A prevalent perception in the investment management industry is that emerging market private equity (PE) funds carry more risk than developed market PE funds. The authors explore this perception and find evidence to the contrary.
How Is This Research Useful to Practitioners?
Dispersion of returns is an indicator of risk. The authors compare the results of private equity (PE) deals conducted in emerging markets (EM) with those in developed markets (DM). They find that dispersion in EM is not higher than dispersion in DM. Intuitively, investment in EM is driven with a lot of caution and such accompanying measures as avoiding investments in very young firms, conservative use of leverage, and creative control rights serve to mitigate risk. Also, PE firms tend to take the earliest possible exit and sacrifice higher but riskier returns over a longer period. Therefore, the results may not be surprising.
To generate higher returns, investment managers must turn toward EM that are in a growth phase, which are generally undervalued even when considering currency devaluation risk. This strategy calls for an active rather than passive approach to investment management. Furthermore, the dynamics of each market within EM are also different and volatile, requiring greater focus from analysts.
How Did the Authors Conduct This Research?
The authors used the proprietary database from CEPRES, which is a private equity research organization set up in 2001 and based in Germany to provide PE and debt portfolio advice to its clients. The database contains 323,000 transactions from 2,700 funds. Deal cash flows are regularly updated so that intermediate valuations can be conducted for deals that are not concluded. The authors have few data constraints—mainly, they use deals not made after 2013 and deals for which complete data are available. The final dataset includes 3,935 deals in emerging markets and 29,442 deals in developing markets. Markets are aggregated by region. The following categorical variables are used in the analysis: country/territory, fund focus, company’s industry classification, and year of investment.
The authors compare the dispersion of deal outcomes between market types, then construct a series of regressions, and finally perform a range of robustness tests to mitigate concerns about data quality and market trends. Two return metrics are used: internal rate of return and total value to paid-in capital (i.e., the invested amount). The authors run the same tests on subsets.
Abstractor’s Viewpoint
Comparable dispersion of risk in PE in EM is undoubtedly influenced by stronger safeguards built into the transaction as well as by cherry-picking from investment managers. Practitioners need to make the effort to understand the market in order to generate higher-than-average returns.