From an investor and fund manager perspective investing in emerging markets presents a unique set of challenges. But most would probably agree that “greater challenges come greater opportunities.”
Emerging Markets Defined
Several factors define what makes up an emerging market. While emerging markets have some aspects of developed markets, they do not yet fully meet all the characteristics. These markets have varied levels of infrastructure, and the workforces earn less than the average per capita income. A component of these markets is that they are experiencing rapid growth and show potential for that growth to continue.
According to the Morgan Stanley Capital International Emerging Market Index, twenty-four countries are defined as emerging markets. While there may be similarities between these markets, investors should realize that no two are exactly alike. Many are working to reform their political, legal, and financial systems, and each has cultural differences. Individually they are at differing levels of progress, and challenges remain.
Characteristics of Emerging Markets
Geographically, emerging markets are found scattered throughout the world. Numerous countries in Central and South America and Eastern Europe are classified as emerging markets. Their populations and subsequent market sizes are somewhat less than other regions of the world.
The MENA region (or Middle East and North Africa) and South Asia contain several emerging markets. This region also has a large concentration of people. The total population of these two regions is approximately 2 billion people. With the exclusion of India, the area boasts an immense market size of roughly 700 million people. While their purchasing power might be somewhat less than their developing country counterparts, numerous attractive business opportunities exist. In perspective, this entire market is just over twice the size of the United States.
A principal characteristic of an emerging market is that it may be affected to differing degrees by higher sociopolitical instability. Some may even be subject to military unease or social upheaval. These qualities can lead to higher volatility for investments. They are also prone to currency fluctuations and varying levels of infrastructure. This poses a challenge for investors and companies operating within them. What can be taken for granted in developed countries may not be fully developed within these markets. Essential services such as access to robust financial systems, cellular networks, or high-speed internet may be inadequate. Infrastructure that allows for efficient e-commerce may also be insufficient, as well as deficiencies within supply chains.
The Appeal of Investing
I have been fortunate to have personally traveled to and conducted business within several of these countries. I have found that companies face the same challenges as their counterparts in developed markets. That does not mean our investment team will invest in all of these markets, as there is more to it than finding an opportunity that looks attractive.
One of the most appealing factors for venture capital firms like 1839 Ventures® is that potential portfolio companies tend to function on a much lower cost basis than they would if they had launched the same product or service within a developed country.
Even sophisticated investors may have a dumb money moment when their team does not take the time to understand the market. As an investor, if you are in a hurry or have not done your research, you are almost destined for failure. Those who rely on the same formulas they use in Silicon Valley will usually wildly overpay for an investment. As valuations and the costs of doing business is much lower. Not only will they overpay, but their portfolio companies may not scale effectively or fail altogether.
Emerging Markets Opportunities
Technological innovation is not strictly limited to Silicon Valley, and for that matter, not developed countries either. While companies in emerging markets are occasionally referred to as copycats, numerous companies have developed innovative products and services that solve unique problems.
Many companies have overcome barriers to scaling without investments and have become regionally successful. These companies have managed to expand into their less developed frontier market neighbors, and a number of these products and services show potential to be brought to developed countries, as they are often solving a niche problem that has been either overlooked or would be too costly to start from scratch and scale within a developed country.
Challenges of Investing in Emerging Markets
Without a physical presence within a given market, venture investors will find it challenging to source and evaluate companies. Having the most innovative products and solid management teams, investors need to be able to monitor their investments. Without direct exposure or being connected within the region, it presents issues when it comes to conducting efficient risk assessments and the ability to monitor investments.
The job of separating the good deals from the bad becomes a daunting task, if not next to impossible. Not to mention researching prospective companies, the potential market sizes, and their growth potential. Investors do not have the time nor the capacity to stay on top of all trends within these markets.
Another challenge of investing in emerging markets is that the capital markets within them are often less mature and often lack access to sophisticated investors. Hence, many companies need foreign-based investment to sustain their growth. The lack of investment funds can have positive side effects as many founders are forced to create a streamlined, efficient, and sustainable business from the beginning.
I am a huge fan of bootstrapping, as founders are forced to do more with less. Bootstrapping encourages efficiency, shifting the founder’s focus to execution and gaining market traction. However, like any business, there is a point where the injection of capital investment is the only way to scale effectively while keeping up with the rapid expansion.
Attractive for Investors
For investors, venture investing in emerging markets produces greater volatility. Alternatively, these markets may be highly-attractive as they possess opportunities for higher-than-average returns. Even for accomplished investors, sourcing suitable direct investments within these markets can be challenging, especially for those who may not have direct exposure to a given market via a physical presence. Still, a large part of the appeal is the potential for greater returns, not only from a financial perspective but often from a social impact and sustainability standpoint.
Another appealing quality for venture investors is that due to a lack of funding sources, valuations become much more reasonable than their counterparts in developed markets. Venture investors will also find that the cost of capital is significantly lower, as companies often will need a smaller amount of funding to operate efficiently. Therefore, the required IRR or Internal Rate of Return on a portfolio company’s securities should be somewhat easier to obtain, barring other challenges.
Realizing Return on Investment
While investing in emerging markets offers less liquidity, exits do exist. While IPOs are somewhat rarer, they are not unheard of. However, according to EY Global Capital Confidence Barometer, the M&A (merger and acquisition) market is much more robust. Due to the COVID-19 pandemic, throughout 2020, MENA executives expect a slowdown in conventional M&A activity as companies focus on shoring up liquidity, cost efficiencies, and raising equity.
According to the same report, the M&A appetite for this region is forecasted to remain healthy. One of the best cases for M&A from this region is that it provides global companies in developed countries access to new markets without having to go in and build something from the ground up.
