Gemcorp Capital writes that its latest research finds that institutional investors expect emerging market private credit to deliver better risk-adjusted returns than developed market yet still rate it a riskier option.
Tom Hughes, Chief Marketing and Communications Officer at Gemcorp Capital, argues that this paradox says more about familiarity than fundamentals.
Reading through our latest study of 250 institutional asset owners on emerging market private credit, one finding confirms what I have heard in many conversations with allocators. When asked about the biggest barrier to increasing their allocations to the asset class, the majority said the risks are higher than in developed markets.
Yet the same investors are not pessimistic about emerging markets. Nearly half expect emerging market private credit to deliver better risk-adjusted returns than developed markets over the next five years, compared with only around a quarter who expect the reverse. On average, they anticipate a premium of around 300 basis points, while the majority also believe emerging market private credit offers superior portfolio diversification.
Their views on returns are supported by actual data. But I would argue their concerns over risk highlight a gap between perception and reality.
It is worth taking the objections in the order investors rank them to see if there is a persistent gap between perception and reality.
First, the belief that risks are higher. More than eight in ten investors believe corruption and legal enforcement risks are greater in emerging markets. Perhaps not coincidentally, these are also the areas where they are least confident in managers’ ability to mitigate them. At the same time, less than half fully understand the structural protections specialist managers can employ in emerging markets. So, while recognising the concern, the information they are basing it on is incomplete. A risk you have experienced and a risk you perceive are not the same thing.
Second, is the idea that are emerging markets are complex. Complexity and risk are often conflated, because both raise the cost of being wrong. But they are different. In private credit, the key risk to mitigate is the probability of loss; complexity relates to the many moving parts and participants within a system. While there is complexity within emerging markets, that does not make them riskier. These are simply markets where fewer people have done the work to understand them. That, in my experience, is usually where more compelling opportunities are found.
Third, developed markets feel safer and easier to deploy into. Familiarity is not the same as safety. Investors may have higher allocations to their home markets because they are a known quantity, not because they are safer. In our study, the majority of investors cited rising defaults, crowding into core segments and rising leverage as significant challenges for developed market private credit over the next two years. This highlights that the more familiar option carries its own problems.
Reality check
As with any asset class, it is critical for investors to challenge their biases and look at what the data says. In emerging market private credit, borrowers tend to operate with lower leverage. With fewer funding options available to borrowers, lenders set the terms. Emerging markets also offer greater access to real economic drivers – infrastructure, energy, commodities and trade. These are the same segments investors told us they want exposure to, offering returns that do not depend on developed market cycles.
Investors who already allocate to emerging markets recognise this. Their concerns are largely focused on how to deploy more into the segment, citing a lack of specialist managers, the size of the universe and a need for vehicles that meet their requirements.
If this pattern feels familiar, it should. Public emerging market debt was once a niche allocation in institutional portfolios, weighed down by similar reservations. The same was true of developed market public credit at one stage. In both cases, the evolution of the market followed a similar path. First, the asset class earned consideration. Then, as track records lengthened, the perception gap started to close and allocations increased.
Emerging market private credit is on a similar journey. Track records are building, returns are compelling and structural protections are intact. It just takes time to improve investors’ understanding and comfort.
The key question is not whether emerging market private credit is riskier than alternatives in developed markets. It is whether investors have examined it closely enough to make an informed decision about both the risks and the opportunities.
