To Invest In Frontier Markets, Private Equity Is the Only Way To Go

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Emerging markets are cooling down, which has investors looking deeper into the frontier for attractive returns. This year alone, $3 billion in fresh capital has flowed into the frontier through various mutual funds and ETFs that provide exposure to these markets. But while the enthusiasm for frontier markets is well-founded, the strategy through which money managers are channeling that enthusiasm is ill-advised: all of these funds focus on investments in public equity markets, which are either underdeveloped or non-existent in most frontier countries. The only way to successfully invest in frontier markets is through private equity.

Frontier markets - defined various ways, but generally comprising those countries that are one stage less developed than the traditional emerging markets - certainly present a compelling investment thesis. Of the ten fastest-growing economies year-to-date, all are frontier markets, and virtually all are growing at rates of almost 10% or more. The BRICs, by contrast, are on track to disappoint, with Brazil and Russia each projected to grow at just over a measly 2%, India at 5%, and China clocking in at between 7% and 8%.

In addition, frontier markets demonstrate growth patterns that are largely disconnected from - and in some cases completely at odds with - global economic trends. This is because frontier markets generally start from such a low economic base that they are able to grow intrinsically, for example by simply introducing new technologies and better management techniques that enhance productivity, allowing these countries to eke out GDP gains irrespective of what is going on in the global economy. For these reasons, frontier markets are considered to be one of the world's only uncorrelated asset classes, and thus an important component of a diversified investment portfolio.

All of this has money managers moving a larger share of their and their clients' capital into products that offer exposure to frontier markets. These include frontier funds that are geographically agnostic like the iShares MSCI Frontier 100 ETF, as well as regional funds like the Market Vectors Africa Index, and, in some cases, country-specific funds like the Market Vectors Vietnam ETF.

But while such funds are a great way to gain exposure to developed markets, and an acceptable way to do so for emerging markets, they really do not work in the frontier. For starters, many of the most attractive frontier markets do not even have public exchanges. Of the ten fastest-growing frontier markets, more than half either have no stock exchange or have a stock exchange on which electronic trading is impossible. Any frontier market investor focused on public equities, then, would not even be able to participate in these markets.

Even those frontier markets that have established stock exchanges are, for the most part, not ripe for public equity investments. Just take the stock exchange of Rwanda, one of the fastest-growing frontier markets in Africa, as an example. The exchange has only four listed companies. Of those four companies, only two even identify Rwanda as their home country - the other two are actually focused primarily on Kenya. The last IPO was in September 2011 and trades in general are rare, meaning the market is highly illiquid and not representative of the investment opportunities currently available in Rwanda.

What's more, regulatory frameworks as well as enforcement mechanisms as they relate to stock exchanges in frontier markets are in their infancy. If you think the SEC misses the occasional case of insider trading in the United States, you are in for a real whirlwind in the frontier. Stock exchanges in those markets abound with trades based on inside information - not just about individual companies, but also about regulatory developments that could affect entire sectors. Money managers sitting at desks in New York and London making trades based on publicly available information are at an insurmountable disadvantage.

In frontier markets, the best companies are unlisted. Typically, they are family-owned businesses with successful operating records and a deep understanding of the local market. To reach the next level, however, they require both growth financing and a partner who can help them introduce modern management techniques, systems, and processes. Finding these businesses means spending significant time getting to know the local market; helping them grow typically entails hands-on participation in the company's day-to-day operations, forming a close working relationship with the company's management.

And that's really the key: It all boils down to relationships. Frontier markets still work the old-fashioned way, where you get to know somebody over time, develop a sense of trust and mutual respect, and only then form a business partnership through a private investment into a non-listed company. Private equity is ideally suited for this kind of business environment. Ticker symbols and stock charts, meanwhile, could not be more removed from the reality of how business gets done in the frontier.


Alexander Benard is COO of Schulze Global Investments, a private equity firm focused on frontier markets.  He is the author of a Foreign Affairs article on investing successfully in the frontier.  

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