Research

The Global Firms’ Views

Koenraad Foulin, Co-Founder and Senior Managing Partner, Capital International Private Equity Funds

For Capital Group, 2013 was a year to invest beyond the BRICs. Our 2011 fund, CIPEF VI, completed four new investments—three of which were in emerging markets outside the BRIC countries. We made our first ever investment in Chile, while returning to Colombia and the Philippines, where earlier vintage funds made successful investments 12 years ago. While Capital Group covers and holds investments in Brazil, Russia, India, and China, which saw increased competition and heated valuations, the most compelling value this year came from beyond BRIC markets. Looking ahead to 2014, we can be sure that the fundamental long-term attractiveness of EM PE remains strongly intact. In particular, we believe that the consumer-driven and natural resources sectors hold distinct potential. Consumer-related stocks are underrepresented within the MSCI Emerging Markets Index and across emerging public equity markets more broadly. As a result, private equity offers investors unique access to this attractive growth sector. In 2014, we are excited to continue to navigate the global EM PE landscape free of top-down country allocations, and seek to opportunistically identify and pursue compelling value in both BRIC and non-BRIC markets.

Viktor Kats, Deputy Head, Global Infrastructure Fund, IFC Asset Management Company

2013 saw many corrections in terms of private equity flows in emerging markets, making opportunities more attractive. A number of companies in big markets tried to list and were unsuccessful, so they went to private markets, where they had to adjust their valuation expectations. Hopefully, in 2014, the gap will narrow between sellers and what investors are willing to pay. Furthermore, for those investors who have a lot of dry powder available, the market is very good right now. For instance, in India, because of currency depreciation and the overall economic slowdown, many investors have been hit. On one hand, investors really have to be careful to pick the opportunities that will survive this slowdown, but on the other hand, they have a greater choice. Looking to 2014, there are several trends from the macroeconomic point of view that we see as favorable for infrastructure investing in emerging markets. First is investors’ increased awareness of this sector/asset class, and second, there is less competition for some of the assets due to growing risk awareness, which translates to less capital available from capital markets, banks or private investors. However, growth for infrastructure assets is still high, and the need to deleverage is increasing. Therefore, terms of trade are shifting more toward investors, so those who understand the risk and have capital are in a good position. We are also seeing pension funds that want to enter emerging markets directly asking us to participate in some of their deals. These types of conversations make for a dynamic infrastructure market. We see a good pipeline, and we plan to preach this “gospel” of emerging markets infrastructure to investors.

The View from China

Benjamin Fanger, Co-Founder and Managing Director, Shoreline Capital

At the end of last year, a trade publication asked me what I thought would happen in 2013 in Chinese private equity, and now with hindsight I would not change a word: in 2013, the investing world woke up. GPs realized China cannot defy economics. LPs realized capital should be allocated toward niche managers with real ability to generate value. And we all realized the next decade will look very different from the last—that successful investing will focus on inefficiencies and value generation rather than just growth. In China, distressed opportunities have been steadily increasing as the economy decelerates, companies face stress and banks begin to sell non-performing loans. Capitalizing on such opportunities requires a local platform and a long history navigating the illiquid credit environment in China. Looking ahead to 2014, I see an increased interest in Chinese distressed opportunities, though prospective investors and fund managers realize the barriers to entry are high.

The View from Asia

Andrew Affleck, Managing Partner, Armstrong Asset Management

Within the context of our specialization as a GP in the clean energy field focused on Southeast Asia, we reflect on the main lessons learned from our fundraising in 2013, and key opportunities and challenges for the sector and region in the year ahead.

Lessons learned in 2013:

• Although we achieved a final close above our target fund size, the timeline from the start of fund marketing to final close was two years. As a first-time fund manager needing to scale the team while developing a credible deal pipeline to convince LPs of the value proposition, it takes a great deal of belief, commitment and patience.

• While this is more of a continued confirmation than a lesson learned, there is no shortcut to getting deals done quickly in Southeast Asia. Time must be spent developing relationships with local sponsors and winning their trust; with no prior relationship, deals can take 12 to 24 months to develop and close.

Opportunities for 2014:

• According to the International Energy Agency, fossil fuel subsidies within ASEAN amounted to US$51 billion in 2012. Key markets in Southeast Asia, such as Indonesia, Malaysia, Thailand and Vietnam, are realizing they can no longer sustain subsidies on their domestic fossil fuel costs at current levels. Action is being taken to reduce subsidies, and therefore fuel and electricity prices are increasing, making the case for renewable energy investment more compelling.

• Growth rate projections in ASEAN are still at a healthy average of 6%. Domestic consumption is a key investment focus for general PE funds, which in turn drives energy demand.

Challenges for 2014:

• Given the degree of regulation impacting the broader energy sector, political uncertainty can lead to delayed policy implementation. This inevitably leads to uncertainty for deal sponsors and fund investors; as a result, rapid capital deployment can be a challenge. This risk can be mitigated by having a regional fund strategy.

• There has been a fair amount of capital raised by generalist funds with a full or partial investment focus on Southeast Asia. Some countries, like Indonesia, may see valuations increase through competition for deals.

Le Hoang Anh, Managing Partner, Private Equity, Dragon Capital

Similar to other emerging markets, investors continue to see that a strong local team, coupled with the patience to promote a disciplined approach, are pre-requisites for private equity in Vietnam, where restructuring and re-stabilizing were key themes in 2013. Notably, the country undertook measures to rebuild its foreign reserves, close its fiscal and trade deficits and reform the state-owned sector. Looking forward, the main challenge for Vietnam remains how to achieve balance between growth and stabilization. Constraints on the balance mostly are drawn to the banking sector, where the burning issues are non-performing loans and a shortage of liquidity, and it is yet to be seen if and when the government’s solutions for these issues will deliver results. In contrast, other macro indicators such as exchange rates, interest rates and inflation have improved. Furthermore, Vietnam will become a large beneficiary to a host of international trade agreements that have been—or will be—signed, including the ASEAN Economic Community (AEC) and ASEAN+6, the TransPacific Partnership (TPP) and a foreign trade agreement with the European Union. These agreements are expected to help increase Vietnam’s exports to large markets, such as the United States, European Union, Canada and Japan, as well as increase M&A activity in the country. A further boost to M&A activity could come from further easing of foreign ownership limits, with an expected increase in early 2014 from 49% to 60% for public non-financial companies, and from 20–30% to 49% or more for banks. With all of these trends in mind, we expect to see more deal flow, which would benefit both buyers and sellers. For Vietnam, three strong themes are imminent: restructuring—particularly in the banking and real estate sectors; government divestments; and, private sector expansion.

The View from India

Shaji Varghese, Partner, EQ India Advisors

2013 was a challenging year for the PE industry in India, as political uncertainty and policy paralysis contributed to economic growth reaching a decade low of less than 5%. Like other emerging market economies, India was adversely impacted by the talk of QE tapering in the United States, as the Indian Rupee faced high volatility and a sharp depreciation in value, which, along with the economic slowdown, added a new dimension to existing challenges faced by PE firms in India. Portfolio performance and the ability of funds to deploy capital also suffered, as industrial and consumer demand fell, and corporate excesses of the high-growth period came into play. While the overhang of high entry valuations for 2005 to 2008 vintage funds remained, exits were hard to come by. Since Indian GPs largely depend on foreign capital for funds, most firms were forced to postpone fundraising due to the prevailing negative sentiment. Indian GPs will have to work harder and more closely with portfolio companies not only to demonstrate their value-add capability, but also to ensure exits with optimum returns. While Indian PE firms have to justify the continued relevance of the Indian growth story and attractiveness of the industry to foreign LPs, the latter will have to recalibrate their return expectations and investment timeframe. Hopefully, a clear mandate in the general election to be held in May 2014 will usher in political stability and much needed positive movement on reform. Regulatory changes, such as the new Companies Bill 2013 and Alternative Investment Funds (AIF) Regulations, bring much needed clarity to the industry and will have a positive impact on PE activity in the country, which can expect a revival in 2014. While consumer-focused sectors remain attractive, opportunities in sectors like industrials and manufacturing and infrastructure will open up. Fundraising, pursuing M&A opportunities and corporate governance issues in investee companies will be some of the key focal points for Indian GPs in 2014, along with the impact of QE tapering at a macro level.

Thew View from Latin America

Roberto Terrazas, Managing Director and Chief Investor Relations Officer, Nexxus Capital

2013 has seen a significant fall—about 40%—in capital raised for EM PE over the prior 12 months. This was partly due to the fact that ten large EM PE funds raised over US$1 billion each in 2012, absorbing some of the allocations LPs had set when rebalancing their portfolios to increase exposure to these regions. Nevertheless, slower GDP growth across the board—particularly in the largest markets of China, India and Brazil—has had an important impact. The more experienced GPs have been doing a pretty good job of maintaining pricing discipline and will have to balance that with a need to put capital to work. Of course, global figures often obscure regional disparities, and in Mexico, for example, we are excited about the opportunities we are seeing, as this is still a relatively underserved market. Asia will continue to attract the greatest investor appetite; however, with investors already heavily exposed to China and generally sitting out the uncertainty in India following the currency devaluation and economic slowdown coupled with political uncertainty, Latin America is increasingly attractive to institutional investors, especially ex-Brazil, where their portfolios are underrepresented. Looking forward, the majority of LPs expect to increase commitments to emerging markets and continue to believe that these will outperform developed markets. Beyond the macro issues, performance, team stability, alignment of interest and transparency will be key factors in attracting global capital, and finding these attributes will be the key challenges for the asset class in 2014.

Diego Cordoba, Director, Teka Capital

Latin America has been growing at a fast pace in recent years, driven by a growing middle class and a global surge in the demand for commodities; and as a result, private equity in the region continues to expand. Regional M&A activity has been concentrated in large buyouts (greater than US$200 million), but recently, middle-market deals are becoming more attractive to PE investors, as the imbalance between capital demand and supply, as well as a competitive environment in higher segments, has reflected higher valuations for large transactions and lower valuations for small transactions, creating middle-market opportunities. 2014 will see an increase in fundraising, investments and exits in Latin America. However, as some economies have slowed and currencies have depreciated, the spotlight will continue to change from Brazil to Mexico, Colombia, Chile and Peru. Investors in private equity will look to experienced, seasoned GPs with proven track records who have been backed by local institutional investors.

Alex Rossi, Managing Partner, LIV Capital

2013 was a great year for private equity and venture capital investment in Mexico. As more capital flows into the asset class, the sophistication of the companies and entrepreneurs we are seeing has increased in a truly positive manner, making for a much more compelling deal flow pipeline. As the asset class overall, and venture capital in particular, starts to truly segment itself, with fund managers having distinct strategies, sector interests, stage preferences and investment sizes, a broader cross-section of deals are getting done. A challenge in this regard will be for fund managers to maintain discipline and rigor when it comes to negotiating deal terms and conducting due diligence. Additionally, fund managers will need to be aggressive in looking for exit opportunities for their portfolio companies. The old adage that “it’s easy to call money and not so easy to distribute money,” will be on the minds of LPs as they watch significant capital being deployed around the region, but they will be keen on seeing realized returns and successful exit stories to remain confident about increasing (or at least maintaining) their commitments to the asset class throughout the region. Overall though, I believe 2014 bodes extremely well for PE and VC managers in Mexico.

The View from Brazil

Ettore Biagioni, Managing Partner, Alothon Group

Economic growth in Brazil in 2013 was less than estimated, and is expected to be around 3% for 2014. Therefore, investors must ensure companies are properly positioned for a period of lower than expected macroeconomic growth, making operationally driven performance essential. General momentum will not increase companies’ top-line growth. Companies must increase market share vis-à- vis the competition, differentiate their product offering and increase efficiency. As a result, the operational side of the business becomes much more important than in the past, when growth pulled everything ahead. Furthermore, in Brazil, we do not have robust IPO markets that will lift valuations at exits; it is almost the opposite. The IPO markets, generally speaking, have been weak. They have not been priced at exuberant levels, but rather much more conservatively. As such, the way to generate value from an investment is by growing the business and its financial performance, and not relying on capital markets multiple expansion. In Brazil, there continues to be a limited amount of long-term capital for companies in the middle market segment, a space where we believe there are very compelling investment opportunities; and in fact, a lower growth scenario has its advantages for an investor, as it makes it easier to identify with more clarity the weaknesses of a potential target company since they are not masked by buoyant growth. For example, fast growth in the economy can also lead to easier financing from various sources, including suppliers and traditional lenders, because of general optimism, allowing a company to take on financing beyond what it can sustain.

On the other hand, less growth in the economy limits these financing sources as they become more conservative, and working capital can get stressed, exposing the more sustainable financing capacity of a company. On the operational side, with slower growth, the level of a company’s efficiency, quality of IT reporting, processes and procedures weigh much more heavily on financial performance, as there is less momentum to smooth over operating weaknesses, and every single item carries more weight. In 2014, we expect to continue to focus on the middle market, and on sectors such as healthcare, food and beverages and general services, which we believe will benefit from the evolution of the middle class and strong employment of Brazil. While the growth of both of these has a limit, we believe they will continue to evolve and have solid foundations for the future.

The View from Sub-Saharan Africa

Andre Roux, Deputy Chairman, Ethos

The last ten years have indeed been a remarkable and successful period for leading emerging markets. Evidence would now seem to be building up of increasing headwinds facing these markets. These vulnerabilities have their source in falling commodity prices, slower growth in China, unfulfilled population expectations, higher inflation and the prospect of higher long rates in the United States, as Federal Reserve tapering becomes a reality. 2013 may well be defined as a sea change year in the emerging markets growth story, as questions are being asked whether these imbalances, in the absence of structural adjustment, will become meaningful obstacles to growth, value creation and, ultimately, macroeconomic stability. A major consequence of these developments for private equity in key emerging markets will undoubtedly be the need to put in place sustainable strategies for value-add at portfolio companies, and place less reliance on external growth drivers to generate returns. Whilst private equity in South Africa has not been immune to these macro environmental challenges, the country continues to benefit from its geographic proximity to Sub-Saharan Africa and its institutional advantages, allowing it to play a significant role as a gateway to the rest of the continent. Sub-Saharan Africa is now regarded as one of the fastest growing regions in the world, recognized by LPs and GPs with fundraising in the region increasing appreciably in 2013, and capital invested also increasing meaningfully over 2012 investment activity. Given the early stage of the region’s renaissance, 2014 should be a similar year of positive growth for pan-Sub-Saharan African private equity.

Ayisi Makatiani, Managing Partner, Fanisi Capital

2013 was an exciting year for PE in East Africa. There continues to be a growing consumer market that is driving consumer-related industries, such as agribusiness, healthcare, education and the general consumer retail space. The growth is being driven more by the middle class and lowermiddle class end of the market, which have access to disposable income and are demanding quality products and services at the right prices. PE has matured, and there has been an increased level of activity, with more companies that may have been unwilling to do deals now open to the idea of having financial investors on board.

The discovery of key natural resources has led to sectors such as oil, gas and mining receiving much more attention, and these sectors will become significant contributors to the region’s GDP once commercialized. Regional blocks have been very active in 2013, and this is expected to continue in 2014. The cross-border opportunities created as a result will continue to attract multinationals to the region, especially in consumerrelated industries. Going forward, local GPs and foreign GPs with local offices will play a bigger role in deal making. Challenges will exist, key among them being the lag between the supply of, and demand for, capital. This will not be because there is more capital chasing after few quality deals, but because targets will pick GPs based on softer issues, such as how comfortable they are with the relationship. In addition, political challenges, though gradually reducing, will also continue to exist.

The View from the Middle East and North Africa

Sharif El Akhdar, Partner, BPE Partners

2013 was a challenging year for the Middle East and North Africa region. Following the political transformations that took place as a result of the Arab Spring, little capital was left to chase an increasing number of opportunities. GPs continued to engage with LPs and portfolio companies by playing a greater role in trying to match the right LPs with the right investment opportunities. In today’s challenging times, GPs play a much bigger part in identifying opportunities for LPs. Investors recognize the role of private equity in creating long-term value and sustainable business models for Egyptian businesses as something that could be replicated for the rest of the region. These challenges and opportunities allow us to place capital where it belongs to build true partnerships among all stakeholders. Going into 2014, the biggest challenge, in my view, is continuing to build trust and confidence among GPs, LPs and portfolio companies. The year 2013 has proven, and 2014 will continue, to be rewarding vintages for private equity in Egypt.

The View from Russia

Tim Demchenko, Global Head of Private Equity and Special Situations, VTB Capital

In 2013, LPs frequently asked us why they should invest in emerging markets when developed markets, notably North America, are showing positive, healthy dynamics and GDP growth during a period of recovery. One strategy for emerging markets that we are exploring is shortening the investment cycle to reduce the risk profile of investment, and these shorter time horizons have been welcomed by many LPs. Since it is difficult to predict ten years ahead due to the changing landscape, the potential to deliver exits within three or four years feels much more comfortable to investors. Another trend we have seen is the whole emerging markets landscape becoming more specialized and focused, by country and by sector. We see a proliferation of GPs focused on just one country or further focused within that country on just one sector, as spreading capital across a variety of markets in an arbitrary way is no longer good enough.

For example, Russia is not quite an emerging market, but one that has experienced a severe transition from a state-owned and -controlled, monopolistic economy to a more market-driven one for the past 20 years, which does not define Russia as “emerging” in the same way that Africa or India are “emerging.” This is all self-evident, but identifying the winning model in these various markets is the key challenge. We have discovered that what we call operational arbitrage—transferring competencies, business models, and very often management teams from developed countries, mainly Western countries—has worked extremely well in Russia. And this strategy complements the idea of a shorter investment duration. Many of the products and services in Russia are identical to those in other European countries, but the consumer experience and price ratio are out of sync in comparison to developed countries. Because Russia traditionally has been—and still is, to some extent—a fairly closed society, there is little knowledge or human capital transfer between the country and developed markets. While Russia already houses a number of large, operational companies and investors do not have to start from scratch, they must enable existing businesses by bringing external know-how and business models that do not exist in the country. Looking ahead, we will continue to embrace these ideas and implement them across our portfolio.