Private Equity Takes Root
More enlightened legislation, easier exits and savvier investment strategies are fueling a revival of private equity in Latin America. The comeback offers a welcome alternative source of capital for entrepreneurs.
The best macroeconomic environment in over a decade and the hunt for higher returns are behind a revival in LatAm private equity (PE), which is slowly taking root. Hedge funds, endowments, offshore and onshore pension funds and public investment firms are increasingly backing the same PE teams that survived the fallout from the last round of fundraising in the 1990s. This regional PE rebound appears smarter, more focused and better placed to withstand market volatility, which returned in earnest during the summer.
“Those who have survived are far more sophisticated in their strategies and above all opportunistic,” says Cate Ambrose, executive director of the Latin American Venture Capital Association (LAVCA). “They recognize there are some very strong opportunities in the region.”
“We are talking about 30% compounded annual growth for some of the companies we invested in,” says Ernest Bachrach, CEO of LatAm for global buyout firm Advent International, which has raised $2.2 billion for the region since 1996. He adds that disposable income flowing into the service sector in LatAm because of deepening macroeconomic stability presents “phenomenal opportunities.” Bachrach says returns in Asia must be at least as attractive given that 80% of the $33 billion in private equity fund raising for emerging markets went to Asia.
Brazil and Mexico are the most buoyant LatAm markets, but there is also plenty of fundraising and investing in Colombia, Central America and the Andean Region, according to Alyssa Grikscheit, partner at law firm Goodwin Procter. “The PE funds are also more sector specific,” she notes.
For example, the largest fund raised last year – Conduit Capital Partner’s Latin Power III $393 million fund – is earmarked for investment in the independent electric power industry in LatAm and the Caribbean. The Latin American Enterprise Fund (LAEF) meanwhile raised a hydrocarbon fund for Colombia in 2005 and is building another for forestry investment in that country.
GP Investments of Brazil, Advent, Darby Overseas Investments and Brazil’s Pátria Investimentos, formerly Patrimônio, are the survivors of the first round of investing in the mid 1990s, which ended in 1999/2000. Currency devaluations in Brazil and Argentina coincided with the dotcom bust just as many funds were preparing to exit and some heavily leveraged companies crumbled. The likes of Dallas-based buyout firm Hicks Muse Tate & Furst and GE Private Equity, the PE investment arm of General Electric, sustained heavy losses.
Those left behind are raising third and fourth generation funds topping $1 billion, with strong subscriptions from existing limited partners and new entrants. For example, when Advent closed what it claims as the largest PE fund ever raised for Latin America, in late July – the $1.3bn Latin American Private Equity Fund IV (LAPEF IV) – it exceeded the target capitalization by 30%, with over $2 billion of interest from 38 institutional investors. Existing limited partners contributed half of capital, says Advent. Bachrach says his firm is still standing because it invested in businesses that were already generating cash, did not require intensive capital, and used virtually no debt so that they could get focus on building businesses. It was also careful only pay a maximum four times Ebitda on average.
New investors in LAPEF IV include Harvard Management Company, California Public Employees’ Retirement System (CalPERS) and Singapore’s Government Investment Corporation (GIC). Bachrach says they sought a manager with a strong track record, and he stresses how investors have learned that robust local teams are critical for success.
CalPERS has 6% of its overall portfolio allocated to global PE and this should remain constant when it comes under review in November, says fund spokesman Clark McKinley. “Our principle requirement is sustaining relationships with good partners regardless of the trends. As long as they are sustained generators of alpha as most of ours have been since the mid 1990s, we are going to stay with them.”
“[Limited partners’] first criteria are performance and sustainability,” explains Bachrach. “We have been in Latin America for 11 years and this is our fourth fund. We have by far the largest team operating in Latin America,” he claims. Advent has 24 investment professionals on staff, says Bachrach. Ten are based in Mexico, nine in Brazil, four in Buenos Aires and Bachrach is based in Miami.
And, in a sign that PE could reach considerable scale in Latin America, the PE arm of Brazilian bank Pátria is also heard to be in the closing stages of raising a $400 million fund. It tapped US PE giant Blackstone as a co-investor in bigger deals.
Opacity Stunts Growth
LatAm PE is far from revolutionary growth, according to Bachrach, because it is restarting almost from scratch. Fund raising has reached $4.3 billion for Latin America this year, but it lags the $5 billion raised at the peak of the 1998 buyout boom. Richard H, Frank, CEO of Darby Overseas Investment, says the buyout funds like Hicks Muse that leveraged companies up with dollar debt hit the wall when those revenues disappeared in the wake of Argentine and Brazilian currency devaluation. “It just killed those companies and the buyout funds were a spectacular failure.”
Bachrach expects allocations to LatAm PE to increase by another 50% next year, given that most LPs allocate funds a year ahead of closing. But he sees constraints on growth. “You are not going to see a lift off because there isn’t the capacity to take that money. It is limited by the number of available funds and professionals who can put that to work,” says Bachrach. He estimates that there are only around 150 experienced PE professionals in LatAm with a five-year track record, compared to thousands in the US, Europe and Asia. “I expect the industry to grow organically,” Bachrach adds.
Others are more optimistic about expansion, based on their expectations of high commodity prices, low interest rates and improved macroeconomic stability in Brazil, Peru and Colombia. Bruno Rocha, partner at Rio de Janeiro-based fund manager Dynamo, with $800 million in assets under management, doubts that the intensifying credit crisis will derail the PE revival. “Private equity is something that flourishes in a lower interest rates scenario. Even if the credit crisis worsens, I don’t think it will reverse the private equity trend in Brazil. It may delay it but it the conditions are there for long-term growth.” The shifting dynamics of savings away from developed countries to emerging market nations means that the Central Banks, particularly at oil producers, are amassing dollar savings and must find ways to invest the excess, he adds.
GIC, set up in 1981 to invest Singapore’s foreign exchange reserves, is a limited partner (LP) in Advent’s LAPEF IV fund and has $100 billion in assets under management. Eduardo Elejalde, founding partner at LAEF, says PE investing in LatAm from public pension funds like CalPERS and Canadian pension fund Ontario Teachers bodes well for the industry in the region, especially since they tend to have longer time horizons and more stable investment styles.
Antonio Bonchristiano, co-chairman of Brazilian PE firm GP Investments, expects to see more interest from PE players migrating from India and China as Brazil’s macroeconomic stability deepens. He says that as competition for assets increases in those countries, opportunities in Brazil look more attractive.
According to the Emerging Markets Private Equity Association’s 2007 survey, published in May, of 81 LPs with $310.5 billion in PE assets, the percentage of that expects to invest in LatAm in five years’ time more than doubled to 64% from 31%.
But they are still not prepared to embrace the region wholeheartedly. Some 47% say they will be opportunistically investing in LatAm, with 30% observing and just 12% active. This compares to 52% of LPs who say they will be actively investing in China, and 53% in India. Nevertheless, the findings are encouraging given the region’s disastrous experience with first round funds – typically run by managers based in the US – in the 1990s.
According to EMPEA, 150 PE-related funds raised $15 billion for LatAm investments between 1993 and 2000 but many fell short of expectations. The 10 and five-year internal rates of return as of June 30 2006 for LatAm funds in private equity and venture capital research firm Cambridge Associates’ (CA) proprietary database, were minus 3.28% and minus 6.13%, respectively. But the survivors have been turning in more impressive gains in recent years and this is picking up as funds are exiting. The three-year return averages 14.14% and one year return 31.03%, according to CA.
Erik Peterson of EM venture capital and PE firm Aureos, says even new funds like his are seeing interest from investors. Aureos raised $36 million for Central America in 2005 and should close an initial $150 million of a planned $300 million LatAm fund in September. Peterson sees abundant opportunities in countries with free trade agreements, high remittance flows and more stable economies. He singles out Colombia and Peru as attractive because they are nearing investment grade. And he sees little in the way of competition from foreign PE firms at present. Aureos’ backers include development banks like FMO of the Netherlands and CDC of the UK, but Peterson says Aureos is getting more interest from institutional investors.
Reaching for Scale
Increasing use of leveraged finance in LatAm should also bring scale to PE deals and boost returns. Advent has spearheaded some of the largest deals in the region, including the $500 million leveraged buyout (LBO) of the Brazilian duty-free retailer Brasif last year. The LBO of Mexico’s Corporativo Javer’s housing business subsidiaries for an amount heard to be around $750 million was Advent’s largest deal so far in the region. Advent claims it also led the first mid-market PE deal to use cash-flow-based debt in Mexico, the $200 million buyout of retailer Milano in May 2006.
Meanwhile, LAEF’s Elejalde says his fund is exiting two investments in Mexico through strategic sales that involve management buy-outs. “That is an exit that wasn’t available before. Because interest rates are lower, banks are more interested because often they provide the bridge financing and then take out is in the bond market.”
Bonchristiano says his firm is working on up to four deals with reais-denominated leverage. “In the past we used 100% equity so leverage means we can reach scale on a smaller number of larger sized deals,” explains Bonchristiano. “It is very novel for us and we are only considering using reais financing that have reais revenues because the mismatch is not a risk that we would like to run.” He adds that Brazilian leverage levels of two to three times debt to Ebitda are more modest than the three to five times Ebitda seen in Mexico and Chile, because of higher rates. Even so, he says local banks are lining up to finance leveraged deals because they stand to make “equity-like returns on debt instruments with interest rates between 11% and 12%.”
GP announced two LBOs in August: the $1 billion acquisition of Latin American Land Drilling and E&P Services from Pride International, with $600 million earmarked for leveraged finance, and a $625 million acquisition of Magnesita, a major producer of refractory material. Some 45% of the latter will be funded with debt. The ability to issue equity locally gives funds more stability and flexibility to fund larger deals.
GP was the first PE firm in Brazil to go public when it raised $307 million in a 2006 IPO, a move that the firm sees as defensive. “We went public to secure permanent capital to allow us to be in business and investing even in down cycle when we can’t raise a new fund,” says Bonchristiano. GP’s general partners put in an unprecedented $400 million of their own cash.
Armínio Fraga, founding partner of Gávea Investimentos, a Rio-based hedge fund and PE shop with $4.5 billion under management, says his firm is also thinking about going public. In the past 18 months, Gávea has taken active PE stakes in companies like McDonald’s’ LatAm business, a Brazilian credit card company called Policard and Mexican entertainment company CIE. Brazilian asset manager Tarpon Investment Group went public in May with a $237 million listing.
Eye on the Exit
At the same time, the choice of exits has broadened. Brazil’s equity market is the most buoyant in LatAm and becoming a hub, with at least three regional companies planning to list Brazil Depositary Receipts. According to Dealogic, Brazilian companies raised $23.37 billion in 60 offerings of the $28.30 billion and 86 equity deals issued in Latin America for the first seven months of 2007. By comparison, Brazilian companies issued $9.28 billion out of a total of $12.28 billion for the first seven months of 2006.
For GP, the Bovespa has been the primary source of exit with eight out of 10 done there and two to strategic buyers. “The public market is willing to price a higher multiple than the strategic market,” explains Bonchristiano. “We don’t count on it being there for ever, it may slow down. Provided you are control investors you can chose the timing and the strategy of exit,” he adds. But, as Darby’s Frank points out. It is also a competing source of capital. He claims Brazil’s thriving public equity market is driving valuation multiples higher making it more difficult to find bargains.
Inter-regional and cross-border M&A has been picking up pace, broadening the universe of strategic buyers. “The IPO markets can be a bit whimsical,” says Bachrach, adding that he prefers sales to strategic buyers. “There can be a window for a few months in Latin America, and then those markets tend to close more tightly than the US and Europe, and it could be years before access,” he adds. “We manage the liquidity and realization side by having a very clear idea of the exit scenario. We will be in dialogue with potential buyers before we close the fund.”
Structuring for All Scenarios
The uptick in PE activity comes at a time when credit markets globally are seizing up in the wake of a sub-prime mortgage crisis in the US. This has scuppered jumbo LBOs lined up in Europe and the US. Bachrach expects the cost of credit in LatAm to increase. “If they get nervous in US and Europe, there is going to be a knock on affect in Latin America and an increase of one or two percent in interest rates is not going to compensate for the risk,” he claims.
At the same time, Grikscheit, who has been advising GPs and LPs on the formation of PE funds since the mid 1990s in LatAm, says she sees more flexibility being incorporated into fund structures at inception. Most of the new PE funds want outright control, whether they buy alone or part of a consortium. They are also being more open-minded about exits.
“General partners are not being as mechanical about exit timing,” explains Grikscheit. “The investment horizons are typically seven to 10 years but if they get a good opportunity at year five, and show a partial history of returns, that can help with the next fund,” she adds. And Bonchristiano says having an equity cushion will help his firm keep investing through the cycle.
Even those taking minority stakes in companies are being more assertive about exerting authority over the board and protecting their investment over the life of a fund. For example, Aureos, which typically takes minority stakes in companies financed with a mix of debt and equity, structures dividend-like payments over the life of investments back to investors.
“We only invest in companies that are cash generative from day one. Where there is excess cash flow we seek to have that returned as soon as possible, reducing exit risk and currency risk,” says Peterson. Minority investors got in trouble by relying too heavily on high exit multiples, adds Peterson, who says Aureos also seeks to sell to strategic buyers.
As the sub-prime crisis in the US infects LatAm credit markets, PE is feeling the pinch, with LBO deals that seemed so easy just a few months back being put on hold. And even though PE participants are optimistic, it remains to be seen how lasting this revival is. A protracted bear market will test the investment strategies and staying power of regional newcomers. And though they may emerge stronger than ever, the PE revival will only endure if there is more transparency on fund raising and returns, says LAVCA’s Ambrose.
“If you want investors to have confidence in the industry, you need to be able to produce the benchmarks as a region,” says Ambrose. LAVCA plans to spearhead an initiative to improve information gathering on fundraising, investments and exits in the region over the next three years, and to support efforts to generate data analysis on internal rates of return. This should help the industry construct a foundation for growth going forward. LF