Into the wild

Emerging markets aren't for the faint of heart. The attractive low valuations and lack of competition are balanced against higher risks related to economic and political stability. It is no surprise, then, that those who've taken such risks and seen them pay off would be willing to make such bets again. If the old adage says ?once bitten, twice shy,? then its corollary may be ?once spared, twice bold.?

As the bulge bracket global private equity firms open offices in Asia, Eastern Europe, Latin America and the Middle East, they are brushing shoulders with successful local GPs, many of whom are crossing nearby borders in search of even less emerged opportunities. For example, local private equity firms in South Africa, Poland and Brazil are investigating the opportunities within their less developed neighbors in Nigeria, Romania and Peru. These local-champion GPs are expanding by hiring local talent and by building off of experiences from earlier funds. All are searching for nearby trends that mirror those that inspired them to enter the private equity business in their home markets. They may be venturing into new forests, but many of the trees are the same.

?Ukraine is [far away from] EU candidacy but we find that valuations tend to rise roughly two to two-and-a-half years prior to ascension into the Union,? says Siwicki.

These local champions are in many ways just as disciplined as their brethren in more developed regions. They simply have a unique ability to assess a certain type of risk ? the risk surrounding a country that may or may not follow an expected trajectory of political or economic progress. Those risks seem more controllable as more deals close and are even exited profitably.

One emerging markets private equity firm that applied experience in one market to a market nearby is Enterprise Investors, headquartered in Poland. ?Initially, we invested exclusively in Poland,? says Jacek Siwicki, president of Enterprise. ?But by 1999, we felt comfortable to invest outside of the country.?

Enterprise was founded in 1990 with a $240 million grant from the US Congress to provide loans and direct equity investments into small and mid-sized Polish businesses, as a way to stimulate the country's post-communist economy. The firm's subsequent success garnered increasing support from institutional investors from around the world. The firm's most recent fund closed in September of 2006 at €658 million ($959 million), over twice the size of its predecessor, which closed at €300 million in 2004. As the firm's capital under management grew, Enterprise expanded its geographic focus.

Polish patterns
Siwicki says that his firm's decision to invest outside of Poland was ?due to some macro-trends we recognized, such as the fact that countries like the Czech Republic, Hungary and Slovakia were on their way to EU membership.?

Enterprise's GPs noticed that Romania and Bulgaria were a little behind this curve but resembled Poland in the early 1990s in some important ways. At about the same time, an opportunity came along to put those observations to work. France Telecom was looking to sell its Romanian operations, and Enterprise recognized the potential. ?Back in 1994, we passed on a Polish mobile operator since the market was so small and unproven, only to watch the industry explode in the next few years,? admits Siwicki.

The Romanian deal offered a chance to seize an opportunity that was lost in Poland and profit from another nascent telecom market. Armed with a special voucher from the limited partnership agreement to do the deal outside Poland, Enterprise joined a consortium with AIG and bought the asset. They would eventually make four times their investment when they exited the company in 2004. ?In 1999, the market penetration [for the wireless company] was around five percent in Romania, and by the time we sold the company, it was well over 50 percent,? says Siwicki.

Enterprise hired a single Romanian professional in 2001 to focus on deals in industries in which the firm had enjoyed success in Poland, such as financial services and supermarket chains. ?We looked for shopping patterns and modern retail penetration in Romania to see if that sector would mature as it did in Poland,? says Siwicki.

The firm took a similar approach to Slovakia, a country in which Enterprise hired a native Slovak professional, trained him in their Warsaw office, and then had him spend increasing amounts of time sourcing transactions back home.

?Since that first telecom deal, we've included a 35 percent mandate to invest outside Poland in our subsequent funds. In our latest fund, we added the Ukraine and Croatia to the mix,? says Siwicki. Two of the firm's partners in Warsaw are already reviewing deals in those two locales. ?Ukraine is [far away from] EU candidacy but we find that valuations tend to rise roughly two to two-and-a-half years prior to ascension into the Union. Romania and Bulgaria went through booms in 2003, pre-ascension, though that rise is happening earlier and earlier,? explains Siwicki.

Beyond South Africa
The speed with which emerging markets can mature these days has left several GPs searching for ever slighter signs of a market's impending growth. ?South Africa is clearly getting more competitive, but opportunities are developing elsewhere on the continent ? if you look hard enough,? says Kevin Johnson, a founding partner of Boston-based Liberty Global Partners, a placement agency for a number of emerging market private equity firms.

One African GP to take serious interest in development trends across Africa is Andre Roux, CEO of South Africa-based Ethos Private Equity. ?We are currently reviewing several opportunities in Nigeria and we're close to the finish line with one in particular,? says Roux.

The rationales for moving into Nigeria range from its configuration of GDP, which is meaningful relative to South Africa's, to a certain degree of political stability. ?We took great comfort in the last civilian election, flawed though it may be,? says Roux. ?Time and time again in Nigeria, the military stepped in when the incumbent couldn't run again. This time, the soldiers stayed in the barracks.?

Macro-developments across the continent also feed Roux's optimism. Among these is the African Peer Review Process, championed by the South African President. ?This process will test corporate governance reforms and is an important component of the new African Union dedicated to improving economies and limiting government intervention into enterprise, such as stiff tariffs,? says Roux.

In exploring opportunities in Nigeria, Ethos relies on local talent, even if it's not currently based in Nigeria. Roux explains the Nigerian diaspora remains well connected to their homeland. ?These are talented executives, internationally trained but with vibrant local networks,? says Roux.

Furthermore, Roux explains his firm's long track record in South Africa has captured the attention of executives from other African countries, many of whom are eager to work in Ethos-backed companies across the continent. Many Nigerians, he explains, have aided in this sourcing effort.

As the firm ventures further outside of South Africa, they narrow their industry parameters. ?When we source deals north of us, we go after tightly regulated sectors like telecoms and financial services where there is greater governance. We are cautious on manufacturing where we'd run into competition with Chinese imports ? though we acknowledge there may be exceptions to that,? says Roux.

However, Roux finds the greatest challenge when expanding geographic focus is communication. ?We appreciate the chance for misunderstandings to occur during negotiations and even during the course of doing business with a company we're managing ? which is one reason we place a premium on local advisors and talented, credible business associates,? says Roux. Working with transcontinental subsidiaries of their South African portfolio companies revealed how much the firm needed to stress proper communication. ?These subsidiaries provided an invaluable experience to working in other parts of Africa,? Roux says.

Latin expansion
Another firm that used their portfolio company investments to gauge their geographic expansion was GP Investments, based in São Paulo. Founded in 1993, the firm grew into a South American powerhouse recently, although investing exclusively in Brazil, by far the region's largest private equity market. GP Investments' latest fund is the first to include a mandate to invest outside of Brazil, although the summer acquisition of Latin American Land Drilling and E&P Services from Pride International, now renamed San Antonio International, also gave the company a direct presence in a number of countries throughout the Latin American region.

Antonio Bonchristiano, GP Investment's co-CEO and co-chairman, explained that his firm's decision to expand geographically grew out of several factors. ?The fact is that many of our Brazilian investments had subsidiaries or branches based in other countries, so we've been working across the continent, in places like Argentina and Mexico, for a long time,? says Bonchristiano.

?The fact is that many of our Brazilian investments had subsidiaries or branches based in other countries, so we've been working across the continent, in places like Argentina and Mexico, for a long time,? says Bonchristiano.

GP Investments' latest fund puts a 25 percent cap on non-Brazilian investments, but Bonchristiano notes they could always approach their LP advisory committee if they felt a compelling reason to raise it. What compelled the firm to pursue any deals beyond Brazil was four distinct factors that when taken together, made the case.

?First off, Brazil is only going to become more competitive, and that means higher prices,? explains Bonchristiano. ?We think in Peru, Colombia and Argentina, that won't be the case.? He expects the broader range will allow them to be even more selective in deals, finding the right asset at the right price.

A second factor for expansion is that GP Investments felt their experience working with family-owned businesses looking for capital was applicable in multiple countries in the continent. ?We understand their concerns and priorities in way that a Blackstone, a Carlyle or TPG doesn't at this point,? says Bonchristiano.

Thirdly, Brazil's maturity can work to their advantage in transcontinental deals. ?Interest rates are coming down to a point that we can start use debt in a way that we haven't been able to before,? explains Bonchristiano. Even more useful is the country's stock exchange which now offers robust exit opportunities. ?We'll be able to buy a company, say, in Colombia, then use that as acquisition platform for companies in various other countries, and eventually take the new entity public in Brazil.? Lastly, as part of the firm's ambitions for growth, a wider geographic reach justifies a larger vehicle.

In staffing for this new reach, the firm marries veteran deal makers with young local talent. ?As a policy, we do not source investment partners,? explains Bonchristiano. ?Instead we hire associates who over three or four years mature into partners.?

The Brazilian firm has opened an office in Mexico City that will be run by a partner from São Paulo. He will be joined by two local associates, one senior and one junior. The idea is to groom young local talent to eventually take the reins of offices in other countries. ?We're talking with one Argentinian banker based in New York who would join as an associate but could in a few years, leave to run an office in Argentina,? says Bonchristiano.

Waiting for Cambodia
While many emerging market GPs expand their horizons, there are plenty that decide to keep their geographic focus. Back in 2002, Vietnam-based Mekong Capital had already built some momentum doing deals in the country and began to explore possibilities in Cambodia. ?In some ways Cambodia had an advantage over Vietnam since the country never had any state-owned companies and as a result, local companies looked to model themselves after multinationals not other state owned enterprises,? explains Chris Freund, a managing director at the firm.

However the other advantages proved to be mixed blessings. ?There were higher profit margins due to a lack of competition, but with a population of only 12 million, a lot of enterprises weren't scalable,? says Freund. They also recognized that the dearth of capable managers meant that many businesses could be radically improved with some basic operational reforms, but most managerial talent preferred to launch their own business, not work for someone else.

There were rumors that Cambodia was to launch its own stock exchange within the year, but Freund didn't trust the timing. ?Vietnam first announced plans for an exchange in 1994, but that exchange didn't open until 2000. We just didn't feel comfortable doing deals without a public market for exits,? says Freund. Their experience in Vietnam might have inspired them to explore Cambodia, but it also argued against doing so at that point, abandoning the effort in 2004. ?The deals remain too small at this point, and we'd never move into a territory without sufficient opportunities to warrant a local presence to monitor and manage deals,? says Freund.

That caution may be the better part of any valor displayed by emerging market GPs. The managers moving ever further into the wilderness are doing so after a track record of success over the life of multiple funds, and with relationships in place to secure talent and deals. From the vantage point of GPs based in the first world, Slovakia, Nigeria and Peru may seem quite the gambit, but for players nearby, such deals represent nothing more than a natural evolution.