While emerging markets have experienced some turbulent conditions over the last 18 months, they may still offer strengths to investors, including multi-asset managers, according to BNY Mellon investment affiliate Siguler Guff.
Investors in emerging markets have endured challenging times lately. Both the Morgan Stanley Capital International (MSCI) Emerging Market and MSCI Frontier Market indicies plummeted in 2015, falling 14.92% and 17.67%, respectively.1 Worse, net capital outflows (including unrecorded flows captured by net errors and omissions) totaled $735 billion in 2015, up from $111 billion the previous year, according to the Washington-based Institute of International Finance.2
For Siguler Guff managing director Ralph Jaeger, however, rumors of the demise of emerging markets have been greatly exaggerated. On the question of demographics alone, he says, the arguments in favor of investing in emerging markets remain persuasive. According to United Nations forecasts, for example, the number of people on the planet is expected to rise from 7.3 billion today to 9.7 billion by 2050. Most of that growth is forecast to come from countries in the emerging world, including India, Nigeria, Pakistan, the Democratic Republic of the Congo, Ethiopia, Tanzania, Indonesia and Uganda.3
For all this potential, however, mainstream strategies for investing in emerging markets are not without their challenges, according to Jaeger. Take equity investing, for example. Jaeger notes how emerging market indices tend to be heavily weighted towards just four sectors: energy, utilities, financial services and materials. By the same token, exposure to health care, consumer or tech is limited.
This is less than ideal, says Jaeger, since those high-growth sectors are exactly the ones that benefit the most from emerging market demographics. This is not to say there are no listed emerging market companies in the tech sector or consumer discretionary space—but these are comparatively few and far between, meaning they have a “scarcity” value. As a result, says Jaeger, they are often overpriced.
At the same time, companies listed on emerging market exchanges also tend to be large, often state-controlled companies. While the large-cap mining and energy companies that make up the bulk of emerging market indices are not necessarily bad companies, their predominance does limit investors’ options if they choose to access emerging markets through the traditional route of buying equities.
Faced with these challenges, investors do have other options. One route is to invest in emerging markets via private equity—a strategy, says Jaeger, that has a range of possible benefits.
First, emerging market private equity funds tend to have their investments spread across a far wider spectrum of sectors than public indices. Crucially, this means areas such as health care and technology—among the key beneficiaries of rising prosperity in developing countries—can be well represented (see Figure 1). It also makes for a less volatile experience for investors as portfolios tend not to be focused in a concentrated subset of sectors that rise and fall in lockstep with each other. The difference can be significant: data provider Cambridge Associates says volatility on its Emerging Markets Private Equity & Venture Capital Index is approximately half that of the MSCI EM Index.4
Second, private equity funds tend to identify and invest in opportunities early in the life cycle of companies and this may equate to better entry and exit multiples. Between 2003 and 2014, for example, Siguler Guff’s emerging market entry multiples for private companies were 25%-40% below those for public companies (see Figure 2). “By definition, a lot of private equity investing is about getting in on the ground floor,” says Jaeger. “Often the aim is to transform the company with a view to unlocking future value through either an IPO or M&A—and, in turn, that means valuations at the point of investing and at exit tend to be more attractive.”
A third argument in favor of emerging market private equity investing is performance. To illustrate this point, Jaeger turns once more to research by Cambridge Associates. Returns from emerging market private equity funds have been broadly comparable to, or marginally better than, developed and emerging market equities as well as U.S. private equity and venture capital funds, depending on the time period.
On closer examination, though, a far more compelling picture emerges. Says Jaeger, “If we consider returns from funds in just the first and second quartile you see spectacular outperformance against equities.” Over a 10-year period, for example, returns for top-quartile EM private equity funds outpace those of U.S. private equity and venture capital funds, the Russell 3000® Index and the MSCI EM Index by 875 bps, 1338 bps, and 1308 bps, respectively.
He concludes, “To us, the message seems clear. If investors are looking to tap into the potential of emerging markets, private equity investing is a potentially attractive route.”