Country-Based Strategy for Future LatAm Investing

Private equity investing in Latin America is starting to resemble the old joke about New England weather. If you don’t like the current climate, wait five minutes.

The Internet was last year’s hot button thanks to excitement generated by the initial public offerings of Starmedia and El Sitio, both of which raised hopes that IPOs would be a viable exit option. The buzz only increased when Patagon and Zipnet were sold at high valuations and a frenzy of disbursement activity took place between fourth quarter 1999 and the Nasdaq crash.

Indeed, it seemed that everyone had hopped on the bandwagon as a survey conducted last year by KPMG reported that 63% of respondents said Internet and e-business would be their primary investment focus through 2003.

This year’s report, however, tells a much different story.

Presented last week at the Third Annual Conference on Latin American Private Equity sponsored by The Economist, the report signals a shift away from general Internet investing and toward country-focused investment.

Overcoming Past Problems

Indeed, aside from a few presentations of successful Internet models like and, the word Internet was hardly mentioned during the Economist conference. Brazil garnered the preference of 60% of respondents when asked where they would be focusing over the next two years, and 37% said they would focus on Mexico. Argentina, which came it at number three, received the remaining 3% of the vote.

This represents an enormous change. Over the past two years, 20% of investments went to Argentina, 3% to Chile, 50% to Brazil and 27% to Mexico.

These numbers also signify a huge vote of confidence in Brazil and Mexico, despite inherent problems for equity investing in both countries, and indeed in all of Latin America. In general – despite much volatility and a seemingly endless string of crisis throughout the region in the 1990s – Latin America also has seen vigorous growth, which has been spurred by privatizations of formerly government-regulated industries, capital market reforms and ADR offerings. However, each country presents its own problems.

For example, Mexico has virtually failed to produce an equity culture despite consistent, NAFTA-driven growth over the last five years, including 7% growth in 2000 despite the great hopes investors hold for the new Fox government. Critics attribute this failing in large part to the difficulty of penetrating family-owned businesses.

Also in Mexico is the question of how much effect the economic slowdown in the U.S. will have on its southern neighbor. Since NAFTA came into effect in 1994, Mexico’s exports to the U.S. have grown at a rate of 20% a year. Thus, economists predict that Mexico’s trade deficit will invariably grow, push the peso down and spur inflation.

In assessing Mexico’s private equity climate, Luis Porras, principal of Monterrey Capital Partners, said access to good deals is too difficult for private equity funds. The reasons for this quality void include too few dedicated full-time local teams, too many funds with limited experience working with the Mexican business community and vice versa and a dearth of basic industry and company information.

As a consequence, he said, corporations have been taking the place of the private equity funds and have even kept the best deals for themselves. As a percentage of GDP, private equity capital in Mexico is lower than either in Brazil or Argentina. In 2000, that number was only 0.04% in Mexico, compared to 0.43% in Argentina, and 0.16% in Brazil.

R. Andrew de Pass, a managing director with CVC Latin America, added that in Mexico, private equity remains an unproven asset class. CVCLA has invested $371 million in 23 transactions in nine Latin American countries since 1998.

“Mexico needs investment grade status, the stamp of macroeconomic approval, banking reforms and new management incentives [for private equity to flourish],” he said. “Mexico needs to move from a cash-bonus-based culture to an options-performance based one.” He added that there is a 30%-to-40% IRR hurdle rate, and a lot of returns come from leverage. “When you risk-adjust the returns compared to the S&P 500, then equity is an interesting but unattractive asset class,” he said.

Trepidation on Entry

Monterrey’s Porras said international private equity funds approach the market mostly opportunistically. Total investment equals only about $250 million, “which is nothing,” he said. The main firms that invested in Mexico between 1992 and 2000 are Hicks, Muse, Tate & Furst (18%); J.P. Morgan Capital Corp. (14%); CVC Latin America and The Blackstone Group (10% each); Newbridge Latin America (7%); and Advent International (6%). The balance of the investment comes from the amorphous “others,” including the scarce local funds.

The survey also provided a glimpse at where the money is being put to work. Primary investments by industry include 19% in telecom; 17% in food and beverages; 15% in financial services; 13% in media and entertainment; 9% in retail; 5% in construction; 1% in IT; and 21% in other categories.

“To date, most of the transactions [have been] looking to capitalize on Mexico’s domestic growth potential,” said Porras, adding, “but the main players have not been consistent one year to the next in participating.”

However, Porras believes, as did 37% of the survey respondents at the conference, that the timing is right for private equity in Mexico right now. “There’s an abundance of SMEs that are undercapitalized. There’s a scarcity of professional management. Business opportunities have been generated by NAFTA and now with Europe. And family-owned companies are facing a third generation change.”

Moreover, important reforms are being presented to Congress beginning this spring, including fiscal reform meant to lower the federal government’s dependence on oil income, which currently provides about a third of government income (plus a concern about whether oil prices will continue to fall), and reform in the electricity sector that will allow private and foreign investment.

“Things are changing,” concluded Porras. “You have to be there not to get lost in this new country.”

Indeed, being there was one of the primary mantrasstated by investors. Repeatedly, they agreed that management was the key issue.

“Don’t fall for the influential partner trap, focus on real management with relevant experience. You can’t run the show from New York,” said Paul Savoldelli, a principal with Hicks, Muse, Tate & Furst. “It’s critical to have resources on the ground to identify opportunities [both deals and exits], and to spot trouble early.”

Robert Wong, managing director, Mercosur Region of Korn/Ferry International, compared foreign corporate executives to soldiers in the Vietnam War, saying “the local companies they invest in fight like they’re fighting for a cause. It’s guerrilla warfare and the [guerillas] always win.”

Perhaps it’s not surprising then that 62% of survey respondents listed “incomplete facts” as the number two reason ventures fail, second only to “lack of available financing”, which won 65% of the vote. As a result, 50% of investors are doing more strategic deals, and 74% are performing even more due diligence, always a major issue in places with a lack of transparency and historical record-keeping.

Meet Me in Rio

That 60% of respondents said they would be focusing on Brazil over the next two years indicates a tremendous boost of confidence for the country that devalued its currency only two years ago. While interest rates continue to come down, reforms that protect minority shareholders have yet to take place.

In fact, last year at this time, in another EIU survey, 80% of respondents cited Brazil as the country whose macroeconomic environment worried them most in 1999. Another 62% said their view of Brazil’s long-term market potential had been damaged by the devaluation. All this led to greater difficulty in justifying investment in Brazil for a majority – 65% – of regional managers.

Today the pessimism has all but faded as interest rates continue to drop, spurring entrepreneurial activity, and the general macroeconomic situation improves.

alvaro Gonzalvez, a partner at Stratus Investimentos Ltd., So Paulo, said that private equity and venture capital activity in Brazil reached record highs in 2000. However, he notes that was due largely to the Internet frenzy. Eight-seven deals were announced last year, 56 of them Internet-related and, overall, a 129% increase to the 38 transactions announced in 1999.

Despite the jump in deal flow, the amount invested fell below expectations. The average investment deal fell from about $22 million in 1999 to $16 million last year.

“Small companies are the name of the game. They have high growth potential,” Gonzalvez said. Two factors should be closely monitored going forward in assessing the scenario for private equity in Brazil this year, he added. These are the increasing presence of players not affiliated with financial institutions and the tendency toward small to medium-sized investments. These SME investments replace the privatizations in 1997-1998, and the pure Internet plays in 1999-2000.

Which Way Out

Another perennial issue in Latin America is exits. A full 33% of respondents said they had not executed an exit strategy to date. Another 33% said they had exited less than 10% of investments; 24% had left 10-19% of investments; and only 3% had divested 40% or more. Of these, 67% have exited by means of a foreign strategic investor; 60% through a local sale; and only 6% through a local IPO.

Eduardo Campiani, managing director at Advent International, and the man credited with bringing private equity to Argentina, said to mitigate against risk his firm often contacts potential buyers before closing a deal. Advent also reviews exit plans against others it has made, compares expected performance to similar deals done, and focuses on Brazil, Argentina and Mexico, the three big Latin American economies, because that is where most M&A activity occurs, presenting greater exit opportunities from the start. Perhaps going against the grain, Advent invests in middle market companies, those with revenues of between $20 million to $60 million a year.

“I don’t know if it’s easier to exit larger companies,” Campiani said. “But it’s more difficult to get good IRRs.”

Holly Werner can be contacted at Story Feedback.