There’s a reason private equity is rushing into emerging markets: major returns on investment. ROI on private equity investments in emerging markets more than tripled from 2000 to 2006, according to a new report by BCG and IESE Business School of the University of Navarra. New markets, however, present new challenges says David Wilton, chief investment officer for the International Finance Corporation's global investment program. BCG recently spoke to Wilton about private equity’s impact on developing economies, what nations need to do to attract additional investment and the role organizations like IFC and the World Bank may play in the industry’s future.
How does private equity contribute to the development of emerging markets?
What private equity brings that other types of investments don’t is real, live expertise and experience—not just capital. It helps companies grow quickly and sustainably. Very often, the businesses in these markets are family-run companies with rapid growth rates, unlike their counterparts in developed markets.
Private equity helps them overcome the growing pains by professionalizing their management; introducing transparency, and helping them understand how to manage growth sustainably. If there was no private equity, a lot of companies would struggle to deal with structural issues such as how to replace cousin Joe with a professional manager and how to identify and implement internationally competitive practices.
The impact of private equity in these markets is very tangible. In the companies that the IFC is backing, we’re seeing job growth rates of around 22 percent on average, compared to 2 to 4 percent for the countries as a whole.
What do emerging markets need to do to make themselves attractive to private equity?
You need a combination of factors to generate private-equity deal flow. If you look at where private equity has expanded, having a market-based economy is clearly the first prerequisite for creating a strong growth situation that will be attractive to private equity. Removing intrusive regulation and lightening the regulatory burden in other areas is part of this process. For large markets such as China, a market-based growth environment can sometimes be enough to trigger sufficient deal flow—but in most markets, it’s rarely enough.
Barriers to international trade and capital flows also have to be lowered so that companies are put under pressure to compete internationally and to specialize where they have competitive advantage.
This shift forces conglomerates to start to focus and sell off noncore businesses. We have seen the impact that lowering barriers to trade and capital flows has had on deal flow in South Africa, Morocco, East Africa, and Colombia, for example.
But attracting private equity isn’t just about removing negatives, you also have to introduce positives. The more positives, the greater the deal flow.
What are the positive steps needed to accelerate deal flow?
Greater transparency and a faster, more efficient legal system are two important measures. Once you get this happening, deal flow will jump as due diligence will become easier. Legal improvements also allow private-equity firms to contract at a distance, knowing that the contracts can be enforced. It also makes it easier for banks to lend for debt capital. Getting banks and capital markets working is important to expand private equity to lower-growth companies. The final and harder stage is establishing local stock exchanges with the size and transparency to provide the liquidity and lower cost of capital that is needed for an active IPO market. However, in many countries, the absence of an active IPO market hasn’t dampened interest, although we know that IPOs tend to produce the best returns.
How easy is it to achieve the transformations?
Things take time because countries usually want to do things in stages to stay within their comfort zones. What you usually find is that when a country sees one of its neighbors doing well, political and business pressures for reform start building up within the country.
How can international development organizations facilitate this transition?
Policy organizations such as the World Bank and IMF have played an important role in creating the building blocks for market economies, greater transparency, and other elements that are essential for attracting private equity to developing markets. Also, the IFC, CDC [the United Kingdom’s development finance institution], European Bank for Reconstruction and Development (EBRD), FMO [the entrepreneurial development bank of the Netherlands], and others have played a fairly big part in backing first-time funds in emerging markets—and once you get these in place, the commercial money follows. In addition, IFC has helped sustain the momentum by investing countercyclically during the financial crisis to plug the gaps. There’s now a good basis for moving forward, although things can always getter better—and I’m sure they will. Ten years ago, there were only four or five emerging markets that we thought could sustain country-dedicated funds, today there are more than 20.