Unlocking High-Growth Potential: Private Equity Trends in Emerging Economies

The study by the International Finance Corporation reveals that private equity in emerging markets offers high-growth potential, particularly in sectors like technology and finance, but is marked by significant return variability driven largely by firm-specific factors and macroeconomic conditions. Diversification and strategic investment timing are critical to navigating these volatile but rewarding markets.

A groundbreaking study by Florian Molders and Edgar Salgado from the International Finance Corporation (IFC), part of the World Bank Group, dives into the underexplored territory of private equity in emerging markets and developing economies (EMDEs). Using a dataset spanning six decades and 2,727 equity investments, the research highlights the pivotal role of firm-specific factors in driving private equity returns. Unlike public equity markets, where macroeconomic trends dominate, private equity in EMDEs is characterized by its high-risk, high-reward nature, underscoring the importance of targeted investment strategies and diversification. This study also provides a sectoral breakdown, revealing significant disparities in returns across industries such as technology, finance, and resource-intensive sectors like mining.

Sectoral Winners and the High-Stakes Game

The study paints a vivid picture of the winners and losers in private equity investments. High-growth industries, particularly technology and finance, stood out for their robust returns, leveraging structural drivers like digitalization, urbanization, and the expansion of financial services. Finance, one of the most prominent sectors in the IFC portfolio, delivered notable "home runs," or investments yielding annualized returns exceeding 50%. Technology, driven by its transformative potential and innovation, also contributed significantly to outsized gains. Yet, the path is not uniform mature industries such as accommodation and tourism produced lower and more stable returns, offering limited differentiation. Investments through private equity funds generally exhibited less volatility than direct investments in individual companies. However, while funds benefited from diversification, they often missed out on the extreme highs that came with direct investments in breakthrough companies.

Returns were highly skewed, with a mean public market equivalent (PME) of 1.27 compared to a median of 0.94, highlighting how a handful of stellar investments inflated the average. Home runs accounted for only 2.4% of all investments, while over 10% of the portfolio delivered negligible or negative returns. This uneven distribution reflects the high-stakes nature of private equity in emerging markets, where careful selection of firms and sectors is paramount to achieving strong overall performance.

The Macroeconomic Puzzle

The study underscores the crucial role of macroeconomic factors in shaping private equity outcomes. Real GDP growth emerged as a key driver, with a one-percent increase in GDP during the investment cycle boosting median returns by 0.49 percentage points. This highlights the significant influence of economic expansion on private equity performance. Conversely, real exchange rate (RER) depreciation had a detrimental effect on dollar-denominated returns, reducing returns by 6.72 percentage points for every 10% depreciation. This makes currency management a critical challenge for international investors.

Interestingly, inflation showed a nuanced, positive correlation with returns, reflecting its complex interplay with other macroeconomic factors like currency devaluation. Sectors generating dollar-aligned revenues, such as technology and financial services, fared better under such conditions, while infrastructure and resource-intensive industries often tied to local currencies were more vulnerable to currency fluctuations.

Firm-Specific Factors: The Key to Unlocking Success

Perhaps the most striking finding of the study is the dominance of firm-specific factors, which accounted for up to 83% of return variability. These factors outweighed sectoral or country-level determinants, underscoring the critical importance of identifying high-performing firms. This aligns with earlier research on equity markets, which showed that idiosyncratic factors are often the primary drivers of performance. For private equity, this effect is even more pronounced due to concentrated exposure and active management.

Shorter-duration investments tended to deliver higher returns, particularly in fast-growing sectors, while longer-term investments often underperformed relative to market benchmarks. This suggests that a tactical approach to investment timing is essential in private equity. While some firms in innovative industries achieved extraordinary success, others failed to deliver, further emphasizing the importance of due diligence and strategic selection.

Charting the Path Forward

The study’s findings hold profound implications for investors and policymakers alike. For institutional investors, targeting high-growth industries and leveraging firm-specific insights can unlock substantial returns, albeit with heightened risks. Diversification remains a cornerstone strategy, as evidenced by the less volatile returns of fund-based investments. However, direct investments in promising firms can yield significant gains, provided that risks are managed effectively.

Policymakers, on the other hand, can use these insights to create a more enabling environment for private equity, fostering sustainable growth in EMDEs. By addressing structural challenges and mitigating risks like currency volatility, they can help attract more private equity investment to their economies.

The report acknowledges its limitations, particularly its inability to account for variables like export reliance or revenue-generation currency, which could further elucidate the sensitivity of returns to macroeconomic shifts. Future research is encouraged to explore these factors while examining the performance of private equity across business cycles and stages of sectoral development.

Private equity in EMDEs represents a complex yet rewarding frontier. While technology and finance lead the pack with outsized returns, the landscape remains fraught with risks, including macroeconomic volatility and sectoral disparities. The findings offer a roadmap for navigating this terrain, emphasizing the need for robust risk management, strategic timing, and a focus on high-growth sectors. For institutions like IFC, this research not only validates past strategies but also provides a foundation for optimizing future investments. By balancing risk and reward, private equity investors can play a pivotal role in shaping the economic future of some of the world’s most dynamic markets.