Barron's Sept. 2016

Investors are finally warming to emerging markets. The iShares MSCI Emerging Markets exchange-traded fund has jumped 17% this year, and emerging markets funds of all kinds have marked more than $130 billion in inflows, according to the Institute for International Finance in Washington.

But numbers from the private-equity sector make you wonder if something is wrong with this picture. New capital commitments to emerging market private-equity funds dropped 42% in 2015 to about $40 billion, and are plunging again this year toward 2009 levels, says London-based data tracker Preqin.

So is the smart money bailing on emerging markets just as the herd rushes in? Not exactly, says Christopher Elvin, Preqin’s head of private-equity products. The industry saw bumper years in 2013 and 2014. Wall Street titan KKR (ticker: KKR) raised $6 billion for Asian private equity, while rival Carlyle Group (CG) amassed $3.9 billion. Then a lot of stuff happened to keep that powder dry, notably China’s growth slowdown and stock market chaos. Three-quarters of emerging market private-equity capital goes to Asia, with China getting the lion’s share. “The volatility in Chinese markets in the latter part of 2015 and the early part of 2016 will certainly have had an impact on fund raising,” Elvin says.

He sees a possible rebound starting later this year as China shows signs of settling into a less-tigerish new normal. Other market watchers are not so sure. “I’d say the mood in Asia is cautious,” says Vish Ramaswami, who follows private equity in Singapore for consulting firm Cambridge Associates.

EMERGING STOCK MARKET returns like those of the iShares MSCI Emerging Market ETF (EEM) remain strongly linked to commodities producers whose fortunes have proved volatile since 2008. But private-equity investors shifted decisively to the consumer, technology, and media sectors after the crash, bidding up Chinese IT security firms or auto finance companies in India, Ramaswami explains. The nominal results have been positive. Private equity and venture capital deployed in emerging markets has returned 9% annually since 2010, while public markets delivered a loss of 4.5%, according to Cambridge.

The private investors are straining to find exits, though, Ramaswami says. Getting regulatory clearance for an initial public offering in China is Mission (Near) Impossible, with 900 companies waiting for authorities’ approval. Leapfrogging the home market to a Nasdaq or London listing is tougher after a wave of Chinese governance scandals. Indian valuations have become stretched.

Searching for a silver lining, Jeff Schlapinski, research director at the Emerging Markets Private Equity Association in Washington, D.C., offers sub-Saharan Africa, where private-equity commitments tripled last year to $4.5 billion. But $3 billion more to Africa is small consolation compared with a $19 billion reduction in new capital for Asian private-equity funds last year.

The message for stock market investors taking a fresh look at emerging markets is less clear. In a sense, public and private markets offer different worlds within the same countries, with an overlapping investor base among global institutions. Faltering confidence in privately funded growth companies may even be positive in the short term for the established giants that dominate listed stock indexes, Ramaswami argues. “Public markets offer a kind of flight to safety.”

But if the dry spell in private-equity funding turns into a more extended drought, that will cast renewed doubts on the long-term future of the emerging markets super-story.