U.S. private equity firms have always been quick to move into new emerging markets. Argentina, Russia and now China are some of the more notable the destinations that have kept PE groups moving around. But just as quickly as they’ve put up new outposts, many firms have shuttered their emerging market offices, as risks such as political uncertainty, exchange rate fluctuations, and tenuous management partnerships have torpedoed at least a handful of these bets.
The lawlessness in Russia was enough to force Carlyle Group to close its Russian operations this past May, while the currency crisis in Argentina was just one of many factors that stung PE groups in Latin America a few years back. Meanwhile, firms entering China today are starting to voice concerns over regulatory inconsistencies, such as a laissez faire attitude toward copyright laws.
So how do private equity groups gain access to emerging markets without going headlong into risks that are beyond their control? Some are answering this question by turning to the emerging domestic market (EDM), which targets businesses that cater to a growing demographic of ethnic minorities in the U.S. (and U.S. commonwealths) or companies that serve inner-city neighborhoods.
“Look at the influence of African-Americans and Latinos on popular culture it’s extremely influenced by what these two groups are doing in terms of what clothes they wear, what foods they eat, music, et cetera,” Palladium Capital Partners Founder and Managing Partner Marcos Rodriguez says. “The EDM approach is premised on looking at the inner cities and realizing that there’s a young vibrant demographic with growth characteristics similar to those described in Latin America, China or other emerging markets-except it’s right here in the Bronx or somewhere else close by… You can invest here in the U.S. behind these trends and realize the outsized growth that you’re aiming for by targeting emerging markets in other countries, with the benefit of proximity and U.S. laws, and without the political risk.”
Often confused as a “social venture,” EDM investing is predicated on actually making money, and is supported by favorable demographics, a traditionally untapped market and a history of past achievement. Not to mention, the influence of ethnic minorities has grown exponentially into the fabric of the U.S. culture. Rap music dominates the radio airwaves, Mexican restaurants rival the presence of American fast food locations, and few kids today aren’t familiar with the Japanese game and entertainment franchise Yu-Gi-Oh!
Moreover, the ethnic minority demographic is growing rapidly enough in the U.S. that “minority” is not always an accurate depiction. And as the population of this group increases, so too does the spending power it wields. In states such as California and Texas the combined Hispanic, African-American and Asian populations represent 51% and 47%, respectively, of the total inhabitants in those states, while other areas, such as Florida and New York, are projected to reach similar pluralities in the coming years. By 2050, according to recent projections, the U.S. population will be roughly split down the middle between non-minorities and minorities.
Targeting this segment is not exactly a new idea, but the money that’s now behind the initiative is making it more of a dedicated strategy as opposed to a one-off investment approach. “People have been investing here for a while,” says ICV Capital Partners Co-Founder and Managing Director Tarrus Richardson. “While investment companies have been targeting ethnic markets in the past, today there are larger pools of capital available to this space and allows these companies to develop and form faster, and heightens the probability that they will ultimately achieve success.”
The BK Broiler
There are a number of firms that have already cashed in on the EDM approach, with some of the bigger successes being passed from buyout shop to buyout shop.
Quad C Management was an early adopter, and was able to profit from its investment in Puerto Rico-based Burger King franchisor Caribbean Restaurants. In 1996 the firm sold Caribbean to American Capital Securities, which further capitalized on the growth of the Puerto Rican market and in three years realized a return of more than 3.5x its investment. Oak Hill Capital Partners was next in line, and acquired control of the business in 1999. After further growth Oak Hill sought out a dividend recap last year, but those plans were preempted by Castle Harlan, which bought out the company for $340 million, giving Oak Hill and its co-investors a roughly 2.5x return.
That’s three firms and counting that have been able profit on the Puerto Rican mainstay, and it comes at a time when a number of other BK franchisors in other markets have had to file for bankruptcy.
Thanks to past successes, institutional investors and GPs are taking a more proactive approach to investing in these markets, and slowly the money has started to flow in. CalPERS, New York City Retirement Systems, the State of Connecticut and a number of other pensions and fund of funds have set up initiatives to invest in the space. More are expected to follow suit.
“Five years ago, this market had $2 billion committed to it. Today there’s between $5 billion to $6 billion, and my sense is that the market will have around $20 billion committed by 2008,” ICV’s Richardson says. “Both entrepreneurs and investors are starting to see that you can make a lot of money in these markets.”
The sectors being targeted within the EDM space are generally legacy areas such as financial services, consumer products, food and restaurants and media and entertainment. Deals such as Yucaipa Cos.’ investment in Sean John, TSG Consumer Partners’ buyout of Don Miguel Mexican Foods, and an investment in Border Media by Goldman Sachs Urban Investment Group and Vestar Capital Partners are just a few of the many EDM deals that have occurred in recent years.
The linchpin to the approach, though, no matter how appealing the demographics or how socially advantageous the cause, is that the investments in EDMs generate profits. The Council of Urban Investors Institute released a report, entitled “In Your Own Backyard: Investment Opportunities in Emerging Domestic Markets.” The study cited research on 24 minority-focused private equity firms that invested between 1989 and 1995, and disclosed that those funds had a mean IRR of 23.9 percent, with a high of 79% IRR.
Carlos Signoret, of Hispania Capital Partners notes, “The point isn’t to invest in the space because it’s a nice thing to do, but rather because it’s a wise thing to do. That’s the reason limited partners are out seeking emerging managers in the first place. It’s the opportunity.”