By Patrick McGinnis
Not long ago, I caught up with a friend who is a private equity investor focused on Latin America. We chatted about the changes in the Latin investment climate over the last ten years and I commented that I still view early stage investing as one of the most compelling and untapped opportunities in the region.
My friend laughed, reminding me that we experienced the early stage space in Latin America from radically different viewpoints. I had invested in the region as part of the team at Chase Capital Partners (later JP Morgan Partners) at the height of the VC boom in 1999 and 2000. My friend entered the industry in 2001, at the beginning of the Latin VC/PE hangover.
I remember the fallout from many of those internet deals, so I understand why some investors have their doubts about venture capital in Latin America. In fact, there is a box full of conference giveaways from the boom days of Latin tech investing that is collecting dust somewhere (my favorite is a leather Viajo.com mouse pad).
But despite the period’s excesses, a number of enduring companies were funded. At Chase Capital, we backed companies such as MercadoLibre, Americanas.com, and Submarino, which now have a combined market capitalization in excess of US$5 billion.
The Decade-Long Hangover
The tech boom is remembered as an irrational period of too much capital chasing too few quality deals. Once the bubble burst, Latin VC investors sold or shuttered large parts of their portfolios. With hindsight, some of these companies were ahead of their time and might have proven successful in the long run. This is especially true in a region where Internet penetration significantly trailed initial expectations but has, over time, grown to exceed 30% of the population.
In the United States and Europe, the sins of the tech boom were forgiven and the industry launched into “Web 2.0.” Meanwhile, Silicon Valley firms have taken a strong interest in China and India, with groups such as Sequoia opening local offices and raising dedicated funds. In contrast, Latin America has not seen the return of significant amounts of institutional capital directed toward early stage companies, even as overall private equity flows into the region reached a record high of $8.1bn in 2011 according to LAVCA data.
Today, the mismatch of capital to quality opportunities that characterized the dot-com boom has reversed. There is interesting deal flow, yet entrepreneurs face limited sources of financing and must choose between “bootstrapping” their companies or seeking venture capital in a market where there is little competition from institutional investors.
This dynamic allows investors who are active in the market, typically family offices and angels, significant leverage as they negotiate valuations and deal terms. At the same time, most of these investors, while invaluable to the start-up community, cannot offer the non-financial resources – investment expertise, deep networks, a track record of building companies – that sophisticated institutional investors bring to bear.
Where Are All The Investors?
Global and institutional investors have largely ignored Latin America as a destination for early stage deals due to a series of concerns:
- Latin American VC is inherently too risky
- The cost of failure is too high
- Few start-ups reach scale
- Exit options are limited
- Latin America’s entrepreneurial ecosystem is deficient
While all of these concerns are legitimate, the dynamic environment in Latin America today justifies a rethink of conventional wisdom:
Latin American Venture Capital is Inherently Too Risky
Let’s start with the question of risk. Undoubtedly, investors in early stage companies assume high levels of execution and (often) technology risks. Add in perceived macroeconomic and political risks, and the required return on investment soars.
So what has changed? Over the past ten years, a series of economic and structural reforms have mitigated many of the region’s endemic risks – hence the growing inflow of traditional private equity. As any veteran of Latin American investing will attest, there will be bumps in the road going forward. Still, many investors believe that there has been a fundamental shift in the region and that risk has been re-priced.
At the same time, the nature of execution risk in the region’s start-ups has evolved. In the late 90s start-ups were largely Internet companies that were too early to the game. Internet penetration was insufficient and e-commerce was in its infancy. Unproven business models that eventually failed in the United States were quickly imported. The litany of failed companies in the Internet space was inevitable.
While tech-related start-ups are plentiful today, I believe that the long term early-stage opportunity in Latin America is much more about innovation than technology. New companies are increasingly applying new strategies or business models (tech-enabled or not) to capitalize on compelling secular trends, such as the emergence of a robust consumer sector, the growing need for consumer credit, or the region’s home grown competitive advantages in natural resources, agriculture, and knowledge industries (i.e. business process outsourcing or BPO).
By targeting proven industries, these start-ups can scale by attacking large existing markets rather than needing to develop entirely new ones. For example, Woodtech in Chile provides measurement solutions for the forestry industry. As that industry is Chile’s second largest behind mining, it’s not surprising that Chilean entrepreneurs would commercialize a forestry-related solution with global growth opportunities.
The Cost of Failure is Too High
Many US investors still see Latin America as a region where weak legal systems expose investors and founders to outsized risks. Veterans of the dot-com bust remember that employees and board members often faced exposure to personal liability and multi-year wind down procedures.
Over the past ten years, bankruptcy reform and new protections for minority investors has combined with growing sophistication with regards to deal structuring and contracts. Critical deal terms such as drag-along and tag-along rights have become mainstream concepts (the LAVCA Scorecard has tracked improvements in regulation affecting VC/PE since 2006).
While there is still room for improvement, especially with regard to Brazilian labor law, today the regulatory environment in Latin America looks relatively favorable compared to emerging markets such as India and China.
Few Start-ups Reach Scale
It’s difficult to reach scale if you’re rolling out an e-commerce business targeting a small, albeit fast growing, segment of the population. Having learned that lesson the hard way, entrepreneurs are now increasingly building businesses that can scale, whether they are targeting the huge emerging middle class in Brazil or exporting their products to the United States and Europe. Argentine online gaming company Three Melons, which was acquired in 2010 by Silicon Valley’s Playdom, is a prime example of a Latin start-up that successfully targets a global audience.
Exit Options are Limited
Generating an exit has never been easy in Latin America, but today thanks to innovation in local capital markets, a developing private equity environment, and increasing regional and global integration there are a lot more options, especially for companies that have reached significant scale. The businesses that will be best positioned for exit are those who can provide a fast growing “local version” of business models from development markets (for bolt-on acquisitions), players who operate in sectors populated by large and acquisitive local strategics, businesses that attract the interest of private equity firms operating in the region.
The most valuable players will be companies that manage to leverage the region’s competitive advantages to grow to regional or global prominence. Globant, the Buenos Aires-based BPO firm, is a prime example of such a company. It draws on Argentina’s well-educated and low-cost labor pool to provide outsourced services to leading companies worldwide. Its sustainable competitive position, fast growth, and high quality customer base, make it a natural IPO or acquisition candidate.
Latin America’s Existing Entrepreneurial Ecosystem is Insufficient
The book “Start-Up Nation” discusses the critical role that government support for innovation played in developing a robust start-up and VC community in Israel. Latin governments may have taken a cue from innovation-minded governments such as Israel over the last decade. Government entities such as FINEP and BNDES in Brazil and CORFO in Chile are dedicating financial resources to supporting emerging businesses. Since first steps are showing tangible benefits in the form of economic growth and job creation, expect to see additional support in the future.
Despite the best efforts of organizations dedicated to fostering entrepreneurship such as Endeavor and others, naysayers question how a true start-up culture can take hold in a region where entrepreneurs face a litany of challenges, not the least of which is raising money. I would argue that success in the face of adversity provides both a blueprint and a source of inspiration for the next generation of entrepreneurs. Buenos Aires is a regional hub for entrepreneurship expressly because of the example set by success stories such as Marcos Galperin (MercadoLibre) and Wenceslao Casares (Patagon).
Finally, Latin America benefits from a community of ambitious young professionals who were either educated by or have worked in leading institutions overseas and are thus connected into the types of global networks that prove invaluable to start-up companies. This flow of human capital – a reverse brain drain – is accelerated by the exciting opportunities available in Brazil and, to a lesser extent, other countries in the region.
Who Says There is No Venture Capital in Latin America?
While the industry remains sub-scale and lacks significant participation from international firms, the venture space in Latin America is heating up. Single-country firms have sprung up and a small number of international managers (such as New Enterprise Associates, Benchmark, Insight Venture Partners, and Accel) have done one-off deals. Brazil is naturally the most developed of these markets, with local groups such as DFJ Fir taking leadership positions.
Current VC and angel investors are in an enviable position: they are able to tap into the best companies and to invest in a market with little competition. As old perceptions yield to an understanding of the new realities in Latin America, I expect the market to become more diverse. Growing numbers of smaller local funds will be joined by international players or regionally focused investors. This network effect will benefit all of the players in the market.
Growth Capitalism is a new column in the Latin America PE/VC Report from Patrick McGinnis. McGinnis has been a private equity investor in Latin America and the emerging markets for over a decade, first at Chase Capital Partners/JPMorgan Partners and later at AIG Capital Partners (now PineBridge Investments). Presently, he sits on the Board of Directors of The Resource Group, a global BPO company, and is a co-founder of Real Influence. Fluent in Spanish and Portuguese and an avid traveler, he blogs about travel at www.huffingtonpost.com/patrick-mcginnis. He can be reached at [email protected]