Emerging Private Equity
Economic and political stability, solid legal framework, thriving financial markets and a well established business culture: Chile is Latin America’s safe bet economy. But does Chilean venture capital and private equity industry lack the buzz of its neighbours? Darius Sokolov reports.
Technically Chile has everything a private equity investor might be looking for. For three years now the Latin America Venture Capital Association (LAVCA), working with the Economist Intelligence Unit, has been producing its annual scorecard assessing the PE/VC environments of countries in the region. And three years in a row Chile has come out on top. In the 2008 analysis Chile scores 78 out of a possible 100. Second-placed Brazil is not far behind on 75, but the other Latin PE powerhouse, Mexico, is a long way off on 58. The regional median score is 53.
“Chile’s first place in our scorecard can be attributed to the strength of the country’s institutions,” explains LAVCA’s report on the findings, “as reflected by its favorable scores on judicial system, perceived corruption and protection of intellectual property rights, particularly when compared to regional neighbors.”
Chile gets full marks for its VC/PE legislation. The basic framework for many Chilean funds was laid in 1989, with Law 18815 establishing rules for Fondos de inversion de desarollo de empresas (FIDEs). The Ley de OPAS of 2000 allowed FIDEs to take majority stakes in companies, and to issue bonds both in home and international markets.
This 2000 legislation also strengthened minority shareholder rights. And as of 2002 pension funds can invest up to 2.5% of their assets in PE/VC. The legal situation for PE has improved still further with a new capital markets law enacted last June. Among other measures, the new law allows banks and the state economic development agency CORFO to invest directly in FIDE equity, and introduced capital gains tax exemptions for a range of seed capital and VC investment types by local investors.
Aside from investment regulation, Chile benefits from well developed local capital markets, strong corporate governance and bankruptcy rules, and a low perception of corruption by Latin American standards. The economy has been growing at stable rates of 4% and over for the last five years; it is by no means the most dynamic in the region, but has a reputation for low volatility and orthodox policymaking that is well liked by investors.
But for all this investor-friendliness, Chile’s private equity market just doesn’t seem to have the same buzz about it as the Latin America’s prime private equity targets Brazil and Mexico, or of headline-grabbing destinations such as Argentina or Colombia. For example, Argentina manages just 50 in the scorecard. But according to LAVCA, Argentina attracted just the same level of private equity investment relative to GDP as Chile in 2007, 13% in each case. What is holding Chile back?
As elsewhere in the region, the history of Chilean PE investment can be read as a two part story: before and after the emerging markets crisis at the end of the last decade. Chile went into recession in 1999, though the effects of the global withdrawal of capital from emerging markets were less pronounced than in neighbours such as Brazil and Argentina, and growth was back up at 4.5% in 2000.
“There was certainly an attempt to build up a private equity scene in the mid 1990s,” says one experienced investor. “The breakthrough then was allowing pension funds to invest in local funds, something which happened in Chile ahead of many other countries. But at that time there was really a lack of experience and expertise in the industry, and many of those investments did not survive.” While a number of international investors stayed active over the years, the investor talks of a gradual rebuilding of the market in recent years.
“It may be true that Chile doesn’t get the same press as some other countries,” he says. “But that doesn’t necessarily tell you everything about the state of the market. It is not a noisy market, but it is active and it is profitable.”
According to Hubert Porte, managing partner at AXA Capital Chile, and founding director of the Chilean association of fund managers ACAFI, a good part of Chilean private equity’s development in the last three years can be attributed to the role played by the government agency CORFO. “CORFO has become a major investor, matching local private funding with its capital and contributing to the setting up of around 15 new funds in the last three years,” says Porte. “A lot of small- and medium-sized funds have started as a result of that opportunity offered by CORFO.”
These funds join a handful of established local names; Monedas is one of the best known. Regional player Southern Cross has an office in Santiago and has made a number of high profile recent investments in the utilities sector. And global funds have a presence in Chile: Credit Suisse’s DLJ South America Partners fund, set up in 2007, has Chile as one of its focuses alongside Brazil and Argentina. Citigroup’s Citi Venture Capital Investors has been active in Chile since the 1990s, and puts the country at the core of its Latin American strategy.
Size and reporting
According to Enrique Bascur, managing director at CVCI based in New York, size is a factor in how Chile is seen in the private equity world. “There is a perception that Chile is a small market, in terms of GDP, and so does not have opportunities of comparable size to those in neighbouring markets,” he says. “However Chile is the most open economy in Latin America, and therefore companies are not constrained by national borders. It is a small country but with a world view; Chilean companies look at the world as their market.”
Some investors say the smaller size of available deals also affects the financing situation for Chilean investors. For example, it rules out using IPOs as exits. While it has a well developed stock market, Chile has not seen anything like the recent Brazilian private-equity fuelled IPO boom.
“None of the funds currently working in Chile are working with a focus on IPOs,” says Porte. But Bascur believes IPOs are a viable option for the future. “I think IPOs are available for private equity exits in Chile,” he says. “There is a deep pool of institutional investors, and a deep local capital market. All the factors that make Chile interesting for private equity also work in favour of strategic investors as well.”
Although outward looking, Chile has a domestic market of just 16 million, compared to Brazil’s 185 million population, Mexico’s 110 million, Argentina’s 40 million and Colombia’s 45 million. Hubert Porte notes two main issues that may have held back more rapid development. “Chile has the biggest pension fund industry in the region,” he says, “the funds control huge amounts of money. They should be able to act as a major source of private equity capital – and yet they do not have a strong presence. Although they are permitted to invest, the problem is that they have to provide very heavy reporting for what are small investments relative to the size of assets they manage.”
Porte says ACAFI has made several proposals to regulators to reduce this reporting burden. In particular, he argues steps need to be taken to end duplication of reporting lines; currently pension funds, fund managers and companies themselves may all face obligations to report separately on the same items. “A lot of pension funds we’ve talked to say they would look more favourably at the asset class if these concerns were addressed,” he says.
While reporting red tape may be the main concern for local investors, the complaint for foreigners is tax. The 2007 Capital Markets law introduced a number of exemptions for local venture capital investors. But non-residents face a 35% capital gains tax on profits from their investments in Chilean companies. “The tax regime can make Chile expensive relative to other countries in the region,” says Porte. “When you have to take into account factors such as currency risk on top of that, investment may not be attractive for foreign buyers.”
When it comes to venture capital, there is another candidate explanation for the quiet in Chile: namely caution. “I remember the speaker at one event I attended last year,” says Susana Garcia-Robles, senior investment officer at the Inter American Development Bank’s Multilateral Investment Fund (MIF). “He was talking about how Chilean investors tend to complain that they don’t have the deal flow for seed and VC investment. And the speaker said, ‘in fact could it be the deals are right there staring at us, but we’re too risk averse to see them?’”
Javier Duarte, deputy general manager at Fundacion Chile, a government-backed agency which with a focus on developing technology-based companies, agrees. “Chileans have been very conservative in the use of venture capital,” he says, “and really the deal flow of projects has been rather poor. To expand this sector it is important to have innovative projects and entrepreneurs who can manage the companies with the adequate incentives.”
“In other countries you may have more of a culture where entrepreneurs are accustomed to betting, losing, and trying again,” says Garcia-Robles. “Perhaps you need a bit of hardship and volatility to have that risk taking mindset.” Enrique Bascur, however, does see Chile as entrepreneurial. “The industries that have developed in Chile have done so because of a high level of entrepreneurship,” he says. “Typically they have been industries where entrepreneurs have been able to identify their comparative advantage on a world level and move to capitalise on that.”
For example, the development of a salmon farming industry that is now said to rival Norway’s; or of a prosperous new salt mining industry with export links to the US. Although how much of the initiative is coming from the private sector, and how much is coming from public enterprise is difficult to determine. For example, notes Garcia-Robles, unlike in Argentina or Colombia, there is no movement from business to set up a trade association to help drive development. Much of the push seems to be coming from the state.
Apart from its private equity support, CORFO has set up a seed fund and backed Angel Investment networks. Fundacion Chile, has also been a key player. According to Duarte it has participated in three venture capital funds and is promoting an international Angels network of Chilean expatriots. MIF has worked with the Chilean agencies investing in funds and educational programmes.
For Hubert Porte, hope lies with a new generation of younger executives. “Banks in Chile tend to be very conservative and that there may be a lack of vision from older executives of larger companies. For example, we see very few management buyout initiatives,” he says. “But Chile is going through a generational change now. There is a new entrepreneurial spirit among younger business leaders, and that looks very good for the future.”