The investment returns from private equity funds in emerging markets overtook those from developed markets last year and the strong performance could continue through 2018.

A key advantage for investors is the relatively lower amount of uninvested capital still held by private equity managers in emerging markets, believes Doug Coulter, partner and head of Asian private equity activities in Asia for LGT Capital Partners.

“One reason to be optimistic about [emerging markets] versus [developed markets] is the fact that relative to GDP there is less dry powder in Asian private equity than there is in the US or Europe. That’s good news,” he said.

In 2016, emerging markets private equity funds in aggregate showed returns of 6.4% compared with 21.1% in the case of developed market private equity funds, according to alternative assets data provider Preqin. But last year emerging market returns jumped to 21.1%, edging out the 19.4% returns posted by developed market funds.

And with lower amounts of unused capital, it could be because fund managers in emerging markets are better placed to be able to identify appropriate investment opportunities and to continue identifying them to maintain their strong run. An excess of dry powder, on the other hand, may indicate that fund managers are having difficulty deploying capital.

There are other reasons to believe that private equity funds in emerging markets can extend their strong performance, and it’s not just limited to positive returns and the amount of underemployed capital waiting on the sidelines.

The amount of capital returned to LPs is also proving to be a big draw.

“Obviously you can look at returns but more importantly you can look at distributions, and what’s really been a game-changer in emerging markets private equity over the past three years has been a strong increase in distributions,” Coulter told AsianInvestor.

Emerging markets capital distributions almost trebled between 2013 and 2016, from around $40 billion in 2013 to about $110 billion in 2016, the Preqin report shows.

With limited partners (LP) receiving more capital back from the general partner (GP) managing the fund, that has led to LPs allocating more to emerging markets private equity, Coulter added.

The money invested in developed market private equity funds outpaced investments in emerging markets in every year from 2009 to 2016, industry data collated by the Emerging Markets Private Equity Association (EMPEA) shows. However, in 2017 emerging market investments grew by about 49% compared with 10% in developed markets.

Making a big difference has been the rise of the Chinese buyout.

“We just have a lot more buyout deals being done in China and obviously when you’re doing buyouts you’re more in control of the exit, you have more exit options,” Coulter said.

There are also many more secondary buyouts taking place in Asia and China than was the case three to five years ago and that has opened up another exit channel, he added.

“All this gives us some optimism that emerging markets can continue to do well, relative to Europe and the US,” Coulter said.

DIFFERENT CHALLENGES

Despite the optimism, investors should be aware of the perceived risks when investing in emerging markets.

One key challenge is foreign exchange risk, especially when dealing with dollar-denominated investments, Ku Seungha, managing partner and head of offshore private equity at CreditEase Wealth Management, told AsianInvestor.

Volatility in currency rates can impact the purchase or sale price of private equity investments, as well as the net asset value of a fund, which represents the value of all investments in the fund.

Another challenge is the depth and maturity of private equity markets in the emerging markets space. In the US or western and northern Europe the market is mature and you see a very deep private equity ecosystem where smaller firms are buying and selling to larger sponsors, or selling to strategic buyers in the corporate space, as well as through initial public offerings, Ku said.

Though exit options in emerging markets are increasing, investors still need to be aware of the relative immaturity of these markets.

“In emerging markets, the history of private enterprise is relatively short and many firms are in a growth stage on a relative basis, and, as a result, emerging markets are [more] conducive to growth-oriented, minority-investment opportunities,” Ku said.

About 57% of emerging markets private equity funds were in venture capital as of the fourth quarter of 2017, compared with 39% for developed market funds, according to a June report by fintech solutions provider eFront.

While growth-oriented private equity investments like venture capital can offer high returns, the exit timelines are often longer than non-growth-oriented funds. Potential buyers may also be less willing to deploy capital to non-controlling stakes in a company.

The time to liquidity of emerging market funds is, on average, 9.3% longer than developed market funds, according to the eFront report.

For more insights on investing in China, AsianInvestor is hosting its 5th China Global Investment Forum in Beijing on September 13. For more details, please click on the link or contact Terry Rayner via email or on +852 31751963.