General partners (GPs) entered emerging market private equity (PE) in the 1990s but experienced disappointing losses when Asian and Russian markets collapsed. Recent performance has also been grim, because of falling commodity prices, capital outflows, the possibility of further interest rate increases in the United States, and dampened growth in such major markets as China and Russia.

PE investing has always been a long-term proposition and, as a whole, exhibits ebbs and flows through investment and fundraising cycles. The authors seek to study the long-term trends present in emerging markets—particularly, how PE could benefit limited partners (LPs) across emerging market cycles.

Despite volatility, the overall secular growth story in emerging markets has remained intact with a continually expanding middle-class population, increasing demand for consumer goods, and a long-term upward trend in per capita GDP. To gain exposure to this increased growth in emerging markets, LPs cannot rely solely on public markets for access to an emerging market’s growth industries and must include PE in their portfolios.

PE investments are seen as more focused on younger and smaller companies in high-growth sectors, which are usually underrepresented in public markets, thus giving LPs the opportunity to have a more balanced exposure to the economic drivers of an emerging market, in which public markets tend to be dominated by resource extraction companies and public utilities.

Minority investment, which is the typical form of PE investment in an emerging market, is found to perform on par with majority investment. In many markets, company founders are reluctant to part with majority stakes, but operational risks—where business operations and strategy decisions taken by management affect majority and minority shareholders differently—can be mitigated by minority shareholders through the inclusion of covenants in the investment agreement.

Because PE investments have a wide dispersion of manager performance, a higher internal rate of return (IRR) is necessary to compensate investors, which makes manager selection critical. The authors find that manager selection remains important because fund manager performance varies widely among different emerging market PE investments and managers’ past performance cannot be proved to repeat itself in later years.

The authors look at the history of fundraising and investment in emerging market PE.

Trends in per capita GDP over the past three decades in several emerging markets are contrasted against data for the United States starting in 1933 and in 1950—the beginning of the two strongest US growth periods—to reveal that the emerging markets are experiencing growth that outpaced the US boom years (after controlling for purchasing power and some downward movement in 2015).

The authors find that 42% of global mid-market companies’ earnings before interest, taxes, depreciation, and amortization (EBITDA) growth comes from emerging markets using a database comprising 16,884 public and private companies. Mid-market companies are those with enterprise values of less than $500 million—or the valuation of a mid-sized firm in a typical PE portfolio.

Sector weights of various industries in the public market in the MSCI EM Index are compared with their PE weights in the Cambridge Associates EM PV/VC Index, which shows that compared with private equity, public markets are dominated by a few large companies in “old” industries and are tilted because of regulatory restrictions, revenue size, and float size, whereas such newer, higher-growth industries as consumer services are underrepresented in the MSCI EM Index. Smaller firms thus have to turn to PE for their capital needs.

The authors discover that investors with a minority position (which is usually the case for PE investments) do no worse than investors holding a majority stake, according to median and average IRRs of emerging market PE exits from the International Finance Corporation broken down by deal type. In emerging markets, 49% of PE exits are made via IPO compared with 10% in developed markets.

Manager selection is key for LP returns because of the wide dispersion of performance among PE managers. The authors note the large variance between the upper quartile and the lower quartile of PE funds in emerging markets and find that, after 2000, the data are less clear as to whether managers’ past performance is likely to repeat itself.

The authors provide a good overview of the history of PE in emerging markets and some of the general characteristics inherent in emerging market PE investment. What might prove more useful to practitioners is a more in-depth study of the characteristics among emerging markets, especially markets where PE is more widespread—for example, the differences in legal jurisdictions and local practices and the potential pitfalls that PE LPs and GPs may have encountered.