Anandh R. HaridhThe world has changed over the last decade — and that is an understatement. As a result and especially since the 2008 crisis, some leaders in finance have called for an end to the classification of the term “emerging market”.
The classification of emerging market boils down to three things: infrastructure, literacy and reliable public institutions. Steps are being taken in many of these countries to address each of these three things. Of them, the issue that requires significant capital and much of that capital comprised of debt, is infrastructure.
However, debt financing for infrastructure is constrained by both availability and cost. And these two constraints inhibit growth in other sectors as well.
In my experience, there are several entrepreneurs in emerging markets willing and seeking to seize the opportunities in front of them. Their source of financing is from the following sources: Domestic banks and hedge funds for private debt, private equity and mutual funds, etc. for public equity and public debt with some crossover. However, unlike say technology entrepreneurs in California, Asian entrepreneurs are very sensitive to equity dilution, more so in a control sense than in economic terms and constantly look to higher levels of debt financing as a result.
Domestic bank financing is still largely secured lending, as it should be, and therefore reserved for more mature companies. Pre-2008 hedge funds stepped in to provide what I call “growth debt” and were active in financing entrepreneurs in Asia. Their chosen method of financing; secured lending with target equity returns, ended in tears for both sides in many situations.
The mistake was these funds attempted to mimic the distressed debt strategy that netted tremendous returns in the post-1998 crisis period in the 2006-2007 bull market. Perversely, the structure of the debt itself drove several investments to a stressed or distressed situation causing much anguish on both sides. With much of the legitimate returns a business can generate paid out contractually to “growth debt” providers and the debt clock ticking, entrepreneurs take on higher and at times reckless risks.
As we look into the future, I would suggest a change in strategy and expectations from various parties.
Return expectations: The starting point (and this message needs to work itself up the chain to the final providers of capital – the pension funds, endowments etc.) is for return thresholds from these economies to be moderated.
Over the next decade, equity markets in the West are projected to provide single digit returns. We could assume a premium over this for financing growth in Asian economies. The premium should not however be based on the traditional approach of looking at historical volatility — neither does that volatility capture the now strong sovereign balance sheets and prudent central bankers nor reflect the fact that much of the volatility was caused by the same Western capital going in and out of these economies.
Both the perceived risk and historical volatility will overstate the actual risk on a look forward basis. If equity-return expectations for Asian emerging markets are moderated to the teens (say), then normal debt returns should be in single digits, no more.
Private debt investors: Once the return expectations from debt investments are at realistic levels, much of the problem is solved. Such debt should also be at least medium term.
For those classes of investors seeking higher returns, the approach should be to supplement the debt investment with real equity risk – not via free warrants and options as is now customary — but via real equity investments. The days of private debt investors demanding “20 percent IRR” should be put behind for everyone’s benefit.
Private Equity: In Asian emerging markets, private equity has by and large focused on providing growth equity and as a result avoided the financial engineering-driven investment losses they have suffered in the West. Asian entrepreneurs have three complaints about private equity: (a) takes too long to make a decision on the investment, (b) requires board seats and interferes in business decisions and (c) offers low valuations.
Taking time to conduct a due diligence on the investment is necessary and private equity investors should not deviate from this. The second point can be addressed if the private equity funds choose board nominees who have real and substantial operating experience in relevant industries and are then able to add value. Modest valuations can be justified since investors take real equity risk.
Entrepreneurs: This group must adjust their modus operandi and view investors as partners. As everyone has by now figured out, financing growth with debt and dependence on public market exits is a risky model for both entrepreneurs and financiers. Equity financing must be part and parcel of any entrepreneur’s plans. The founders of Microsoft and Cisco ended up with very small percentages of their companies but they still stayed at the helm of their companies for decades. Sacrificing growth for perceived threat to control leaves everyone poorer.
Governments: Asian governments can do their part by depoliticizing business and making capital market regulations more flexible. Listed companies in many places find rules governing size and pricing of follow on equity offerings unworkable. For instance, listed Indonesian companies can raise only 10 percent new equity once every two years on a non-preemptive basis (versus 20 percent every year in Singapore and 10 percent every year in Malaysia). For a fast growing economy these conditions are very restrictive.
There is a crucial role the US government (and other governments) can play here: Provide reasonable cost medium to long term debt financing (directly or through its various arms) to the growing regions of the world.
It makes sense both financially and politically. There is a genuine need that can be fulfilled and they are better investments than lending via quantitative easing to the over levered Western consumer.
Attempts to make credit more readily available to Americans or inflate the debt away have not yielded results (yet) – deflation remains a possibility and job creation has stalled.
I have spoken to employees of American corporations in Asia: They are hiring here, they are just not hiring in America. America can attach preconditions to provisions of such funding such as purchase of American-made goods or even selected hiring of Americans overseas. If we go to Africa or other parts of the world where China is playing a similar role, we will find thousands of Chinese workers of all levels
stationed.
The recent announcement by IFC, ADB, German Investment Corporation and the Indonesian government to form Indonesia Infrastructure Finance (IIF) with US$180 million corpus is a welcome first step. The need is for significantly more reasonable cost term debt for the infrastructure sector and also for entrepreneurs and small to medium enterprises in other sectors.
We are in early stages of a decade or longer expansion in Indonesia. If each party does its share and expectations are fair, the pie can indeed expand and there will be prosperity to be had for all.
The writer is chief investment officer at Bakrie & Brothers.
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