Private Equity and Victoria Capital Partners LP.

Thao Hua is a reporter for sister publication Pensions & Investments.

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