Capitals Teresa Barger As an experienced investor in both the private equity and public equity markets, where do the core invest- ment principles of these two asset classes converge and where do they differ? There are signifcant differences between the private equity and public equity worlds. Whereas my life is largely about news, a private equity professionals life is primarily focused on personnel and operational problems. While my time is spent analyzing monetary policy, theirs is centered on issues such as production bottlenecks. However, many of the macro factors that are important to usinterest rate policies, levels of infation, current account defcits, reserve requirements for banks and the resulting looseness and tightness of creditshould also be important to private equity. While the private equity industry doesnt need to follow these policy changes on a daily basis, to understand the market as a whole, private equity funds should pay special attention to who the decision makers are and what political pressures these politicians face. We look to go into countries where public policies are changing for the better. The best deals are those that have been made when people go into a market perceived as high risk and exit at a point in time after positive policy changes have been cemented. Despite differing time- frames, this is a successful strategy for both private and public equity investors. Today, there are widely divergent pricing dynamics between these two asset classes. We are currently seeing big splits in places like Brazil, Turkey and Indiaand the reason is that a lot of money tends to tumble into private equity at one time as people follow the trend of the moment. As a result, people are paying large sums for private companies in these markets. In Brazil, we are seeing an average 8x price-to- earnings ratio in the public markets, while valuations are around 810x EBITDA in the private markets. And so, the question for institutional investors is: what is the rationale for putting new money into Brazilian private equity when they can go into the stock market more cheaply than the private markets? What is the right time frame and what are the right comparisons? In emerging markets, the line between public and pri- vate equity can sometimes get blurry. What, if any, risk is there for private equity frms that employ a strategy of investing in listed companies? In several emerging markets, there is a growing trend of pri- vate equity frms buying shares in listed companies. Firms that do this have to be aware of the plans of the other investors in the company, as these investors are ultimately going to make or break their price. For instance, a private equity frm can try to exit a listed company by selling to a competitor, but they can only do so if the majority owner is willing to sell. We have found that sometimes private equity investors are thrown off by the rules regarding non-public information. For example, we looked at a listed company in China, in which a large PE frm owns a 24% stake. When we spoke with the investment offcer running the deal about basic strategy, he refused to discuss his own thesis for the investment, in part, I suspect, because he was uncertain what was public and what was not. But there are certain ground rules every- one knows about talking up ones book. If he doesnt care enough about the stock price to be enthusiastic about his own investment thesiswhich is not material non-public informationwhy should anyone care about the stock? In India, in particular, a lot of private equity ends up in public companies. Surprisingly, sometimes when we come across private equity funds going into public companies, we can fnd that they are doing nothing in terms of creating value. Theyll negotiate the purchase of a block with the control- ling family, who will sell it to the private equity frm because either it was the frst to ask or because it carries a good brand name. But the private equity players in many cases dont seem to be deeply involved. Im someone who believes if you have a relationship with the people who are controlling the company and you have something to say, it is not that hard to get people to do things that are in their own self interest, such as creating value in their own companies. Some skeptics argue that value creationin both public and private equitiesis a myth and that professional investors merely buy low and sell high. What is Cartica Teresa Barger, Managing Director of Cartica Capital, discusses the dichotomy between private equity and public equity markets and argues that private equity investors could learn a great deal from their listed market-focused counterparts and vice versa. Ms. Barger has spent more than 20 years investing in emerging market companies, previously serving as Director of Corporate Gov- ernance for the World Bank and IFC as well as Director of Private Equity and Investment Funds at IFC. Cartica is an alternative asset management frm focused exclusively on emerging markets and is the sponsor of the frst global emerging markets corporate governance fund. Cartica invests primarily in listed companies using private equity-style due diligence. Emerging Markets Private Equity Review December 2011 15 doing to create value before exit and what lessons are there in your approach for private equity investors? We can often realize value by getting a portfolio company to behave like a listed companyand not like the private company it used to be. On the fip side, the private equity folks could realize greater value on exit by making some of these changes happen before the company gets listed. For example, we like going into companies that are not covered by analysts. Generally, they dont have coverage because they are small; but even small companies can get coverage if they make it reasonably easy for the analysts to cover them. This means having discipline around granular reporting that includes line of business disclosure (seg- ment reporting), a quarterly earnings calendar, quarterly earnings calls with the analysts, and published information that is easy to understand and available to everybody at the same minute. We see signifcant opportunities in fnding these frms that have great products and solid positioning, but lack the disclosure needed to get analyst coverage. We can also work with companies to help them understand the pitfalls of being cash heavy, which investors discrimi- nate against. Most companies in emerging markets have too much cash, which ultimately creates a cash drag, or a rate of return that is lower than what it could have been. Getting an emerging market company to part with its cash is like taking a newborn away from its mom. While it is certainly understandable how many have developed an attachment to cash, having been through previous cycles when no bank credit was available, there needs to be a happy medium, such as having a dividend policy that shows investors the company is thinking about how to ensure management is effcient with cash. Today, headline and macro risk seem to be driving pub- lic markets more than core fundamentals. With all this volatility in the market, how do you ensure that the beta doesnt overwhelm any alpha that you can try to drive in an underlying company through initiatives such as greater fnancial disclosure? Public markets in the last few years have been completely different from public markets in the preceding 100 years. Today, its ordinary for a companys stock price to go up or down by 78% in one day, which was unusual before 2007 2008. Synchronicity (meaning the correlation of stocks to the index) in the United States is typically the lowest in the world. In other words, the prices of good companies go up and bad companies go down of their own volition, regard- less of how the index performs. However, this August, correlations in the United States reached a high of 90% for one day. As an investor, you cant fght that. Synchronicity in the emerging markets tends to be higher than in the United StatesSaudi Arabia, where there is lit- tle analyst coverage of companies, has one of the highest synchronicity quotients in the world. What we like about the emerging markets is that all of these countries are on a curve moving from more to less synchronistic, and so one can take advantage of this deepening of the markets. In times of high volatility like today, there is not much to be doneprices are going to move up and down together. But, over time, companies can distinguish themselves as winners in the marketplace. Many of EMPEAs members believe that often the best investment opportunities in the emerging markets are those that are unlisted and not yet able to access fnance for further growth. By ring-fencing your investment strat- egy around countries that have deeper and more robust capital markets, are you giving up more attractive invest- ment opportunities in less developed or frontier markets? There are certain country opportunities better accessed by private markets and others that are either better or equally accessed through the public markets, and therefore, an insti- tutional investor needs to think long and hard about asset allocation for any given country. Some markets, including many in Africa where market capitalization and liquidity are limited, cant be tapped through public markets at all. In China, where there are more options, a lot of investors still prefer to go in through private equity. There is a huge cor- porate governance crisis going on in China right now and people are very suspicious of investing in local companies in the wake of Sino-Forest, [a commercial forest plantation operator in China that has recently been accused of infat- ing its revenue and assets]. That is not to say that there arent very good listed opportunities, but there is comfort in a private equity frm being the majority owner of a Chi- nese company, and thus owning the corporate governance. The reason I chose to work in public equity is because I can fnd good companies that produce good products, and which are essentially mispriced. Because of the lower liquidity in emerging markets versus developed markets, there is less price discovery. We can fnd undervalued stocks, work with the owner to take actions that unlock the companys true value, and then realize a higher returnand we can do it in a short period of time. Private equity frms are often waiting anywhere from 3 to 7 years to realize the fruits of their labor, whereas, in our experience, if the company is ripe, it can hap- pen in 1 to 2 years. With an auction on your company every day, one can get the returns much more quickly. Inside Perspectives, continued We can often realize value by getting a portfolio company to behave like a listed companyand not like the private company it used to be. On the fip side, the private equity folks could realize greater value on exit by making some of these changes happen before the company gets listed.