Description
Private equity activity in emerging economies has recovered appreciably since the steep contraction experienced during the global financial crisis in 2007–2009.
1. Introduction
Private equity activity in emerging economies
has recovered appreciably since the steep con-
traction experienced during the global ?nancial
crisis in 2007–2009. Fundraising reached pre-cri-
sis levels in the ?rst half of 2011 and although
investing has remained relatively subdued, the
strong increase in commitments to private equity
funds investing in the emerging markets sug-
gests that acquisitions by ?nancial sponsors
should soon regain momentum as well.
Therefore, it appears that the underlying trend of
expanding the private equity model beyond the
traditional markets in the US and Western
Europe has remained intact, despite the large
cyclical variation in fundraising and investing in
the wake of the global ?nancial crisis.
Against this background, this paper has two
objectives: ?rst, to identify the determinants of this
long-term trend and second, to assess where
emerging economies stand in their process of
catching up with the mature private equity mar-
kets. Private equity is considered a form of ?nan-
cial intermediation and an integral part of ?nancial
deepening, which is generally regarded as a criti-
cal precondition for sustained economic growth.
As this paper shows, foreign investors have played
a pivotal role in this process by supplying signi?-
cantly large amounts of private equity capital in
the emerging markets. While push factors have
probably played a signi?cant role, this paper
argues that pull factors have probably been even
more important. Speci?cally, emerging markets
are found to generate considerable ‘macroeco-
nomic alpha’, which is expected to be translated
into higher investment returns. This is by no means
an automatic process, but as this paper discusses,
the prospects for ?nancial deepening have
improved as domestic private equity industries
have emerged and foreign private equity ?rms
have better adapted their business models to
local conditions.
Looking forward, the recent trends in private
equity fundraising and investing in emerging
markets are likely to be further solidi?ed. With
the growth gap vis-à-vis advanced economies
expected to widen further in the foreseeable
future, emerging markets are primed to absorb a
growing share of private equity capital world-
wide. However, the speed at which these mar-
kets become further integrated will not only
depend on the relative growth of economic activ-
ity; institutional and legal reforms will be critical
in achieving higher investment-to-GDP ratios,
thus contributing to the general ?nancial deep-
ening and economic development. This integra-
tion process is likely to be uneven among the
various countries. While emerging markets as a
Financial deepening,
private equity and capital
flows to emerging markets
Peter Cornelius*
VOLUME ONE | NUMBER TWO | FALL 2011 1
Peter Cornelius is an
economist and is respon-
sible for analysing the
economic and ?nancial
environment for private
equity markets and exam-
ining the implications for
AlpInvest Partners' strate-
gic asset allocation.
e: Peter.Cornelius@
alpinvest.com
* The author has benefited from many discussions with his colleagues at AlpInvest Partners, notably Wim Borgdorff, Marek Herchel,
Sander van Maanen, Elliot Royce, Maarten Verwoort and Wendy Zhu. However, this paper should not be reported as represent-
ing the views of AlpInvest Partners. The views expressed in this paper are solely those of the author.
whole are expected to see higher penetration
rates, this paper ?nally argues that the process
may lead to a bifurcated outcome. While some
countries might become emergent by the end of
the decade (by 2020), if not earlier, others could
fall behind. Therefore, the paper concludes that
despite the generally favourable prospects for
private equity in emerging markets, investors will
need to take a highly differentiated view in their
due diligence approaches.
2. Financial deepening in
emerging markets
Financial development is a critical and inextrica-
ble part of the economic growth process. In fact,
there is considerable evidence that the level of
?nancial development is a good predictor of
future economic growth (Levine, 1997 and
2005), suggesting that there is a causal relation-
ship between the two. In explaining this relation-
ship, academic research has pointed to the role
of ?nancial systems in promoting capital accu-
mulation and technological innovation by facili-
tating the trading, hedging, diversi?cation and
pooling of risk; allocating resources; monitoring
managers and exerting corporate control;
mobilising savings; and facilitating the exchange
of goods and services (Levine, 1997).
A key indicator of ?nancial development is the
depth and breadth of an economy’s ?nancial mar-
kets.
1
Measured by the supply of equity and debt
outstanding, emerging markets have made sub-
stantial progress in catching up with advanced
economies. According to estimates by the
McKinsey Global Institute (2011), the ?nancial
supply in emerging markets grew by an annual
average rate of almost 18 percent between 2000
and 2010, compared with less than 5 percent in
advanced economies. As a result, the share of
emerging markets in the world’s ?nancial supply
almost doubled to 18 percent, as global ?nancial
supply reached $212 trillion at the end of 2010
(see Figure 1). During the same period, real GDP
in emerging markets rose at an average annual
rate of 6.2 percent, more than three times faster
than in advanced economies.
The process of catching up with advanced
economies has been particularly rapid in the
equity markets due to a combination of higher
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 2
1
The World Economic Forum’s Financial Development Index (2010) also takes into account the quality of a country’s institutional and
business environment and the policies aiming at ensuring financial stability; the efficiency of financial intermediation in banking and
non-banking financial services; and access by households and businesses to different forms of capital and financial services.
Figure 1: Global supply of outstanding debt and equity (1990–2010)
Source: McKinsey Global Institute (2011).
Note: End-of-period, constant 2010 exchange rates.
G
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a
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s
u
p
p
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(
$
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0
50
250
100
150
200
1990 1995 2000 2005 2006 2007 2008 2009 2010
Securitised loans outstanding Non-securitised loans outstanding
Non-?nancial corporate bonds outstanding Financial institution bonds outstanding
Public debt securities outstanding Stock market capitalisation
valuations amid rapid economic growth and a
growing number of initial public offerings (IPOs)
of emerging market companies. By the middle of
2011, the stock market capitalisation in emerging
economies totalled $17.7 trillion, comprising
around one-third of the global stock market cap-
italisation of $56.6 trillion, which is up from less
than 10 percent in 2000. An important factor in
this context has been the portfolio rebalancing
by international investors in response to the
changing composition of global investment
benchmarks; the portion of stocks from emerg-
ing markets in the MSCI World Index has risen
more than threefold to 14 percent since 2000.
Therefore, several emerging markets now have
stock market capitalisations that are broadly
comparable with those in advanced countries,
when normalised by the size of their respective
economies. For example, the capitalisation of the
Chinese and Indian stock markets amounted to
almost 100 percent of GDP at the end of 2010,
not much lower than in the US and greater than
in Japan and Western Europe (see Figure 2). By
contrast, bond markets in these emerging
economies have remained relatively shallow
compared with advanced economies.
Private equity investing has been an integral part
of ?nancial deepening in emerging market
economies, with acquisitions by ?nancial sponsors
having increased nearly tenfold over the last
decade. At the peak of the last cycle in 2007, pri-
vate equity funds deployed almost $55 billion in
the emerging markets, up from just a couple of bil-
lions at the beginning of the decade (see Figure
3). Although investment activity has fallen consid-
erably in the wake of the recent ?nancial crisis, it
has declined signi?cantly less than in advanced
economies. As a result, emerging markets have
increased their share of global private equity
investing to an average of around 15 percent in
the period from 2008 to the middle of 2011 from
just 3 percent in the ?rst few years from 2000 (see
Figure 4). The substantial rise in private equity
investments has been made possible by a similar
increase in commitments to private equity funds
targeting emerging economies, as well as larger
allocations to markets outside North America and
Western Europe by global funds. In fact, in the ?rst
half of 2011 private equity fundraising for emerg-
ing economies returned to pre-crisis levels, with
total commitments almost equal to the full year
2010 level. Finally, there are also more exits, an
important precondition for sustained growth in
private equity investing and fundraising in emerg-
ing economies (Cornelius, 2011). While some
assets have been divested through trade sales to
strategic buyers or to other private equity funds,
others have bene?ted from a more buoyant IPO
market. See Table 1 for a list of notable exits.
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 3
Figure 2: Global supply of outstanding debt and equity, as % of regional GDP (year-end 2010)
Source: McKinsey Global Institute (2011).
G
l
o
b
a
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s
u
p
p
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y
(
%
o
f
G
D
P
)
0
100
500
200
300
400
United
States
Japan Western
Europe
Other
developed
China India Middle East
and Africa
Other
Asia
Latin
America
CEE
and CIS
Securitised loans outstanding Non-securitised loans outstanding
Non-?nancial corporate bonds outstanding Financial institution bonds outstanding
Public debt securities outstanding Stock market capitalisation
119
72
69
152
97
93
96
62
57 48
Emerging Asia has attracted the largest share of
private equity capital, in both absolute terms
and in relation to its size (see Figure 5). In 2010,
the region’s penetration rate averaged 0.16
percent of GDP, significantly below its cyclical
peak in 2007, but still considerably higher than
in 2000. Latin America follows a similar pattern,
whereas private equity investing in the Middle
East and Africa and in Central & Eastern
Europe/Commonwealth of Independent States
region have yet to recover from the massive
market correction associated with the recent
global financial crisis. Overall, private equity as
a form of financial intermediation has played a
growing role in the deepening and broadening
of financial markets in emerging economies.
Penetration rates vary not only across regions,
but also within regions. The BRICs (Brazil,
Russia, India and China) are generally the most
penetrated economies in their respective
regions. These countries accounted for more
than 50 percent of all private equity investments
in emerging markets between 2005 and 2010
(see Figures 6 and 7). Although there remains a
significant gap in penetration rates vis-à-vis
mature private equity markets in the US and in
Europe, this gap has narrowed noticeably in
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 4
Figure 3: Private equity fundraising and investment in emerging economies (2001–2011)
Source: EMPEA.
Note: 2011 ?gure to June 30.
F
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(
$
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)
0
10,000
70,000
20,000
30,000
40,000
50,000
60,000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
H1
CEE/CIS Emerging Asia
Latin America MENA
Sub-Saharan Africa Multi-region
Fundraising
Investment
Figure 4: Private equity capital invested in emerging markets, as % of global investments
(1990–2011)
Source: Lerner, Sorensen Strömberg (2008); EMPEA; author’s calculations.
Note: 2011 ?gure to June 30.
C
a
p
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(
%
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20
10
15
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1
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H
1
Table 1: Notable exits in emerging markets (2006–2011)
Year of
exit
Year of
entry
Amount
invested Type of exit Country Portfolio company Sector General partner
2011 2009 $ 171m Share sale Brazil CETIP Financial services Advent International
2011 2005 $10m Share sale China China Paci?c Insurance Insurance The Carlyle Group
2011 2006 $900m Trade sale Turkey Mey Icki Sanayi Food & beverages TPG, Actera Capital
2010 2006 $163m Auction sale Brazil BR Malls Shopping malls GP Investments
2010 2006,
2010
$134m,
$144m
IPO China Changsha Zoomlion Heavy
Industry Science & Technology
Industrials Hony Capital
2010 2007 $1.4bn Trade sale China China Network Systems Cable TV MBK Partners
2010 2009 $95mn IPO China Yashili Food & beverages The Carlyle Group
2010 2004 $150m Share swap China Shenzen Development Bank Financial services TPG
2010 2006 $149m Trade sale India Paras Pharmaceuticals Health care Actis, Sequoia Capital India
2010 2007 $500m Trade sale Russia Nidan Soki Food & beverages Lion Capital
2010 2006 $167m Trade sale Uruguay Nuevo Banco Comercial Financial services Advent International
2009 2009 $171m IPO Brazil CETIP Financial services Advent International
2009 2007 $137m Trade sale Brazil Hypermarcas Consumer GP Investimentos
2009 2005,
2007
$800m IPO China China Paci?c Insurance Insurance The Carlyle Group
2009 2008 $45m Trade sale China Lenovo Mobile Telecom Hony Capital
2009 2007,
2009
$242m IPO India Adani Power Power 3i Group
2009 2005 $69m Trade sale Korea The FaceShop Consumer Af?nity Equity Partners
2008 2007 $140m Trade sale Brazil Lab. Amer. de Farmacoterapia Health care GP Investments
2008 2007,
2008
$351m IPO China Renhe Commercial Holdings Capital International, Sequoia
Capital China, Warburg Pincus
2008 2000 $450m Trade sale Korea Mando Corporation … Af?nity Equity Partners CCMP
Capital
2008 2004 $40m Secondary sale Nigeria Lagos Palms Shopping centres Actis, Tayo Amusan
2008 2004 $87m Trade sale Philippines Etelecare Global Solutions Telecom AIG global Investment, Crimson
Capital, Electra Partners
2008 2006 $40m Trade sale Russia News Media Media UFG Private Equity
2007 2005 $100m IPO Argentina Empresa Distribuidora y
Comercialzadora Norte
Distribution Dolphin Management
2007 2006 $231m IPO Brazil Comp Prov. Indust. e Comercio Industrials AIG Capital, GG Investments
2007 2005 $158m IPO China Belle ... CDH Investments, Morgan Stanley
Private Equity
2007 2006 $125m Share sale China Gome … Warburg Pincus
2007 2004 $500m IPO India Genpact Global Holdings ... General Atlantic, Oak Hill
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 5
recent years. For instance, private equity invest-
ments were essentially non-existent in India in
2000. As of press time in October 2011, it is
the most deeply penetrated BRIC economy,
with an average investment-to-GDP ratio of 0.5
percent between 2005 and 2010, compared
with 1.8 percent and 1.4 percent in the US and
Europe, respectively.
Buyout fundraising for emerging markets has
essentially kept pace with the rise in market
capitalisation (see Figure 8). Although inflows to
emerging market buyout funds accelerated
substantially in nominal terms in the mid-2000s,
this increase was significantly more moderate
relative to the size of public markets. This is an
indicator that has been used in academic
research on mature private equity markets
to identify potential boom-bust cycles (Kaplan
and Strömberg, 2009). This is in stark contrast
to inflows to buyout funds targeting mature
markets in the US and Europe, where commit-
ments to buyout partnerships roughly quadru-
pled between 2004 and 2007, normalised
by the capitalisation of their equity markets.
In the mature economies, the subsequent
decline in new inflows has been so dramatic
that its ratio to market capitalisation essentially
converged to the average level in emerging
economies.
2
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 6
2
This does not even take into account that global funds may actually deploy part of their capital in emerging markets as well.
Table 1: Notable exits in emerging markets (2006–2011) continued
Year of
exit
Year of
entry
Amount
invested Type of exit Country Portfolio company Sector General partner
2007 2005 $750m Trade sale Korea Hi-mart Shopping Af?nity Equity, Temasek
2007 2004 $59m Trade sale Malaysia,
Vietnam
Unza Holdings ... Actis, Standard Chartered
2007 2003 $35m IPO South Africa Platmin Mining Actis
2006 1998 $136m IPO Brazil Odontoprev … TMG Capital
2006 2003 $325m Trade sale Hungary Invitel Telecom Mid Europa, GMT
2006 2003 $135m Secondary sale Mexico Convermex … JP Morgan Partners
Source: EMPEA (Quarterly Report, various issues).
Figure 5: Penetration rates in emerging markets (1994–2010)
Source: EMPEA; IMF; author’s calculations.
P
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(
%
o
f
G
D
P
)
0.00
0.05
0.45
0.10
0.15
0.20
0.25
0.30
0.35
0.40
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Africa/Middle East
Emerging Asia
CEE/CIS
Latin America
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 7
Figure 6: Private equity investments in BRIC economies as % of all emerging economies (2002–2010)
Source: EMPEA.
I
n
v
e
s
t
m
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t
s
(
%
)
0
20
100
40
60
80
2002 2003 2004 2005 2006 2007 2008 2009 2010
China Brazil India Russia/CIS Other
Figure 7: Penetration rates in BRIC economies and the US (2002–2010)
Source: EMPEA; IMF; Lerner et al.; author’s calculations.
P
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%
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)
0.0
0.5
4.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2002 2003 2004 2005 2006 2007 2008 2009 2010
China Brazil India Russia/CIS
Europe US
Figure 8: Fundraising by buyout funds as % of end-of-period market capitalisation
Source: Preqin; World Federation of Exchanges.
Note: 2011 ?gure to June 30.
F
u
n
d
r
a
i
s
i
n
g
(
%
)
0.0
0.2
1.8
0.4
0.6
0.8
1.0
1.2
1.4
1.6
2003 2004 2005 2006 2007 2008 2009 2010 2011
H1
Europe US Global emerging markets
3. Cross-border private equity
investments in the emerging
markets
The preceding section discussed recent devel-
opments in private equity in emerging markets in
the broader context of ?nancial deepening. As
observed, these economies have absorbed a
substantially larger amount of private equity cap-
ital over the past decade, subject to signi?cant
cyclical variations. The discussion now turns to
the supply side: to what extent has the emer-
gence of a private equity market in emerging
economies been driven by foreign investors as
opposed to domestic funding sources?
Balance of payments statistics are of little help in
this regard, as they do not identify cross-border
investments by ?nancial sponsors separately.
Instead, private equity transactions are buried
within labels such as ‘direct equity investment’
and ‘portfolio equity investment’.
3
Specialised
data vendors, however, do provide detailed
information about the acquirer in M&A transac-
tions. It is from these sources we know the num-
ber and the volume of assets acquired by
?nancial sponsors in individual countries, as
opposed to strategic buyers. What is unknown,
however, are the limited partners (LP) in the
private equity fund(s) that undertake(s) acquisi-
tions. While certain data vendors identify some
LPs in individual funds, this information is usually
incomplete, as it is based on information from
LPs rather than the general partners (GP) manag-
ing a fund. Further, there is no information on the
capital commitments LPs have made to individ-
ual funds. Conceivably, the investor base of a
domestic fund could largely, or even entirely,
comprise of foreign limited partners. Conversely,
a transaction in an emerging economy could be
led by a foreign GP, whose fund has been raised
to a signi?cant or dominant degree from domes-
tic investors in the target country.
Nevertheless, there are good reasons to assume
that non-resident investors have played a key
role in the recent surge in fundraising for private
equity acquisitions in emerging markets. First,
in?ows to private equity funds targeting emerg-
ing markets and ?nancial-sponsor-led acquisi-
tions in these economies show a pro?le that
closely resembles the overall ?ow of capital (see
Figure 9). Importantly, there have been two pri-
vate equity cycles in the mid-1990s and an even
more pronounced cycle in the mid-2000s that
largely coincide with a substantial increase in
gross (and net) capital ?ows to emerging mar-
kets, relative to the size of their economies. The
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 8
3
These labels depend on the share of capital acquired in a transaction. Generally, acquisitions of 10 percent or more of a firm’s
capital are recorded as ‘direct investment’, whereas smaller acquisitions are recorded as ‘portfolio investment’ in balance of pay-
ments statistics.
Figure 9: Gross and net private capital ?ows to emerging markets as % of GDP (1980–2010)
Source: IMF; author’s forecast for 2010 on the basis of IIF estimates.
C
a
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-2
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12
1
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1
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1
0
f
Net ?ows Gross ?ows
similarities are particularly striking when com-
pared with direct and portfolio investment ?ows
(see Figure 10). The pro?le of private equity
activity is also broadly consistent with the region-
al distribution of overall private capital ?ows to
emerging economies (see Figure 11).
Second, a substantial portion of capital commit-
ments to emerging market funds have been
made to partnerships formed by GPs that are
headquartered outside of emerging markets
(see Figure 12). While commitments to buyout,
venture capital and growth capital funds man-
aged by GPs from emerging market economies
rose tenfold in 2003–2008, commitments to such
funds managed by GPs from advanced
economies grew even faster. In?ows to the latter
rose particularly strongly during the peak years
from 2006–2008, allowing foreign funds to
increase their market share to more than 45 per-
cent from around 28 percent pre-peak.
Examples include multi-billion-dollar funds
raised by: The Carlyle Group (Carlyle Asia
Partners II, 2006, $1,800 million); Kohlberg
Kravis Roberts (KKR Asia, 2007, $4,000 million);
CVC (Capital Partners Asia Paci?c III, 2008,
$4,119 million); and TPG (Asia V, 2008, $4,250
million). This implies that funds managed by GPs
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 9
Figure 10: Net direct and portfolio investment in emerging markets and private equity fundraising
(2001–2011)
Source: IIF; EMPEA.
Note: 2011 ?gure to June 30.
N
e
t
d
i
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e
c
t
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p
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t
f
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(
$
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)
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100
150
350
200
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300
0
10
80
20
30
40
50
60
70
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
H1
Net direct and portfolio investment
Private equity fundraising
Figure 11: Net capital ?ows to emerging economies, by region and investment type
Source: IIF (2011).
N
e
t
c
a
p
i
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a
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?
o
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s
(
$
b
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)
-200
-100
700
0
100
200
300
400
500
600
Emerging
Asia
CEE Latin
America
Africa/
Middle East
Emerging
Asia
CEE Latin
America
Africa/
Middle East
2009 2010
Portfolio investment Direct investment Commercial banks Non-banks Total
headquartered outside of emerging markets
were the main driver behind the fundraising and
investment boom during this period. Since then,
however, their share has fallen back amid a
recovery in in?ows to funds managed by GPs
from emerging economies.
Third, although the investor base of individual
funds – whether managed by foreign or domestic
GPs – is unknown, it is important to note that of
the 3,542 LPs listed in Preqin’s global database,
only 487 are headquartered in emerging markets
(see Figure 13).
4
Similar to the US and Western
Europe, the largest group of LPs in emerging
market private equity funds comprises public and
private pension funds and insurance companies.
Apart from a limited number of large pension
reserve funds, such as Korea’s National Pension
Fund ($235 billion in assets under management
at the end of 2009), China’s National Social
Security Fund ($114 billion) or South Africa’s
GEPF ($111 billion), these institutions generally
manage smaller resources than their counterparts
in more mature economies. Of the $11.3 trillion
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 10
4
Downloaded on July 15, 2011.
Figure 12: Emerging market capital raised and share of GPs headquartered outside emerging markets
(2003–2010)
Source: Preqin; author’s calculations.
C
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d
o
u
t
s
i
d
e
e
m
e
r
g
i
n
g
m
a
r
k
e
t
s
(
%
)
0
10,000
60,000
20,000
30,000
40,000
50,000
0
10
50
20
30
40
2003 2004 2005 2006 2007 2008 2009 2010
Buyouts Venture capital Growth capital Funds raised by GPs
headquartered outside
emerging markets
Figure 13: Emerging market LPs, by geography
Source: Preqin.
Emerging
economies (487)
Other advanced
economies (487)
Western Europe (907)
United States (1,661)
Sub-Saharan Africa (11)
MENA (115)
Central & Eastern
Europe (35)
Latin America (85)
Asia-Paci?c (200)
Africa (41)
managed by the top 300 public and pension
funds at the end of 2009,
5
only 11.1 percent
($1.26 trillion) was held by pension funds in
emerging markets. Many of these funds, howev-
er, are subject to restrictions in particular asset
classes, which often rule out or restrict invest-
ments in alternative assets, such as private equity
(Cornelius, 2011). Furthermore, even where regu-
latory caps do not exist or are set at relatively high
levels, many pension funds maintain internal
restrictions on private equity investments
(EMPEA, 2011).
Sovereign wealth funds (SWF) are usually less
constrained. Few disclose their investment
strategies in terms of asset classes and geogra-
phies. However, Bernstein, Lerner and Schoar
(2009) suggest that a non-trivial share of SWF
capital is actually invested outside their home
market. While there is no information on SWFs’
commitments to private equity funds, the authors
examine their direct private equity investment
strategies. Merging three publicly available
investment databases (Dealogic’s M&A Analytics,
Security Data Company’s (SDC) Platinum M&A
and Bureau van Dijk’s Zephyr), Bernstein et al.
identify 2,046 and 532 transactions made by
seven Asian SWFs and 15 Middle Eastern SWFs
between 1984 and 2007.
6
On average, these
funds are estimated to have had $132 billion and
$124 billion in assets under management,
respectively. For Asian funds in particular,
around three quarters of their investments were
made in Asia itself, but only slightly more than
one-third were made in the actual home nation
of the fund. Outside of their region, the Asian
SWFs were found to invest predominantly in
Europe and North America. By contrast, Middle
Eastern SWFs invested mostly outside their
region (83.5 percent). Within their own home
countries, direct private equity investments
accounted for only 9 percent.
4. Push versus pull factors
What has caused the recent surge in global
investors’ interest in private equity in emerging
markets? Are these the same factors that have
led to a general recovery in private capital ?ows?
Additionally, to what extent is today’s situation
different from the 1990s that had already seen a
wave of private equity ?ows to emerging
economies, which, however, proved short-lived?
Generally speaking, capital ?ows may be driven
by ‘push’ and ‘pull’ factors. Push factors tend to be
more cyclical. In the current global economic envi-
ronment, the substantial increase in private capital
?ows to emerging markets has been in part attrib-
uted to exceptionally low interest rates in
advanced economies, motivating investors to
chase potentially higher yields in emerging
economies. Recent research by International
Monetary Fund (IMF) (2011b) ?nds that short-term
bank credit is particularly sensitive to a widening in
interest-rate differentials. However, push factors
are likely to have also played an important role in
explaining signi?cantly larger in?ows to emerging
market equity and bond funds. Yield differentials
may be compounded by the growing risk appetite
among foreign investors who generally consider
emerging market investments as a higher-risk
asset class. While global interest rates and risk
appetite have not always moved in tandem, in the
post–crisis era extremely low bond yields in the
US, in the core economies in Europe, and in Japan
are believed to have encouraged investors to
accept greater risk.
While access to foreign savings may generally
be considered to be a good thing, the sharp rise
in capital ?ows to emerging market economies
in 2010 and the ?rst half of 2011 has raised con-
siderable concern. As IMF (2011b) has pointed
out in the April 2011 edition of its World
Economic Outlook: “…policy makers in many
(emerging market economies) have eyed the
recent turnaround in capital ?ows with mixed
enthusiasm”, as such ?ows “… may ?uctuate
unpredictably, exacerbating domestic or ?nan-
cial boom-bust cycles.” More recently, this warn-
ing has gained renewed relevance, as the
repricing of macro risk and renewed turmoil in
?nancial markets in the summer of 2011 led to
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 11
5
Towers Watson.
6
Their analysis also includes 84 observations from seven SWFs in the US, Australia and Europe. As we are interested in investment
strategies of investors in emerging economies, we ignore these transactions here.
signi?cantly weaker net capital in?ows, and in
some cases outright out?ows, including from
emerging market equity funds.
7
Pull factors tend to have longer-term character-
istics. Foreign capital may be pulled into a par-
ticular country or region by a stable macro and
political environment supporting sustained eco-
nomic growth and promising investors attrac-
tive returns. Although push factors have gained
importance over time, recent IMF (2011b)
research concludes that economy-specific (pull)
factors remain dominant and explain around
two-thirds of the variation in capital flow move-
ments in emerging market economies, with the
remainder due to common global and regional
factors. IMF (2011b) interprets the findings of its
research as: “…suggestive evidence in favour of
a secular trend of capital flows to recipient
economies driven by the economies’ structural
characteristics. Thus, any formal analysis of the
role of global cyclical variables as causes of cap-
ital flows must control for these economy-spe-
cific characteristics.”
The recovery in investors’ risk appetite and the
record-low level of interest rates in the post-cri-
sis era may have also played some role in
explaining the recent growth in commitments to
private equity funds for emerging markets.
Further, private equity investors may have been
pushed to new markets by the high degree of
competition in the traditional markets of the US
and Western Europe, a factor that has been
compounded by the huge in?ows to private
equity funds during the last cycle. Acquisition
prices in mature markets have remained surpris-
ingly robust despite sharply lower transaction
volumes in the aftermath of the crisis, which has
been attributed to the substantial amount of dry
powder that private equity funds continue to
have at their disposal as well as huge cash
reserves held by strategic buyers. In addition,
investors’ desire to diversity their private equity
portfolios have likely further pushed investments
outward into emerging markets.
The long-term nature of private equity investing
suggests that pull factors have probably been far
more important. In fact, many investors view pri-
vate equity as an additional asset class that
allows them to participate in the growth potential
that emerging markets can offer. However, an
individual economy’s size, stage of development
and potential to achieve sustained growth over
the medium-to-long-term varies substantially,
which is particularly critical for investors that
essentially lock in capital for a period of ten years
or more, as do LPs in a private equity fund. The
deployment of such funds has been highly con-
centrated in a small number of economies, to an
even higher degree than investments in emerg-
ing economies in other asset classes. Therefore,
it seems that investors are predominantly pulled
by the perceived attractiveness of, rather than
pushed into, such investments.
Pull factors played a key role in the ?rst investment
wave in the 1990s. At the time, private equity had
already looked like a clear winner when the
emerging Washington Consensus postulated that
the private sector, rather than the state, should be
the dominant driver for new investment and eco-
nomic growth (Leeds and Sutherland, 2003). As
the private sector expanded, it became necessary
for ?rms to move beyond the traditional ?nancing
model. However, their risk pro?le and lack of track
record prevented many private investors from
borrowing from banks or raising equity and debt
capital in the securities markets. Private equity
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 12
7
Several emerging market governments have put in place policy measures that aim at discouraging excessive capital inflows (IIF,
2011; IMF 2011a). Introduced as defences against imported irrational exuberance (Davies and Drexler, 2010), some countries
have relied on quantitative capital controls, including China whose authorities have imposed limits on Hong Kong banks’ net
open positions and their ability to access renminbi (RMB) through China’s foreign exchange market; Indonesia where short-term
external bank borrowing has been limited to 30 percent of capital; and Korea whose government has introduced a cap on the
size of banks’ foreign exchange derivatives books. Other countries have favoured tax measures. Examples includes Brazil’s IOF
tax, which has recently been raised from 4 percent to 6 percent; Korea’s reintroduction of a 14 percent withholding tax on for-
eign holdings of government bonds and central bank securities; and Thailand’s reintroduction of a 15 percent withholding tax on
non-resident interest earnings and capital gains on new purchases of government bonds. Others countries have decided to
impose unremunerated reserve requirements, such as Brazil’s 60 percent reserve requirements on banks’ short dollar position in
the spot market and Turkey’s reserve requirements that have been expanded to repo transactions. Finally, some countries have
taken measures to encourage outflows, either on a standalone basis or coupled with measures focusing on controlling inflows,
by raising existing ceilings on outward investments.
appeared to be ideally positioned to ?ll this gap.
On the capital supply-side, investors were attract-
ed by the potentially highly attractive returns in a
high-growth environment with low valuations. As
it turned out, however, returns fell signi?cantly
short of investors’ expectations because of a com-
bination of macro and micro factors. On the
macro side, investors found out that they had
substantially underestimated country risk, as a
huge correction in asset prices and massive
depreciation of local currencies in the Asian,
Russian and Latin American ?nancial crises in the
late 1990s wiped out a substantial part of private
equity returns. In some cases, the absence of well-
functioning institutions and a predictable legal
framework aggravated the situation further. On
the micro side, many foreign private equity ?rms
had failed to adapt to local conditions; they had
simply tried to transplant their traditional business
models to very different markets. Therefore, the
early investment boom in the 1990s was short-
lived, with private equity failing to gain traction as
a form of ?nancial intermediation.
Is this time different? From a macro standpoint,
there is a tendency towards answering this
question in the affirmative. Today, the macro-
economic situation looks substantially more
robust, with emerging markets having outper-
formed advanced economies by a wide margin
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 13
Figure 14: Real GDP growth in advanced and emerging economies (1990–2010)
Source: IMF WEO Database, April 2011.
R
e
a
l
G
D
P
g
r
o
w
t
h
(
%
)
-6
-4
10
-2
0
2
4
6
8
1
9
9
1
1
9
9
0
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
Emerging economies
Advanced economies
Figure 15: Correlation of advanced and emerging economy de-trended output (1980–2009)
Source: IMF (2010).
Note: Rolling correlations, 20-year window, window-end years on x-axis.
C
o
r
r
e
l
a
t
i
o
n
0.00
0.05
0.45
0.10
0.15
0.20
0.25
0.30
0.35
0.40
1
9
9
1
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
in terms of economic growth. This divergence
between emerging and advanced economies
has gained considerable momentum since the
year 2000 (see Figure 14). At the same time, busi-
ness cycles have become increasingly synchro-
nised, as emerging markets have become more
integrated into the global economy (see Figure
15). Although emerging markets were also sub-
stantially affected by the recent ?nancial crisis, as
a group they have been able to avoid an outright
contraction in output, and even helped to pull
the global economy out of its steepest downturn
in at least three generations. Therefore, emerg-
ing markets are said to have generated consider-
able ‘macroeconomic alpha’, while providing
less scope for diversi?cation due to a rise in their
‘macroeconomic beta’.
The share of global output of emerging markets
vis-à-vis developed markets is progressively clos-
ing. IMF projects that, in purchasing power pari-
ty terms, emerging economies will actually have
a relatively larger share by 2013 (see Figure 16).
These shifts in the global economy, whose extent
has become increasingly visible only in the last
few years, are underpinned by macroeconomic
fundamentals. Whereas the ?scal situation in
most advanced economies has deteriorated
sharply in the wake of the crisis, debt-to-GDP
ratios in emerging economies are on average
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 14
Figure 16: Advanced and emerging economies share in world GDP (1980–2016)
Source: IMF WEO Database.
Note: Based on purchasing power parity.
S
h
a
r
e
i
n
w
o
r
l
d
G
D
P
(
%
)
0
10
80
20
30
40
50
60
70
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
2
0
1
6
Emerging economies
Advanced economies
Figure 17: Public debt as % of GDP (1950–2015)
Source: IMF (2010).
P
u
b
l
i
c
d
e
b
t
(
%
o
f
G
D
P
)
0
20
140
40
60
80
100
120
1
9
5
0
1
9
5
2
1
9
5
4
1
9
5
6
1
9
5
8
1
9
6
0
1
9
6
2
1
9
6
4
1
9
6
6
1
9
6
8
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
G-7
Emerging economies
Advanced economies
substantially lower, with most countries running
signi?cantly smaller de?cits or even surpluses
(see Figure 17). Likewise, several emerging
economies have continued to accumulate large
foreign exchange reserves by running sizeable
current account surpluses, ampli?ed by strong
capital in?ows (see Figure 18).
There are also microeconomic reasons to believe
that today’s situation is signi?cantly different
from the 1990s. Importantly, private equity fund
managers have fundamentally adjusted their
global expansion strategies. One of the reasons
why early efforts often failed is the fact that many
foreign GPs simply tried to transplant their oper-
ating models, largely ignoring important institu-
tional, legal and cultural differences in their
target markets. The lessons learned from this
experience has encouraged fund managers to
adopt local strategies, open new of?ces, develop
strategic alliances with local ?rms and hire invest-
ment staff with expertise in the target markets.
Some ?rms also require experienced partners to
move to foreign locations instead of just para-
chuting them in periodically to help source and
execute deals. At the same time, local GPs that
tend to have a competitive advantage due to
their local knowledge have become more
sophisticated in ?nancial, operational and gover-
nance matters. Some GPs have been able to raise
multi-billion-dollar funds, ensuring an increasing-
ly competitive private equity industry in emerg-
ing economies. Finally, in sourcing and
undertaking acquisitions in emerging markets,
both domestic and foreign investors can rely on
an ecosystem of accounting ?rms, law of?ces,
business consultancies, investment banks and
other intermediaries that is substantially more
developed today than it was just 15 years ago.
Overall, these changes in macro and micro fun-
damentals suggest that private equity in emerg-
ing markets is coming of age both as an integral
part of ?nancial deepening and as a secular
trend of capital in?ows to these economies. This
trend is widely expected to gathering increased
momentum – unlike in the 1990s when a combi-
nation of macroeconomic imbalances and inad-
equate investment strategies prevented private
equity in emerging markets from getting suf?-
cient traction. While there are good reasons to
expect emerging economies to become increas-
ingly integrated into the global private equity
market, this does not mean that this process will
be smooth. From the mature markets, we know
that private equity is a high cyclical, which has
been attributed to imbalances between the
demand for, and the supply of, private equity
capital (Gompers and Lerner, 2000). Little sug-
gests that boom-bust cycles in private equity are
con?ned to the US and Western European mar-
kets, and fears that the substantial increase in
private equity capital in?ows from abroad could
exceed the absorptive capacity in emerging
markets would therefore appear to be legiti-
mate. If this were the case, the performance of
recent private equity investments in emerging
markets would be likely to fall short of investors’
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 15
Figure 18: Reserves (1995–2010)
Source: IMF WEO Database.
R
e
s
e
r
v
e
s
(
$
b
n
)
-200
0
1,400
200
400
600
800
1,000
1,200
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sub-Saharan Africa
Latin America
CEE and CIS
Middle East and North Africa
Developing Asia
expectations, with an ensuing, expected reduc-
tion in their supply of capital accordingly.
However, this scenario of a cyclical adjustment
around a longer-term trend needs to be clearly
differentiated from the expected slope of the
long-term trend itself.
5. Outlook and conclusions
Emerging economies are widely expected to
continue to play catch-up with the advanced
economies in the coming years and decades. In
the study Dreaming with the BRICs (2003),
Goldman Sachs projected that Brazil, China,
India and Russia would belong to the world’s ?ve
largest economies by the middle of the 21st cen-
tury. The recent growth trajectory of these coun-
tries relative to today’s industrial economies
suggests that this milestone could be reached
signi?cantly earlier. In a post-crisis update,
Goldman Sachs (2009) brought forward the pro-
jected date when the BRICs would become as
big as today’s G7 (Canada, France, Germany,
Italy, Japan, UK and US) to 2032. Goldman Sachs
also expects China to take over from the US as
the world’s largest economy by 2027. Even this
date may be a signi?cant underestimation of the
underlying growth dynamics, as argued by
Subramanian (2011). The catch-up process is not
con?ned to the BRICs; this process has been
more broadly based, which has caused growing
interest among institutional investors especially
in countries that rank after the BRICs in terms of
the size of their economies and growth potential.
Conveniently, Goldman Sachs has coined the
term ‘N-11’ – the next 11 emerging markets – for
a group comprising Bangladesh, Egypt,
Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan,
Philippines, Turkey and Vietnam.
Even if penetration rates in emerging markets
remain unchanged in the medium-to-longer
term, their expected macroeconomic outperfor-
mance should result in a growing share in global
private equity activity. A simple back-of-the enve-
lope calculation may help illustrate this scenario.
Let us take medium-term GDP projections from
the IMF’s World Economic Outlook. Assume that
emerging markets’ average penetration rates
stay at their 2005–2010 level. Under these
assumptions, the annual volume of private equity
transactions should reach around $80 billion by
2016. Under similar assumptions for advanced
economies, the share of emerging economies
would increase to around 15 percent from 12.5
percent in the ?rst half of 2011. Importantly, this
share refers to the expected volume of private
equity transactions, rather than the equity invest-
ments made by private equity ?rms. Assume,
?nally, that deals in emerging markets are, on
average, 20 percent debt-?nanced, compared
with a ratio of 60 percent in mature markets.
Under this additional assumption, the former
would account for around 25 percent of global
equity investments by the middle of the decade.
However, penetration rates may not remain
unchanged. Instead, they are likely to increase as
?nancial deepening gathers further momentum
as part of the general development process.
Goldman Sachs (2011) projects that the market
capitalisation in emerging economies may
increase from $14 trillion to $37 trillion and $80
trillion in 2020 and 2030, respectively, due to real
GDP growth, higher valuations and market deep-
ening. This implies a compound annual growth
rate (CAGR) of 9.3 percent. However, as the mar-
ket capitalisation of advanced economies is pro-
jected to grow at a CAGR of 4 percent, emerging
markets’ share in global market capitalisation is
forecast to grow to 44 percent and 55 percent in
2020 and 2030, respectively, from a share of 31
percent today (see Figure 19). The weight of
emerging markets in the MSCI World Index
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 16
Figure 19: Share of emerging markets in
world economy (2010–2030)
Source: Goldman Sachs (2011).
S
h
a
r
e
o
f
e
m
e
r
g
i
n
g
m
a
r
k
e
t
s
(
%
)
0.0
0.1
0.7
0.2
0.3
0.4
0.5
0.6
GDP Market cap MSCI world
weight
2010 2020 2030
could thus reach almost one-third by the end of
the projected horizon.
If private equity fundraising and investment
were to grow more or less in line with the pro-
jected long-term trajectory of market capitalisa-
tion in emerging economies, this would imply a
signi?cant rise in the average penetration rate.
Suppose, ?nally, that private equity investing
would average 0.3 percent of GDP by 2016.
Although this would be a considerable increase
from the average rate between 2005 and 2010,
it would still fall far short of the current penetra-
tion rates in advanced markets. Under this
assumption, emerging markets could account
for almost 20 percent of global private equity
transactions by 2016, and represent some 30
percent of equity investments, other things
being equal (especially with regard to the use of
debt in acquisitions).
While these scenarios are subject to substantial
uncertainty about the global macroeconomic out-
look and economic policies, they do indicate that
private equity markets in emerging economies
look set to continue to become more integrated.
As discussed in this paper, this process is now
well underway. Considering private equity as part
of a broader process of ?nancial deepening, this
integration is fuelled by increased cross-border
fundraising and investment activity. While private
equity capital ?ows to emerging markets may in
part be due to push factors (by global ?nancial
conditions and highly competitive private equity
markets in advanced economies), to a larger
extent it seems that they are attributed to pull fac-
tors (by economy-speci?c conditions in the recip-
ient countries). More speci?cally, foreign
investors are attracted by strong economic
growth in emerging markets, with private equity
representing an additional entry route to gain
exposure to ‘macroeconomic alpha’. As emerg-
ing markets continue to play catch-up and
advanced economies face a ‘new normal’ where
economic growth is set to remain ?atter due to
continued deleveraging, ?scal restraint and more
regulation, this alpha is expected to increase even
further in the next few years.
However, emerging markets are far from homog-
enous. For buyouts, the most important category
of private equity investing, Lerner, Sørensen and
Strömberg (2009) ?nd that cross-country varia-
tions are largely explained by differences in the
potential for operational engineering (that is,
measures to improve portfolio companies’ pro-
duction processes, working capital management
and marketing and production mix).
Implementing appropriate measures requires
adequate corporate governance standards. In
cross-country analyses, corruption is generally
found to hamper operational improvements and
is therefore associated with fewer buyouts.
Similarly, barriers to entrepreneurship – in empir-
ical estimates sometimes proxied by the number
of procedures required to start a new business
and the costs associated with them – is usually
found to be inversely related to the volume of
buyout deals. Additional factors hampering buy-
outs include high regulatory trade barriers, inter-
national capital controls and high taxes on
international trade. While several countries have
taken important measures aiming to improve the
business environment of their economies (see the
yearly World Bank Report on Doing Business), this
process is often dif?cult and time-consuming, as
private equity country attractiveness indexes
show (Groh, Liechtenstein and Lieser, 2011).
In conclusion, several economies are likely to see
further signi?cant increases in their penetration
rates as their institutional and legal frameworks
continue to improve. By 2020, if not earlier, some
of today’s emerging private equity markets might
become emergent, exhibiting a substantially
improved country-risk pro?le. Others, however,
may fall behind even further. Although emerging
markets as a whole may absorb a growing per-
centage of the world’s available private equity
capital, this possible bifurcation makes it essen-
tial for institutional investors to clearly differenti-
ate investments in this broad asset class. v
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 17
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Cornelius, Peter, 2011, International Investments in Private Equity: Asset Allocation, Markets and Industry Structure. Amsterdam et
al.: Elsevier/Academic Press.
Davies, Howard and Drexler, Michael, 2010, Financial Development, Capital flows and Capital Controls, The Financial Development
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Emerging Markets Private Equity Association, 2011, Local Pension Capital in Latin America, EMPEA Insight, July 2011.
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99-dreaming.pdf
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Kaplan, Steven N. and Strömberg, Per, 2009, Leveraged Buyouts and Private Equity, Journal of Economic Perspectives, Vol. 23 No.
1, pp. 121 –46.
Leeds, Roger, and Sunderland, Julie, 2003, Private Equity Investing in Emerging Markets, Journal of Applied Corporate Finance, Vol.
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Lerner, Josh, Strömberg, Per and Sørensen, Morten, 2009, What Drives Private Equity Activity and Success Globally? In Globalisation
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688–726.
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freepass_pdfs/Mapping_global_capital_markets/Capital_markets_update_email.pdf
Subramanian, Arvind, 2011, Eclipse: Living in the Shadow of China's Economic Dominance, Washington, DC: Peterson Institute for
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http://www.weforum.org/s?s=financial+development+report+2010.
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 18
doc_740140648.pdf
Private equity activity in emerging economies has recovered appreciably since the steep contraction experienced during the global financial crisis in 2007–2009.
1. Introduction
Private equity activity in emerging economies
has recovered appreciably since the steep con-
traction experienced during the global ?nancial
crisis in 2007–2009. Fundraising reached pre-cri-
sis levels in the ?rst half of 2011 and although
investing has remained relatively subdued, the
strong increase in commitments to private equity
funds investing in the emerging markets sug-
gests that acquisitions by ?nancial sponsors
should soon regain momentum as well.
Therefore, it appears that the underlying trend of
expanding the private equity model beyond the
traditional markets in the US and Western
Europe has remained intact, despite the large
cyclical variation in fundraising and investing in
the wake of the global ?nancial crisis.
Against this background, this paper has two
objectives: ?rst, to identify the determinants of this
long-term trend and second, to assess where
emerging economies stand in their process of
catching up with the mature private equity mar-
kets. Private equity is considered a form of ?nan-
cial intermediation and an integral part of ?nancial
deepening, which is generally regarded as a criti-
cal precondition for sustained economic growth.
As this paper shows, foreign investors have played
a pivotal role in this process by supplying signi?-
cantly large amounts of private equity capital in
the emerging markets. While push factors have
probably played a signi?cant role, this paper
argues that pull factors have probably been even
more important. Speci?cally, emerging markets
are found to generate considerable ‘macroeco-
nomic alpha’, which is expected to be translated
into higher investment returns. This is by no means
an automatic process, but as this paper discusses,
the prospects for ?nancial deepening have
improved as domestic private equity industries
have emerged and foreign private equity ?rms
have better adapted their business models to
local conditions.
Looking forward, the recent trends in private
equity fundraising and investing in emerging
markets are likely to be further solidi?ed. With
the growth gap vis-à-vis advanced economies
expected to widen further in the foreseeable
future, emerging markets are primed to absorb a
growing share of private equity capital world-
wide. However, the speed at which these mar-
kets become further integrated will not only
depend on the relative growth of economic activ-
ity; institutional and legal reforms will be critical
in achieving higher investment-to-GDP ratios,
thus contributing to the general ?nancial deep-
ening and economic development. This integra-
tion process is likely to be uneven among the
various countries. While emerging markets as a
Financial deepening,
private equity and capital
flows to emerging markets
Peter Cornelius*
VOLUME ONE | NUMBER TWO | FALL 2011 1
Peter Cornelius is an
economist and is respon-
sible for analysing the
economic and ?nancial
environment for private
equity markets and exam-
ining the implications for
AlpInvest Partners' strate-
gic asset allocation.
e: Peter.Cornelius@
alpinvest.com
* The author has benefited from many discussions with his colleagues at AlpInvest Partners, notably Wim Borgdorff, Marek Herchel,
Sander van Maanen, Elliot Royce, Maarten Verwoort and Wendy Zhu. However, this paper should not be reported as represent-
ing the views of AlpInvest Partners. The views expressed in this paper are solely those of the author.
whole are expected to see higher penetration
rates, this paper ?nally argues that the process
may lead to a bifurcated outcome. While some
countries might become emergent by the end of
the decade (by 2020), if not earlier, others could
fall behind. Therefore, the paper concludes that
despite the generally favourable prospects for
private equity in emerging markets, investors will
need to take a highly differentiated view in their
due diligence approaches.
2. Financial deepening in
emerging markets
Financial development is a critical and inextrica-
ble part of the economic growth process. In fact,
there is considerable evidence that the level of
?nancial development is a good predictor of
future economic growth (Levine, 1997 and
2005), suggesting that there is a causal relation-
ship between the two. In explaining this relation-
ship, academic research has pointed to the role
of ?nancial systems in promoting capital accu-
mulation and technological innovation by facili-
tating the trading, hedging, diversi?cation and
pooling of risk; allocating resources; monitoring
managers and exerting corporate control;
mobilising savings; and facilitating the exchange
of goods and services (Levine, 1997).
A key indicator of ?nancial development is the
depth and breadth of an economy’s ?nancial mar-
kets.
1
Measured by the supply of equity and debt
outstanding, emerging markets have made sub-
stantial progress in catching up with advanced
economies. According to estimates by the
McKinsey Global Institute (2011), the ?nancial
supply in emerging markets grew by an annual
average rate of almost 18 percent between 2000
and 2010, compared with less than 5 percent in
advanced economies. As a result, the share of
emerging markets in the world’s ?nancial supply
almost doubled to 18 percent, as global ?nancial
supply reached $212 trillion at the end of 2010
(see Figure 1). During the same period, real GDP
in emerging markets rose at an average annual
rate of 6.2 percent, more than three times faster
than in advanced economies.
The process of catching up with advanced
economies has been particularly rapid in the
equity markets due to a combination of higher
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 2
1
The World Economic Forum’s Financial Development Index (2010) also takes into account the quality of a country’s institutional and
business environment and the policies aiming at ensuring financial stability; the efficiency of financial intermediation in banking and
non-banking financial services; and access by households and businesses to different forms of capital and financial services.
Figure 1: Global supply of outstanding debt and equity (1990–2010)
Source: McKinsey Global Institute (2011).
Note: End-of-period, constant 2010 exchange rates.
G
l
o
b
a
l
s
u
p
p
l
y
(
$
m
)
0
50
250
100
150
200
1990 1995 2000 2005 2006 2007 2008 2009 2010
Securitised loans outstanding Non-securitised loans outstanding
Non-?nancial corporate bonds outstanding Financial institution bonds outstanding
Public debt securities outstanding Stock market capitalisation
valuations amid rapid economic growth and a
growing number of initial public offerings (IPOs)
of emerging market companies. By the middle of
2011, the stock market capitalisation in emerging
economies totalled $17.7 trillion, comprising
around one-third of the global stock market cap-
italisation of $56.6 trillion, which is up from less
than 10 percent in 2000. An important factor in
this context has been the portfolio rebalancing
by international investors in response to the
changing composition of global investment
benchmarks; the portion of stocks from emerg-
ing markets in the MSCI World Index has risen
more than threefold to 14 percent since 2000.
Therefore, several emerging markets now have
stock market capitalisations that are broadly
comparable with those in advanced countries,
when normalised by the size of their respective
economies. For example, the capitalisation of the
Chinese and Indian stock markets amounted to
almost 100 percent of GDP at the end of 2010,
not much lower than in the US and greater than
in Japan and Western Europe (see Figure 2). By
contrast, bond markets in these emerging
economies have remained relatively shallow
compared with advanced economies.
Private equity investing has been an integral part
of ?nancial deepening in emerging market
economies, with acquisitions by ?nancial sponsors
having increased nearly tenfold over the last
decade. At the peak of the last cycle in 2007, pri-
vate equity funds deployed almost $55 billion in
the emerging markets, up from just a couple of bil-
lions at the beginning of the decade (see Figure
3). Although investment activity has fallen consid-
erably in the wake of the recent ?nancial crisis, it
has declined signi?cantly less than in advanced
economies. As a result, emerging markets have
increased their share of global private equity
investing to an average of around 15 percent in
the period from 2008 to the middle of 2011 from
just 3 percent in the ?rst few years from 2000 (see
Figure 4). The substantial rise in private equity
investments has been made possible by a similar
increase in commitments to private equity funds
targeting emerging economies, as well as larger
allocations to markets outside North America and
Western Europe by global funds. In fact, in the ?rst
half of 2011 private equity fundraising for emerg-
ing economies returned to pre-crisis levels, with
total commitments almost equal to the full year
2010 level. Finally, there are also more exits, an
important precondition for sustained growth in
private equity investing and fundraising in emerg-
ing economies (Cornelius, 2011). While some
assets have been divested through trade sales to
strategic buyers or to other private equity funds,
others have bene?ted from a more buoyant IPO
market. See Table 1 for a list of notable exits.
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 3
Figure 2: Global supply of outstanding debt and equity, as % of regional GDP (year-end 2010)
Source: McKinsey Global Institute (2011).
G
l
o
b
a
l
s
u
p
p
l
y
(
%
o
f
G
D
P
)
0
100
500
200
300
400
United
States
Japan Western
Europe
Other
developed
China India Middle East
and Africa
Other
Asia
Latin
America
CEE
and CIS
Securitised loans outstanding Non-securitised loans outstanding
Non-?nancial corporate bonds outstanding Financial institution bonds outstanding
Public debt securities outstanding Stock market capitalisation
119
72
69
152
97
93
96
62
57 48
Emerging Asia has attracted the largest share of
private equity capital, in both absolute terms
and in relation to its size (see Figure 5). In 2010,
the region’s penetration rate averaged 0.16
percent of GDP, significantly below its cyclical
peak in 2007, but still considerably higher than
in 2000. Latin America follows a similar pattern,
whereas private equity investing in the Middle
East and Africa and in Central & Eastern
Europe/Commonwealth of Independent States
region have yet to recover from the massive
market correction associated with the recent
global financial crisis. Overall, private equity as
a form of financial intermediation has played a
growing role in the deepening and broadening
of financial markets in emerging economies.
Penetration rates vary not only across regions,
but also within regions. The BRICs (Brazil,
Russia, India and China) are generally the most
penetrated economies in their respective
regions. These countries accounted for more
than 50 percent of all private equity investments
in emerging markets between 2005 and 2010
(see Figures 6 and 7). Although there remains a
significant gap in penetration rates vis-à-vis
mature private equity markets in the US and in
Europe, this gap has narrowed noticeably in
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 4
Figure 3: Private equity fundraising and investment in emerging economies (2001–2011)
Source: EMPEA.
Note: 2011 ?gure to June 30.
F
u
n
d
r
a
i
s
i
n
g
a
n
d
i
n
v
e
s
t
m
e
n
t
(
$
m
)
0
10,000
70,000
20,000
30,000
40,000
50,000
60,000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
H1
CEE/CIS Emerging Asia
Latin America MENA
Sub-Saharan Africa Multi-region
Fundraising
Investment
Figure 4: Private equity capital invested in emerging markets, as % of global investments
(1990–2011)
Source: Lerner, Sorensen Strömberg (2008); EMPEA; author’s calculations.
Note: 2011 ?gure to June 30.
C
a
p
i
t
a
l
i
n
v
e
s
t
e
d
(
%
)
0
5
20
10
15
1
9
9
1
1
9
9
0
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
H
1
Table 1: Notable exits in emerging markets (2006–2011)
Year of
exit
Year of
entry
Amount
invested Type of exit Country Portfolio company Sector General partner
2011 2009 $ 171m Share sale Brazil CETIP Financial services Advent International
2011 2005 $10m Share sale China China Paci?c Insurance Insurance The Carlyle Group
2011 2006 $900m Trade sale Turkey Mey Icki Sanayi Food & beverages TPG, Actera Capital
2010 2006 $163m Auction sale Brazil BR Malls Shopping malls GP Investments
2010 2006,
2010
$134m,
$144m
IPO China Changsha Zoomlion Heavy
Industry Science & Technology
Industrials Hony Capital
2010 2007 $1.4bn Trade sale China China Network Systems Cable TV MBK Partners
2010 2009 $95mn IPO China Yashili Food & beverages The Carlyle Group
2010 2004 $150m Share swap China Shenzen Development Bank Financial services TPG
2010 2006 $149m Trade sale India Paras Pharmaceuticals Health care Actis, Sequoia Capital India
2010 2007 $500m Trade sale Russia Nidan Soki Food & beverages Lion Capital
2010 2006 $167m Trade sale Uruguay Nuevo Banco Comercial Financial services Advent International
2009 2009 $171m IPO Brazil CETIP Financial services Advent International
2009 2007 $137m Trade sale Brazil Hypermarcas Consumer GP Investimentos
2009 2005,
2007
$800m IPO China China Paci?c Insurance Insurance The Carlyle Group
2009 2008 $45m Trade sale China Lenovo Mobile Telecom Hony Capital
2009 2007,
2009
$242m IPO India Adani Power Power 3i Group
2009 2005 $69m Trade sale Korea The FaceShop Consumer Af?nity Equity Partners
2008 2007 $140m Trade sale Brazil Lab. Amer. de Farmacoterapia Health care GP Investments
2008 2007,
2008
$351m IPO China Renhe Commercial Holdings Capital International, Sequoia
Capital China, Warburg Pincus
2008 2000 $450m Trade sale Korea Mando Corporation … Af?nity Equity Partners CCMP
Capital
2008 2004 $40m Secondary sale Nigeria Lagos Palms Shopping centres Actis, Tayo Amusan
2008 2004 $87m Trade sale Philippines Etelecare Global Solutions Telecom AIG global Investment, Crimson
Capital, Electra Partners
2008 2006 $40m Trade sale Russia News Media Media UFG Private Equity
2007 2005 $100m IPO Argentina Empresa Distribuidora y
Comercialzadora Norte
Distribution Dolphin Management
2007 2006 $231m IPO Brazil Comp Prov. Indust. e Comercio Industrials AIG Capital, GG Investments
2007 2005 $158m IPO China Belle ... CDH Investments, Morgan Stanley
Private Equity
2007 2006 $125m Share sale China Gome … Warburg Pincus
2007 2004 $500m IPO India Genpact Global Holdings ... General Atlantic, Oak Hill
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 5
recent years. For instance, private equity invest-
ments were essentially non-existent in India in
2000. As of press time in October 2011, it is
the most deeply penetrated BRIC economy,
with an average investment-to-GDP ratio of 0.5
percent between 2005 and 2010, compared
with 1.8 percent and 1.4 percent in the US and
Europe, respectively.
Buyout fundraising for emerging markets has
essentially kept pace with the rise in market
capitalisation (see Figure 8). Although inflows to
emerging market buyout funds accelerated
substantially in nominal terms in the mid-2000s,
this increase was significantly more moderate
relative to the size of public markets. This is an
indicator that has been used in academic
research on mature private equity markets
to identify potential boom-bust cycles (Kaplan
and Strömberg, 2009). This is in stark contrast
to inflows to buyout funds targeting mature
markets in the US and Europe, where commit-
ments to buyout partnerships roughly quadru-
pled between 2004 and 2007, normalised
by the capitalisation of their equity markets.
In the mature economies, the subsequent
decline in new inflows has been so dramatic
that its ratio to market capitalisation essentially
converged to the average level in emerging
economies.
2
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 6
2
This does not even take into account that global funds may actually deploy part of their capital in emerging markets as well.
Table 1: Notable exits in emerging markets (2006–2011) continued
Year of
exit
Year of
entry
Amount
invested Type of exit Country Portfolio company Sector General partner
2007 2005 $750m Trade sale Korea Hi-mart Shopping Af?nity Equity, Temasek
2007 2004 $59m Trade sale Malaysia,
Vietnam
Unza Holdings ... Actis, Standard Chartered
2007 2003 $35m IPO South Africa Platmin Mining Actis
2006 1998 $136m IPO Brazil Odontoprev … TMG Capital
2006 2003 $325m Trade sale Hungary Invitel Telecom Mid Europa, GMT
2006 2003 $135m Secondary sale Mexico Convermex … JP Morgan Partners
Source: EMPEA (Quarterly Report, various issues).
Figure 5: Penetration rates in emerging markets (1994–2010)
Source: EMPEA; IMF; author’s calculations.
P
r
i
v
a
t
e
e
q
u
i
t
y
i
n
v
e
s
t
m
e
n
t
(
%
o
f
G
D
P
)
0.00
0.05
0.45
0.10
0.15
0.20
0.25
0.30
0.35
0.40
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Africa/Middle East
Emerging Asia
CEE/CIS
Latin America
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 7
Figure 6: Private equity investments in BRIC economies as % of all emerging economies (2002–2010)
Source: EMPEA.
I
n
v
e
s
t
m
e
n
t
s
(
%
)
0
20
100
40
60
80
2002 2003 2004 2005 2006 2007 2008 2009 2010
China Brazil India Russia/CIS Other
Figure 7: Penetration rates in BRIC economies and the US (2002–2010)
Source: EMPEA; IMF; Lerner et al.; author’s calculations.
P
r
i
v
a
t
e
e
q
u
i
t
y
i
n
v
e
s
t
m
e
n
t
(
%
o
f
G
D
P
)
0.0
0.5
4.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
2002 2003 2004 2005 2006 2007 2008 2009 2010
China Brazil India Russia/CIS
Europe US
Figure 8: Fundraising by buyout funds as % of end-of-period market capitalisation
Source: Preqin; World Federation of Exchanges.
Note: 2011 ?gure to June 30.
F
u
n
d
r
a
i
s
i
n
g
(
%
)
0.0
0.2
1.8
0.4
0.6
0.8
1.0
1.2
1.4
1.6
2003 2004 2005 2006 2007 2008 2009 2010 2011
H1
Europe US Global emerging markets
3. Cross-border private equity
investments in the emerging
markets
The preceding section discussed recent devel-
opments in private equity in emerging markets in
the broader context of ?nancial deepening. As
observed, these economies have absorbed a
substantially larger amount of private equity cap-
ital over the past decade, subject to signi?cant
cyclical variations. The discussion now turns to
the supply side: to what extent has the emer-
gence of a private equity market in emerging
economies been driven by foreign investors as
opposed to domestic funding sources?
Balance of payments statistics are of little help in
this regard, as they do not identify cross-border
investments by ?nancial sponsors separately.
Instead, private equity transactions are buried
within labels such as ‘direct equity investment’
and ‘portfolio equity investment’.
3
Specialised
data vendors, however, do provide detailed
information about the acquirer in M&A transac-
tions. It is from these sources we know the num-
ber and the volume of assets acquired by
?nancial sponsors in individual countries, as
opposed to strategic buyers. What is unknown,
however, are the limited partners (LP) in the
private equity fund(s) that undertake(s) acquisi-
tions. While certain data vendors identify some
LPs in individual funds, this information is usually
incomplete, as it is based on information from
LPs rather than the general partners (GP) manag-
ing a fund. Further, there is no information on the
capital commitments LPs have made to individ-
ual funds. Conceivably, the investor base of a
domestic fund could largely, or even entirely,
comprise of foreign limited partners. Conversely,
a transaction in an emerging economy could be
led by a foreign GP, whose fund has been raised
to a signi?cant or dominant degree from domes-
tic investors in the target country.
Nevertheless, there are good reasons to assume
that non-resident investors have played a key
role in the recent surge in fundraising for private
equity acquisitions in emerging markets. First,
in?ows to private equity funds targeting emerg-
ing markets and ?nancial-sponsor-led acquisi-
tions in these economies show a pro?le that
closely resembles the overall ?ow of capital (see
Figure 9). Importantly, there have been two pri-
vate equity cycles in the mid-1990s and an even
more pronounced cycle in the mid-2000s that
largely coincide with a substantial increase in
gross (and net) capital ?ows to emerging mar-
kets, relative to the size of their economies. The
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 8
3
These labels depend on the share of capital acquired in a transaction. Generally, acquisitions of 10 percent or more of a firm’s
capital are recorded as ‘direct investment’, whereas smaller acquisitions are recorded as ‘portfolio investment’ in balance of pay-
ments statistics.
Figure 9: Gross and net private capital ?ows to emerging markets as % of GDP (1980–2010)
Source: IMF; author’s forecast for 2010 on the basis of IIF estimates.
C
a
p
i
t
a
l
?
o
w
s
(
%
o
f
G
D
P
)
-2
0
14
2
4
6
8
10
12
1
9
8
1
1
9
8
0
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
2
2
0
0
3
2
0
0
1
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
f
Net ?ows Gross ?ows
similarities are particularly striking when com-
pared with direct and portfolio investment ?ows
(see Figure 10). The pro?le of private equity
activity is also broadly consistent with the region-
al distribution of overall private capital ?ows to
emerging economies (see Figure 11).
Second, a substantial portion of capital commit-
ments to emerging market funds have been
made to partnerships formed by GPs that are
headquartered outside of emerging markets
(see Figure 12). While commitments to buyout,
venture capital and growth capital funds man-
aged by GPs from emerging market economies
rose tenfold in 2003–2008, commitments to such
funds managed by GPs from advanced
economies grew even faster. In?ows to the latter
rose particularly strongly during the peak years
from 2006–2008, allowing foreign funds to
increase their market share to more than 45 per-
cent from around 28 percent pre-peak.
Examples include multi-billion-dollar funds
raised by: The Carlyle Group (Carlyle Asia
Partners II, 2006, $1,800 million); Kohlberg
Kravis Roberts (KKR Asia, 2007, $4,000 million);
CVC (Capital Partners Asia Paci?c III, 2008,
$4,119 million); and TPG (Asia V, 2008, $4,250
million). This implies that funds managed by GPs
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 9
Figure 10: Net direct and portfolio investment in emerging markets and private equity fundraising
(2001–2011)
Source: IIF; EMPEA.
Note: 2011 ?gure to June 30.
N
e
t
d
i
r
e
c
t
a
n
d
p
o
r
t
f
o
l
i
o
i
n
v
e
s
t
m
e
n
t
(
$
b
n
)
P
r
i
v
a
t
e
e
q
u
i
t
y
f
u
n
d
r
a
i
s
i
n
g
(
$
b
n
)
100
150
350
200
250
300
0
10
80
20
30
40
50
60
70
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
H1
Net direct and portfolio investment
Private equity fundraising
Figure 11: Net capital ?ows to emerging economies, by region and investment type
Source: IIF (2011).
N
e
t
c
a
p
i
t
a
l
?
o
w
s
(
$
b
n
)
-200
-100
700
0
100
200
300
400
500
600
Emerging
Asia
CEE Latin
America
Africa/
Middle East
Emerging
Asia
CEE Latin
America
Africa/
Middle East
2009 2010
Portfolio investment Direct investment Commercial banks Non-banks Total
headquartered outside of emerging markets
were the main driver behind the fundraising and
investment boom during this period. Since then,
however, their share has fallen back amid a
recovery in in?ows to funds managed by GPs
from emerging economies.
Third, although the investor base of individual
funds – whether managed by foreign or domestic
GPs – is unknown, it is important to note that of
the 3,542 LPs listed in Preqin’s global database,
only 487 are headquartered in emerging markets
(see Figure 13).
4
Similar to the US and Western
Europe, the largest group of LPs in emerging
market private equity funds comprises public and
private pension funds and insurance companies.
Apart from a limited number of large pension
reserve funds, such as Korea’s National Pension
Fund ($235 billion in assets under management
at the end of 2009), China’s National Social
Security Fund ($114 billion) or South Africa’s
GEPF ($111 billion), these institutions generally
manage smaller resources than their counterparts
in more mature economies. Of the $11.3 trillion
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 10
4
Downloaded on July 15, 2011.
Figure 12: Emerging market capital raised and share of GPs headquartered outside emerging markets
(2003–2010)
Source: Preqin; author’s calculations.
C
a
p
i
t
a
l
r
a
i
s
e
d
(
$
m
)
F
u
n
d
s
r
a
i
s
e
d
b
y
G
P
s
h
e
a
d
q
u
a
r
t
e
r
e
d
o
u
t
s
i
d
e
e
m
e
r
g
i
n
g
m
a
r
k
e
t
s
(
%
)
0
10,000
60,000
20,000
30,000
40,000
50,000
0
10
50
20
30
40
2003 2004 2005 2006 2007 2008 2009 2010
Buyouts Venture capital Growth capital Funds raised by GPs
headquartered outside
emerging markets
Figure 13: Emerging market LPs, by geography
Source: Preqin.
Emerging
economies (487)
Other advanced
economies (487)
Western Europe (907)
United States (1,661)
Sub-Saharan Africa (11)
MENA (115)
Central & Eastern
Europe (35)
Latin America (85)
Asia-Paci?c (200)
Africa (41)
managed by the top 300 public and pension
funds at the end of 2009,
5
only 11.1 percent
($1.26 trillion) was held by pension funds in
emerging markets. Many of these funds, howev-
er, are subject to restrictions in particular asset
classes, which often rule out or restrict invest-
ments in alternative assets, such as private equity
(Cornelius, 2011). Furthermore, even where regu-
latory caps do not exist or are set at relatively high
levels, many pension funds maintain internal
restrictions on private equity investments
(EMPEA, 2011).
Sovereign wealth funds (SWF) are usually less
constrained. Few disclose their investment
strategies in terms of asset classes and geogra-
phies. However, Bernstein, Lerner and Schoar
(2009) suggest that a non-trivial share of SWF
capital is actually invested outside their home
market. While there is no information on SWFs’
commitments to private equity funds, the authors
examine their direct private equity investment
strategies. Merging three publicly available
investment databases (Dealogic’s M&A Analytics,
Security Data Company’s (SDC) Platinum M&A
and Bureau van Dijk’s Zephyr), Bernstein et al.
identify 2,046 and 532 transactions made by
seven Asian SWFs and 15 Middle Eastern SWFs
between 1984 and 2007.
6
On average, these
funds are estimated to have had $132 billion and
$124 billion in assets under management,
respectively. For Asian funds in particular,
around three quarters of their investments were
made in Asia itself, but only slightly more than
one-third were made in the actual home nation
of the fund. Outside of their region, the Asian
SWFs were found to invest predominantly in
Europe and North America. By contrast, Middle
Eastern SWFs invested mostly outside their
region (83.5 percent). Within their own home
countries, direct private equity investments
accounted for only 9 percent.
4. Push versus pull factors
What has caused the recent surge in global
investors’ interest in private equity in emerging
markets? Are these the same factors that have
led to a general recovery in private capital ?ows?
Additionally, to what extent is today’s situation
different from the 1990s that had already seen a
wave of private equity ?ows to emerging
economies, which, however, proved short-lived?
Generally speaking, capital ?ows may be driven
by ‘push’ and ‘pull’ factors. Push factors tend to be
more cyclical. In the current global economic envi-
ronment, the substantial increase in private capital
?ows to emerging markets has been in part attrib-
uted to exceptionally low interest rates in
advanced economies, motivating investors to
chase potentially higher yields in emerging
economies. Recent research by International
Monetary Fund (IMF) (2011b) ?nds that short-term
bank credit is particularly sensitive to a widening in
interest-rate differentials. However, push factors
are likely to have also played an important role in
explaining signi?cantly larger in?ows to emerging
market equity and bond funds. Yield differentials
may be compounded by the growing risk appetite
among foreign investors who generally consider
emerging market investments as a higher-risk
asset class. While global interest rates and risk
appetite have not always moved in tandem, in the
post–crisis era extremely low bond yields in the
US, in the core economies in Europe, and in Japan
are believed to have encouraged investors to
accept greater risk.
While access to foreign savings may generally
be considered to be a good thing, the sharp rise
in capital ?ows to emerging market economies
in 2010 and the ?rst half of 2011 has raised con-
siderable concern. As IMF (2011b) has pointed
out in the April 2011 edition of its World
Economic Outlook: “…policy makers in many
(emerging market economies) have eyed the
recent turnaround in capital ?ows with mixed
enthusiasm”, as such ?ows “… may ?uctuate
unpredictably, exacerbating domestic or ?nan-
cial boom-bust cycles.” More recently, this warn-
ing has gained renewed relevance, as the
repricing of macro risk and renewed turmoil in
?nancial markets in the summer of 2011 led to
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 11
5
Towers Watson.
6
Their analysis also includes 84 observations from seven SWFs in the US, Australia and Europe. As we are interested in investment
strategies of investors in emerging economies, we ignore these transactions here.
signi?cantly weaker net capital in?ows, and in
some cases outright out?ows, including from
emerging market equity funds.
7
Pull factors tend to have longer-term character-
istics. Foreign capital may be pulled into a par-
ticular country or region by a stable macro and
political environment supporting sustained eco-
nomic growth and promising investors attrac-
tive returns. Although push factors have gained
importance over time, recent IMF (2011b)
research concludes that economy-specific (pull)
factors remain dominant and explain around
two-thirds of the variation in capital flow move-
ments in emerging market economies, with the
remainder due to common global and regional
factors. IMF (2011b) interprets the findings of its
research as: “…suggestive evidence in favour of
a secular trend of capital flows to recipient
economies driven by the economies’ structural
characteristics. Thus, any formal analysis of the
role of global cyclical variables as causes of cap-
ital flows must control for these economy-spe-
cific characteristics.”
The recovery in investors’ risk appetite and the
record-low level of interest rates in the post-cri-
sis era may have also played some role in
explaining the recent growth in commitments to
private equity funds for emerging markets.
Further, private equity investors may have been
pushed to new markets by the high degree of
competition in the traditional markets of the US
and Western Europe, a factor that has been
compounded by the huge in?ows to private
equity funds during the last cycle. Acquisition
prices in mature markets have remained surpris-
ingly robust despite sharply lower transaction
volumes in the aftermath of the crisis, which has
been attributed to the substantial amount of dry
powder that private equity funds continue to
have at their disposal as well as huge cash
reserves held by strategic buyers. In addition,
investors’ desire to diversity their private equity
portfolios have likely further pushed investments
outward into emerging markets.
The long-term nature of private equity investing
suggests that pull factors have probably been far
more important. In fact, many investors view pri-
vate equity as an additional asset class that
allows them to participate in the growth potential
that emerging markets can offer. However, an
individual economy’s size, stage of development
and potential to achieve sustained growth over
the medium-to-long-term varies substantially,
which is particularly critical for investors that
essentially lock in capital for a period of ten years
or more, as do LPs in a private equity fund. The
deployment of such funds has been highly con-
centrated in a small number of economies, to an
even higher degree than investments in emerg-
ing economies in other asset classes. Therefore,
it seems that investors are predominantly pulled
by the perceived attractiveness of, rather than
pushed into, such investments.
Pull factors played a key role in the ?rst investment
wave in the 1990s. At the time, private equity had
already looked like a clear winner when the
emerging Washington Consensus postulated that
the private sector, rather than the state, should be
the dominant driver for new investment and eco-
nomic growth (Leeds and Sutherland, 2003). As
the private sector expanded, it became necessary
for ?rms to move beyond the traditional ?nancing
model. However, their risk pro?le and lack of track
record prevented many private investors from
borrowing from banks or raising equity and debt
capital in the securities markets. Private equity
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 12
7
Several emerging market governments have put in place policy measures that aim at discouraging excessive capital inflows (IIF,
2011; IMF 2011a). Introduced as defences against imported irrational exuberance (Davies and Drexler, 2010), some countries
have relied on quantitative capital controls, including China whose authorities have imposed limits on Hong Kong banks’ net
open positions and their ability to access renminbi (RMB) through China’s foreign exchange market; Indonesia where short-term
external bank borrowing has been limited to 30 percent of capital; and Korea whose government has introduced a cap on the
size of banks’ foreign exchange derivatives books. Other countries have favoured tax measures. Examples includes Brazil’s IOF
tax, which has recently been raised from 4 percent to 6 percent; Korea’s reintroduction of a 14 percent withholding tax on for-
eign holdings of government bonds and central bank securities; and Thailand’s reintroduction of a 15 percent withholding tax on
non-resident interest earnings and capital gains on new purchases of government bonds. Others countries have decided to
impose unremunerated reserve requirements, such as Brazil’s 60 percent reserve requirements on banks’ short dollar position in
the spot market and Turkey’s reserve requirements that have been expanded to repo transactions. Finally, some countries have
taken measures to encourage outflows, either on a standalone basis or coupled with measures focusing on controlling inflows,
by raising existing ceilings on outward investments.
appeared to be ideally positioned to ?ll this gap.
On the capital supply-side, investors were attract-
ed by the potentially highly attractive returns in a
high-growth environment with low valuations. As
it turned out, however, returns fell signi?cantly
short of investors’ expectations because of a com-
bination of macro and micro factors. On the
macro side, investors found out that they had
substantially underestimated country risk, as a
huge correction in asset prices and massive
depreciation of local currencies in the Asian,
Russian and Latin American ?nancial crises in the
late 1990s wiped out a substantial part of private
equity returns. In some cases, the absence of well-
functioning institutions and a predictable legal
framework aggravated the situation further. On
the micro side, many foreign private equity ?rms
had failed to adapt to local conditions; they had
simply tried to transplant their traditional business
models to very different markets. Therefore, the
early investment boom in the 1990s was short-
lived, with private equity failing to gain traction as
a form of ?nancial intermediation.
Is this time different? From a macro standpoint,
there is a tendency towards answering this
question in the affirmative. Today, the macro-
economic situation looks substantially more
robust, with emerging markets having outper-
formed advanced economies by a wide margin
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 13
Figure 14: Real GDP growth in advanced and emerging economies (1990–2010)
Source: IMF WEO Database, April 2011.
R
e
a
l
G
D
P
g
r
o
w
t
h
(
%
)
-6
-4
10
-2
0
2
4
6
8
1
9
9
1
1
9
9
0
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
Emerging economies
Advanced economies
Figure 15: Correlation of advanced and emerging economy de-trended output (1980–2009)
Source: IMF (2010).
Note: Rolling correlations, 20-year window, window-end years on x-axis.
C
o
r
r
e
l
a
t
i
o
n
0.00
0.05
0.45
0.10
0.15
0.20
0.25
0.30
0.35
0.40
1
9
9
1
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
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5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
in terms of economic growth. This divergence
between emerging and advanced economies
has gained considerable momentum since the
year 2000 (see Figure 14). At the same time, busi-
ness cycles have become increasingly synchro-
nised, as emerging markets have become more
integrated into the global economy (see Figure
15). Although emerging markets were also sub-
stantially affected by the recent ?nancial crisis, as
a group they have been able to avoid an outright
contraction in output, and even helped to pull
the global economy out of its steepest downturn
in at least three generations. Therefore, emerg-
ing markets are said to have generated consider-
able ‘macroeconomic alpha’, while providing
less scope for diversi?cation due to a rise in their
‘macroeconomic beta’.
The share of global output of emerging markets
vis-à-vis developed markets is progressively clos-
ing. IMF projects that, in purchasing power pari-
ty terms, emerging economies will actually have
a relatively larger share by 2013 (see Figure 16).
These shifts in the global economy, whose extent
has become increasingly visible only in the last
few years, are underpinned by macroeconomic
fundamentals. Whereas the ?scal situation in
most advanced economies has deteriorated
sharply in the wake of the crisis, debt-to-GDP
ratios in emerging economies are on average
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 14
Figure 16: Advanced and emerging economies share in world GDP (1980–2016)
Source: IMF WEO Database.
Note: Based on purchasing power parity.
S
h
a
r
e
i
n
w
o
r
l
d
G
D
P
(
%
)
0
10
80
20
30
40
50
60
70
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
2
0
1
6
Emerging economies
Advanced economies
Figure 17: Public debt as % of GDP (1950–2015)
Source: IMF (2010).
P
u
b
l
i
c
d
e
b
t
(
%
o
f
G
D
P
)
0
20
140
40
60
80
100
120
1
9
5
0
1
9
5
2
1
9
5
4
1
9
5
6
1
9
5
8
1
9
6
0
1
9
6
2
1
9
6
4
1
9
6
6
1
9
6
8
1
9
7
0
1
9
7
2
1
9
7
4
1
9
7
6
1
9
7
8
1
9
8
0
1
9
8
2
1
9
8
4
1
9
8
6
1
9
8
8
1
9
9
0
1
9
9
2
1
9
9
4
1
9
9
6
1
9
9
8
2
0
0
0
2
0
0
2
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
G-7
Emerging economies
Advanced economies
substantially lower, with most countries running
signi?cantly smaller de?cits or even surpluses
(see Figure 17). Likewise, several emerging
economies have continued to accumulate large
foreign exchange reserves by running sizeable
current account surpluses, ampli?ed by strong
capital in?ows (see Figure 18).
There are also microeconomic reasons to believe
that today’s situation is signi?cantly different
from the 1990s. Importantly, private equity fund
managers have fundamentally adjusted their
global expansion strategies. One of the reasons
why early efforts often failed is the fact that many
foreign GPs simply tried to transplant their oper-
ating models, largely ignoring important institu-
tional, legal and cultural differences in their
target markets. The lessons learned from this
experience has encouraged fund managers to
adopt local strategies, open new of?ces, develop
strategic alliances with local ?rms and hire invest-
ment staff with expertise in the target markets.
Some ?rms also require experienced partners to
move to foreign locations instead of just para-
chuting them in periodically to help source and
execute deals. At the same time, local GPs that
tend to have a competitive advantage due to
their local knowledge have become more
sophisticated in ?nancial, operational and gover-
nance matters. Some GPs have been able to raise
multi-billion-dollar funds, ensuring an increasing-
ly competitive private equity industry in emerg-
ing economies. Finally, in sourcing and
undertaking acquisitions in emerging markets,
both domestic and foreign investors can rely on
an ecosystem of accounting ?rms, law of?ces,
business consultancies, investment banks and
other intermediaries that is substantially more
developed today than it was just 15 years ago.
Overall, these changes in macro and micro fun-
damentals suggest that private equity in emerg-
ing markets is coming of age both as an integral
part of ?nancial deepening and as a secular
trend of capital in?ows to these economies. This
trend is widely expected to gathering increased
momentum – unlike in the 1990s when a combi-
nation of macroeconomic imbalances and inad-
equate investment strategies prevented private
equity in emerging markets from getting suf?-
cient traction. While there are good reasons to
expect emerging economies to become increas-
ingly integrated into the global private equity
market, this does not mean that this process will
be smooth. From the mature markets, we know
that private equity is a high cyclical, which has
been attributed to imbalances between the
demand for, and the supply of, private equity
capital (Gompers and Lerner, 2000). Little sug-
gests that boom-bust cycles in private equity are
con?ned to the US and Western European mar-
kets, and fears that the substantial increase in
private equity capital in?ows from abroad could
exceed the absorptive capacity in emerging
markets would therefore appear to be legiti-
mate. If this were the case, the performance of
recent private equity investments in emerging
markets would be likely to fall short of investors’
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 15
Figure 18: Reserves (1995–2010)
Source: IMF WEO Database.
R
e
s
e
r
v
e
s
(
$
b
n
)
-200
0
1,400
200
400
600
800
1,000
1,200
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sub-Saharan Africa
Latin America
CEE and CIS
Middle East and North Africa
Developing Asia
expectations, with an ensuing, expected reduc-
tion in their supply of capital accordingly.
However, this scenario of a cyclical adjustment
around a longer-term trend needs to be clearly
differentiated from the expected slope of the
long-term trend itself.
5. Outlook and conclusions
Emerging economies are widely expected to
continue to play catch-up with the advanced
economies in the coming years and decades. In
the study Dreaming with the BRICs (2003),
Goldman Sachs projected that Brazil, China,
India and Russia would belong to the world’s ?ve
largest economies by the middle of the 21st cen-
tury. The recent growth trajectory of these coun-
tries relative to today’s industrial economies
suggests that this milestone could be reached
signi?cantly earlier. In a post-crisis update,
Goldman Sachs (2009) brought forward the pro-
jected date when the BRICs would become as
big as today’s G7 (Canada, France, Germany,
Italy, Japan, UK and US) to 2032. Goldman Sachs
also expects China to take over from the US as
the world’s largest economy by 2027. Even this
date may be a signi?cant underestimation of the
underlying growth dynamics, as argued by
Subramanian (2011). The catch-up process is not
con?ned to the BRICs; this process has been
more broadly based, which has caused growing
interest among institutional investors especially
in countries that rank after the BRICs in terms of
the size of their economies and growth potential.
Conveniently, Goldman Sachs has coined the
term ‘N-11’ – the next 11 emerging markets – for
a group comprising Bangladesh, Egypt,
Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan,
Philippines, Turkey and Vietnam.
Even if penetration rates in emerging markets
remain unchanged in the medium-to-longer
term, their expected macroeconomic outperfor-
mance should result in a growing share in global
private equity activity. A simple back-of-the enve-
lope calculation may help illustrate this scenario.
Let us take medium-term GDP projections from
the IMF’s World Economic Outlook. Assume that
emerging markets’ average penetration rates
stay at their 2005–2010 level. Under these
assumptions, the annual volume of private equity
transactions should reach around $80 billion by
2016. Under similar assumptions for advanced
economies, the share of emerging economies
would increase to around 15 percent from 12.5
percent in the ?rst half of 2011. Importantly, this
share refers to the expected volume of private
equity transactions, rather than the equity invest-
ments made by private equity ?rms. Assume,
?nally, that deals in emerging markets are, on
average, 20 percent debt-?nanced, compared
with a ratio of 60 percent in mature markets.
Under this additional assumption, the former
would account for around 25 percent of global
equity investments by the middle of the decade.
However, penetration rates may not remain
unchanged. Instead, they are likely to increase as
?nancial deepening gathers further momentum
as part of the general development process.
Goldman Sachs (2011) projects that the market
capitalisation in emerging economies may
increase from $14 trillion to $37 trillion and $80
trillion in 2020 and 2030, respectively, due to real
GDP growth, higher valuations and market deep-
ening. This implies a compound annual growth
rate (CAGR) of 9.3 percent. However, as the mar-
ket capitalisation of advanced economies is pro-
jected to grow at a CAGR of 4 percent, emerging
markets’ share in global market capitalisation is
forecast to grow to 44 percent and 55 percent in
2020 and 2030, respectively, from a share of 31
percent today (see Figure 19). The weight of
emerging markets in the MSCI World Index
Financial deepening, private equity and capital flows to emerging markets
The Review of Private Equity 16
Figure 19: Share of emerging markets in
world economy (2010–2030)
Source: Goldman Sachs (2011).
S
h
a
r
e
o
f
e
m
e
r
g
i
n
g
m
a
r
k
e
t
s
(
%
)
0.0
0.1
0.7
0.2
0.3
0.4
0.5
0.6
GDP Market cap MSCI world
weight
2010 2020 2030
could thus reach almost one-third by the end of
the projected horizon.
If private equity fundraising and investment
were to grow more or less in line with the pro-
jected long-term trajectory of market capitalisa-
tion in emerging economies, this would imply a
signi?cant rise in the average penetration rate.
Suppose, ?nally, that private equity investing
would average 0.3 percent of GDP by 2016.
Although this would be a considerable increase
from the average rate between 2005 and 2010,
it would still fall far short of the current penetra-
tion rates in advanced markets. Under this
assumption, emerging markets could account
for almost 20 percent of global private equity
transactions by 2016, and represent some 30
percent of equity investments, other things
being equal (especially with regard to the use of
debt in acquisitions).
While these scenarios are subject to substantial
uncertainty about the global macroeconomic out-
look and economic policies, they do indicate that
private equity markets in emerging economies
look set to continue to become more integrated.
As discussed in this paper, this process is now
well underway. Considering private equity as part
of a broader process of ?nancial deepening, this
integration is fuelled by increased cross-border
fundraising and investment activity. While private
equity capital ?ows to emerging markets may in
part be due to push factors (by global ?nancial
conditions and highly competitive private equity
markets in advanced economies), to a larger
extent it seems that they are attributed to pull fac-
tors (by economy-speci?c conditions in the recip-
ient countries). More speci?cally, foreign
investors are attracted by strong economic
growth in emerging markets, with private equity
representing an additional entry route to gain
exposure to ‘macroeconomic alpha’. As emerg-
ing markets continue to play catch-up and
advanced economies face a ‘new normal’ where
economic growth is set to remain ?atter due to
continued deleveraging, ?scal restraint and more
regulation, this alpha is expected to increase even
further in the next few years.
However, emerging markets are far from homog-
enous. For buyouts, the most important category
of private equity investing, Lerner, Sørensen and
Strömberg (2009) ?nd that cross-country varia-
tions are largely explained by differences in the
potential for operational engineering (that is,
measures to improve portfolio companies’ pro-
duction processes, working capital management
and marketing and production mix).
Implementing appropriate measures requires
adequate corporate governance standards. In
cross-country analyses, corruption is generally
found to hamper operational improvements and
is therefore associated with fewer buyouts.
Similarly, barriers to entrepreneurship – in empir-
ical estimates sometimes proxied by the number
of procedures required to start a new business
and the costs associated with them – is usually
found to be inversely related to the volume of
buyout deals. Additional factors hampering buy-
outs include high regulatory trade barriers, inter-
national capital controls and high taxes on
international trade. While several countries have
taken important measures aiming to improve the
business environment of their economies (see the
yearly World Bank Report on Doing Business), this
process is often dif?cult and time-consuming, as
private equity country attractiveness indexes
show (Groh, Liechtenstein and Lieser, 2011).
In conclusion, several economies are likely to see
further signi?cant increases in their penetration
rates as their institutional and legal frameworks
continue to improve. By 2020, if not earlier, some
of today’s emerging private equity markets might
become emergent, exhibiting a substantially
improved country-risk pro?le. Others, however,
may fall behind even further. Although emerging
markets as a whole may absorb a growing per-
centage of the world’s available private equity
capital, this possible bifurcation makes it essen-
tial for institutional investors to clearly differenti-
ate investments in this broad asset class. v
Financial deepening, private equity and capital flows to emerging markets
VOLUME ONE | NUMBER TWO | FALL 2011 17
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