Private equity is an asset class that seeks to create value long term, and to do so it focuses on identifying growth drivers. Although some emerging markets are generally regarded as risky, they offer genuine opportunities and private equity investors are aware of this. Many international financial groups have set up investment funds dedicated to Sub-Saharan Africa. The Edmond de Rothschild group, too, has demonstrated its ability to ear-mark capital for the emerging regions. The reasons, it says, include diversification, the return on investment and sometimes also the environmental and social impact. Macro-economic and political conditions have improved markedly in numerous emerging countries. Strong GDP growth, easing inflation and unemployment, fewer violent conflicts, the spreading rule of law and reduced corruption are among the factors that are enhancing investors' visibility.
These markets moreover boast considerable strengths, chief among them demographics. The median age in many emerging countries is under 30. Large numbers of young people represent an engine of growth and a pool of labour. Urbanisation and the emergence of a middle class are enabling some countries to shift from an economy relying on exports of raw materials to one powered by domestic consumption instead. Africa is one of the few regions in the world that can claim natural growth. Investors can ride it without having to resort to leverage.
The emerging countries are moreover opening up—to each other, for starters, thanks to regional free-trade agreements. Since 2013 92% of merchandise trade within the Pacific Alliance, which includes Chile, Mexico, Peru and Colombia, is not subject to any tariffs. And the emerging regions are eager to attract foreign investment. In Colombia ColCapital, the national private equity association, and Bancoldex Capital, a fund supported by the government, have worked to create framework conditions that are conducive to private equity.
There is real local demand for private equity investments. Family-controlled companies often seek backing to implement more efficient forms of governance. Many markets remain fragmented and are destined to consolidate. In the Andes currency devaluation is forcing firms that have borrowed in foreign currency to find new sources of liquidity to refinance their debt and shore up their balance-sheets. Small and medium-sized businesses are often unable to obtain credit from banks, which only lend to big companies. Small wonder then that in a country like Colombia the number of private equity funds shot up from two in 2005 to 38 in 2014.
Despite this growth there is an imbalance between demand for capital and its supply. Even today private equity funds seem to prefer large enterprises. As a consequence demand for capital remains grossly under-satisfied among SMEs, whose shares are cheap because of intense competition. Thus enticing opportunities beckon. But despite these glowing prospects, the emerging markets embody widely varying situations. Africa alone has 54 countries with yawning disparity between them. To know where to invest, one has to proceed methodically. In our view the per-capita GDP/ economic diversification ratio is a very good indicator. It has allowed us to rule out countries that are too dependent on commodities or where the uneven distribution of wealth leaves no scope for sustainable growth.
Based on this analysis we have identified diversified markets with solid middle classes. These countries show strong potential in the consumer goods, telecommunications and banking sectors. It is a proven fact, for example, that the penetration of banking services creates a virtuous circle by better integrating people who work in the underground economy into society. The most promising markets, in our view, are to found in countries like Colombia, Peru, Ivory Coast, Mauritius and Kenya.
These markets contain gems—companies that are successfully doing business and that, in some cases, have done so for generations. At present many of them need capital, advice, networks and opportunities to expand. All this can be provided by private equity funds. These companies are often invisible to foreign investors. To capture opportunities, we advise them to give preference to link-ups with teams of experienced investors and local promoters.
Many emerging markets have real long-term growth potential driven by economic fundamentals and demographics. Shrewd investments in top-quality players that stud these regions can generate highly attractive returns. In our view the gap between real and the perceived risks is considerable.
With an appropriate methodology and link-ups, we believe that investing in the emerging markets can prove far less risky than buying into certain traditional assets.