How to win in private equity in emerging market and developing economies

Notes: The multiple of the S&P 500 is calculated as the public market equivalent (PME), a measure of financial return that compares the investment to an equivalently timed investment in the public index. The PME is preferred to alternative measures of return (i.e., the internal rate of return, multiple of money) because the PME accounts for the value of payouts that are less correlated with the market, as in the capital asset pricing model. Investments in the chart are grouped by vintage year—the year of first cash flow.

There is large variance in returns across investments within this strategy (Figure 1). Our analysis identifies three factors that drive investment performance at the country-level, providing insight for any international investor who contemplates investing in EMDEs to realize an above market return on equity.

First, go where others do not. Economic theory suggests that to achieve superior returns, investors need to identify markets where they face less competition. Consistent with this idea, IFC’s returns have been highest in the economies where it is hardest for other investors to operate. Within countries, returns tend to fall when countries relax the capital controls recorded in the International Monetary Fund’s Annual Report on Exchange Arrangements and Exchange Restrictions, making it easier for other investors to enter. Deepening of the banking system is also associated with lower returns. An increase in the private sector credit-to-GDP ratio of the magnitude experienced by Brazil from 1990 to 2020 is associated with a 4.9 percent lower annual excess return (versus the S&P 500) on the average investment.

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Second, focus on the forecast of macroeconomic fundamentals, rather than the situation at the time of investment. A surprising result is that country risk factors, including political risk, perceived corruption, and the ease of doing business, do not significantly predict financial performance when measured at the time of investment. However, macroeconomic conditions over the course of the investment have material effects, with a 1 percent increase in cumulative annualized real GDP growth over the life of an investment increasing the annual excess return by almost 1 percent.

Third, patient capital is rewarded. Unlike a fund that must liquidate over a short time horizon—typically five years—the IFC operates more like a holding company, holding equity investments for longer, around eight years on average and often much longer. This turns out to be a key to financial success, especially in EMDEs where macroeconomic volatility can harm performance in the short run. In our data set, longer holding periods are associated with stronger performance at the investment level, even when controlling for sector and vintage year.

There are of course some caveats.

First, IFC’s membership in the World Bank Group may offer it protection from expropriation that is not available to other investors, even though by charter it is prohibited from taking explicit government guarantees. Nonetheless, given it is the only international investor with a portfolio spanning such a large and diverse set of countries and because it co-invests with several funds, the portfolio still provides a unique view of the returns to private investment in EMDEs.

Second, when restricting the portfolio to only investments with vintage years including 2010 and after, performance has been considerably worse than the S&P 500, although still on par with the MSCI EM index, which the IFC targets. An explanation could be that fewer investments in the recent decade (just 26 percent) have been realized, and there has not yet been time for the benefits of patience to play out. Another explanation, which would explain the recent underperformance of EMDEs in other data sets, is that international capital markets are now better integrated than they were when the IFC was founded, and there are today fewer opportunities to go where other investors do not.

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The best investment strategy is often to buy and hold the public index. The IFC’s experience shows that historically one can do better in private equity by buying and holding companies in the right economies. To find these economies, investors should focus on the growth forecast, rather than political risk or regulation, and seek the economies where there is less competition from other investors, due to a less developed banking system or capital controls . Quantitatively, finding a market with less competition appears to be even more important for returns than growth.

Although there may be fewer economies that fit this profile today than in the last century, there are still a few. Potential examples are Ethiopia and Myanmar, two large countries with closed economies that are nonetheless expected to grow rapidly.

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