Editor’s Letter

Looking Beyond a Year of Turmoil

This year, 2012, is experiencing many diverse and competing forces that are trying to gain control of global economic activity. As seen in the Market Snapshot section, private equity fundraising has been difficult as almost 1,900 funds are seeking $775 billion at a time of restricted distributions from existing funds. Exit activity remains soft at about last year’s levels, near $21 billion in the first quarter of 2012, with most activity concentrated in the business products and services sector. One bright spot is the dramatic growth in the secondary market, where activity has risen sharply during the past three years and is expected to hit an all-time high of $25 billion this year, with Lexington Partners emerging as a major force in this growth.

The center of this battle for control of global economic activity is the U.S. economy, followed by that of Europe and Japan. The U.S. faces a tug-of-war between the forces of consumer demand, which is showing more confidence as unemployment creeps downward, and the production industries, which now, after a year of capital investment (particularly in the technology sector), are showing signs of pausing. Even so, the Federal Reserve has just released a positive report on the economy for the rest of this year. But uncertainties loom—banks and the financial system have not recovered and are plagued by additional regulation, the housing market still faces an uphill battle, the federal budget deficit issue continues to boost the unresolved U.S. national debt, and U.S. elections are in the final laps, becoming contentious for political leaders and unsettling for future fiscal policy.

Conditions are not much better overseas, as serious debt problems continue their unsettling rotation through the weaker countries of Europe. Britain’s economy has returned to a recession in the second quarter, and a socialist has just been elected to the presidency of France, which already contends with high and rising national debt. The third major advanced country in the world, Japan, has yet to record positive growth in real GDP this year, which is currently estimated to rise by more than 1%.At the recent Thunderbird 8th Annual Global Private Equity Conference (TPEC) in Phoenix, Arizona (April 4–5, 2012),Mark O’Hare, founder of Preqin, a major private equity research company, said that despite the negative global profile of private equity in the media and political circles (the newly elected president of France Monsieur Hollande promised to ban private equity from France), many limited partners (LPs) intend to either maintain or increase their allocations to the asset class. An increasing number of LPs are considering investments in emerging markets through managers with proven track records.

With not particularly outstanding growth prospects in the advanced countries of the world, global financial flows are continuing to look to the developing and rapidly growing emerging market economies for more promising investment opportunities. For the BRIC countries (Brazil, Russia, India, and China), the TPEC speakers Luiz Fraga of Gavea Investimentos, Scott Foushee of Acme Partners, Tom Greer of China Enterprise Capital, and Sumeet Jain of CMEA Capital emphasized continuing opportunities found in the middle market and infrastructure-related assets categories in emerging markets.

Global capital flows between advanced and emerging market economies have become particularly complicated in character over the past decade. Because the economic growth of most emerging markets depends largely on exports to advanced countries, emerging market growth is slowing but still equal to about three times that of advanced countries in real terms. Financial liberalization has made it easier for investors to get their funds out of countries than in the past, which has made it attractive to invest in these selected emerging market countries. The need for foreign investments has also promoted the development of equity markets and provides an incentive (or the discipline) for governments to support and protect foreign investors’ interests. Thus, Argentina’s nationalization of a foreign oil company’s interests last month raises questions about Argentina as a viable foreign investment target. Even in countries where governments behave in the best interests of promoting economic activity, several complicated issues could give rise to future risks to foreign investors.

One such concern and cause of economic disruption is the source of inflowing funds and their rate of inflow. This year, oil-exporting countries will again run an estimated $750 billion current account surplus on top of the $4 trillion surplus they have had since 2000.Only a fraction of this amount has gone into imports or international reserves; most of it has been channeled through various intermediaries into equity, private equity, hedge funds, property, commodities, and other risky investments in other countries, from Asia and Africa to Latin America and Eastern Europe. Not much is known about the impact or consistency of these funds’ investments, but they can have a major impact on any economy they flow into (upward sector price pressures and countrywide inflation) and out of (serious economic downturns and recessions).

The Bank for International Settlements (BIS) and the International Monetary Fund (IMF) have been studying the globalization of financial flows over the past decade and have found that the opening of financial markets to capital flows can make certain countries more vulnerable to economic policies in other countries. This can influence the effectiveness or even offset the impact of domestic economic policy management in recipient countries; it can eliminate or bankrupt uncompetitive companies more quickly, and it can impact the speed of reaction and degree of variability in economic cycles that are transmitted internationally from more volatile financial flows to real-side implications. Preliminary research suggests that emerging market economies that are above a certain threshold of real GDP growth may benefit from financial globalization, but economies whose real GDP growth is low may suffer serious domestic economic damage with limited upside recovery likely. So far, the research is only preliminary, but this finding is indicative of the new risks of investing in emerging markets.

F. JOHN MATHIS

Editor

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