Published: November 11, 2008
Four of the top professionals in emerging markets private equity recently held a lively debate at PEI’s emerging markets forum in London, on the proposition ‘This house believes the western credit crisis is good for emerging markets private equity’.
The participants would like to make it clear that the views expressed were purely in the spirit of the debate, and not necessarily their or their organisation’s actual view.
Speaking for the proposition first was Jonathan Bond, partner, Actis:
There are three main reasons why the western credit crisis is a good thing for emerging markets.
First, its effect on valuations. How often in the last few years have you found prices were too high, and local entrepreneurs said they could list on local exchanges at multiples of 19 or 20? In this sense, the corrections in stock exchanges around the world are very good news for our business.
The MSCI is down 60% year-to-date. The index’ average PE has gone from 17 to seven. And yet earnings are still strong. Of the 38 companies in our portfolio, 80% of then are traded above their 2007 EBITDA. So the value for money that we’re able to create is probably never better.
The 2008-2009 vintage deals are going to be crackers, and will easily achieve 30-40% return. And the IPO markets are closed, so where will owners go for growth capital? Private equity companies are very fortunate now in the balance of power when they talk to entrepreneurs.
Secondly, if you look at inflation, it was causing considerable distress to many emerging market economies. Now there’s a correction in prices for oil and food. Overall, that’s very good news for emerging market economies.
Thirdly, this is a unique time for the profile of emerging markets private equity. If we get it right, and prove we’re better than developed markets private equity, we can provide that emerging markets private equity should be a key part of a balanced portfolio.
However, we’ll need to be highly selective. The phrase ‘emerging markets’ is now a useless term, because it’s so broad, it includes as different markets as China and Haiti. The portfolio should focus on the upper end, on the BRIC economies.
Because of these three reasons, the next two to three years should prove very advantageous for emerging market private equity.
Speaking against the proposition first was Chris Rowlands, managing partner, Asia, for 3i
The question is whether you want to be ruled by your head or your heart. We’ve heard lots of very Romantic notions from Jonathan, but we need to come back to reality.
How on earth can you support the notion that the credit crunch is good for emerging markets when some emerging markets are being rescued by the IMF? When we now know that Asia has not decoupled? When sovereign wealth funds are now having to account to their domestic public for their losses in private equity?
Whether we like it or not, emerging market private equity relies on leverage, and the whole notion of leverage has been inextricably swept up into the western credit crunch.
Now, public sentiment and government sentiment will get tougher, there will be all sorts of unpleasantries in regulation, you just watch as it unfolds.
Jonathan is right that stock markets are down all over the world. And stock markets have been a very important source of exits. Around 50% of all private equity exits last year were via stock markets. Now those markets are all shut. That means it will be harder and slower to exit, which will prolong the holding period for investments.
You could try to exit via M&A sales to corporates, but corporates are having trouble funding themselves, they are finding it difficult to roll over their commercial paper funding, they can’t raise equity, so they’re not going to be in a rush to buy companies.
So it’s a pretty bleak prospect for liquidity in private equity. So what LP in their right mind would consider investing in emerging markets? Surely they’ll do a flight to safety. They’ll go to the markets they think they understand.
There’s also the question of the people working in emerging markets private equity. How many of them have 10,20 years’ experience, or have worked through several business cycles? Not many.
And are entrepreneurs really looking forward to dropping prices and selling their companies cheap? No. What we’re likely to see instead is a hiatus. They’ll wait another 12-18 months before selling. So we’re in a period of low liquidity, low leverage, slow exits and reluctance to sell.
Next to speak for the proposition was Antonio Bonchristiano, president of GP Investments
Chris’ argument was well-put, but not at all convincing. Decoupling was always a Romantic concept, no one believes it makes any sense. Clearly, decoupling is not happening.
But the issue is relative growth. Anyone working in private equity relies on economic growth, and the key attraction of private equity in emerging markets is that that’s where the growth is. The US and the West are not growing, while the BRIC countries will continue to do so. So that’s the strongest argument for emerging markets – that’s where the growth is.
Chris is right about the equity markets being closed. Last year, there was an unprecedented level of IPOs in BRIC countries. In Brazil alone, there were 60 IPOs raising US$35bn, which was unprecedented. That clearly won’t be the case this year or next year.
But that’s not such terrible news for private equity. Between 1994 and 2004, we did 24 exits, and only one of them was an IPO. You can’t be in this business if your only exit route is via IPO. I think exits via controlled investors can continue to grow regardless of the state of public markets.
Another point is that this is not the first crisis we’ve had in emerging markets. I can remember, in my working life, the Russia crisis, the Brazil crisis, two Argentina crises, the Asia crisis. But this is the first crisis that is not of our making. It’s a very important point, because emerging markets today are better prepared for such situations than they’ve ever been. A decade ago, this situation would have been a major disaster for emerging markets, but that’s not happening today.
Emerging markets have learnt their lesson from the 1990s. We’ve been through many crises, some of which have been worse for local markets than the present crisis. By comparison with many developed markets, emerging markets are a much more attractive place to do business.
Last to speak, against the proposition, was Ahmed Heikal, chairman of Citadel Capital
People are reeling in emerging markets. It’s not because we don’t have money. It’s because people have lost a lot of money. You look at the largest sovereign wealth funds – if you think they’re not reeling, think again. They have lost so much money in the last nine months.
Given that, they can’t help but be depressed. They have liquidity, but they’re seriously depressed. So investors are going to be extremely cautious going forward, even in the Middle East.
Secondly, raising money is going to be extremely difficult. The private equity business will go through a serious shake-out. Most of the private equity deals done in 2006 and 2007 will be underwater for quite some time. A lot of work will need to be done on those portfolios.
The industry needs to go through a process of deleveraging. Credit is not there, so strategies will be extremely cautious, and the performance of private equity will be seriously impacted.
Finally, the valuations of companies on the public markets are very attractive right now. So why take a long-term illiquid position in private equity when stock market valuations are where they are?