By Laura Kreutzer and Sabrina Willmer
Dow Jones Private Equity Analyst
August 2010 – Putting the turbulent history of investing in Latin America behind them, private equity firms are bulking up on capital to deploy in the region. They’re drawn by a new stability, economic growth, stronger capital markets and regulations that encourage investment. Still, the region is light on expertise and knowledge and some worry about too much competition for deals.
HarbourVest Partners LLC saw its share of pain from bets it took in Latin America during the mid-1990s, like many limited partners that invested there at the time. But now older and wiser, the firm sees renewed promise in the region’s private equity market, which may finally have come into its own.
“The macro story is much more positive today than it was 15 years ago,” said HarbourVest Principal Scott Voss. “You can find firms that are on Fund V or Fund VI. The private equity practitioners are more sophisticated now, and as an asset class private equity is better understood by both buyers and sellers than it was 15 years ago.”
Over the past 12 months alone, HarbourVest has committed $85 million to Latin American funds and estimates that it could commit another $50 million or so there in the next couple of years.
The firm is among a growing number of North American and European institutional investors that have found new love for Latin American private equity. Many are attracted by the tremendous macroeconomic growth in the region, particularly Brazil, stronger governance models and improved returns in recent years. At the same time, concern about the volume of capital invested in emerging markets such as India and China is pushing LPs to look increasingly to regions such as Latin America and Africa, which have been less trafficked by private equity firms.
But this time, North American and European LPs aren’t alone. Institutional investors in countries including Brazil, Colombia and Mexico have also begun to turn their attention – along with their pocketbooks – to their local private equity markets, introducing a new chapter in the evolution of the region’s private equity industry. However, as more capital flows into Latin America, it raises questions of whether the industry there could get overheated.
In the past two years, a growing number of global firms, including Apax Partners LLP, Carlyle Group and Weston Presidio, have also made their first investments in the region.
The overall total of deals remains fairly small, reaching $3.3 billion in 2009, compared with a peak of $9 billion in 2007, according to the Latin American Venture Capital Association.
However, Latin America-focused funds appear to be on track to match, if not exceed, 2009 fund-raising levels, according to limited partners and general partners in the region. In 2009, Latin America-focused funds attracted $3.63 billion in commitments, according to LAVCA.
Fund sizes have also grown. In April, Advent International Corp. closed the largest Latin America-focused fund to date at $1.65 billion and Southern Cross Group recently raised the $1.5 billion hard cap for its latest fund, which the firm expects to wrap up by early September amid strong demand, according to the fund’s backers (see table on page 15).
A Distant Memory
Some of the investors behind this revival still remember the losses they suffered a decade ago from Latin American bets made in the mid-1990s. Back then, money flowed into the region, particularly in Argentina, with a significant share of capital invested in the privatization of state-owned industries like telecommunications and energy.
However, by 2000, a series of global currency crises that spread to the region, combined with political changes in Argentina and the impact of the technology downturn, hurt returns and drove many international investors away for years.
Exxel Capital Partners V LP, an $867 million fund raised by Exxel Group in 1998, was one of a number of funds that took a hit. As of Dec. 31, 2009, the fund was generating a negative 42% net internal rate of return, according to the California Public Employees’ Retirement System, which committed $75 million.
These days, limited partners writing checks to Latin American funds say that much has changed since the late 1990s. They point to a greater ease in making control investments and the emergence of a middle class of consumers driving increased domestic consumption.
At the same time, currencies in many Latin American countries have stabilized and capital markets have strengthened, two trends that became clear during the recent financial crisis, according to James Korczak, partner at Chicago-based Adams Street Partners LLC, which recently made its first commitment to Latin America.
“The region came through the global economic crisis in fairly decent shape and maybe better than the U.S. and Europe, which gave us comfort that they had learned from past mistakes,” said Korczak.
An improved environment for exits in recent years, both through initial public offerings and strategic sales, has also given investors more confidence in the region.
Although the total volume of exits declined by 29% to $1.78 billion in 2009, according to LAVCA, there have been several this year, including the sale of a 50% stake in Argentine wine manufacturer and distributor Group Penaflor SA by DLJ South American Partners.
“One of the challenges I had on deals 12 to 15 years ago was the exit,” said HarbourVest’s Voss. “Often when the exit window was shut, it was shut for years.”
That said, the universe of private equity firms with established track records in the region remains small. Only a handful of groups, including Advent International, DLJ South American Partners, GP Investimentos Ltd. and Southern Cross Group, survived the disruption of the late 1990s with their firms intact.
“Those institutional LPs that are looking for long uninterrupted track records are not going to find that in most cases,” said Patricia Dinneen, managing director at New York-based Siguler Guff & Co., which has raised more than $1.5 billion for two funds of funds focused on Brazil, Russia, India and China.
She added that the macroeconomic challenges of the late 1990s made fund-raising extremely tough during the years that followed, even for talented firms, forcing a number of professionals to raise money on a deal-by-deal basis. More recently, a new generation of managers has emerged, including many firms raising their first or second institutional fund.
“We are finding that many of the new managers have embraced the lessons from the past with stronger governance models and a more experienced talent pool,” said Dinneen, adding that Siguler Guff plans to open a Sao Paulo office soon, given the expanded universe of managers and deals.
The Home Team Arrives
A new generation of limited partners has also emerged in the region since the late 1990s, as local governments and political leaders have shifted their support to private equity and venture capital. This shift has led to the formation of several state-backed fund-of-fund programs and changes in regulation that allow local pension funds in particular to invest money in the asset class.
State programs have cropped up in several countries, including Brazil, Chile, Colombia and Mexico.
In Brazil, the Financier of Studies and Projects (Finep), which is connected to the Ministry of Science and Technology, has invested in 17 venture capital and private equity funds since the formation of its innovation program in 2001. Finep most recently decided to start backing funds of funds.
The Colombian Development Bank also formed a program that supports private equity and venture capital in that nation.
Meanwhile, the Chilean Economic Development Agency, CORFO, has been backing venture capital funds in Chile to help form a venture capital industry in the country, while the Mexican development bank has been primarily investing in small and medium-sized start-ups in Mexico.
State support is proving crucial for growth, especially in younger private equity markets, such as Mexico and Colombia, “State backing has been important in all Latin American markets at the outset, including Brazil,” according to Cate Ambrose, executive director at LAVCA.
Local pension funds have also moved into the asset class, thanks to recent regulatory changes. In Brazil, where pension funds have been able to invest in the asset class for a while, they are a small but growing source of local capital.
Local pension funds in Mexico, meanwhile, are just beginning to invest in private equity thanks to reforms last fall. These LPs are also now allowed to differentiate which stage of investment they want to be in thanks to changes that allow them to invest directly in initial public offerings.
Pension funds of ING Mexico, which is part of ING Group, for example, have invested nearly $250 million so far in private equity, taking up 1.9% of the total $13.3 billion in assets under management.
The regulatory changes in Mexico, however, are a bit tricky as these local pension funds can only invest in vehicles that are structured as trusts that issue development capital bonds on the Mexican Stock Exchange. About six firms so far, including Wamex Private Equity and Nexxus Capital, have issued these bonds, and a number are lined up for issuances.
“We participated in every issuance,” said Luis de la Cerda, senior portfolio manager at ING Investment Management. “We will be able to invest almost all of our capacity in five or six years.”
Participation by local pension systems brings more than capital to the region’s private equity market, said Ernest Bachrach, a managing partner and co-head Latin America at Advent International.
“It creates more transparency and [a better] understanding of the mechanics of capital markets, if you have fundamental institutions like pension funds involved,” said Bachrach. “One of the biggest challenges in these countries is [that] people don’t understand what private equity is.”
At the same time, participation by local institutions can help lay the foundation for a stronger venture capital industry.
“It starts to pry open the local capital markets, which means you can start to look at companies that have a long-term dependence on capital markets to grow, or companies that can tap various rounds of capital markets,” said Bachrach. “You can’t have a viable venture market until you have that.”
All Eyes On Brazil
Market improvements in Latin America have perhaps been the most dramatic in Brazil, which accounted for 62% of the total deal volume of Latin American private equity investments in 2009, according to LAVCA.
The number of private equity and venture capital firms operating in Brazil had grown to around 150 by the end of 2009 from only around 65 firms in 2004, according to Professor Claudio Vilar Furtado, executive director of the GVcepe-Private Equity and Venture Capital Research Center at Brazil’s FGV-EAESP Graduate School of Business in Sao Paolo.
“In 2004 and 2005, the big private equity story begins,” said Furtado, who said that improved liquidity in international capital markets and sustained macroeconomic growth helped reopen the window for IPOs in Brazil between late 2004 and 2007.
Meanwhile, he said social programs implemented over the past decade have increased domestic consumption in Brazil, creating more opportunities for mid-sized companies that aren’t dependent on exports. That’s helped drive more investments in companies focused on domestic consumers in the region across a variety of industries like travel or health care.
Since 2008, Carlyle Group, for example, has backed two such companies: private health insurance provider Grupo Qualicorp and travel agency CVC Brasil Operadora e Agencia de Viagens SA.
Meanwhile, in 2008, Weston Presidio financed Brazilian airline start-up Azul Linhas Aéreas Brasileiras SA alongside David Neeleman, founder of JetBlue.
But the money flowing into the country raises questions about whether deals, particularly at the largest end of the market, may be getting too richly priced.
“In Brazil, entry pricing may rise given the amount of capital to be raised, which may cut into overall return,” said Gene Pohren, a managing director at PCGI, a Washington-based discretionary manager focused on emerging markets.
General partners operating in Brazil say that although more players may have entered the market in recent years, there are still plenty of good deals to be had at attractive prices, particularly compared to more developed markets like the U.S.
“If you look at Brazil, there aren’t that many deals done on an auction basis, which is where you would face the most intensive form of competition” said Bachrach. “If a bank is going to run an auction, the deal will often go for values north of $100 million, and there aren’t that many groups that can write that size of check.”
He added that there still aren’t that many firms in Brazil with a large local presence, which is critical to both accessing and executing deals.
“When you’re buying a private company from a family group, you need someone who’s dealing with the owner and someone else to deal with the CEO, who’s thinking ‘what happens to me when this gets done?’,” Bachrach said. “Then [you need someone to deal] with the CFO, who knows where the skeletons are hidden. This takes a lot of local manpower, especially if you are perusing several deals at a time.”
Advent has done the bulk of its deals in Brazil and Mexico, according to Bachrach. The firm is also one of the largest private equity investors in the Caribbean, particularly the Dominican Republic, with around 10% to 15% of its portfolio invested there. The rest of the portfolio is deployed across other countries such as Argentina and Uruguay.
Advent and other Latin American firms are also looking hard at Colombia and Chile, which have yet to see as much penetration by private equity firms. Advent, for one, has looked at 50 to 60 deals in Colombia and aims to open an office there by the end of this year. The firm has also looked at some 200 deals in Chile.
However, the firm has yet to deploy capital there, in part because of the challenges posed by the small sizes of those markets.
“In Chile, for example, there are few transactions over $100 million and you’re competing with institutions like pension funds, strategic local investors and the local IPO market, making it a more challenging place for us to find attractive deals,” said Bachrach.
Once Bitten, Twice Shy?
Although conditions seem considerably more favorable today than in the 1990s, general partners still have much to prove to their limited partners.
Improved macroeconomic conditions, increased involvement by local limited partners and the presence of more established and experienced managers are all playing in private equity’s favor this time. But the memories of the past still linger in many investors’ minds, making it crucial for general partners to get it right.
“Private equity managers need to be disciplined when looking at valuations in markets where competition for deals is heating up,” said LAVCA’s Ambrose.
That’s especially true given record amounts of capital being raised by individual firms.
“We’re moving into uncharted territory where they [some private equity firms] haven’t managed funds of this size,” said HarbourVest’s Voss. “The message that I try to send general partners is “You need to make good this time or you could suffer another lost decade.”
Those managers that fail to embrace the lessons of the past could see some LPs flee for good.
“You can’t get away with it twice,” said Adams Street Partners’ Korczak, although he quickly added, “I do think that’s recognized by the higher quality groups there.”