Jake Cusack, chair of EMPEA’s Frontier Markets Council and a managing partner at CrossBoundary, moderates a discussion with fellow EMPEA members on opportunities and risks in frontier market private equity between Hurley Doddy at Emerging Capital Partners (ECP), Leith M. Masri at Foursan Group, and Thomas C. Barry at Zephyr Management, L.P.

Cusack: Why do frontier markets appeal to the private equity (PE) industry – both from a general partner (GP) and limited partner (LP) perspective? Why are PE fund managers launching standalone frontier funds or allocating more assets to frontier markets within existing emerging-markets strategies?

Doddy: African frontier markets, such as Ethiopia and Republic of the Congo have historically seen less investment despite their large populations. The relatively unexplored nature of these markets can be attractive to investors because there is less competition and because access to largely untapped markets carries the potential to deliver significant returns with proven business models. Often, investments in frontier markets are made as a part of an existing regional or pan-African investment strategy, rather than within a standalone fund because they can be accessed from companies based in more established economies, such as South Africa or Kenya. This more diversified method promises greater risk control, especially with a GP that has local investment professionals on the ground, with a deep reach into African markets and insights into the region’s local economies. Standalone funds have also been raised for certain frontier countries, but they tend to be small.

Barry: Frontier markets appeal to both GPs and LPs because they contain niches of high economic growth. Many businesses in frontier markets do not have strong competition, so those market places can be opportunities for experimentation and innovation. In a globalised economy, a business headquartered in a frontier country can be a regional or global competitor. Scale, which is so important in an industrial world, can be achieved in the cloud in a digital economy. Consequently, businesses in frontier countries can be globally competitive. LPs perceive frontier markets PE as an opportunity for high growth returns, diversification from other markets and the only equity option because listed markets are usually not an alternative either because they are small or non-existent.

Masri: The appeal of frontier markets to GPs and LPs begins with the opportunity to generate strong returns investing ‘off the beaten path’, often in assets that are under the radar or not part of the geographic remit of mainstream investors. This is enhanced for some players by an impact or ESG angle, where the investments are contributing meaningfully to the development of certain communities or economies. Frontier market investing is most often about achieving growth for portfolio companies, as opposed to extracting cost savings, depending on multiple expansion or other traditional PE levers for creating or achieving value. For GPs, it can also be an opportunity to invest in one’s home market or region, where they believe they can more meaningfully, economically and otherwise, spend their energies and build their careers. For other GPs, it may not be their home market but a new market that holds greater potential and excitement for them than more traditional markets. In the case of LPs, investing with frontier market GPs is a way to expand their investing horizons by having talented managers be their eyes and ears in a market that they do not know well. LPs may be interested in access to that market, either for investment purposes and overall diversification, or as a future potential operating geography, depending on the investing LP’s core business.

Cusack: Are there unique challenges given the shallower and smaller nature of frontier markets, i.e., smaller fund and deal sizes? In the context of smaller funds, how do you address the challenges of good gross performance at the investment level, but potentially challenging net performance once fund management and transaction costs are taken into account?

Barry: Frontier markets’ deal size is small, reflecting the size of the local economy. In addition, most of these markets do not have a tradition of M&A and buyouts. Most transactions are minority, growth capital. Consequently, the average size of investment and the resulting fund size are small; usually well below $100m. Therefore, this asset class is not attractive to GPs whose compensation is solely related to assets under management. I believe that a new compensation framework is appropriate to incentivise managers to participate in small but economically dynamic frontier economies. A further challenge is lack of divestment options. Many frontier markets do not have stock markets which have material trading volume nor local institutional investors. Therefore, divestments are cross-border to strategic buyers or international investors. Standalone frontier market funds have investment logic, however the size may be too small to be a viable business entity. Alternatively, in regional or global funds, frontier market investments are so small that they can be immaterial.

Masri: Smaller funds can sometimes provide challenges, as can large funds that cannot be deployed effectively. This ‘Goldilocks principle’ is important in achieving attractive returns by matching a sensible fund size against the universe of opportunities in the target frontier market. In the case of small funds, their size may also restrict them to acquiring ineffectual minority stakes, whereas the GP is more likely to be an effective investor and achieve better returns if they are able to acquire significant minority or majority stakes where they can exercise certain controls and maintain protections that are often enshrined in shareholder agreements. GPs of smaller funds can also be challenged to maintain strong teams, due to the economics afforded by the fund size. Another factor that can be a challenge in certain frontier markets that are less familiar with PE is the lack of understanding around how PE funds operate, such as the J-curve, the difference between gross and net returns, multi-year LP commitments and drawdowns on an as needed basis, among others. The GP has to carefully navigate challenges and communications with those investors that have limited or no experience previously with PE.

Doddy: One of the main challenges of frontier markets is their size, in relation to their risk profile. Deal sizes in more mature African markets, such as Kenya or Nigeria, are usually around $30m to $250m but for frontier markets, deal sizes are often smaller. However, a local GP with a regional platform strategy doing deals with companies that have the potential to scale across emerging markets and into frontier markets can achieve the returns and exit options that investors seek. For these investors, investing in frontier markets presents an opportunity to develop an effective, diversified investment strategy.