Reward is worth risk for emerging market gurus

As war broke out between Russia and Georgia this month, several western private equity executives were breaking off from their summer holidays to monitor the situation in South Ossetia with particular concern.

Having just spent hundreds of millions of dollars on big Russian companies, including a fruit juice maker, a vodka producer and a drug distributor, senior executives at Lion Capital and TPG Capital have much at stake in the region.

Their acquisitions are part of a $2.7bn spending spree by private equity in Russia during the 12 months to June – more than six times the previous 12 months, according to Dealogic – underlining the rapid rise of emerging market private equity activity.

The attraction of places such as Russia, China and India has grown stronger for private equity since their strong economic growth proved more immune to the credit crunch than the US and Europe. As private equity remains relatively new in many of these markets, there is also huge potential for growth.

However, the war in South Ossetia is the latest, albeit extreme, reminder of the pitfalls in these new markets. An arguably more serious example of these risks is BP’s battle for control of its Russian TNK-BP joint venture.

Peter O’Driscoll, a lawyer at Orrick in London, says: “In Russia, Ukraine and other countries in Central and Eastern Europe, foreign investors are often lumped together and treated with the same disdain and disregard”.

Johannes Huth, head of Kohlberg Kravis Roberts in Europe, says: “Big deals in stable markets, that is what we sell to people. So we don’t see an emerging market like Russia as our core focus. Oligarchs are inevitably going to be better connected than us.”

Nonetheless, Mr Huth admits KKR, like many US and European rivals, has been expanding in some emerging markets, notably India and China, as it seeks to profit from rapid economic growth in these countries.

Paul Fletcher, senior managing partner of Actis, the emerging markets private equity group with $6.8bn of assets, says: “Five years ago no one wanted to do deals in these markets. Now it is the premier league of private equity.”

Even before the credit squeeze, buy-out groups were being drawn to these markets by the successes of early pioneers. Actis, Goldman Sachs and DragonTech Energy Investment were among the early-stage investors to make big profits from the US flotation of Suntech Power, a Chinese solar panel maker, three years ago.

Most emerging market private equity activity is still concentrated in the so-called Bric countries – Brazil, Russia, India and China. Investment by buy-out groups in these countries reached almost $17bn in the twelve months to June, an increase of about 80 per cent from the previous year, according to Dealogic.

Emerging market private equity groups raised $35.3bn in the first half of 2008, up two-thirds from a year ago, according to the Emerging Market Private Equity Association. The growth was particularly strong for funds targeting Asia and, on a smaller scale, Africa.

Ernest Bols, chief executive of Auda International, the fund of funds that has $5bn invested in private equity and hedge funds, says: “We find there is very significant interest in gaining access to Asian private equity from European investors”.

Mr Bols says emerging market private equity groups are being launched by people leaving western buy-out groups or banks to set up on their own. “Their funds are new, but they have typically jumped from a bigger shop, so they have experience,” he says.

The growth of the Chinese, Indian, African and Russian middle classes has Mr Fletcher rubbing his hands. He says: “Everywhere we look there is huge domestic-led growth, not just cheap labour driving export-led growth, and that is a huge change.

“We are also seeing huge capital expenditure on infrastructure, though there is a question whether China will back off after the Olympics.”

Moreover, the Actis chief argues that political unrest in regions like Africa can create opportunities. “We might re-enter Zimbabwe when it gets pointed in the right direction, as there are strategies you can adopt by going into defensive sectors, like mobile phones, which are used more in war, while hotels are less good,” he says.

However, there are risks for western private equity groups that charge headlong into such new and exotic markets, where deals typically use little or no debt and involve the purchase of minority stakes rather than controlling positions.

Mr Fletcher says: “Taking minority stakes is a very delicate skill set and you can get misaligned with the sponsor.

“Many of these big firms are control buy-out houses, if they can’t fire the chief executive, they don’t want to be there.”

Mr Fletcher warns there is “amazing” competition for deals. “We see that competition from Blackstone or Apax or whoever. They are trading down in deal size and we are raising more funds and trading up in deal size.”

An added complication is the currency risk of using local revenues to service debt in US dollars or euros. BC Partners this year raised €1bn of debt to acquire Migros, the Turkish supermarket chain. Nikos Stathopoulos, senior partner at BC Partners, says it covered some currency risk with financial hedging. But he admits that the best protection in emerging markets is “to take a longer term view”.

Then there is the risk of losing everything. Mr O’Driscoll at Orrick warns: “There has been a recent rash of expropriations in Latin America, and in Russia there are several high profile cases in which local courts have been used by Russian shareholders as part of an effort to force out foreign investors”.

Investors are worried by the rush into emerging markets. In Coller Capital’s recent barometer of private equity investors, three-quarters said their biggest concern was “strategy drift” by fund managers shifting away from core investment areas.

Meanwhile, investors are themselves shifting their allocation to emerging market managers and away from “mega buy-out” funds struggling with the credit crunch.

The crucial question is whether investors seeking more emerging market exposure will be happy for the bigger, more established western buy-out funds to do it for them, or whether they will prefer to find their own local fund managers.