In June 2020, University of Oxford Professor Ludovic Phalippou caused a ruckus in the private equity (PE) world when he alleged that the industry is nothing but a “billionaire’s factory.” A diehard PE critic, Ludovic has become something of a champion of the alternative view regarding PE. He has interrogated the performance of PE investments, their glorified returns and general impacts. Yet, the author of ‘Private Equity Laid Bare’ remains largely isolated. The popular consensus is that PE is a game changer in the world of finance and investments.
The PE industry is today deeply entrenched and widely recognised. In fact, with assets under management (AUM) increasing from $423.6bn in 2001 to $1.3trn in 2010 before shooting to $5trn in 2020, the industry is poised to play a greater role in the form of driving economic recovery and anchoring future growth. The evolution of the industry attests to the fact that the days when PE investments were basically meant to keep companies afloat are long gone. In its place a powerful force that is a cog for sustainable economic development has emerged. It is bolstered by the emerging trend of PE investors taking a longer-term perspective beyond the five-year investment horizon.
The new formidable PE industry is backed by a colossal number of resources. Data by Preqin show that by 2025, PE AUM will hit a staggering $9.1trn, a 15.6 percent compound annual growth rate. At this pace, the industry will in due course overtake the insurance industry in terms of gross premiums, which stood at $6.3trn in 2019 but contracted to $5.8trn last year. “The PE industry has achieved phenomenal growth over a few decades,” says Eric Deram, managing partner at global private investments firm Flexstone Partners.
The industry is today sitting on almost $1.9trn in dry powder. This is unallocated capital that is ready to be invested and that can be central to accelerating recovery in emerging markets and developing nations particularly in Asia, South America, Latin America and Africa (see Fig 1). The amount is bound to increase with surveys showing that more than 80 percent of international institutional investors – the largest investors in the industry – say they will invest in PE in 2021 at least as much as they did in 2020.
There is no doubt that across emerging markets and developing nations, COVID-19 badly ravaged economies in 2020. The World Bank reckons that due to the brutality of the pandemic, East Asia’s economic growth stalled for the first time in 60 years, growing by a mere 1.2 percent, with 19 million people plunging into poverty. Latin America and the Caribbean experienced the worst economic contraction with the economy declining by 6.7 percent. The economic downturn could push 28 million people into extreme poverty, with unemployment rates projected to reach 13.5 percent. Sub-Saharan Africa experienced its first economic recession in 25 years, with the economy declining by two percent.
The recovery begins
The pangs of COVID-19 are slowly easing. Vaccine roll out coupled with government intervention have seen countries embark on a cautious journey to return to normalcy. However, for most countries, it will be a while before economies can fully recover. For instance, it’s projected that the Indian economy, the world’s fifth largest, could take years to recover from the effects of the pandemic. For years, India has been among the stellar performers with economic growth averaging 7.2 percent the past decade. However, a brutal wave of COVID-19 this year is threatening to have prolonged negative impacts. During the first week of May this year, the country was experiencing an average of 380,000 in daily infections and 3,600 deaths.
It would be hyperbolic to expect the PE industry to save the world’s economy on the road to recovery. However, the industry has the potential to be a strategic catalyst in the recovery. No doubt the pandemic has negatively impacted traditional providers of capital, such as banks. In some regions, banks have seen an unprecedented spike in non-performing loans, prompting them to be more conservative. This has opened up opportunities for PE firms to fill the funding gap considering the need of private companies for fresh capital either to strengthen balance sheets weakened by the prolonged crisis or to make fresh investments to profit from new business opportunities arising from the crisis.
“As companies recover and emerge from the impact of COVID-19 they need growth and working capital,” says Anthony Mwangi, International Finance Corporation (IFC) Private Equity Lead for Africa. He adds that PE can play a seminal role in deploying capital towards recovery, especially considering the investable opportunities at attractive valuations that have emerged from the crisis.
The opportunities are vast, and diverse. They come at a time when the face of PE is fast evolving and investors appear to have a stronger risk appetite. When the industry started gaining prominence some two decades ago, the traditional PE model was PE firms buying into undervalued companies, building them up and exiting. While PEs are not ready to entirely discard this model, a shift towards the principles of sustainability guided by environmental, social and corporate governance (ESG) is emerging. PEs are investing in longer-term quality assets in sectors like technology, media, and telecom (TMT), medical, renewable energy, infrastructures, real estate, financial services, education, agriculture, water and sanitation, among others.
A McKinsey report on ‘Unlocking private-sector financing in emerging markets infrastructure’ contends that while developing countries require massive resources to finance infrastructure projects, they face challenges in mobilising the resources. To keep pace with projected gross domestic product (GDP) growth over the next 15 years, they need to invest more than $2trn annually. Africa alone must raise power and transport infrastructure investments to $55bn and $45bn annually respectively. Other countries facing huge financing gaps include Indonesia, Mexico, Brazil, India and Saudi Arabia.
Tragically, despite these financing gaps, many countries, including most of Africa, have shot themselves in the foot for failing to create an environment to attract PE funding for infrastructure projects. This explains why major private equity investors like Carlyle and Blackstone have left the continent ostensibly because they could not find large enough deals.
A dependable source of capital
Apart from investments in mega projects, private companies provide a vast arena of opportunities. In developing countries and emerging markets, the private sector is the engine of economic growth, job creation and poverty alleviation. PE firms have amassed substantial experience in investing in private companies and have become important providers of liquidity, debt and equity financing that is a catalyst for growth and transformation. “One of the primary sources of fresh capital for private companies that cannot tap the public equity markets and may not be able to incur more debt is PE,” observes Deram.
In fact, PE firms have proved they can be a dependable source of capital for companies. According to the Global PE Report 2020 from intelligence and research firm Acuris, the long-term growth of private credit has been nothing short of stratospheric. Two decades ago, the market scarcely existed, considering it was worth $40bn. It has since ballooned to more than $800bn. “This has been propelled by direct lending funds, which have grown in number and size in tandem with the leveraged buyout market they almost exclusively finance,” avers the report. It adds that private credit continues to grow in popularity, with 35 percent of firms having increased their use of these loans in the past three years and almost half (49 percent) now using private credit as much as traditional bank financing in their buyouts.
Unlike traditional lenders, particularly banks whose sole drive is to provide credit, the success of companies inspires PE firms. That is why PE investors take a hands-on role by providing advice and support in areas such as strategy, financial management and operations. This emanates from the understanding that for a majority of private companies, liquidity alone is never enough in guaranteeing growth. “Investing in PE is hands on. Fund managers generally take control (or significant minority positions) of the private companies they invest in because they want them to grow,” notes Deram.
The impact of PE investments and ripple effects on economic development are evident taking into account the value and volume of deals in regions like Asia-Pacific and Africa. A report by Bain & Company indicates that in the Asia-Pacific region, deal value defied the impacts of COVID-19 to rise to a record of $185bn last year, up 19 percent over 2019 and 23 percent over the previous five-year average. The region is forecast to be the biggest growth market with AUM set to increase from $1.6trn to $4.9trn in the next five years.
During the period 2015–20, a total of 1,257 PE deals worth $21.7bn occurred in Africa according to the 2020 Annual African Private Equity Data Tracker report. The rise was indicative of investors’ confidence in the continent’s economic resilience. Even at the height of the COVID-19 crisis last year, deal value declined only marginally to $3.3bn from $3.8bn in 2019. The ripple effects sprouting from the firms that have received PE funding are notable. They range from business expansion (for some, beyond their home markets), job creation and tax revenue for the exchequer.
“Emerging markets in Africa and Asia remain fundamentally attractive,” says Tristan Reed, economist at the World Bank. He added these markets are attractive because they offer PE firms excess returns owing to their limited financial sector development. “This makes sense because these are economies where capital is scarce, and there is also less competition for deals from other investors,” he says.
Helping hand from the IFC
The economic impact is well amplified by IFC, the private sector arm of the World Bank. IFC, which works to increase the involvement of PE funds in emerging markets, is often the first PE investor in some of the world’s poorest countries. Today, the organisation boasts of significant PE investments amounting to $7bn committed across a portfolio of over 330 funds. Through these investments, IFC has managed to deliver impact and development by addressing gaps in access to equity and growing private sector participation.
This stems from the fact that in emerging markets and developing countries, lack of risk capital hinders economic growth and slows entrepreneurship. By providing capital where it is scarce, IFC’s support of PE plays a critical role in development by helping build up companies that create jobs, drive prosperity, provide affordable and relevant goods and services, and strengthen a growing middle class. The organisation’s participation has also contributed significantly to sustainable development goals (SDGs) such as access to education, affordable housing, agribusiness, financial inclusion and job creation.
In Kenya, IFC investments in companies like Twiga Foods have had transformative effects. The agri-tech start-up buys agricultural produce from smallholder farmers and makes them available to urban populations at affordable prices. Last year IFC invested $30m in the firm to support more than 300 irrigated medium-scale contract farmers to complement its seasonal farmer supply base. As a link between smallholder farmers and the market, Twiga Foods has been instrumental in improving the livelihoods of over 4,000 farmers by providing a ready market for their produce. With its model a success in Kenya, the firm intends to use the funding from IFC and other PE investors to scale up and replicate the model in other African countries including Rwanda, Uganda, Tanzania, Nigeria and Ghana.
To ensure that PE firms become more involved in driving economic development, emerging markets and developing countries need to implement structural adjustments to tap more capital. On this front, they haven’t performed well. Currently, only about 13 percent of PE investments go to these regions. This is a fraction of the $1.9trn PE dry powder. Broadly, it is an indication that compared to developed markets the scale of PE in emerging markets remains substantially limited and is mostly concentrated in Asia. In 2018, for instance, only 23 percent of PE global fundraising went to emerging markets even though they represent 60 percent of global GDP.
“Emerging markets PE is far from homogenous, with stark differences between different markets. However, there are some headwinds that to varying extents do affect most of the regions,” says Mwangi. The stark differences are glaring. About 85 percent of PE capital raised in these regions goes to emerging Asia, with China and India accounting for 38 percent and eight percent respectively. Only a paltry amount of the capital finds its way to a region like sub-Saharan Africa.
Apart from investments in mega projects, private companies provide a vast arena of opportunities
Addressing the headwinds is imperative. In essence, emerging markets and developing nations must undertake structural adjustments to create an environment that is conducive to growing the pie of PE investments. This includes increased transparency, better governance and more supportive legal and regulatory environments. Others are creating deeper and more sophisticated capital markets, providing a wider plurality of exit options and allowing for more open market-based economies with increased entrepreneurial activity and competitive pressure. Another critical factor is the need to put in place a reasonable, transparent and stable tax system.
The forex factor
While these measures are vital, the forex factor remains a cornerstone in the PE industry. For PE funds, investing in emerging markets usually comes with a currency risk. Consequently, uncertainties regarding foreign exchange are not healthy and the absence of, or weak, forex controls has often been a deterrent for investments. This is because most PE funds are either dollar or euro denominated. Mitigating currency risks thus becomes crucial.
“Having a stable and predictable exchange rate is probably the most important factor in attracting PE investment,” says Reed. He explains that international PE firms typically book returns in dollars. This implies that currency devaluation can severely harm returns even if a portfolio company is growing fast in local currency terms. Moreover, when the price of foreign currency is ambiguous, for instance given the existence of multiple rates on formal or informal markets, it is difficult for PE investors to accurately price investments in dollar terms. “The uncertainty will make them less likely to invest,” he reckons.
Risk factors notwithstanding, PE firms are always on the lookout for quality deals in emerging markets and developing nations. Apart from the drive to make impactful economic contributions, impressive returns are a major motivation. To a large extent, it explains the rapid bounce back of the PE industry following a challenging year occasioned by COVID-19. Preqin data show that in the first quarter of the year, PE fundraising activity had managed to return to pre-pandemic levels. Funds raised amounted to $188bn across 452 funds during the quarter, up from $163bn and 431 funds in the same period last year (see Fig 2).
In terms of returns, the PE industry continues to maintain a splendid trajectory outperforming public equity markets and outpacing other private markets asset classes. By all accounts, they put into disrepute the logic propagated by Professor Phalippou that PE managers, as opposed to investors, are the key beneficiaries of PE returns owing to the exorbitant fees they charge.
Good governance and transparency are basic requirements in private companies in which PE firms invest
In the first quarter of 2020, the industry recorded a sharp decline in performance, according to McKinsey. But it recovered quickly to post a nine-month trailing pooled net internal rate of return (IRR) of 10.6 percent through September 30. On a pooled basis, PE has produced a 14.3 percent annualised return over the trailing 10-year period, beating the S&P 500 return of 13.8 percent by 50 basis points.
Notably, all other private markets asset classes posted negative returns over the same period. Infrastructure and private debt with 1.3 percent and 2.1 percent returns respectively came closer to breaking even. However, closed-end real estate and natural resources – at 4.2 percent and 16.7 percent – faced more challenging return environments.
“The long-term performance of PE remains strong,” observes Preqin in its 2021 report. It adds that while it is too early to gauge the full impact of the pandemic, buoyant stock markets, the resumption of economic growth and prolonged low interest rates augur well for future performance.
The inspiring returns are encouraging yield-hungry institutional investors and high-net-worth individuals to continue directing resources to PEs. Last year, 66 percent of institutional investors like pension funds and insurance companies invested in PE, up from 57 percent in 2016.
The World Bank headquarters, Washington, DC
The resilience of PE has been momentous. Across the globe, COVID-19 has caused devastating damages on the private sector. Despite the Covid-inflicted disruptions, PE-backed private companies have fared relatively well and are emerging somewhat unscathed. A key reason has been the ‘all hands on deck’ attitude of fund managers who were instrumental in supporting companies during the difficult months of the pandemic. Entrenching the principles of ESG and impact investment is a key factor in propelling the PE industry to the centre stage of economic development. The PE industry acknowledges the world is facing threats on all fronts. These threats, which cut across climate change, environmental pollution, bad governance, and corruption to name a few, are even more pronounced in emerging and developing nations.
In Africa, for instance, climate change is a major threat to human health and safety, food and water security and socio-economic development. At the current rate of global warming, the continent is on the verge of losing up to 15 percent of GDP by 2030 according to the Economic Commission for Africa. The PE industry is determined to be a champion of sustainable development.
The headquarters of management consulting firm, Bain & Company, Boston
In this respect, PE firms have avoided investing in polluters like fossil fuels, mines and sections of the manufacturing sector. Besides, good governance and transparency are basic requirements in private companies in which PE firms invest. This explains why more investors are actively incorporating ESG into their due diligence processes and investment committee decision-making. Blackstone, for instance, is leading on this front. Last year it announced that its next step in ESG is reducing emissions in new acquisitions by 15 percent.
“There has been increasing awareness that investments need to take account of ESG risks and in our experience investments that do so generate better financial returns,” explains Mwangi. He adds that as more PE investors embrace investing for impact, it will be a win-win for all because financial returns will be generated while taking care of the greater good by protecting the environment, generating jobs and reducing poverty.
The PE industry has visibly demonstrated its ability to propel economic recovery and drive future growth in emerging and developing nations. Though still on a smaller scale, the changing dynamics point to the industry increasing its contributions substantially in the coming years.
As American billionaire investor Bill Ackman accurately observed, PE investors have proved they create a lot more economic value than they destroy.