Allocating to emerging markets infrastructure and private equity 

Some of the world’s largest, most sophisticated asset owners and fiduciaries (collectively “asset owners”) have established dedicated allocations to emerging markets infrastructure and/or private equity as part of their strategic asset allocations or other means of deploying their risk budgets. The purpose of this article is to inform and support asset owners who have not yet established such allocations on some of the common considerations that come into play when deliberating the pros and cons of such an endeavor.

For the purposes of this article, we define emerging markets infrastructure as one asset class, and emerging markets private equity, by which we mean venture capital and early-stage growth private equity (as opposed to buyout), as a separate asset class. Further sub-divisions and other definitions are possible, but these are two “asset classes” we commonly see put forward for consideration by asset owners who already invest in “infrastructure” and “private equity” in developed economies. In some cases, selective, opportunistic, or more systematic investment is also deliberately made in some markets considered “frontier”. For simplicity, we explicitly consider emerging markets exposure only, while acknowledging implicitly that some institutional investors have gone beyond emerging markets to potentially further enhance their expected returns and diversification.

We acknowledge that the distinction between “developed” and “emerging” is becoming less and less meaningful, and in any case was typically established for consideration of public market equity investments. For example, Taiwan’s per capita GDP was US $32K per annum as of 2022 (non-purchasing power parity adjusted), and South Korea’s was $33K, just below Japan’s $34K. Taiwan’s corruption perceptions index score is 68, just one point below the United States’ score of 69 on a 100-point scale (Japan has a score of 73 and South Korea a score of 63).  Yet Taiwan and South Korea are still considered emerging markets by key benchmark providers. 

To be provocative, if we took the facts, data and experience of policymaking and government/regulatory stability in the US and UK since 2016 – a period which has seen populist political outcomes in both countries, a government bonds crisis in the UK that forced a government out of power, repeated threats to shut down the US government, a physical invasion of the US capital building etc, and documented these facts while leaving out the names of the countries, would an impartial observer perceive these countries as “stable”?

Some of the key qualitative considerations that typically come into play include: First, emerging economies represent an outsized share of the global economy as measured by GDP, and/or GDP growth and population. According to World Economics, emerging markets accounted for 50% of global GDP as of 2022 and 66% of global GDP growth for the 10 years ended 2022. (The frontier markets account for an additional 7% of global GDP and 10% of global GDP growth.) The emerging markets are home to 54% of the world’s population. (The frontier markets are home to an additional 14%.)

On a forward-looking basis, the IMF expects emerging market and developing economies to grow by 4% in both 2023 and 2024, while advanced economies are projected to grow by 1.5% in 2023 and 1.4% in 2024.  While it would follow that higher economic growth leads to higher investment returns under Keynesian theory, this is not always the case. Because per capita income is lower on average in emerging markets, these economies are expected to continue to grow faster as they adopt global technologies and move up the economic development curve.

A case can be made that global multinational, of the type commonly held in globally diversified public equity portfolios, already provide exposure to the GDP growth potential in emerging economies. These multinationals may engage in production in emerging markets and derive revenue and earnings from sales in emerging markets. This case is harder to make for infrastructure investments, and for venture capital and early-stage growth investments, except those made in entities that operate globally even early in their lifecycles. When an infrastructure investment is made in a particular economy, its relative success or failure is typically highly correlated with the economic and political health of the specific country in which the investment is made. When a venture capital or early-stage private equity investment is made, the portfolio company is typically focused first and foremost on its home country market.

So, to obtain private markets exposure to emerging economies, investors must “go local”. By doing so, they can expect to achieve attractive diversification relative to their private market investments in developed economies, since the underlying growth drivers (local economic health and political stability) are country-specific and therefore uncorrelated.

It has become generally recognized that asset class returns are not distributed in line with a mean/normal distribution. Nonetheless, it remains common practice to use mean-variance optimization (MVO) to develop candidate strategic asset allocations for input into more complicated/nuanced capital market simulation models that seek to correct for the shortcomings of MVO.

Whatever model is used, asset owners generally consider the opportunity, the risk, and the potential diversification benefits of adding exposure to any given asset class.  In an MVO model, these expectations are quantified in terms of expected returns, standard deviation of returns, and correlation of returns with other asset classes in the model.

Simply put, the case for investment in emerging market infrastructure and private equity can be made quantitatively because, compared to their developed market equivalents, on a forward-looking basis, the assumptions are generally that:

1. Expected returns are potentially higher,
2. Volatility of expected returns is usually higher, and
3. Correlation of returns with those of other major asset classes already in the portfolio (mainly developed market public equities, fixed income and alternatives) needs to be lower to offset higher volatility.

Quantitative modeling typically finds these two “new” asset classes so attractive that a “reasonableness constraint” must be applied to limit their allocation.

Mercer developed assumptions for these asset classes as an addition to our standard set of US$ capital market assumptions as of October 2023. While an unconstrained “optimal allocation” would imply a weighting of XX% to these asset classes, we applied a reasonableness constraint of 2.5% of the total fund to be allocated to each area. This aggregate 5% allocation improved the expected returns at points on the efficient frontier relevant for a typical sovereign wealth fund (SWF), or for an endowment or foundation (collectively “E&F”) by more than 35 bps at the total fund level.

While this result is specific to our current assumption set and relative to strategic asset allocations, we believe it to be representative of an “average” SWF or E&F; it is qualitatively similar to the results we have observed in live strategic asset allocation and risk budgeting studies for large, sophisticated asset owners. While 35 bps may not appear to be a large number, for a $1bn E&F, it represents $3.5m more per year in additional expected returns to help fund that organization’s mission. For a $50bn SWF, it represents an additional $175m per year.

We applied reasonableness constraints of 2.5% in the quantitative analysis referenced above. For asset owners domiciled in developed markets, we typically see these types of constraints applied. However, emerging and frontier market asset owners often have much larger allocations to these two asset classes for their home country, in some cases for similar investments in neighboring countries, and in some cases for emerging markets in general. Even excluding home country exposures, we have seen exposures to each of these asset classes in the 10-20% range. We observe that asset owners domiciled in emerging and frontier markets do not perceive the level of risk inherent in these asset classes that their developed market peers express in practice by applying relatively low reasonableness constraints.

There is a great deal of variety and variance of economic, regulatory and capital market circumstances across emerging and frontier markets, and generalizations risk overlooking the nuances of each underlying market. Both infrastructure and early-stage private equity also provide a huge variety of underlying investment opportunities, vehicles and governance arrangements as potential access points. In this context, some of the major risks at the forefront of investors’ considerations in these asset classes include:

• The risk of economic underperformance by the host economies.
• Political risk – a political regime can change, or a given political regime can “change the rules” after an investment has been made.
• Currency risk.
• Counterparty credit risk.
• The potential for corruption, unsafe labor standards, use of child or prison labor, and other reputational risks.
• A lack of historical data based on which assumptions around future expected returns, standard deviation of returns and correlations can be established. And even where historical data exists, local economic growth and changes in the political, regulatory and capital market environment may render that data less relevant as a basis for developing forward-looking expectations.

Some of the emerging and frontier market-based asset owners we reference above have been investing in these asset classes in their home countries and neighboring countries for more than 20 years. As such, the market environment, local asset owners investing, and precedents for such investment are well established in a broad subset of emerging markets. With that said, as with any statement about emerging economies, there is huge variation in circumstances and one size does not fit all.

In practice, most asset owners will ask commercial general partners (GPs) to implement their dedicated allocations to these asset classes, either by picking from amongst the growing lineup of specialist private market funds that focus on these markets, or by asking a panel of GPs that have experience managing such portfolios to manage separate account of fund-of-one structures based on the same research and deal flow that supports these “flagship” multi-client funds. As asset owners progress up the learning curve, and build relevant talent in-house, they may pursue co-investment, secondary or even direct market transactions, in a directionally equivalent way to what they may already be doing for their developed market alternative exposures. 

It is true that the number of predecessor funds for a given GP is likely to be lower, and their historical track record shorter, in these asset classes relative to their developed market equivalents. The range of fund vehicles available in a given vintage year will also be more limited. However, there is now a significant and growing range of firms operating in these asset classes, with plenty of relevant funds to choose from, such that “availability of appropriate managers and vehicles” should no longer be a practical barrier to implementation.

The entire analysis set out above rests on economic and market analysis that does not explicitly factor in ESG considerations. We observe that asset owners who have explicitly considered these asset classes have generally found the case for investment to be compelling, without factoring in any ESG considerations. With that said, several ESG considerations can be factored in to make the case even stronger. These are set out below.

Before we get to the positive arguments, we must acknowledge that the “ESG screening” approach and emphasis on global reporting standards that some asset owners have adopted for their public market stock and bond portfolios, or more broadly including their alternative asset classes, tend to “penalize” investment in emerging markets. While there is significant variation across these countries and one size doesn’t fit all, in general, environmental regulations and labor standards may be less stringent, the availability of data, including emerging standards for climate or natural capital reporting (TCFD and TNFD), may be more limited, and negative practices such as corruption may be more prevalent. An investor screening to identify “good” actors may screen out investments in these countries. 

Alternately, some asset owners prioritize a focus on shifting companies “from brown to green” in environmental terms, or the equivalent in social and corporate governance terms. Such investors will tend to find fertile opportunities to improve dynamics in emerging markets. By contrast, a “screen for green” approach will tend to underweight emerging markets.

Turning to the positive ESG case, with regard to mitigating the risk of climate change and helping the world transition to net zero, a strong case can be made that a dollar invested in green infrastructure, clean technology or green technology in the emerging markets will produce a greater impact than the equivalent dollar invested in the developed markets. 

Developed economies have already “bent the curve” of their carbon emissions, reducing emissions substantially since the peak years of 2004 in Europe and 2007 in the US.  While much more work needs to be done, including by means of additional green infrastructure, clean tech and green tech investment in developed economies, they have generally started down the relevant path. Emissions from emerging markets, by contrast, are rising, and, as the Shanghai Cooperation Council’s 2022 communication made clear, emerging market governments have competing financial priorities related to basic economic development, and are unlikely to be able to give primary focus to climate change.  As one example, 10 years ago (in 2013), for every dollar invested in infrastructure in sub-Saharan Africa, $25 was invested in North America and Western Europe. As of 2022, that differential had deteriorated to more than 50:1. Simply put, the money is not going to where it would have the greatest marginal impact. 

Many asset owners considering these asset classes will apply a broader ESG lens to capture issues beyond climate change. As this relates to alleviating poverty, ensuring access to basic healthcare, and other sustainable development goals, practically any infrastructure or early-stage private equity investment in the emerging markets will support local economic development, create higher-quality jobs, improve the local quality of life, and help create or free up resources for local governments to address other pressing issues. Through a diversity, equity and inclusion (DEI) lens, the emerging markets also provide attractive opportunities to help address inequalities in the distribution of wealth, income, educational and employment opportunities by race and gender.

In our experience, impact-focused investors generally conclude that their money can have greater impact in emerging markets than in their developed counterparts. Those values-based investors that are location agnostic (as opposed to focusing on their own local community, country, etc.) generally also see strong alignment with their missions.

One other observation that some asset owners make is that there is a strong “universal shareholder” argument for investing in these asset classes. Most large asset owners effectively own a share of global GDP through their investment in a diversified portfolio of global public market equities. As previously mentioned, many global multinationals engage in production in emerging economies, where they derive a large proportion of their revenue and profits. When an asset owner makes local infrastructure or early-stage private equity investments in these countries, they generally produce positive externalities, which help to raise local GDP growth. 

Those “externalities” get captured by the universal shareholder, in part, through their globally diversified public market equity holdings, i.e. the multinationals have higher earnings from their emerging market sales, because of the local economic stimulus from the asset owner’s investment. To the extent that an asset owner adopts the viewpoint of a universal shareholder and believes that investment activity will create relatively greater positive externalities in emerging economies (because of relative scarcity, the opportunity to improve productively via technology transfer, etc.), this provides yet another argument in favor of these asset classes.

While there are always specific investments in a portfolio that disappoint relative to expectations at the point of investment, on balance, we observe that asset owners building allocations in these areas are positive about their decision and, generally, increase them over time. In other words, for those that have moved into these asset classes, the experience has generally been deemed favorable from an investment perspective, as well as from an ESG perspective in scenarios where this has been a key criterion. 

When we have supported asset owners in considering and initiating investment into these asset classes, both the qualitative and the quantitative cases have generally been deemed compelling.

Implementation was daunting 20 years ago and challenging even 10 years ago, but it is now relatively straightforward, with the opportunity set continuing to expand and improve. 

For impact-oriented, values-based and other ESG-oriented investors, these asset classes – and themed sub-components – may be considered attractive relative to their developed market equivalents. For these reasons, investors may inevitably consider these asset classes for inclusion within portfolios. A first step when considering an allocation could be incorporating an emerging market infrastructure allocation within their reference portfolios. 

Our research suggests that doing so may improve returns where rational limits are applied, such as the reasonableness constraint we describe above.