By Matt Atkins
Ocotober 2011 — With an improving political and regulatory framework and a positive economic outlook, Latin America is fast-becoming an attractive environment for private equity investment. With over $17bn worth of private equity deals closed in 2010 – five times the previous year – and greater results expected for 2011, the future looks bright, though there are, of course, challenges to making successful investments. The diversity of the region makes market knowledge and an extensive local network key factors in dealmaking. For PE firms looking to enter the market, forewarned is forearmed.
Decades of subdued growth, elevated inflation, and political instability have been reversed in recent years as far-reaching structural reforms have improved economic prosperity and generated sustained growth. GDP growth of 6.1 percent in 2010, year on year, saw the region post the second strongest growth rate globally, surpassed only by emerging Asia. Goldman Sachs expects the region to generate GDP of $5.3 trillion in 2011. Furthermore, sound fiscal and monetary policies coupled with a strengthened regulatory framework have helped to boost sovereign credit ratings across the region.
It is of little surprise then that Latin America is fast becoming one of the most sought-after regions for private equity, as limited partners and general partners alike recognise its untapped potential. Following a slump during the hardest years of the financial crisis, investment activity surged. According to the Latin American Venture Capital Association (LAVCA), in 2010 PE investment in the region reached $7.2bn – an increase of 120 percent over 2009 and 57 percent over 2008. In a similar vein, the amount of capital generated from exits grew almost 100 percent in 2010 compared with 2009. In addition, transaction sizes have increased notably in deals conducted by PE groups.
This accelerating pace in investment is easily matched by fundraising activity. Fundraising by Latin America-focused PE funds reached a new record of $8.1bn in 2010, more than double the amount raised in 2009, according to LAVCA. PE groups have also achieved larger fund sizes. However, while fund managers are well capitalised and looking to make new investments, because asset prices have been driven up with so many bidders in the market, it may be a challenge to find attractive valuations.
In geographic terms, the deal environment is one of intense competition, particularly between the major players Brazil, Colombia, Mexico and Peru, while Argentina and El Salvador lag behind. That Brazil receives much of the attention from PE firms is no real surprise, seeing that the country has enjoyed an annual growth rate of 4.3 percent since 2003, and expects a rate of 5.8 percent for then next four years, according to the Brazilian Ministry of Finance. Brazil, then, is the powerhouse of the region. “It is noteworthy that most of the capital invested during 2009 and 2010 was in Brazil, which accounted for 72 percent of the total capital invested during that period,” explains Alfredo Alfaro, managing partner for Latin America at Advent International PE Advisors, S.C. “This was followed by Mexico and Colombia, which each accounted for 6 percent of the total funds invested in the region, according to the 2011 LAVCA Industry Data report. Activity in the region has tended to concentrate on growing industries such as healthcare, energy, technology and education. These sectors, combined, attracted more than 60 percent of investment dollars during 2010 and a similar percentage in 2009.” These areas present attractive investment opportunities due largely to strong internal demand; however the region’s growing economic prosperity and stability have also boosted demand in consumer-related products.
The Economic Commission for Latin America and the Caribbean (ECLAC) has observed that in the past 15 years, 56 million Latin Americans have joined the middle classes. Moreover, in 2010 more than 50 percent of the continent’s population was below the age of 30 and nearly 50 million people are estimated to join the economically active population by 2020.
The booming middle class has seen a surge in the consumption of non-essential goods, and placed great demand on the leisure industry. Demand for consumer-related products such as accommodation, cars, and watches is only expected to rise. A report by the global private market investment firm Partner’s Group notes that 52 percent of Brazil’s GDP is generated in consumer related sectors. However, just 14 percent of all public market equity is allocated to this sector, with an emphasis on volatile commodity companies and financials. This pattern is one seen across the region, and, in the absence of public equity, PE players are offered great exposure to the consumer sector, which they can capitalise upon for long-term growth. The region has already seen a great number of deals in retailing and restaurant chains, including investments in Fogo de Chao, Scarlat and Taco Holding. IT and online companies have also seen increased PE investment, where examples include a new round for Brazilian deal-a-day site Peixe Urbano, and software/BPO related investments in Certisign, Sascar Tecnologia and ALOG data centres. PE investments in the consumer sector look set to continue along with the region’s growth. Indeed, PE firms may well find it difficult to keep up with the region’s rate of expansion.
Attractive opportunities also exist in the infrastructure sector, where rapid economic growth is straining the capacity of roads, railways, ports and airports, making increased investment a priority. “There is a keen awareness within the public and private sector in Latin America of LAVCA,” says Cate Ambrose, president and executive director of the LAVCA. “However, despite abundant available capital for this sector there have been significant delays in seeing new projects realised. This is typically attributed to slow bureaucracy and regulatory processes. Nonetheless, there have been new deals realised in 2011, notably a major port container deal in Brazil by Advent International.” Investment into Brazil is made all the more urgent with the country due to host the FIFA World Cup in 2014 and the Summer Olympic Games in 2016.
The country will need to invest heavily in everything from stadiums and hotels to highways and airports to accommodate the expected crowds. Major projects include a high-speed railway between São Paulo and Rio de Janeiro, a hydroelectric power station and numerous road projects. JPMorgan Brazil Investment Trust estimates that infrastructure spending for the two events could hit $50bn by 2014. Such commitments make it likely that the government will rely on private investment to a much greater extent in the coming years.
Various incentives and policies have been implemented to actively welcome foreign private equity into the region. Brazil’s government, for instance, has reduced the financial transactions tax (IOF), set at 6 percent in October 2010, to 2 percent with the specific intention of attracting PE investors. The higher rate has been kept in place for short term speculative flows into liquid assets. Authorities across the region are taking care to iron out country-specific obstacles to investment. In Colombia, the aggressive promotion of minority shareholder rights has supported the case for private equity investing. Ranking fifth-highest for investor protection on the World Bank’s ‘Doing Business Index’, the country surpasses the UK, and is equal to the US.
Across Latin America, authorities are doing their utmost to entice PE players, tackling long-standing preconceptions of the region. “In Mexico regulators are beginning to take a more aggressive stance to combat monopolies in key sectors for investment such as telecommunications and media, which would create important opportunities for PE investors,” Ms Ambrose says. “In Peru, it was feared that the new government would reverse market and investor-friendly policies, but it now appears that the president is aiming to assure investors that Peru will continue to welcome foreign capital and project private interests.”
A number of factors, then, have converged to make Latin America a more favourable investment destination. There has been an improvement in corporate governance and financial reporting transparency. Capital inflows are driving up the value of local currencies, and governments are committed to protecting local currencies from overvaluation, which in turn protects exports. Financial systems in the region are well-capitalised. In addition, local pension funds which, until recently, were largely restricted from investing in PE funds are playing an increasingly important role in the PE sector and in creating a secondary market.
Overall, Latin America is now seen as a much more secure investment target. “The risk perception of Latin America has improved in the past 20 months, with credit default swap spreads declining during this period, giving the region a better risk-reward profile,” says Mr Alfaro. “Latin American countries are also being recognised for their stable regulatory environments. For example, the 2011 edition of the LAVCA Scorecard on the Private Equity and Venture Capital Environment in Latin America gives high rankings to countries like Brazil, Chile and Mexico, not far behind traditional, popular PE markets such as the UK.”
With foreign investors eager to tap into the opportunities offered by Latin America, what can we expect to see going into 2012 and beyond? Many global firms have opened offices in the region in the past year, or formed partnerships with local firms to access deal flow. Those investment teams are now focusing on deploying capital, and it is expected that this could herald an increase in the number and size of deals in 2011 as compared to 2010. Record fundraising is also predicted for the region this year. “Approximately $5bn was raised by four firms in Brazil in the first half of the year, as compared to the $8.1bn raised for all of Latin America in 2010,” explains Ms Ambrose, though she admits, this may not be a sustainable trend. “It is difficult to predict how long this cycle of increasing fundraising and investments will last. Today global institutional investors are keen to gain exposure in Latin America and there seems to be somewhat of a herd mentality that is contributing to the heated environment in the region. Once that demand cools down we may see a levelling off, which I think many fund managers would welcome.”
PE investments in Latin America will continue to have a high potential for attractive returns as countries carry on expanding at a fast pace, Mr Alfaro suggests. “Investors will seek to diversify from traditional PE markets in North America and Europe. Investors’ enthusiasm for PE investments in Latin America is already translating into fund commitments. The challenge is not whether enough private equity capital will be provided, but whether Latin America will be able to absorb the amount of funds that limited partners want to invest in the region without the risk of overhang and increased valuations.”
Latin America is likely to remain a major focus of global economic growth and investors should allocate a proportionate share of funds to this growing market. However, investments in the region are not without risk. The political environment in emerging markets can be volatile, particularly in times of political power shifts. Though there has been impressive progress, corruption in these countries is still perceived as a risk. Red tape is also an obstacle at times. In the case of Brazil, it takes an average of 150 days to set up a business, for example, and in many Latin American markets there are further tax, pension, and budget reforms that still need to be addressed.
But there is a great deal of variation between Latin American countries, and while particular issues may cause concern in one state, in another they may not. It is wise, for instance, for PE players to consider the exit environment of a country before committing themselves. While exits in Brazil, for example, are fairly uncomplicated, due to its deep stock market, PE firms would find it harder to exit via IPO in a country such as Peru. This factor must be taken into account when formulating any investment strategy. In order to make the most of a transaction, local knowledge is more than a requirement, it is essential. Latin American countries are highly diverse in terms of GDP composition, natural resources and institutional and political stability. Therefore, a local presence, local market knowledge, and an extensive network of local players are key for making successful investments in the region. Building relationships is also essential for regional expansion. Once a firm has its portfolio well established in one country, it is much easier to reach out to regional neighbours.
With the region quickly becoming a new playground for private equity, nearly all Latin American countries show a relative under-penetration of investment as a percentage of GDP. There is then, still a large ‘catch-up’ potential compared to the advanced world and other emerging markets, and a wealth of opportunities for prospective players.
Latin America offers compelling long-term openings in a wide array of sectors, but each country entails a unique set of advantages and challenges. Those who are tempted must look at each country individually, taking on board the input of local advisers. But despite any teething troubles, the region will continue to benefit from structural improvement, rising wealth and strengthening economic ties to create an exciting environment for PE investors.