Over the last 14 years, I have had the unique opportunity to work and live in countries that are today categorised as frontier markets. I have come to experience first-hand many of the challenges associated with private equity investing in these markets. I have also learned that if you choose the right partners and opportunities, there are significant returns to be had and shareholder value to be created.
While living in Kazakhstan from 1994-2002, I worked on the privatisation of state-owned assets, and subsequently invested in small and medium-sized companies. My colleagues and I also toyed with setting up private equity funds in early 2000, but we found we were ahead of our time.
When I joined the Asian Development Bank (ADB) in March 2002, probably one of the most rewarding investments I made was into the first post-Taliban local commercial bank in Afghanistan, Afghanistan International Bank (AIB). The bank was started from scratch with investments from three investor groups from the Afghan Diaspora, as well as ADB. AIB, in which I remain involved as an independent board member, continues to operate and is generating a monthly profit. Of course, Afghanistan does not even qualify as a frontier market. Informally, we sadly refer to this market as “post-devastation”.
During my time at ADB, through the emerging markets private equity fund commitments that we were making, I was able to look more seriously at supporting new private equity managers in frontier markets such as Indonesia, Kazakhstan, Pakistan and Vietnam.
I also began working in Pakistan, the focus of this article, in 2002. I worked on one significant transaction that unfortunately did not come not to fruition. This transaction and the evaluation of other opportunities over the years, however, provided me with the chance to network in the business community and start to evaluate prospects for the emergence of a private equity industry in Pakistan.
Pakistan arguably suffers from a poor image. The current instability both prior to and following the assassination of Benazir Bhutto is likely to give pause to the most daring of investors. This was certainly reflected in the markets when the Karachi Stock Exchange lost 9.9 percent of the KSE-100 benchmark value in just one week at the end of 2007.
To be sure, when President Pervez Musharaff imposed a state of emergency in November 2007, foreigners pulled back all the portfolio investment they had made. The market, however, did not crash as it found ready support from local players. It is important when evaluating frontier, or even emerging markets for that matter, to always pay attention to local investors' risk appetite as it gives a more measured indication of actual market risk. Indeed, Pakistani stocks have risen 5 percent since the start of the year.
In fact, the perpetually negative portrayal disseminated by the media is often at odds with reality from an investor perspective. The short-term political unrest can be unsettling for most investors, but if brought under control, the long-term investment potential for Pakistan is quite promising. Despite the relentless political and social challenges, Pakistan's economy is expected to grow 6.8 percent in the year ending 30 June 2008, according to the ADB, just slightly down from the last three years when the economy grew at an average of 7.5 percent per annum. The corporate sector is expected to show 18 percent growth in earnings for FY08. The equity market is currently trading at a 25 percent discount to its regional peers according to a recent Credit Suisse research report.
Over the past ten years or perhaps longer, there seems to have been something of a decoupling of politics and social issues from economics in Pakistan. Political uncertainty and risk have been a mainstay in the country's history. Despite this reality, Pakistan has had a functioning parliament and democracy for the last five years. The last government was the only one in Pakistan's 60 year history that successfully completed its tenure and gave way to elections. Pakistan's stock markets returned 40 percent per annum from 2002-07, which won it the designation of best performing stock market globally on multiple occasions. During this period the index jumped from 1,273 to 13,000 – more than a 10-fold rise over a six year period. The multiple political crises and periods of violence throughout 2007 did not seem to deter the stock market which stood its ground and rose by over 40 percent.
Furthermore, all political parties are pro-business, pro-trade, and favour liberalisation and a reduction in government ownership of business.
Given these facts, it is important to focus on the underlying fundamentals and how they affect the overall economy when evaluating whether or not to risk capital in Pakistan. Believe it or not, the World Bank in their 2008 ranking on ease of doing business again ranked Pakistan as the best place for business among the major countries in South Asia – significantly ahead of India.
Pakistan offers an interesting part of an investor's diversification strategy, because it has a low correlation to developed markets due to the fact that the economy and its stock market are largely supported by domestic investors. The relatively closed nature of the economy is likely to insulate it from the global turmoil in debt markets and any slowdown in Western economies. The country has a population of 160 million people, 63 percent of which are under the age of 25, a growing middle class, massive infrastructure and energy requirements, and an inefficient economy that still offers above average returns/margins. It is a place that should not escape an experienced emerging markets private equity investor's attention. Perhaps Pakistan should even be described as an emerging instead of a frontier market.
The definitions of “frontier”, “emerging” and “developed” markets vary drastically depending on the perspectives of the investor and their level of risk tolerance. The terms also generally address capital markets development versus that of the private equity markets. In today's world, frontier markets offer investors a unique opportunity to diversify their portfolio, and to benefit from future long-term growth. This certainly applies to Pakistan given its low correlation to developed markets.
Nevertheless, one can question whether Pakistan really is best classified as a frontier market nowadays.
Credit Suisse Research has developed an index in which frontier markets are identified according to the following criteria: (i) macroeconomic potential; (ii) population well-being; (iii) financial market development and (iv) political stability. As highlighted throughout this article, one can assume that Pakistan ranks fairly high in connection with the first three factors. It is only the fourth factor, political stability, where Pakistan continues to face its greatest challenges and remains in the frontier market rather than the emerging market category. If Pakistan is able to prevail over its formidable political and social challenges, then the country is poised for continued extraordinary growth – provided the economy remains on its current trajectory and economic reforms and prudent fiscal management keep apace.
Personally, I expect that Pakistan will soon be grouped with other emerging market economies. I'm encouraged by recent developments in that there is likely to be more checks and balances in the government as power becomes shared between the office of the president, parliament and the judiciary. Probably one of the most significant outcomes of Pakistan's elections in February was the defeat of the religious parties that have run the North-West Frontier Province for the last five years. Voters in this critical border province instead elected moderates from a small regional party, Awami National Party or A.N.P. The victory of the A.N.P. is seen as a clear rejection of the Taliban. It is expected to serve as an effective intermediary between the militants and the central government in Islamabad given cultural similarities shared with respect to resolving conflicts, and overall decision-making.
Since the events of 11 September 2001, Pakistan's economy has improved dramatically. It has experienced economic growth that is some of the highest in Central Asia, fiscal balances and external accounts are in a healthy position, and the country's sovereign rating has improved. Remittances and FDI constituted almost 8 percent of GDP in 2007. Despite the turbulence, FDI flows into Pakistan have remained strong at over $2 billion, registering 10 percent growth over the same period. The government will have to remain vigilant in the coming years with respect to maintaining high growth rates, despite growing fiscal discomfort from rising commodity and energy prices, a rising current account deficit, a tight monetary policy in place to control inflation, and falling consumer/investor confidence.
I believe that if Pakistan's people and Government remain disciplined and bring greater political stability to the country, it will remain on track to achieve continued high levels of economic growth benefitting from high levels of investment. Today, the continuation of economic expansion is fortunately backed by solid structural changes (such as demographic transition, developing financial sector, easier access to credit) in the economy rather than transitory factors (such as foreign aid or remittances).
The ongoing growth of religious fundamentalism in Pakistan still remains a serious threat to the progressive forces in the country, and this fact should not be taken lightly by investors considering whether or not to make a long-term investment in Pakistan. This is the real wild card that can effect long-term investment returns and overall political and economic stability. I am hopeful that the new government is able to manage these countervailing forces wisely.
If Pakistan is on course to become a bonafide emerging market, what are the implications for private equity investors studying opportunities in Pakistan? From an industry perspective, Pakistan remains underdeveloped, but the talent pool of private equity professionals and interest by investors is beginning to grow. I believe that investors can feel relatively safe in making long-term bets and participate in the economic growth in Pakistan through commitments to private equity managers currently operating in Pakistan or perhaps directly. My recommendation is that no investor without local experience attempt to make private equity investments directly. The risks are too great and cannot be easily mitigated without longstanding local relationships and on the ground knowledge.
While the economy is characterised by strong fundamentals and a fairly well developed regulatory environment and ongoing reform agenda, Pakistan's private equity industry remains nascent. To date, I have committed to only two managers in Pakistan, but I see others that are coming up and offering an interesting investment opportunity. The following firms comprise what limited partners have to choose from among up and coming general partners in Pakistan:
In addition, there are several groups that invest in private equity-style transactions or from a fund focusing on a broader geography, including Synthos, Hamilton Bradshaw, and Actis South Asia Fund. There are also a number of Middle-Eastern institutions, some of them family-owned, that can also invest in Pakistan and have done so on an ad-hoc basis. This investor group tends to focus on deals with enterprise values in excess of $100 million and, given their ability to pay high prices to secure a transaction, probably offers the greatest competition for institutionally backed private equity fund managers.
It is unlikely that for the time being any other private equity groups will emerge. Investors will want to see how the first generation of local managers performs before committing to any new managers that come to the market. Most likely, Pakistan's private equity industry will be challenged to grow very quickly despite the availability of deal flow due to a shortage in the financial talent required. This shortage is currently being felt in all segments of Pakistan's financial sector.
Nevertheless, I feel confident that the small talent pool that has evolved will be able to generate the returns that will attract further investment into the asset class in the medium to long term.
In conclusion, the growth of Pakistan's private equity industry is constrained more by the lack of professional talent than its underlying economic fundamentals or political challenges. Access to the private equity markets will be limited for the time being. Investors with the foresight to commit to the emerging managers can expect to do well. If you missed the boat this first round, then I suggest that you closely monitor the performance of these managers and develop relationships early on so that you have access to their next round of funds.
At the same time, however, remember to never compromise on manager selection, especially in a market as unproven as Pakistan. The country is seeing large numbers of native professionals coming back from overseas to capitalise on the country's growth and future opportunities. Some of them will try to set up PE funds while lacking the skills, track record, and local knowledge to do so. It is important to be wary of these groups, they are not likely to generate the risk adjusted returns that an investor might be seeking.