Why Private Equity Is Thriving and Set for Strong Returns in Emerging Markets

It isn't easy to imagine a world now without private equity. These institutions have permeated every aspect of the globe, leaving the United States as their point of origin, to stretch across the continents. One would not be wrong if they stated that the innovation in the current business landscape is powered by private equity, as they have historically put funds in places where traditional investors will not put their funds. 

In this article, we will talk about private equity, the emerging markets funds that have flowed into, and what sectors can benefit from in emerging markets.

Where did Private Equity start?

Wealthy individuals in the United States—the Vanderbilts, Rockefellers, J.P. Morgan—have always bought and sold companies. J.P. Morgan handled one of the first buyouts by purchasing the Carnegie Steel Company for $480 million.

However, after World War II decimated several economic structures worldwide, a vacuum persisted where capital could flow as economies and international trade rose again. As economic activity picked up after the war, the first venture capital company, the American Research and Development Corporation (ARDC), was founded by Georges Doriot, considered the father of venture capital, in 1946. The mission of the ARDC was to encourage investments in the businesses started by soldiers who had returned from the war. It was the first institutional private equity firm to source funds from other sources instead of wealthy families, as was done before. The ARDC made its first private equity deal by putting up $70,000 to invest in the Digital Equipment Corporation. This deal would net the ARDC over 500 times what it had invested in it about nine years later (over $30M), and wealth created from that deal would spill over into the creation of several prominent venture capital firms.

The Small Business Investment Act of 1958 allowed the licensing of Small Business Investment Companies to help manage and finance small businesses in the US. At this time, the US hoped to spur its economic growth and develop faster technologically to keep up with Russia in the Cold War. The SBIC Act of 1958 allowed the government to lend money to venture capital firms so they could invest in the economy. This stimulated the US economy, which began to grow rapidly. Thus, there is the development of institutionalised private equity firms.

Currently, venture capital funds are invested in smaller companies developing new technology or disrupting the market. Giant companies like Electronic Arts, Compaq, and even Apple enjoyed funding from venture capital to rise to where they are today. However, as we know them today, private equity operations were the conception of Kohlberg, Roberts, and Kravis, who started to acquire family-owned businesses that were too small to be taken public but big enough that a sale to a buyer was attractive. It would help to know that some of these businesses also belonged to the soldiers who returned from the war and had run their course. The trio would later form their own company—Kohlberg, Kravis and Roberts (KKR)--and engineer a deal known as the first leveraged buyout in private equity as KKR acquired R.J. Reynolds Tobacco.

In a leveraged buyout (LBO), an investor purchases a company using debt, where most of the money used to finance the acquisition is borrowed using the company to be bought as collateral for the loans. Investors can get up to 5x the amount of the collateral. Sometimes even more.

KKR used a leveraged buyout to acquire R.J. Reynolds Tobacco and sold it about ten years later for over 500 times the amount. This would set a precedent for many more private equity acquisitions.

Private equity would continue to grow in the following decades, after relaxations on trade regulations in the EU, first investing in new businesses exploring the frontier of technology, and slowly moving into investing in already established companies using LBO to acquire these companies and creating an exit strategy to sell these companies for a profit. Private equity began to move to traditional markets with the invention of the internet in the 2000s, which increased connectivity and eased mergers & acquisitions. New markets opened up in Europe and Asia with relaxing trade regulations, and private equity started to gain presence in these countries. However, the industry would be more scrutinised, particularly in the 2008 financial crisis.

Currently, private equity is back on track and raging like a wildfire. The COVID-19 lockdown unveiled the rare opportunity of outsourcing business operations and the immense potential for gains in emerging markets outside the US and Europe. With a market size of $481 bn from last year, the market is expected to add another $50bn this year.

PE Flows towards other emerging markets  

The idea of 'emerging markets' posits that fertile economies exist outside the developed economies that offer long-term opportunities for investors. And this piqued the interest of private equity firms. Emerging markets provide a lot of potential to private equity for several reasons.  

The developing economies attached to emerging markets will only get bigger, and whatever investments are sunk into these economies will also balloon as these economies grow. Emerging markets with the necessary infrastructure always have undervalued companies and assets. This presents a rare opportunity for private equity firms to surely double, triple or even 100x their investments when these companies reach peak valuation. The uncovered ground and unmet needs in these regions is like a capital multiplier for businesses forming.

The rising middle class in these emerging markets are more than ready to accept the value any company would create. Thus, wealth is created far more easily than in established markets. The increasing digitisation in this region provides businesses with new ways to engage with customers and to run their operations, thus increasing the value of disruption and maximising potential when identified.

Emerging markets differ in size, opportunities, and growth potential. Developing economies like China and India are large and often attract most of the money from private equity firms as they possess the infrastructure needed to put capital to work. India has a powerful and robust healthcare infrastructure that provides goods and services to serve medical needs, and China is the world's manufacturing capital, providing commodities wholesale to the world. Both EMs picked up a combined value of $61.8bn in 2023, about 67% of the total deal value of private capital outside traditional markets.

Smaller EMs exist in the lower digits, with Africa taking only $5bn out of the $93.8bn shared amongst the emerging markets that year. The latter is not a small amount, yet it is just slightly above 21% of the total PE flow of the $438bn globally, as reported.

The growth has seen expansions and contractions for over forty years, during which PE has flowed into capital markets. Global financial crises have often injected more funds into emerging markets, as they usually have more capital potential. However, they reverse when developed markets recover and offer slightly less returns but with increased capital safety.

For instance, the 2020 pandemic heralded a new cycle where China enjoyed the input of funds from private equity firms, only for capital to retreat in the face of inflationary crises and trade disagreements with the West. This was a global trend, as several venture capitalists pulled back from investing in emerging markets in the years that followed the pandemic.

Private equity is recovering in emerging markets, with data revealing a 50% year-over-year increase to $159bn. While most funds are still centred in developing markets, it is only the start of another investment cycle.

Sectoral Hotspots in Emerging Markets

Private equity firms looking to involve themselves in emerging markets can look to these sectoral hotspots in these geographical regions to maximise their returns. As not all emerging markets are the same, several sectors in these markets may have the necessary infrastructure for PE firms to increase the value of their investments and position themselves for a nice and clean exit.

Healthcare and Pharma

Starting with India, the nation's GDP grew from $1.9 trillion to $3.6 trillion over the past decade and it hopes to rank amongst the top three economies in the world over the next two decades. India has decided to focus on the industry where it holds a strong position, its pharmaceutical and healthcare industry, which drives about 4% of direct FDI into the country. India's pharmaceutical market is expected to range between $120 billion - $130 billion by the end of the decade, all based on a market that exports almost as much as it imports. India's healthcare is also one of the most developed in the world. While the other two countries leading India are China and France, neither has its growth potential.

With over 10,000 manufacturing facilities and 3000 pharma companies, India holds the most extensive pharma infrastructure outside the US, and nowhere is drug and medicine manufacturing cheaper than in India. Thus, exports from India serve over 50% of Africa's pharmaceutical requirements and 40% of the US demand. 

Latin America is currently one of India's most reliable healthcare customers. Receiving over 2 million doses of the vaccine in the pandemic, the region's need for pharmaceuticals and healthcare has been increasing drastically, and they have enjoyed cheaper but same quality products from the Indian market, adding more value to the balance sheet of the Asian country. Even India has begun to build manufacturing plants in the region to improve the supply chain and continue to lower costs.

By cornering the Latin American market, already twice the size of the African market for pharmaceuticals, private equity will not only find a high-growth economy in India's health care and pharma sector, but will also likely enjoy support from the laws of the land as India's government zones in on growing this sector in the next half decade.

Infrastructure & Renewable Energy

South East Asia and Africa possess an infrastructure deficit that cannot manage the region's burgeoning youth population. With over 70% of sub-Saharan Africa under 30, millions will soon come to middle age and demand better roads, more electricity, housing, clean water and education. Current investments in infrastructure are not nearly enough to handle the growth needed; thus, an investable opportunity exists in areas like electrification, logistics, social infrastructure and renewable energy.

Singapore-based Clime Capital secured a $127m first close in January for its Southeast Asia-focused clean energy fund.

Private equity funds flowing here can fund these areas with capital and put in professional management and strategic operational expertise to unlock more value in these areas. There is growing state support for attractive project pipelines, and private equity funds can situate themselves inside these projects to take advantage of the upcycles in these areas. Returns in these sectors often outperform those in potential markets due to the power of first-mover premiums, long-term government partnerships and untapped demand.

Tech Sector

Digitalisation across South East Asia and Africa has recorded significant investments in fintech, e-commerce, and digital infrastructure. The year 2024 saw an almost 20% jump in digital assets in Southeast Asia, with Indonesia, Vietnam, and the Philippines registering the fastest growth in start-up creation and digital payments penetration. 

In Africa, M-Pesa has conquered Kenya, while Nigeria is rife with Fintechs like Flutterwave and Paystack, and keeps attracting venture capital to the industry. As these two countries have also become test markets for financial innovation outside traditional markets, many fronts for private equity to come in through have been opened. Digital businesses often scale rapidly in underpenetrated markets and provide numerous entry and exit points for private equity firms looking to invest or use a buy-and-build model.

The unique thing about the markets in Africa is how heavily undervalued they are. The data on the value of exits has been complex to pinpoint, but the consistent attraction of private equity to the continent is an overall strong signal that gains are to be made.

Consumables Sector

With India's fast-growing middle class projected to reach over half a billion in the next three years, leading PE firms are already moving into investing in Indian brands to position themselves for the explosion in demand for fast-moving consumer goods (FMCG).

The same narrative is playing out in sub-Saharan Africa. The urbanisation of African cities and increased population growth will also drive up the demand for consumer goods. Increased retail formalisation and digital payment adoption help make logistics and distribution more efficient, lowering costs and creating new opportunities for scale.

Private equity invested in these sectors will thus work and grow massively over the years. Private Equity firms can consolidate the fragmented markets, boost local companies' ability to capture market share, increase in value fast and drive high valuations for private equity firms.

GDP Watch

In the last quarter of the century, India's GDP has grown by 6.8, and China's has multiplied by 14. The slowing growth in the previous three years has done nothing to decrease the potential of these markets. If we go by the projection from the global economic outlook, the growth projection is 3.9% for the medium-term, which is far ahead of 2.7% for developed markets.

Barriers to Entry into Emerging Markets

Some of the risks attached also match the potential to multiply capital in emerging markets. 

Aside from the fact that profitability in the emerging market is predicated on long-term growth, which carries its risks, these markets often find themselves more exposed to macroeconomic headwinds, like global volatility, extreme foreign exchange swings and global recessions. Regulatory restrictions from the states may limit what private equity firms can own as compliance laws, and tax regimes may differ.

Another issue is that these economies may never reach the stability of already established markets. While they do not have to go the size of developed markets, the lack of trust in the markets to weather negative political headwinds and global instability may weaken the potential for capital to grow.

Furthermore, a large portion of their private capital markets is underdeveloped. The lack of experienced private equity firms in these markets may make the addition of value to portfolio companies difficult. Since many private equity firms are not themselves based in emerging markets, there is a lack of on-ground knowledge of the business scene, which may not work in their favour. I must highlight, however, that this is changing.

Rising ESG demands may also curtail the entry of private equity into emerging markets, as businesses in these locations may need to consider the environmental impact of their activities as they industrialise.

Our Takeaway 

Undoubtedly, emerging markets will only get bigger, even just by necessity. 

If private equity firms use data analysis to make informed predictions to pick targets and decide how much of an investment to make, the headwinds would be in their favour. 

In addition, the countries' governments that host these emerging markets are looking for more foreign revenue and investments in their economies. If private equity wins in their emerging markets, these governments also win; therefore, they are more likely to soften the landing for the firms entering their markets.

Private equity firms have always been a step ahead of the market through adequate research and understanding the local business environment before engaging in it. As long as these fundamentals are adhered to, joining the current private equity capital flow into these areas of emerging markets is a trend one can get behind.