Does Private Equity Really Work in Emerging Markets? (1 of 2)

by Justin Harlow

In this Part 1 of 2, we look at the principal obstacles to private equity investments in the emerging markets and examine how PE firms can improve the situation. Part 2 of 2 will explore the role local companies can play in enhancing opportunities for private equity investors in these markets.

OldWestAfricaThe emerging markets account for 82% of the world’s population, but only 13% of investments made by private equity firms. When you speak to investors about the lack of investment in these markets, you generally get the “events are out of our control” excuses such as “too much political risk”, “lack of investor protection”, “poor regulatory environments” or “no exit liquidity”. These are certainly valid concerns and no doubt can negatively impact investor appetite. However, are we really that helpless? Or is there something within our control as PE investors that we can do to increase the level of PE investment in the emerging markets?

What’s the Problem?

In the developed world, we have a habit of trying to replicate the same strategies with the same people that have been successful at home when we operate overseas. Why do we assume that the standard model of private equity that has served the developed world so well is the best fit for emerging markets? It appears that there are some fundamental inconsistencies between what conventional private equity firms need and the environment that emerging markets provide:

1) Investment Sizes of USD30 million+

Most PE funds look to invest upwards of USD30million in each transaction. Unfortunately, this size implies a level of maturity in the marketplace that doesn’t often exist in the emerging markets. PE firms are looking to invest in Series C, but what about Series A and B? As most PE firms discover, these markets are barely VC markets let alone PE markets. Even when you do find larger deals the competition is so fierce that the price paid to secure the deal ensures the “winner’s curse”, destroying returns and track records from the outset and inhibiting future capital raising.

2) High Quality Management Teams

If you ask experienced PE fund managers about the most important factor in determining a successful investment, the majority of them will say the quality of the management team. In fact, many of them rely on funding the same management teams over and over again. The problem in the emerging markets is that most sectors are in their infancy or have been historically dominated by international companies. As emerging markets rightfully push for more local involvement, there is inevitably going to be a short-term talent gap and that scares away many private equity investors.

3) Holding Periods of 3-5 Years

The typical holding period of a PE investment is 3-5 years. That’s fine in developed markets where you can identify targets that are primed for growth and can generate the necessary value enhancements in time. However, given that emerging markets are generally “build” not “buy” markets, value creation is often inconsistent with a 3-5 year time horizon.

4) Low Risk Investments

The blind-pool structures employed by private equity firms require a significant leap of faith from LPs. The PPM clearly provides some guidance, but LPs have little idea where their capital will be deployed prior to making capital commitments. This risk can be overlooked in developed markets where the relevant investment risks are lower. However, the inability of investors to clearly see where capital will be allocated prior to commitments in risker emerging markets is often a bridge too far.

5) Homogeneous Environments

The PE model works best for homogeneous investment environments where you can cram a significant number of LPs into a one-size-fits-all structure. The emerging markets are anything but homogeneous. Unfortunately, this forces private equity firms to converge on emerging markets popular with the herd, leaving many frontier markets to fall by the wayside.

What’s the Solution?

There is no silver bullet to address the lack of private equity investments in the emerging markets. Some solutions require adjustments by existing private equity firms; others require an entirely new approach. We believe the following recommendations are logical places to start:

1) Start Small

Very few opportunities satisfy the USD30 million investment size hurdle in the emerging markets. Therefore, PE firms must be prepared to start small and allocate additional capital over time. We strongly encourage the equity-line-of-credit approach in the emerging markets where the focus is on the total capital deployed not the initial outlay. This approach does necessitate a more entrepreneurial mind-set, which is sometimes lacking in PE firms. If that mind-set is absent, we would encourage PE firms to start VC divisions in their target markets to act as feeders for their late-stage funds or alternatively for PE firms to form alliances with external early-stage venture partners.

2) Staff Differently

PE firms need to look past the quality of the incumbent management team in the emerging markets; otherwise investments will continue to stall. However, such an approach requires a dramatic shift in the staffing at PE firms. For the most part, PE firms are packed with former investment bankers, many having never built or run businesses before. That approach might work in developed markets where investment targets have strong management, but that isn’t an effective strategy in the emerging markets. PE firms need to staff with entrepreneurial executives who have built businesses in these markets. We would go as far to stay that the 5:1 Managing Partner to Operating Partner ratio witnessed at many firms needs to be inverted to adequately address the managerial challenges of the emerging markets.

3) Collaborate with Investors

The traditional top-down approach employed by PE firms where a fund is designed and then marketed “at” investors is an outdated model and inappropriate for the emerging markets. A new collaborative approach is required where VC and PE firms tailor opportunities for investors to provide a better marriage of opportunity and appetite. PE firms may claim that their economics will take a hit if they take a more bottom-up approach. However, think about the opportunities we could open up with this newfound flexibility. Want to finance a 15-year investment in the emerging markets? Approach insurance companies or pension funds that generally have longer time horizons. Need to finance a gold project in Nicaragua? Secure the base capital from local investors who are comfortable with country risk and fill in with international investors who have the appetite for Nicaragua risk.

We would argue that often fund vehicles aren’t required at all. With the increased appetite from institutional investors seeking direct investments, perhaps the focus should be on building world-class companies not funds. Such direct investments are perfectly suited to the emerging markets as they provide investors with a clear line of sight to the investment, removing the blind-pool obstacles suffered by conventional funds.


The emerging markets have been dramatically underserved by private equity capital. Some of the reasons are market factors out of our control and we have to live with them. However, we are not helping our cause by employing the standard conventional private equity models from developed markets that are inherently inconsistent with the opportunity set in the emerging markets. Existing private equity firms need to adapt and new players need to materialize if private equity in the emerging markets is to ever realize its undoubted potential.

Justin Harlow is a Managing Partner at Emergo Partners