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White Paper

Defining The Frontier Markets Opportunity

The Frontier Markets Ship Is Sailing


June 2012

Zin Bekkali, CFA CEO & Group CIO

Frontier Markets: capturing the opportunity

Abstract Frontier Markets have proven to be amongst the best investment destinations during the past decade and are increasingly attracting the attention of global investors. These rapidly expanding economies are already home to 25% of worlds population and 11% of worlds GDP. Now that their capital markets have reached the critical size required to attract global investors, there is an increasing need, not only to better understand these new investment destinations, but also to determine the role these markets should play within investment portfolios. In this white paper we define Frontier Markets (FM), explore the investment case and showcase why an active investment approach to them will deliver the best results. This paper will also quantify the growth opportunity and provide guidance on how investors should build exposure to these markets. Todays opportunity Investors can build exposure to Frontier Markets across various asset classes. The combination of high growth prospects, attractive valuations and solid sovereign balance sheets makes the case for investing in Frontier Markets as appealing today as the BRIC markets in the 1990s. Defining Frontier Markets Frontier Markets are the next generation of Emerging Markets which are not yet included in the main Emerging Markets (EM) indices. The leading index providers, MSCI, S&P and FTSE, define the following 39 markets to be currently recognized as 'Frontier Markets'. Africa Botswana Ghana Ivory Coast Kenya Mauritius Namibia Nigeria Tunisia Zambia Asia Bangladesh Kazakhstan Pakistan Sri Lanka Vietnam Europe Bulgaria Croatia Cyprus Estonia Georgia Latvia Lithuania Romania Serbia Slovakia Slovenia Ukraine Americas Argentina Colombia Ecuador Jamaica Panama Trinidad & Tob. Middle East Bahrain Jordan Kuwait Lebanon Oman Qatar U.A.E.

Let history be your guide

Already a recognized investment universe

Capital Markets & BRIC

Similar evolution to BRIC markets Similar to the BRIC markets in the 1990's, capital markets in todays frontier countries excluding Saudi Arabia (KSA) are still relatively young. However, they already have an aggregate market capitalisation above US$500b ($800b including KSA) and daily trading volumes of over US$300m ($2.8b including KSA). Similar to the BRIC markets, we expect frontier capital markets to deepen further in the coming decade. Over the past decade, for instance, Brazil's market capitalization increased from approximately US$ 100 billion to its current level of nearly US$ 1 trillion. Moreover, its daily trading volumes grew from less than US$ 100m to a current total average turnover that exceeds US$ 2b. Phase I As of June 2012, Frontier Markets have just completed their first 10 year cycle on the international stage and have delivered 5.8% annualised return, well exceeding the MSCI Worlds 2.2%. The better returns for Emerging Markets illustrate what lies in store for Frontier Markets when they start to successfully absorb significant portfolio flows. African Frontier Markets have already delivered returns in line with their strong economic growth fundamentals as this cycle has generated an impressive 10.5% annualized return.
20.0% 10.0% 0.0%

Frontier Markets have delivered in Phase I

10 Years Annualized USD returns


10.3% 2.2% MSCI World MSCI EM 5.8% 10.4%

MSCI FM

MSCI FM Africa

Source: MSCI; Silk Invest

Frontier Markets could outperform Emerging Markets by 3% annually

Phase II BRIC markets finished a 10 year cycle in December 2004 when they underperformed both developed and Emerging Markets. During the next phase, this pattern was strongly reversed when the BRIC markets posted an annualized return of just under 12%. Looking ahead, we expect a similar trend for Frontier Markets in which they should outperform Emerging Markets by 3-4% annually. Global flows were one of the key catalysts for the BRIC markets and investors used the low valuations in 2004 as an entry point to the BRIC markets. Total assets of BRIC funds held by European investors jumped from only 100m to 4b during that year. A similar momentum is building in Frontier Markets.

20.0% 10.0% 0.0%

Annualized USD Returns


6.6% 5.7% 8.9% 2.9% 11.6% MSCI World MSCI EM MSCI BRIC

1.4% Phase II 2004 - Present

Phase I 1994-2004 Source: MSCI; Silk Invest

Benchmarks overlook significant opportunities

Benchmark weights The constructors of the main market indices have typically applied traditional factors like market capitalization to define the constituents for various Frontier Market indices. This approach has resulted in weightings that fail to reflect the true macro-economic identity of these regions. The recognized frontiers in the Middle East, the Americas and Europe account, on average, for around 70% of the weights of the main Frontier Markets indices. In reality, these regions account for only 24% of the population in Frontier Markets.
100% 80% 60% 40% 20% 0%

Weight of FM regions in indices


26% 45% 15% 15% 21% 3% 47% 29% Population Other FM Middle East Frontier Asia

Industry benchmarks Source: S&P; FTSE; MSCI; Silk Invest

Frontier Africa

Frontier Markets account for 25% of worlds population

Expanding the Frontier Markets Opportunity set Beyond the drawbacks of a capitalization-weighted methodology, these indices also only cover a limited number of potential Frontier countries. A better definition of Frontier Markets is one that encompasses all countries which have or are in the process of opening up public markets. This would not only dramatically increase the number of Frontier Markets to 83 countries (see appendix A), but it would also better reflect the weight of the Frontier Markets countries in the world economy. Using this market access definition, Frontier Markets represent 25% of the worlds population rather than the 14% reflected by traditional indices. Moreover, this extended Silk Invest frontiers universe accounts for 11% of worlds GDP instead of only 7% for the countries followed by the indices. India in comparison accounts for only 5% of the worlds GDP.

30% 25% 20% 15% 10%

Share of Frontier Markets in global economy


25%
14% 5% 18% Recognized Frontier Markets Extended Silk Frontier Markets

7%

11%

5% 0%

India

GDP (PPP) Population Source: World Bank; IMF; UN; Silk Invest

Beyond public markets

The attraction of private equity

Private equity opportunities abound in Frontier Markets, however, data points are scarce. Analyzing the performance of the IFC, an investment division of the World Bank, provides some clues about the potential for return on investment. The IFC is one of the most active players in Frontier Markets and has generated an annualized return of 22.2% on its private equity investments over the past 10 years. This is impressive when compared to the 11.4% return of the Cambridge Associates US PE index and the 12.1% generated by their Emerging Markets index. The IFCs portfolio is strongly biased towards Frontier Markets with around 25% of investments in Sub-Saharan Africa. More than with other asset classes, timing is of chief importance to Private Equity. Investing in the right vintages and avoiding periods of market crowding can have a big impact on performance. The IFC has reaped the rewards of being an investment pioneer in new markets.

Net "End-to-End" Returns as of June 30, 2011


20.0 15.0 10.0 5.0 -

15.5 11.2

6.6

10.0

11.4

12.1

3 Years

5 Years

10 Years

US Private Equity Index

Emerging Markets VC & PE Index

Source: Cambridge Associates; IFC ;Silk Invest

The long-term view

The world in 2100 Today the developing economies account for more than 50% of worlds GDP. Only three decades ago, this number was just 31%. This shift was driven predominantly by better infrastructure, the breakdown of information barriers, increased institutionalization and the development of human capital. Today we are witnessing Frontier Markets progressing through a rapid convergence cycle which will allow them to capture 18% of the worlds GDP in 2050 and 34% of the worlds GDP in 2100.
50% 40% 30% 20% 10% 0%

Expected share of world in 2100 by FM region


27% 13% 5% 8% Frontier Asia 11% 4% 5% 2% Other FM Total Frontiers 34% 42%

GDP Population

Frontier Africa

Middle East

Source: UN; World Bank; Silk Invest; For GDP per capita growth we assumed 3% average annual global growth and 4% growth for Frontier Markets

Silk Road

The Silk Road regions are most relevant frontier markets

The Silk Route gave the world its first extensive and interconnected global trade network, spanning across Asia, Africa and the Middle East. Today, these three regions account for 70% of the total population in the Frontier Markets rendering them the most relevant regions within the category. Favourable demographics will further increase the importance of these economies, driven by the significant number of individuals entering the work force to become consumers. BY the end of this century, these three Silk Road regions will account for 29% of worlds GDP and 39% of worlds population. Growth opportunity There is broad academic consensus on the relationship between GDP growth and corporate earnings, it is especially strong in Emerging Markets where the earnings growth has often been a multiple of nominal GDP growth. However, this does not always translate into positive market returns; asset valuations matter and investors should avoid chasing growth at any cost. The positioning of portfolios towards future incremental growth should pay off as long as prices have not yet discounted all future upside. This strategy has already delivered for the early BRIC investors. We see a similar potential pattern for investors who are willing to allocate to Frontier Markets today. To fully capture this opportunity, investors should utilize fundamental macro-economic factors such as GDP to define their allocation rather being guided by poorly constructed indices. Allocations should take into account the 14% share of global GDP represented through frontier markets. Risk Management Investors in Frontier Markets can mitigate investment risks by simultaneously developing a realistic assessment of the external environment and an internal execution strategy. The following sections will highlight two building blocks and identify for each 3 factors that can used to manage risk.

Follow the growth opportunity

Risks can be managed

External Assessment Institutions Balance sheets Capital Markets

Internal Execution Consumer focus Active & local Diversification

Institutions The institutional strength and political stability of Frontier Markets differs from the developed world but are broadly in line with emerging markets. As shown in the next graph, Frontier Markets actually score better on average than some of the major emerging markets, especially when it comes to the independence of the legal system or the protection of minority interests. Moreover, these risks can be mitigated through a well diversified portfolio diversification limits the risk of overexposure to one specific market, currency or political system. That said, investors should focus on the best in class countries as Frontier Markets vary significantly in their institutional development.

10.0 5.0

Rating of institutional strength


5.1 3.9 5.6 3.2 2.2

3.6

6.2

4.6

6.1

Frontier regions
Russia China

Reality is better than perception

Judicial Corruption Protection Independence Minority interests Source: World Bank; IMF; Transparency International; Silk Invest

Strong sovereign balance sheets

Balance sheets The importance of strong sovereign balance sheets has been highlighted by the ongoing Euro Zone debt crisis. Over the past few years, institutional investors have started to include Emerging Markets Debt (EMD) as a strategic asset class which has driven credit spreads to historical lows. In contrast, Frontier Markets are still financing themselves with spreads on average at 500bps despite having better balance sheets in comparison with both Developed and Emerging Markets. Similar to EMD, credit spreads in Frontier Markets will come down when investors start to realize the relative strength of their balance sheets and attractive yields. In the meantime, Frontier Markets continue to improve their monetary policies and their management of domestic inflation and currencies. 224

Total issued Debt and Central Bank Reserves (% of GDP)


Debt 1 50 39 13 48 20 18 FX Reserves

250 200 150 100 50 -

USA

Frontier Asia

MENA

Source: World Bank; IMF; Silk Invest

Sub-Saharan Africa

Well governed and functional capital Markets

Capital markets Frontier Markets have reached critical size and allow investors to choose from over 1000 listed equities and bonds. On the equities side, market capitalization is typically below 50% of GDP in comparison with over 100% in Emerging Markets. Investing in individual markets can be a challenge but the Frontier Markets universe is sufficiently broad in aggregate. It is also underappreciated that the frontier capital markets tend to be well governed and are increasingly open to foreign investors. 400

Market Cap (USD, xB) and as % of GDP


50%
28%

100%

200

10%

9%

9%

14%
Kenya

50%
0%

Market Cap (xB, USD) Market Cap as % of GDP

Saudi Arabia

UAE

Pakistan Vietnam Nigeria

The consumer opportunity is the main theme

Local consumer A number of investors define the Frontier Markets opportunity driven by commodities. We believe it makes more sense to define the opportunity as a consumer play which translates into more corporate earnings and better institutions. Frontier Markets tend to be rich in resources but commodities do not automatically translate in good sovereign reserves or solid corporate earnings. Moreover, investors should make the most of the non-benchmark Frontier Markets exposure and invest in securities which have limited correlation with globally driven commodity price cycles. Investment Approach A sound investment approach for the various Frontier Market asset classes requires the right definition for the long term opportunity and a proper approach to bottom-up sourcing and execution. The starting point across asset classes is the recognition that Frontier Markets are under-researched and require a deep local understanding in order to fully reap the benefits. Within these markets, local consumers, entrepreneurs and institutions will drive returns. Diversification Investors can significantly reduce investment risk by making diversification a core part of their investment approach. The various Frontier Markets have different economies, currencies, and political systems which allow investors to take one sided exposure to specific countries. Moreover, Frontier capital markets tend to be less correlated with each other and global market sentiment. Investors can further increase diversification by investing across large, mid and small caps, which in turn help to reduce risk and increase long term exposure to the most promising investment opportunities. Another source of diversification is through operational execution where access to a larger number of local brokers can facilitate better access to trading flows and information. Diversification and construction of deeper portfolios allow investors to better deal with the limited liquidity in certain markets.

Active and Local vs. Passive and Distant

Various sources of diversification

Daniel Broby, FCSI, FSIP & Visiting Professor CIO Public Markets & Deputy CEO
Chris Muller, Investment Director South Africa Funmi Akinluyi, Investment Director Sub-Saharan Africa Hesham Saad, Investment Director MENA & Frontier Asia John Bates, Investment Director and Head of Fixed Income Richard Odumodu, Investment Director Africa Fixed Income
Right Time for Frontier Markets Equities Frontier Markets represent less than 0.1% of most investment portfolios. This is clearly too low. With the current levels of market volatility many investors are reluctant to invest in these new markets. Our view is that investors would actually be de-risking by investing in Frontier Markets as diversification matters, especially during periods of uncertainty. The correction in Frontier Markets after 2008 was more severe than in most other markets. The result is that Frontier Markets today trade at less than 50% of their 5 year peak levels. We see this as an attractive discount to global developed and Emerging Markets which are trading at around 75% of their peak levels. Another way to look at this is to say that, even if Frontier Markets go up by 50%, they will still only be trading at similar levels to the rest of the world.
100% 50% 0%

The right time to benefit from 50% potential upside

77%

Current level vs. 5 year peak


76% 48% 46%

MSCI WORLD
Source: MSCI; Silk Invest

MSCI EM Local

MSCI FRONTIER MSCI FM AFRICA MARKET

Attractive valuation multiples

Valuations This discount in Frontier Markets is not driven by earnings compression but can be fully explained by valuation multiples. Consumer staples companies in Russia generally trade at twice the level of their peers in the Frontier Markets universe while the companies in the financial sector within our universe are typically valued at a 50% when compared to similar companies of the same sector in the MSCI Emerging Markets..
40 30 20 10

Forward PE 2012
28.7 20.3 13 12.8 10.8 9.8 9.6 MSCI EM 6.6 6.2 Russia Silk FM

Consumer Staples

Telecom

Financials

Source: MSCI; Morgan Stanley; JP Morgan; Silk Invest

Expanding the opportunity universe

Top-down expansion of the opportunity set Country allocation is an important determinant in capturing the Frontier Market opportunity. In the same way investors allocate to BRIC markets as a proxy to capture Emerging Markets growth, we believe that a long term top-down allocation framework is necessary for Frontier Markets and that it should be driven by population, GDP and FDI. Consumer markets are driven by population dynamics, and that should be an important starting point. Likewise, investors need an investment universe, so GDP should be taken into account. There will, however, be little opportunity unless the pre-conditions for growth are in place. We use Foreign Direct Investment as a proxy for this. When making FDI decisions, international companies have to do extensive work on the investment basics, such as rule of law, business conditions and red tape. Companies will not invest unless these are favourable and the aggregate investment picture therefore provides a great sanity check. The above metrics (Population, GDP and FDI) provide a solid framework of where to invest in Frontier Markets. These metrics allow long term strategic allocation to be tilted to those economies that are most likely to succeed. Bottom-up alpha generation The long term strategic allocation is only a starting point and is not worth much without a rigorous bottom-up selection of the best stocks. Essentially, a portfolio view is required, driven by the bottom up opportunity. In markets where there are clear inefficiencies, pricing anomalies abound. The closer the investor is to such under-developed capital markets, the more these become obvious, as do the value traps. Frontier capital markets may be inefficient, so the importance of sound fundamental financial analysis remains equally or even more important than in the other markets. The fact that the majority of price setters in these markets are simplistic in the way they value opportunities is only more beneficial to the disciplined investor. Local presence is not a luxury but a necessity, as each of the 83 countries has different contexts which need to be understood. Diversification Investors can significantly improve their risk adjusted returns by diversifying across markets and securities which tend, on average, to have far lower correlation with each other. Beyond analyzing expected returns of bottom up opportunities, portfolios need to be optimized by spreading risks across countries and sectors in the universe. As risk is mispriced due to incorrect perceptions, such diversification gives investors greater benefits than would be achievable elsewhere in Emerging Markets.

Understanding alpha opportunities from a local perspective

Gearing for success while diversifying

10

Return vs. Volatility of various Frontier Markets


Annualized return

60.0% 40.0% 20.0%

MSCI Frontier Markets

0.0%
-20.0% -40.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%

Annualized Volatility

Source: MSCI; Silk Invest; 10 Year data

The table above illustrates the benefits of the diversification we explain in this white paper. The MSCI Frontier Markets Index had an annualized volatility of approximately 25% over the last 3 years. The average Frontier Market had a volatility of approximately 23% with outliers of 60% annualized volatility.

A strategic reallocation could reduce volatility while increasing returns

Optimal Portfolio Allocation Correlation levels between Frontier Markets and global markets is low at around 60% (see appendix B) which providers investors with ample opportunity to improve the risk/return profile of their portfolios. A starting point for a portfolio weight could be to re-allocate part of the portfolio from Emerging Markets to Frontier Markets. For the analysis shown below, we used expected Frontier Markets returns of 2.6% higher than the historical Emerging Markets returns and we compiled a Frontier Markets index with a tilt to MSCI Frontier Markets Africa (25%) as the global MSCI Frontier Markets index has only around 15% allocation to Africa. The result of this exercise is that replacing 30% of Emerging Markets with the Silk Invest Frontier Markets index would significantly reduce annualized expected volatility by 3.2% while increasing returns by 1.3% annually.
14.0% Annualized Return 13.0% 12.0%

Return vs. Volatility when replacing part of EM by FM


100% Silk FM (25% MSCI FM Africa & 75% Global) Annualized Return: 12.9% Annualized Vol: 20.6%

11.0%
10.0%

30%
70% EM nd 30% Silk FM Return: 11.6% Vol: 21.5%a 100% EM Return: 10.3% Vol: 24.7%

9.0% 19.0%

20.0%

21.0%

22.0%

23.0%

24.0%

25.0%

26.0%

11

Annualized Volatility
Source: MSCI; Silk Invest; 10 year historical data for EM; FM data are compiled using historical volatility data while increasing return trend line to put it in line with EM plus 2.6% annualized

Higher yield for less risk

Fundamentals should lead and not issuance

The bond opportunity Looking at the Emerging Market credit curve, there are also opportunities in Frontier Markets which are by definition off benchmark but should not be missed. These opportunities are in both local currency and dollar denominated bonds. From a portfolio construction standpoint, these bonds tend to have a unique combination of higher beta and positive convexity profile that allows investors to capture higher returns. Hard currency yields in Frontier Markets are very attractive and mispriced across the range. The table below shows indicative 5 year yields in the Frontier Markets space with YTM ranging from 2.8% in Abu Dhabi to 13% in Tanzania. Frontier fixed income markets are often small and illiquid. The sovereigns are generally considered to be at an earlier stage of economic and financial market development than other emerging bond markets. That said, these markets are enjoying the benefits of globalization, industrialization, and technology.
Tanzania Mozambique Cameroon Benin Senegal Kazakhstan DRC Azerbaijan Armenia Nigeria Mongolia Ghana Botswana Georgia Mauritius AbuDhabi USA

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Source: Various local sources; Silk Invest

Fundamentals should lead and not issuance

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Building the Portfolio Fixed income indices have a inherent design flaw; they give the most exposure to nations with the most issuance. To avoid blindly following indices, a better base for strategic country allocation uses similar metrics as explained for equity strategies. However, the final portfolio allocations are driven mainly by an assessment of the available universe. Frontier countries have consistently outstripped GDP growth across the globe as a whole, supported by increasing FDI and M & A flows, low levels of debt, substantial capital reserves and natural resources. They also have double-digit population growth, and generally improving policy and reform agendas.

Corporate credit is in full development

Corporate Credit While sovereign credit is an obvious area to look at, Frontier Market corporate credit is also attractive, albeit characterized by lack of supply. That said, only the strongest of companies obtain financing, which means the credit quality of these issuers is remarkably good. Typically, corporate issuers in the Frontier Markets have to achieve a strong level of transparency and management competency in order to successfully issue debt. In many cases governmentcontrolled entities or quasi-sovereign companies are able to raise debt capital on the strength of the underlying government support or by virtue of their strategic value to the sovereign as a whole. Financials, specifically banks, are typically the first to issue bonds due to their own balance sheet matching requirements. As a banking sector matures and the tenor of lending is extended, the banks are compelled to seek out longer term funding solutions such as raising funds on the debt capital markets. For this reason approximately 70% of non-government or quasi-government debt issuance is from the banking sector in the frontier space. High yields The Frontier fixed income asset class offers unique investment opportunities with the potential for high income and attractive returns in a low return environment. As with equities, these markets are relatively uncorrelated with other asset classes, thus providing significant diversification potential for both fixed income and equity portfolios. With improving fundamentals, many frontier marker economies are undergoing a multi-decade reform process toward more open economies. This will lead to higher credit quality, lower defaults, and more supply. Next to our expectations of strong economic growth in Africa, Frontier Asia and the Middle East, these regions are also improving their institutions. Better educated local human capital and technical assistance from international organizations like the IMF will facilitate stronger fiscal management and governance. This will all further improve the relative attractiveness of frontier fixed income. These regions warrant serious consideration for allocation in investors portfolios vis--vis long term strategic positioning. Today the frontier fixed income space is where emerging markets debt was less than a decade ago.

The perfect answer for todays low return environment

13

Waseem Khan, PhD, CFA CIO Private Equity


Jamil Akhundov, Investment Director North Africa Nigel Bannerman, Investment Director West Africa Patrick Landi, Investment Director East Africa
Increasing returns through private equity Frontier Markets are under-explored regions with relatively low private equity penetration. EMPEA data indicates that, when compared to developed markets such as the United States, the PE industry in Frontier Markets has ample room to develop. As a proportion of GDP, India has 7 times more PE capital invested in comparison with frontier markets. This sets the scene for attractive investment opportunities where early investors have the first-movers advantage.
1.50 1.00 0.50 -

Frontier Markets are underexplored

PE Flows as% of GDP


0.05 Frontier Markets 0.14 China 0.16 Brazil 0.36 India

1.05

United States

Source: 2010-2011 EMPEA; Silk Invest ; FM as defined by average of SSA & MENA

Alignment with the owners is key

Growth capital Investors looking for large buy-out opportunities tend to struggle to find opportunities in Frontier Markets as the current cycle favours growth capital. The most interesting PE targets are generally smaller and in their first generation of ownership. Beyond the available universe, the success of companies is heavily driven by the quality of management and scalability. The right business model tends to differ from one country to another where a deep understanding of the integral value chain is critical. The differences range from product price points to optimal distribution strategies. A wise approach starts with acknowledging the importance of local management and to align interests by building partnerships. Active management An active investment approach is critical to successfully move companies to their full potential in such markets. Building solid partnerships is not an exact science but the best results will generally be achieved when local business models can be institutionalized and raised to a higher level. In addition to improving corporate governance and management systems, it is imperative to add value by taking an active advisory role. The objective is not to manage day-to-day operations but rather to steer companies towards better results. Board seats, while important are not sufficient on their own.

Active approach drives results

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Structuring

Structuring needs to be customized

The starting point for successful structuring is a good understanding of the intended use of proceeds and finding the right balance between the preferences of the investor and investee. The key objective is to influence decision making by seeking control of the business and exit routes while allowing local owners to keep the majority of the economic interests. A balance of equity and convertible debt facilitates this but translation to investment terms is not straightforward. The underdeveloped legal environment in many Frontier countries limits the investors ability to structure preferential share and loan agreements. Here local business knowledge, affinity with regional, cultural and social norms, the right contacts and appropriate legal advice therefore plays an important role. Foreign Direct Investments FDI flows into Frontier Markets have surged over the last twenty years reaching approximately $153 billion in 2011. In comparison, FDI flows to China in the same year were around $100 billion, while India has been able to attract less than $25 billion. These FDI flows have had a dramatic impact on the local economies and have accelerated convergence and increased productivity. They have also enabled many countries to improve their foreign investment rules and institutions. Returns on FDI in Sub-Saharan Africa have outperformed the rest of the Emerging Markets universe since 2006. These flows are very diverse in terms of target sector and origin. China is an important investor but Europe, India, US and intra-regional investments are equally important. M&A transactions tend to be the most important segment with large transactions in telecom, banking and fast moving consumer goods.

FDI is Frontier Markets most unknown story

FDI (x Billion, USD)


160 120 80 40 -

153 115

1 1970

4 1975 1980

4 1985

5 1990

21 1995

37

2000

2005

2011e

Source: UN; IMF; World Bank; Silk Invest

Diversification is the only answer to political risks

15

Diversification The perception of frontier markers is changing slowly while the reality on the ground is changing rapidly. It is the gap between the two that breeds investment opportunity. While the political and legal environments have improved significantly over the past two decades, there is of course still room for continued improvement. Therefore, diversification at the country and company levels is critical to successful investment in Frontier Markets. The best companies have a diverse range of clients and preferably product categories which are unlikely to be easily affected by changes in regulation.

Africas consumer base as the most attractive area

Consumer Play in Africa A structured analysis of the PE opportunity in our target regions results in a clear preference for Africa and its deep consumer base. As shown below, Africas potential consumers (people living above poverty line) are today around 750 million yet will grow to 1.2 billion in the coming 15 years. This is an incredibly rich opportunity which will translate to a significant multiplier effect on corporate earnings for sectors who are servicing this consumer base.
1,500 1,000 500 -

Population by income group (x millions)

1980 < Poverty Line

2010 > Poverty Line & < 5k GDP

2025 > 5K GDP per capita

Source: UN; World Bank; Silk Invest ; Mc Kinsey

Catching the right cycle is important

Investment opportunity does not wait Timing is critical and Investors must be conscious of the right times for entry and exit. We analysed several investment sectors and concluded that the consumer facing food and beverages sector was Africas most attractive investment opportunity. Our starting point was the low level of proprietary transactions and attractive valuations in the food sector. As shown below, consumption levels of specific product categories are low in comparison to both the US and a proxy for Emerging Markets (average of Turkey and Mexico). This explains why fast moving consumer goods firms in Africa have been able to realize 20-30% annualized growth in their top-line earnings. From an investment point of view, the sector is defensive and has a deep investment universe. The number of companies in this sector tends to be larger than other sectors which allows PE investors to develop a diverse pipeline and be more selective.

10.0% 5.0% 0.0%

Per capita consumption in sub-Saharan Africa in comparison with US and EM


7.2% 4.5% 2.5%

1.4% 1.4% Beverages

2.4%

US EM proxy

Dried food

Dairy products

16

Source: Various local and international sources; Silk Invest

Generating IRR We recommend building an investment approach diversified by country with a focused sector orientation. This allows the investor to diversify inherent country specific risks while optimizing towards economies of scale. The main objective is to work in parallel on three areas to generate high IRRs for investors. The most important areas are top-line growth and margins. To succeed it is important to work closely with management and ensure that companies fully capture the market opportunity. Investee companies are expected to generate top-line growth equal to or above 20-30% annually within Africas branded food sector. More importantly, however, the bottom-line must also grow. Many of our investee companies are operating at EBITDA margins which can grow 3x-4x over the cycle of the fund. This is driven in part by increasing scale and in part by improving profit margins on the back of upgraded management, information, technical and distribution systems and an enhanced understanding of segment and product profitability. The final pillar of a high potential IRR is to build around conservative valuation multiples at entry point. In combination, investor realization of a rich exit multiple is very achievable within these markets. Exits Within private equity investment, the discussion of prenuptial arrangements is not only important but imperative, especially in countries with a limited private equity track record. Global data shows that 50% of exits over the last 10 years were through strategic trade sales. Within Frontier Markets, we estimate that 6070% of exits are accomplished through trade sales, which are often found not to be the preferred exit route of investee companies. Securing investor rights at the outset if things do not work out as planned, or at the exit is, therefore, critical as investee companies need to work very closely with investors to monetize their holdings.

Sector focus and diversifying sources of returns

Exit strategy should be formalized

400 200 0

Global PE exits (x $ Billions)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Strategic Sales Secondary sales IPOs
Source: E&Y; Silk Invest

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Dr. Heinz Hockmann Chairman

Conclusions
During my career in global banking and asset management, I have been an early mover into many new asset classes and over time, it has always paid off. Frontier Markets have undergone major changes over the last decade and remind me of the Asian Tigers in the Eighties. In fact, the similarities between a country like Ethiopia now and Indonesia when I first visited it, are striking. Opportunities in Frontier Markets exist in abundance across asset classes and investors can unlock the full potential of these markets if they follow a credible and active approach which is in touch with local markets. The right timing is now. The ship is already sailing.

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About the Authors


Zin Bekkali, CFA

Zin Bekkali is the founder of Silk Invest, a specialist fund manager focused on frontier markets in Africa, the Middle East and Asia.
Throughout his career Zin has successfully developed and implemented strategic initiatives mainly focusing on emerging markets. He has worked for ING Investment Management, Bain, Ahold and Fortis Investments. Today Silk Invest is one of the leading frontier markets managers with staff from over 10 different frontier markets and based in 7 different offices. Silk Invest among others manages an African private equity fund and a range of public markets funds. Zin has a MS in applied Econometrics (University of Amsterdam), completed his MBA at London Business School and is a CFA Charterholder.

Daniel Broby, FCSI, FSIP & Visiting Professor Mr. Broby is the CIO of the Public Markets division at Silk Invest and the group Deputy CEO. With a longstanding career in the asset management industry of more than 25 years, Mr. Broby is one of the industrys most experienced emerging and frontier market investors. Prior to joining Silk Invest, he was CIO at Renaissance Investment Management, CIO at Bankinvest, Chief Portfolio Manager at Nordea Investments and Head of International Research, Morgan Stanley Quilter. In addition, Mr. Broby is a Capital Markets Policy Council member at the CFA Institute. Mr. Broby is author of 3 books and numerous published articles on investment management. He holds a MPhil in Economics (Brunel University) and an MSc in Investment Analysis (University of Stirling) and is a visiting professor at the University of Strathclyde. Waseem Khan, PhD, CFA Mr. Khan is the CIO of the Private Equity division at Silk Invest. He has over 25 years of global investment experience obtained at some of the worlds largest sovereign wealth funds and leading financial institutions. Prior to Joining Silk Invest, Mr Khan was Senior Investment Advisor at the Abu Dhabi Investment Authority (ADIA), Chief Economist and Head of Capital Markets at the Kuwait Investment Authority (KIA) and head of Head of Investments, Wealth Management Middle East at Citigroup. He holds an MBA (Ito), a PhD (Claremont Graduate University), and has completed various Programmes at Harvard and Stanford University.

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Appendix A Silk Invest Frontier Markets Universe


Africa Botswana Ghana Ivory Coast Kenya Mauritius Namibia Nigeria Tunisia Asia Bangladesh Kazakhstan Pakistan Sri Lanka Vietnam Europe Bulgaria Croatia Cyprus Estonia Georgia Latvia Lithuania Romania Americas Argentina Colombia Ecuador Jamaica Panama Trinidad & Tobago Middle East Bahrain Jordan Kuwait Lebanon Oman Qatar U.A.E.

Mainstream Frontier Markets

Zambia

Serbia Slovakia Slovenia Ukraine

Additional Frontier Markets in Silk Invest universe Algeria Angola Benin Burkina Faso Cameroon DRC Malawi Mozambique Niger Rwanda Senegal Sudan Swaziland Togo Uganda Tanzania Zimbabwe Afghanistan Azerbaijan Cambodia North Korea Kyrgyzstan Mongolia Myanmar Nepal Tajikistan Uzbekistan Armenia Belarus Bosnia Macedonia Malta Moldova Montenegro Barbados Bolivia Costa Rica El Salvador Uruguay Venezuela Iran Iraq Saudi Arabia Syria Yemen

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Appendix B Performance & Correlation Indexed Performance 800 600 400 200 May May May May May May May May May May 02 03 04 05 06 07 08 09 10 11
MSCI WORLD MSCI FM AFRICA MSCI EM Silk FM MSCI FM

Correlation levels

MSCI WORLD MSCI EM MSCI FRONTIER MARKET


MSCI WORLD MSCI EM MSCI FRONTIER MARKET MSCI FM AFRICA Silk FM Index 100% 90% 60% 39% 59% 100% 59% 36% 57%

MSCI FM AFRICA Silk FM

100% 60% 96%

100% 79%

100%

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References Goldman Sachs, Jim ONeill, Linking GDP growth and equity returns Morgan Stanley, Rashique Rahman & Juha Seppala, EM Profile: Small Fish in a Big Pond Morgan Stanley, Manoj Pradhan & Patryk Drozdzik, Will reblancing or risk premia raise repressed real rates? MSCI Barra, Is there a link between GDP Growth and equity returns? Ernst & Young, Global IPO trends 2012 Prepare early, move fast Emerging Markets Private Equity Association, Perspectives of an LP in Emerging Markets Private Equity Hui Guo, Why are stock markets returns correlated with future economic activities Broby, Daniel., Spring 2008. Professional Investor. One of the worlds best kept secrets Chan-Lau, Jorge A., 2005. Pension Funds and Emerging Markets. Financial Markets, Institutions & Instruments, Vol. 14, No. 3, Cross, James., 2008. Managing foreign debt and liquidity risks in Emerging Markets Nemerever, William L., 1996. Opportunities in Emerging Market debt. In Investing worldwide vii: Focus on Emerging Markets.

Disclaimer
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The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any interests or to participate in any trading strategy.

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