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Global private equity watch 2012 - Seek out niches and market gaps - EY - Global

Global private equity watch 2012

Seek out niches and market gaps

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PE firms must look beyond the obvious by seeking out new sources of capital and identifying the most promising businesses in the sectors and geographies that will underpin global economic growth.

New capital sources, new asset classes

PE has also been quick to identify a shift in capital flows. While most existing LPs remain supportive of PE, firms have recognized that to continue growing, they must tap new capital sources. The industry's most successful players have built out extensive investor relations capabilities to connect with investors across the world, particularly those in Asia and the Middle East.

As their investor bases grow, some of the larger firms are taking the opportunity to expand their business to offer LPs a wide variety of investment strategies and asset classes. They have extended into new areas, such as hedge funds, real estate and distressed debt evolving into multi-asset managers. This is true not only of firms in the more established markets, but also in Asia Pacific.

Unconventional financing

At the same time, debt financing for PE deals is more difficult. While credit is available for high-quality assets, this varies from market-to-market. Still, even as credit has turned away from high tide, PE is demonstrating its determination to sign high-quality deals by seeking out less obvious sources of debt finance.

PE is also proving itself to be highly entrepreneurial in the way that it structures deals and manages its portfolio. Our analysis shows that the equity component in buyouts has increased from less than a third to around 40% in recent years. And, in the emerging markets, there is even willingness to put in 100% equity for the right deal.

Consequently, PE has increased its focus on driving fundamental changes to the businesses it backs, moving profit growth rather than financial engineering to the top of the agenda as a way to offset the drag on returns.

Smaller funds, opportunistic strategies

Many of the largest PE players have downsized their latest funds to adapt to an environment of smaller commitments from LPs and a more hands-on strategy of targeting smaller, growth assets. In addition, many of the larger players have taken the proactive step of raising funds that target specific regions or strategies.

This approach not only provides LPs with expanded alternatives for their allocations, but also enables GPs to take an opportunistic approach that places them at the forefront of regional and sector developments.

Tapping emerging markets

Over the last few years, PE has extended well beyond its traditional markets into fast-growth economies such as India, China and Brazil in an attempt to capitalize on the emerging middle class in these geographies. These have proved highly successful markets for many PE firms, which have tapped these regions for new investments as well as expanded existing portfolio companies there.

However, even these markets have become more established. International and local firms now compete for deals in these markets, and competition for deals has increased significantly. Meanwhile, there are also signs of a slowdown in the breakneck GDP growth some of these countries have witnessed over recent years. The World Bank recently revised its 2012 growth forecasts for China, Brazil and India downward.

Even so, these countries will continue to grow strongly compared with developed markets, and they still hold plenty of promise for PE. In addition, there are many cities beyond the well-trodden path of the capitals in which strong PE investment potential resides.

PE pioneers will go beyond BRICs

But it is possible that PE firms with the vision to tap into the world's frontier markets will reap the best rewards. Markets such as Turkey, Indonesia, Vietnam, Africa, Colombia, Chile, Mexico and Peru all exhibit similar trends to the BRICs.

Consumer culture is taking hold in these countries, and economic growth is rapid. Yet valuations remain more moderate and competition more limited than the more established growth markets.

Governments are also increasing regulatory oversight and improving legislative frameworks to improve shareholder protection. As a result, many of these countries are attracting PE's most entrepreneurial firms seeking risk-adjusted returns.

Gaining access to these newer markets and finding investments in second-tier cities in countries such as China, India and Brazil will be challenging. Lack of governance, clarity in the rule of business law, foreign currency and talent identification represent complex hurdles to being a successful investor.

Achieving success will require a heavy dose of pioneering spirit, backed up by local talent and sophisticated management processes to ensure that risks are appropriately managed. Yet the PE model has adapted in the past. Sponsors have proven that they can deploy a variety of different strategies for success, from building local teams through to harnessing local knowledge and contacts via partnerships.

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