The Mid-Market Squeeze

In recent months, I’ve enjoyed some great conversations with individuals who have welcomed a frank discussion of the EM PE industry’s challenges. One recurring topic of conversation is the imbalance between supply and demand for capital for PE funds operating in the lower- and mid-market segments in EMs.

The hollowing out of mid-market funds animated my decision to found Portico, and it served as the impetus for our EM Mid-Market Survey, which we conducted in May. I am pleased to announce the release of Portico’s second research piece, The Mid-Market Squeeze, which shares findings from our survey.

We undertook this project with two objectives in mind: (i) to test our hypotheses for the supply-demand imbalance; and (ii), to illuminate potential paths toward solutions.

Most of our hypotheses were affirmed, in whole or in part, but the report’s overarching finding is that the declining number of EM mid-market funds is more than just a funding gap, it is a symptom of industry-wide problems. Our survey reveals four drivers for the mid-market squeeze:

  • Macroeconomic developments in EMs are not the reason why LPs aren’t committing to mid-market PE funds; it’s the failure of EM PE funds to deliver returns.
  • There is an acute funding gap for EM PE funds smaller than $100 million in size.
  • Development finance institutions are walking away from smaller EM PE funds, and investing with larger, more established firms. Moreover, their preferred ticket sizes are in the sweet spot of where commercial LPs prefer to play.
  • Institutional investors lament the lack of transparency in the EM PE industry.

The report offers a few thoughts on potential solutions to the mid-market squeeze, and prognostications on the road ahead. I invite you to click the button below to download a copy of the report. Please feel free to share it with colleagues, and of course, all feedback is welcome.

Finally, thanks go out to the 76 industry professionals who participated in this survey, as well as the winner of our prize drawing—a representative from an Asia-Pacific sovereign wealth fund—who selected the donation to UNICEF.

Alla prossima,
Mike

Indonesia: So Hot Right Now

Having freshly returned from a trip through Southeast Asia, I was interested to see KKR’s Henry McVey release a new report on Indonesia, stating:

Indonesia has one of the most compelling stories that we see … and unlike in past trips, we are now confident stating that we think Indonesia is harnessing its potential into near-term economic and investment realities.

The macro is certainly compelling, and there are reasons to be optimistic (not least the forthcoming rail line connecting the airport with downtown).

I agree with McVey that “public market indices are often not the appropriate investment vehicles to actually gain access to compelling GDP-per-capita stories;” and based on my own meetings in the country, I share McVey’s conviction that there are attractive tech opportunities in private markets (see charts below). KKR is actively pursuing this thesis, having invested alongside Capital Group Private Markets, Farallon Capital Management, and Warburg Pincus in the local ride-hailing / transportation company GO-JEK last year.

Still, translating the macro into compelling investment returns requires deft navigation. One dynamic working in mid-market managers’ favor is the general scarcity of capital; there is less competition for deals from other financial sponsors in this segment, though local families and investors play an important role in the private markets ecosystem. The game changes once tickets climb north of $100m, where a large volume of PE capital is searching for deals.

KKR_Indonesia

Coffee Talk

In our April newsletter we highlighted the rise of secondary buyouts as an exit channel in Africa, and there’s big news from ECP portfolio company Nairobi Java House. Abraaj won the auction for the company, which reportedly drew 12 non-binding bids (including from Carlyle and TPG). Abraaj shall take full control of the company, which includes two additional franchises: Frozen Yoghurt and 360 Degrees Artisan Pizza. By my count this is Abraaj’s third secondary buyout in Sub-Saharan Africa out of four deals since 2014 (Mouka from Actis in 2015, Libstar from Metier in 2014).

While Abraaj has some experience in the QSR segment (Kudu in Saudi Arabia), and I’m curious about potential synergies with its investments in Brookside Dairy, Fan Milk, and Libstar, the firm has its work cut out for it. I struggle to think of an East African firm that has been able to achieve pan-African scale.

One experienced advisor in the region tells us:

The pan-African strategy is very difficult to execute due to: (a) the small size of most of Africa’s 40+ markets, which means you’re spreading the fixed costs of market entry across a small customer / revenue base; (b) the high cross-border costs of trade, which makes supply chains expensive to run; and (c), the economic, regulatory, and cultural differences between East, West, and Southern Africa. The difficulties cut in every direction.

While Ecobank is a partial exception (it has a long way to go to become a consolidated, sustainable business with deep insight into all of its local markets), the failures are numerous. For example, United Bank of Africa, which has met success in its home market of Nigeria, got burned in Kenya. South African retailers, such as Shoprite and Massmart, have struggled to gain traction north of the Limpopo.

The general lesson I draw is that African markets do not have a broadly even playing field. Any attempt to expand beyond one’s own region will only work if you make a massive investment, and you bring in heavy hitters with political influence. A more sensible strategy is to aim to become the number one player in your region rather than overstretching by seeking a continental presence.

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Will Private Equity Build Africa’s Manufacturing Sector?

No.

The FT recently ran a comment piece imploring PE firms to drive the development of Africa’s manufacturing sector. Private equity can deliver—and has delivered—powerful developmental impacts in Africa. For example, an impact assessment of CDC Group plc’s Africa fund investments between 2004-12 shows direct job creation of 40,500 positions and a $600 million increase in taxes paid. I’m a believer in the potential of the asset class to deliver dignity in EMs; however, some of the author’s overzealous assertions bear some scrutiny:

Private equity has largely ignored investment in African manufacturing and industrial projects. [EMPEA] data show that 23 PE firms have made only 53 investments in the industrials sector in Sub-Saharan Africa since 2008.

PE firms have not ignored African manufacturing companies. First, by excluding deals in manufacturing companies outside of the industrial sector (e.g., consumer durables, food and beverage), the data understate the volume of investments that have been made in manufacturers.

Second, how many manufacturing companies are there in Africa? Within the industrials sector, according to Thomson Reuters Eikon there are only 57 private African companies generating between $50m and $500m in revenue.

Middle market funds, in particular, have an enormous opportunity to unlock potential in this sector. Doing so will … create value for investors by creating a robust deal pipeline with attractive exit opportunities …

Maybe? There have been—and will be—some excellent returns from manufacturing deals in Africa; but has the traditional EM PE model created value for investors?

According to Cambridge Associates’ African Private Equity & Venture Capital Index, the 10-year horizon pooled return is 4.51%, and the pooled return has not exceeded 5% over any multi-year period. This may be a function of the constituents in Cambridge’s database—Ethos, for example discloses a USD gross IRR of 20% since its third fund—but the pooled return suggests investors are taking on equity risk + country risk + illiquidity, and receiving 200 basis points over 10-year Treasurys.

With this return profile, why should pensioners, endowments, and foundations be subsidizing African industrial policy?

On a related note, McKinsey Global Institute released a fascinating report on Chinese investment in Africa that shows who is likely to drive the growth of manufacturing on the continent: Chinese firms. McKinsey estimates that there are more than 10,000 Chinese firms operating in Africa—3.7x more than previously estimated—and nearly one-third of them are in the manufacturing sector (generating ~$60 billion in local revenue, with 12% market share). Says McKinsey:

In sectors such as manufacturing, there are too few African firms with the capital, technology, and skills to invest successfully and too few Western firms with the risk appetite to do so in Africa. Thus the opportunities are reaped by Chinese entrepreneurs who have the skills, capital, and willingness to live in and put their money in unpredictable developing-country settings.

In the Beach Bag

Jul17Books

I don’t know if these are the books I’ll end up reading, but here’s what I’m planning to pack for the beach this year:

  • Business Adventures, by John Brooks
    The “best business book” say Warren Buffett and Bill Gates.
  • Evicted: Poverty and Profit in the American City, by Matthew Desmond
    Most Americans are one accident away from financial ruin: 25% can’t pay their monthly bills in full, and 44% can’t meet a $400 emergency expense. Desmond’s book looks at the precarious state of Americans’ living situations. In Milwaukee, for example, “a city of fewer than 105,000 renter households, landlords evict roughly 16,000 adults and children each year.”
  • The Devils of Loudun, by Aldous Huxley
    I quite enjoyed Huxley’s Grey Eminence, which chronicled the life of Father Joseph—advisor to Cardinal Richelieu and advocate of policies that led to the Thirty Years’ War—so I thought I’d return to the trough for his take on mass hysteria and witch hunts in 17th-Century France.
  • The Demon in Democracy: Totalitarian Temptations in Free Societies, by Ryszard Legutko
    A Polish freedom fighter contemplates the similarities between liberal democracy and communism.
  • Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages, by Carlota Perez
    A recommendation from Marc Andreessen.
  • The Thirty Years War, by C.V. Wedgwood
    With talk of the Westphalian system’s decline, why not read Dame Wedgwood’s classic for a refresher on the madness that led to the peace?
  • Musashi, by Eiji Yoshikawa
    A novel chronicling the life of the infamous samurai, and teacher of bushido, Miyamoto Musashi.

From the Bookshelf

I have given up newspapers in exchange for Tacitus and Thucydides, for Newton and Euclid; and I find myself much the happier.

— Thomas Jefferson, letter to John Adams, 21 January 1812 (Monticello, Virginia).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2017, all rights reserved. 

First Move

It has been five months since we released our first research piece, Is Emerging Markets Private Equity Dying?, and though Portico is still in its infancy, we’re excited about the doors this study continues to open, and the conversations we’ve been having with firms across geographic and market cap segments.

Two recent developments suggest that the trends highlighted in Is EM PE Dying? are unlikely to reverse anytime soon:

  • Fundraising data from EMPEA show that the number of final closes for funds <$250m in size continues to decline; meanwhile, capital raised for EM VC and private credit funds has reached all-time highs.
  • Apparently IFC is looking to commit up to $25m to Carlyle’s fifth Asia growth fund, underlining the trend of DFIs supporting established fund managers (that probably should have graduated from DFI capital).

Keep your eyes peeled for Portico’s forthcoming Middle Market Survey. We’d truly value your input. For those suffering survey fatigue, there will be a prize drawing for a Year in Books Subscription from the delightful booksellers at Heywood Hill in Mayfair.

Best wishes,
Mike

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Coming to Southeast Asia in May

I’ll be traveling through Southeast Asia next month, with stops planned for Singapore, Jakarta, and HCMC. I’m looking forward to (re-)connecting with several firms, and to kicking the tires on a hypothesis that the region presents a qualitatively different opportunity set than was on offer five years ago. Back then, investors got bulled up on the region, but had questions about the investable market. Have things changed? (It’s a small sample, but Cambridge Associates Benchmark data show TVPI of 1.07 for 2010-13 vintage Southeast Asia funds).

I’m particularly excited about the visit to Vietnam, where there have been some big deals taking place, including:

  • KKR’s $150m transaction in Masan Nutri-Science, continuing the firm’s quality food thesis (seen with its Modern Dairy and COFCO Meat deals in China);
  • VinaCapital’s joint venture with Warburg Pincus to create a hospitality JV (valued at up to $300m); and,
  • TPG’s intention to acquire a stake in Vietnam Australia International School, providing a potential liquidity event for Mekong Capital.

If you’re in the region, I’d love to meet with you. Drop me a line and I’ll try to find a time that works for you!

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Deal Flow in Africa

AVCA and EY released their latest study on exits in Africa, and the data point that jumps off the screen is the rapid growth of secondary buyouts as an exit channel, which hit *17* last year. There haven’t been more than 7 secondary buyouts / year going back to 2007.

The other dynamic at play—and I haven’t pulled data on this, so it’s just an impression—is a steady drumbeat of GPs co-investing in deals on the continent. Taken together, these two dynamics suggest that deal flow may very well be an issue in Africa (at least for firms managing traditional 10-year, closed-end structures).

But at the same time, the clear growth in secondary buyouts and (suspected) increase in GP co-invests may not necessarily be a bad thing. We could be witnessing a phenomenon similar to tier one PE / VC in the United States, where sequences / consortia of private capital investors scale up winner-take-most (if not all) platforms, or build out category leaders with decent moats. Time will tell!

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The Gift that Keeps on Giving in Eastern Europe 

Speaking of secondary buyouts and private capital building category leaders, Zabka Polska—operator of convenience stores, Freshmarkets, and supermarkets—has been sold to a PE buyer once again. Over the last 17 years, Zabka has changed hands from:

PineBridge Investments Penta Investments Mid Europa CVC

The company’s growth over the last two decades is truly astonishing. For its part, Mid Europa reportedly fetched €1.1B after growing Zabka’s top- and bottom-lines 3x and 4x, respectively, and opening 500 stores / year. Na zdrowie!

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Consumer Sentiment in Latin America

It’s not a good idea to try to call tops or bottoms—so I won’t—but one of the data streams I’ve been monitoring with interest is consumer sentiment in Brazil and Mexico. Given the political and economic turmoil in the former, and the fact that average manufacturing wages have been flat for a decade in the latter, it’s little surprise that consumers in these countries have been gloomy for five years running.

And yet, since the beginning of 2015, there has been a marked divergence in retail sales volumes across these two markets. Brazilian retail sales have declined in line with a contraction in consumer lending. By contrast, Mexican retail sales have been on a tear, fueled, in part, by a rapid expansion in household credit.

Brazilian consumer confidence is recovering, as are retail sales, and consumer credit growth remains restrained. Though the politics are slippery, it appears like a bottoming process is at hand. Mexico’s debt-fueled consumption binge, however, gives one pause. It’s hard to look at the chart below without contemplating a parallel to the morning after a night out in La Condesa, having imbibed too much mezcal and consumed too few tacos.

LatAmConsumer

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From the Bookshelf

Earlier this year, I read Carroll Quigley’s Evolution of Civilizations (1961). One of Quigley’s core arguments is that societies create instruments to meet basic human needs (e.g., security, the accumulation of wealth and savings, etc.), but these instruments evolve into institutions, which over time become less effective at achieving their original purposes.

When discussing the interwar period (1919-39), Quigley makes an insightful point about the evolution of the economic system that seems germane to today’s debates about secular stagnation.

The purpose of any economic system is to produce, distribute, and consume goods … As [the economic system] became institutionalized, profits became an end in themselves to the jeopardy of production, distribution, and consumption.

The rub is that the expansion of profit margins through higher prices and lower costs of production ultimately reduced consumption, and increased wealth inequality. Quigley continues:

Such an inequitable distribution of wealth was a very excellent thing as long as lack of capital was prevalent in the economic system, but such a maldistribution of income ceases to be an advantage as soon as the productive system has developed out of all proportion to the processes of distribution and of consumption.To some extent this situation was made worse by the growing separation … between ownership and control of corporations, since this led to an increased accumulation of undistributed profits held by the corporations in control of the management rather than distributed as dividends to the owners. Such undistributed profits became savings with no possibility of serving as consumer purchasing powerIncreasing proportions of the national income were going to those persons in the community who would be likely to save and decreasing proportions were going to those persons in the community who would spend their incomes for consumers’ goods.

As someone who genuinely believes in long-term investment, the passage above left me wondering whether this world awash in capital—one in which U.S. after-tax corporate profits (net dividends) amount to $982 billion (see below) and the pension assets of 22 countries total $36.4 trillion—is one that consigns us all to Keynes’s paradox of thrift.

USCorpProfits

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

 

Copyright © by Portico Advisers, LLC 2017, all rights reserved.