Fast deteriorating risk profiles of Emerging Markets and Developing Economies (EMDE) are expected to slow down investment into these countries. Rising economic distress coupled with de-globalization momentum are triggering major business and economic reset in EMDE. 

These developments are likely to cause a paradigm shift in the Private Equity (PE) landscape of EMDE – especially in smaller nations. It is probable that this paradigm shift will take PE investing in EMDE back to basics, and back in time when plain growth investing in Small and Medium Enterprises (SME) was the main theme.   

PE in EMDE have gone through several transformations during the last two decades, and the overall results (in terms of profit for investors) have been below expectation. According to Cambridge Associates Private Equity and Venture Capital Index, PE returns in EMDE lag developed markets (except in few countries in Asia). Strong financial returns are essential to ensure sustainable PE for capital starved nations. Risk capital plays pivotal role in catalyzing economic growth in EMDE, and decent economic growth is in turn needed to ensure good return on PE investment. 

Expansion of Impact, and ESG (focused) investments (in fragile business models) is probably dampening the overall PE returns in EMDE.  In addition, the shift from traditional SME growth financing to larger buyouts (in fragile economies) are also proving to be disappointing.  For example, global PE giant TPG’s US$ 117 million (buyout) investment in Sri Lanka’s Union Bank in 2014, is now worth around 10 percent of the investment! Nevertheless even in smaller markets like Sri Lanka, some PE investors – notably traditional SME investors, have made decent returns. For instance, now defunct Aureos Capital was estimated to have realized around 3x return (by 2014) from its 2008 vintage US$ 4.5 million investment in Sri Lankan consumer group Sunshine.

The winning formula?
A recent article published by Word Bank’s IFC (“How to win Private Equity in Emerging Markets ad Developing Economies”) highlights very relevant and timeless points on investing in EMDE. According this analysis which is based on IFC/World Bank data, PE returns in EMDE are highest in markets where there are less competition – i.e., difficult markets with few players; and in markets which are not entirely open and developed (especially the financial sector).  

IFC article also suggests the most important factor in determining PE returns in EMDE is the GDP growth, and hence it is essential to take an accurate view on economic growth scenarios at the time of investment. According to this survey, situation at the time of investment (i.e., current and historical economic variables) or other popular indices like political stability, perceived corruption index, ease of doing business index, etc. are not important in driving PE returns. Another key success factor highlighted in this analysis is the need to hold investment for longer periods as EMDE are subject to short term volatility. 

Many EMDE are currently going through economic downturn, and many global investors are seen reducing exposure into these markets. But these countries will eventually come out of the current situation with stronger growth. Certainly many EMDE are currently having less competition for PE investments, have already resorted to many protectionist policies or imposed certain restrictions (on trade, investment, etc.), and on ground business environment have deteriorated. 

But this is an ideal situation for PE investors to book a healthy long-term return according to World Banks/ IFC findings! The key is to identify what factors would drive each country in fast de-globalizing scenario? Realignment of overall recovery strategies aimed at reviving primary and secondary sectors are likely to dominate. When these EMDE will emerge from the slump, it is the SME sector, which is going to grow faster as SMEs are the backbone of EMDE. 
 (Indika Hettiarachchi  is a Sri Lanka based PE investment advisory professional with over two decades experience in Private Market investing and advisory in Emerging Markets. He can be contacted via: indika.h@jupiter
capitalpartners.com)
■This article was originally published in https://www.eurasiareview.com/