More and more, commercial investors are shifting capital from developed to developing countries in order to generate returns. The Emerging Market Private Equity Association (EMPEA) reported that fundraising for emerging markets grew by 64% in 2011 to USD 39 billion, accounting for 15% of global fundraising, up from 11% in 2010. The lion’s share of this amount is however aimed at just a few countries; private equity funds dedicated to China and Brazil alone captured 61% of funds raised.
This concentration of commercial funds is in line with Dutch development bank FMO’s experience. One of their main roles is to mobilize commercial parties to co-invest in emerging markets. A recent review of FMO’s current strategy revealed that in the past few years, the majority (nearly 70%) of catalyzed commercial funds (in debt and equity) was aimed at upper-middle income countries like Argentina and Turkey, while around 30% went to lower-middle income countries like Bolivia and Indonesia. Interestingly, FMO has hardly been able to attract commercial investors in deals in low income countries (1). This finding is perhaps not surprising as in these times of decreased risk appetite due to the global economic crisis, commercial investors will be hesitant to bet on a dark horse.
Perception is not always in line with reality. Findings from a recent FMO evaluation provide improved insights in returns that can be generated from a well-diversified emerging markets portfolio, including significant exposure outside BRICs and other upper-middle income countries. An analysis of FMO private equity investments from 2001 to 2010 shows that financial returns (IRR, 2) are not only solid but also remarkably comparable across country income classifications. In fact, the IRR on lower-middle income countries is higher than for upper-middle income countries (24% vs. 21%). With an IRR of 18%, low income countries are not far behind.
FMO has invested more than 80% of its private equity portfolio in low and lower-middle income countries. In these countries they also deal with first time fund managers. FMO’s experience is that commercial investors’ reluctance to invest in first time fund managers is not justified. Actually, much to their own surprise, first time fund managers have been able to achieve (much) higher returns than experienced fund managers (35% IRR versus 9%). A result that was earlier established in an elaborate analysis of International Finance Corporation (IFC) private equity investments. A possible explanation for the good performance is that these funds mostly operate in a sector or region with still few private equity players, allowing these funds to optimally use their first-mover advantage and select the best deals.
Past studies have shown that returns have been highest on investments (3) made during periods of low capital availability. Conversely, there is concern that periods of greater capital availability, depress returns; the competition for deals is higher, leading to more overpriced investments. The current focus of commercial investors on countries like China and Brazil could lead to similar effects. The challenge is to look for the new growth markets where there are still ample opportunities for investment and competition for deals is less fierce. FMO’s findings demonstrate that diversification across a wider range of emerging markets can improve returns while at the same time mitigate risks. Development banks like FMO are more than willing to show commercial investors the way. With their proven capacity to make sustainable investments in a wide range of emerging markets, development banks can generate attractive returns for investors as well as realizing much needed local development impact.
Author: Jeroen Horsten, Evaluation Officer, FMO
 The income groups are defined as follows (2010): low income, USD1.005 Gross National Income per capita, or less; lower middle income, USD 1,006 – USD 3,975; upper middle income, USD 3,976 – USD 12,275; and high income, USD 12,276 or more.
 Internal Rate of Return, in euro’s, net of fees and carried interest
 Liechtenstein, H., Meerkatt, H., 2010, New Markets, New Rules, Will Emerging Markets Reshape Private Equity?, The Boston Consulting Group, IESE Business School, November.