Private Equity Investing in Emerging Markets

I have been thinking about this book, perhaps subconsciously, ever since I disembarked in Brazil about 40 years ago as a wide-eyed, naïve Peace Corps volunteer. Fresh out of college, I was assigned to work as a rural agricultural extension agent in one of the country’s poorest and most remote regions. This initial grass-roots immersion in the problems of underdevelopment was then followed by a career path that zigged and zagged after graduate school from a Wall Street investment bank to the International Finance Corporation at the World Bank, back to the private financial sector, including a stint at a private equity firm, and finally academia, where I have been privileged to teach graduate students what I had practiced for decades.

On the outskirts of Rio de Janeiro, far from the pristine beaches and luxuryapartments of Copacabana and Ipanema, Claudio, the owner of a midsize company that provides scaffolding equipment for large construction projects, was reflecting on the turbulent history of his 40-year-old business.¹ “We had a fantastic reputation! The company had a steady stream of reliable clients, a great brand name, and gradually we became a leader in our market. But no matter how fast we grew our revenues, the company was always encountering financial difficulties because we took on too much short-term debt. We never made any money.” This paradox of growth without profitability is a frustrating pattern repeated by “successful” entrepreneurs throughout the developing world. And for those who survive, the story usually gets even worse.

A principal theme of this book is that private equity in developing countries bears little resemblance to its counterpart in more advanced countries, where it benefits from a supporting ecosystem, which includes, for example, enabling government policies; confidence-inducing legal frameworks that enforce contracts and protect investors; efficient financial markets that offer firms affordable access to diverse sources of capital; a range of viable exit options; relatively stable macroeconomic and political conditions; business adherence to internationally accepted best practices, such as standards of accounting, financial reporting, and corporate governance; and deep pools of entrepreneurial, managerial, and operational talent. However, it is important to keep in mind that it took more than half a century for this foundation to develop and evolve.

In the years following the 2007 investment in the Brazilian scaffolding equipment business described at the beginning of chapter 1, the company performed at an extremely high level. In addition to seeing accelerated growth within its core business of supplying the heavy construction industry, the company used the proceeds from the private equity injection to launch an equipment rental business that deepened its relationship with its core client base and additionally acquired a major competitor. The expansion strategy was fueled by booming activity in the Brazilian construction sector at a time when the economy was in the midst of a period of sustained growth. As a result, the company benefited from unprecedented demand for large-scale investments in physical infrastructure, as well as commercial and residential real estate. These favorable external factors, coupled with internal improvements fostered by close collaboration between Claudio and his new private equity partner, generated enviable financial results between 2007 and 2009: revenues increased at a compound annual rate of 45 percent and net earnings soared 155 percent during the period.

By the 1990s, a global consensus had emerged among policymakers, development finance specialists, and academics that the private sector, rather than the state, should be the primary catalyst for economic growth and development. A number of encouraging events had begun to unfold across many emerging markets: the 1980s debt crisis that had crippled the growth prospects of so many middle-income countries, particularly in Latin America, was largely resolved; the November 1989 crumbling of the Berlin Wall had led to the sudden opening of an entirely new group of countries that were enthusiastically embracing a transition to capitalism; privatization of state-owned enterprises was becoming a high priority for many countries; and leaders such as Deng Xiaoping in China and Manmohan Singh in India had begun the process of opening up their countries to foreign trade and investment. It seemed that in every region of the developing world a new, more receptive attitude toward private investors, both domestic and foreign, was in full swing.

Nearly every asset class was severely tested in the wake of the global financial crisis that erupted in the fall of 2008, and emerging markets private equity was no exception. The crisis that began in the United States rapidly spread around the world, causing global economic output to drop precipitously. The result was the worst financial downturn since the Great Depression, with an estimated US$14.5 trillion—or 33 percent of the value of the world’s publicly listed companies combined—erased between September 2008 and February 2009.1 As stock markets across the globe plummeted, the interrelated collapse of large US financial institutions such as Northern Rock, Countrywide Financial, Bear Stearns, Lehman Brothers, AIG, Fannie Mae, and Freddie Mac generated contagious aftershocks almost everywhere. Following close on the heels of this damaging global calamity, a sovereign debt crisis unfolded in the Eurozone beginning in 2011, further straining liquidity and undermining investor confidence.

The main contours of China’s private equity history bear a striking resemblance to the road map the country has carefully followed for more than 30 years during its remarkable transformation from a tightly controlled, centrally planned economic model to one driven increasingly by market forces and an expanding private sector. But even as the role of private equity has steadily evolved in China, it has done so under the watchful eye and steady guidance of a constellation of omnipresent government actors. Some private equity practices have been carefully and selectively emulated from the West, providing much-needed capital and expertise to select portfolio companies. But in many respects the industry has evolved in ways that are distinct from any other country, developed or developing, reflecting the country’s unique circumstances and approach to economic development.

With more than a hint of fatalistic resignation, Brazilians have long observed that theirs is the country of the future … and always will be. Geographically immense, with an economy and a population almost twice as large as any other in Latin America, Brazil is also endowed with enviable natural resources. But time and again throughout the country’s tumultuous history, one or the other economic or political crisis has undermined the predictions of hopeful optimists and provided rich fodder for cynics. As former president Fernando Henrique Cardoso explained about his country, “this special kind of failure that results when tantalizing potential falls tragically short of expectations. That is the kind of failure that Brazil has always specialized in.”¹ The country profile has been marked by endless boom-and-bust cycles of rampant inflation, anemic economic growth, a huge external debt burden, income inequality, systemic corruption, notoriously unreliable legal enforcement, low labor productivity, and abysmal physical infrastructure. As one of the country’s leading economists explained in early 2014, even taking into account the relatively strong economic performance of 2008 to 2010, “the government has failed to undertake many fundamental reforms in the past decade.”

“One of my biggest frustrations when speaking with outsiders is explaining that Africa is not a country,” explained a longtime private equity adviser residing in Nairobi. “There are 54 countries, each with its own distinct culture, ethnic mixture, and business environment that must be taken into account by prospective investors, whether private equity or otherwise. You cannot cross a border and think everything will be the same.”¹ As this chapter will demonstrate, Kenya is endowed with a set of characteristics—including its relatively large population and long history as the primary hub for East African business and finance—which in some respects sets it apart from the majority of the other 53 African nations from a private equity perspective. But set aside these distinctions, and it bears more similarities to than differences from most nations on the continent, as well as other low-income countries throughout the developing world, that are striving to build a private equity industry.

Yogi Berra, the New York Yankee baseball player renowned for his famous quips, is alleged to have pronounced with his characteristic wisdom, “It’s very difficult to make predictions, especially about the future.” If forecasting future trends is generally a fool’s errand, as Berra suggested, emerging markets private equity poses especially precarious challenges due to its relatively brief history and limited data. Compounding the dangers are the obvious difficulties of generalizing about what may or may not come to pass in more than 150 countries, each with its own history, culture, demographics, and capabilities. Nevertheless, one prediction can be made with reasonable confidence: just as the asset class is unrecognizable today from its embryonic beginnings about 20 years ago, it is likely to bear little resemblance a decade from now to its present profile.