Feature: Latin America Risks May Be Worth Taking –

Attention private equity investors: Are you tired of hearing about too much money and too few deals? Are you looking for traditional sectors in a tech-crazed market? Do you wish you had made Internet investments when the industry was still young? Well, look no further. Latin America is ready and waiting – maybe.

While buyout firms have been flocking to invest in Western Europe, and some are taking gambles on the recovering Asian markets, a handful of investors have settled into Latin America, which they think could be a neglected emerging market with lucrative possibilities. To see the big names that have chosen to focus funds on the region, like Hicks, Muse, Tate & Furst, Chase Capital Partners, Carlyle Group and Texas Pacific Group, one would think that Latin America is the best thing since slicedbread.com. But in actuality, only 12% of international alternative investment from North America was allocated to Latin America in 1999, as compared with 70% to Western Europe for the same time period, according to the 1999 Goldman, Sachs & Co. and Frank Russell Co. Report on Alternative Investing.

However, unlike investments in Asia, that percentage has been increasing since the mid-1990s. Since 1997, Latin America witnessed an increase of 11.8%, or $1.7 billion, in alternative asset investments from North America, according to the same report.

In Merrill Lynch’s March 15, 2000 Theme & Profile Investing Update, Latin America, along with Southeast Asia, is currently considered to be one of the most attractive emerging markets for the globalization sector. To be sure, Latin America is still small potatoes in the grand scheme of international private equity investing, considering its volatile political systems, weak capital markets and uncertain exits, but sources say that if you have what it takes, the returns may outweigh the vices.

Privatization, Consolidation, Telecommunication, Oh My!

With the economic downturns of Asia and Russia fresh in the minds of investors, investing in developing markets may not be for everyone. But in Latin America, opportunities are arising from changing political and economic systems abound, and investors remain optimistic. Investors currently active in the region identify privatization, consolidation, growing family businesses and technology as the main sources of deal flow.

“[Opportunities] are coming from family businesses,” says Federico Carballo, a principal at Compass Capital, a private equity firm focused mainly on growth equity in Latin America. “They want money to grow and because of the difficult capital markets that the region faces, [they] can’t raise that money in the capital markets, so they have to raise it privately.”

Privatization is opening up numerous industries. One example is the recent announcement that the Paraguayan government plans to sell off state owned companies in telecommunications, water and sewage, power, cement, oil, and railways.

Darby Overseas Investments Ltd., a Washington, D.C.-based firm focused on Latin America, has found a vast spectrum of opportunities in infrastructure due to privatization. Darby Latin American Mezzanine Finance, the only U.S. fund providing mezzanine financing to the region, has made investments in the telecommunications industry, power and energy, water treatment and water supply, and all forms of transportation. “We’ve found as the only provider of mezzanine that we’re seeing everything . . . including private equity providers coming to us,’ says Robert Graffam, managing director of that fund.

Since the region is relatively new to the private equity world, there are also a number of sectors yet to receive adequate attention.

Compass Capital’s Carballo says the business services sector is one that he sees becoming an important component of the Latin American economy, as it is in the U.S. Business services has “very interesting risk-return dynamics,” he says.

Compass Capital Fund LP, a Latin America fund sponsored by Compass Capital, Chase Capital Partners, and Capital International CDPQ, in April partnered with Iron Mountain Inc. to target records management companies throughout the region (see story page 14).

The paradox of Latin American investing is the unrelenting optimism considering the outward distress of the region. With few exceptions, buyout firms that have invested in the region while fully aware of the economic and political turmoil, have only positive outlooks, as evidenced by the fact that Argentina, currently in a recession, remains one of the most competitive markets in Latin America.

“One country we like is Argentina,” said John Crocker, a placement agent at Donaldson, Lufkin & Jenrette Asset Management. “Even though they’re in a severe recession right now, they’ve been making significant economic reforms . . . and it’s been reassuring to investors that the parity between the Argentinean peso and the dollar has remained. And that the new government is pursuing labor reform.”

Carballo says he is confident that Latin America is moving toward certain improvement. “Yes, you have the cycles, you have a devaluation here and there, you have interest rates in the U.S., you have Nasdaq falling,” he says. “All these things are going to cause pressure and the appearance of deterioration, but the underlying trend in my mind is clear.” Despite constant transition, most investors agree that better times are on the horizon.

The Tech Revolution

As has been the case in much of the developed world, Latin America has been infected with the technology bug. Sources say that technology and Internet-related projects are hot there.

In a region of reform, technology has brought the most dramatic change to the region, says Pedro Chomnalez, a director with a focus in Latin American investments at CSFB Private Equity. “It’s replicating what has happened in the U.S. but with a lag time of at least 3 years,” says Chomnalez. “So, it’s very comparable to what is happening in Europe right now. The portals occurred in 1997-1998 . . . [now] I would say most people are focusing on business-to-business projects, infrastructure and technology support.”

Private equity firms are certainly taking hold of the opportunities and have been for some time, all the while recognizing possible pitfalls.

New York-based Chase Capital Partners took a chance on StarMedia Networks Inc. back in 1997, purchasing about one-third of the company for $25 million. The company now operates the largest Internet portal in Latin America.

Banc of America Equity Partners Latin America last month launched Structured Intelligence (SI) to provide Latin American corporations with IT services. The company expects to see growth of 20% to 30%, according to SI’s president and chief executive officer Daniel Vinoly, despite industry analysts’ prediction that Latin American markets, as a whole, will grow 13% through 2003 (BUYOUTS, May 1, p. 25).

Media giant Hicks Muse teamed up with Liberty Media Corp. and Motorola Inc.’s broadband communications sector in May to form Digital Latin America (DLA) to accelerate the launch of digital programming and Internet service throughout the region.

Although the technology rage is spreading with the same enthusiasm it had in the U.S., the markets are smaller and the proliferation of Internet companies will not spread itself as thin.

“Over the last year and a half or two, you might see three or four companies maximum in any kind of sector,” says Frederick Smith, managing director of the international private equity group at CSFB Private Equity. “That would be the most you see – it’s much more selective and by the time you’ve got twp or three sites in something it’s viewed as being crowded.”

Under the Microscope

Unlike the Western European market, the countries making up Latin America are vastly different with respect to their market maturity and industry opportunities.

“It’s hard to generalize,” says CSFB Private Equity’s Smith, which has invested approximately $275 million in the region. “You can say oil and gas [have good opportunities] if you are talking about Brazil or Mexico, [but] there’s no significant opportunities for investment in oil or gas in Chile. In Chile you may be talking about natural resources, banking insurance because of the level of development and the sophistication of the financial system relative to others.” CSFB Garantia, a Brazil-focused fund affiliated with CSFB Private Equity, has made investments in cable television, construction, railroads, a regional airline, and an Internet-related company.

To date, most firms have focused on Mexico, Argentina and Brazil, although Chile and Venezuela have also seen activity.

Mexico

Mexico, one of the largest markets in the region, has recovered its position as a favored country for investments since the “Tequila Crisis” in 1994, when the peso collapsed. Mexico, like Argentina and Brazil, has a lot of fragmented industries that could benefit from consolidation. “When we started off in 1996, it was just after the Tequila Crisis, and we weren’t sure what we would be able to do in Mexico at that time,” says Ernest Bachrach, chief executive of Advent International’s Latin America office. “We were looking more toward Argentina, which seemed more developed in terms of capital markets. As it turns out we have almost two-thirds of the portfolio in Mexico, and the smallest part of our activity is in Argentina.”

Despite the fact that Mexico has not embraced the technology sector to the same extent as Argentina and Brazil, it continues to offer a plethora of opportunities in infrastructure and other traditional sectors. Between 1995 and 2010, foreign investment opportunities in basic infrastructure, such as highways, electricity, natural gas, and water, is expected to total as much as $46 billion, according to the Ministry of Communications and Transportation and the Mexican Investment Board.

Additionally, Mexico’s trade relationship with the United States has offered investors some level of protection in a sometimes unstable market.

“Obviously when you are trying to mitigate currency risk in a country like Mexico, you would tend to be investing in the North where there’s been a lot of economic development after NAFTA where it’s really export-oriented to the States,” says CSFB Private Equity’s Smith. “You don’t have the same level of currency risk as a company that is operating purely in domestic context.”

Argentina

Before its recession, Argentina was the country of choice for private equity investors in the region. Between 1990 and 1993, Argentina witnessed the third largest inflow of foreign investment in the world — US$28 billion, a third of which was invested in privatized assets, according to Fundacin Invertir Argentina, an organization formed by CEOs and government officials to promote business investments in Argentina. The country lost investments in the years following the Tequila Crisis, but saw another inflow in the late 1990s, with most investments in oil and gas, telecommunications, energy, financial services and mining. Furthermore, $11 billion worth of foreign investment projects have already been announced for 2000-2002.

In March, the government began selling 11 energy firms, five railroads and the remaining shares of YPF, which was the largest publicly owned oil and gas company in Latin America before the majority of its shares were purchased by European oil giant Repsol SA.

Sources say Argentina’s size, population and high standard of living are some of the reasons investors find it appealing. “[Argentina] may not have the industrial potential of Brazil but [it] also lacks the social dynamics that create problems that Brazil has,” says DLJ’s Crocker.

Another investor says he is a little more wary. He says he would be more inclined to look for deals in Brazil, Chile and some sectors in Mexico, than in Argentina right now.

Argentina, a country in recession, is the epitome of the paradox of Latin American investing, holding its position as one of the strongest candidates for investment.

“You have a dichotomy in the economies here [in Latin America],” says Advent’s Bachrach, “which is that, for example, Argentina is coming out of a recession now, Brazil had one, Mexico had one, and despite a recession climate where you have the car manufacturers down say 40% in terms of production, at the same time you have sectors like the IT sector growing at 40%. So from the outside the country may look like its in recession . . . but from the inside, there’s a lot of sectors, particularly the IT sector, that is growing in double digits despite the overall performance of the country.”

Brazil

A newer market than Argentina, the obvious reason investors take a good look at Brazil is sheer size.

Brazil represents one half of the Latin American market and has great potential for consumer markets, according to an analysis conducted by the Investment Committee of Amcham Brasil – Sao Paulo. The same report concludes that the least attractive factors in the Brazilian market are taxes, lack of control on the public debts and the Brazilian legislation, which restricts foreign investments in various sectors.

For example, foreign investments in financial institutions and insurance companies are restricted to minority stakes and are prohibited in the development of electric and atomic power. However, reforms are being made to give foreign investors more freedom.

Donde Esta la Salida?

The big question mark that looms over Latin America, for most general partners, is all about the exit. In a market with a volatile currency, unpredictable markets, and limited liquidity, exit options are few.

Investors agree that the Latin American public market – and even the Nasdaq to an extent – is not the way to go. “We rarely rely on the public market for exit,” says Compass’ Carballo. “We are mostly looking at investments that can be sold to strategic buyers.”

However, the Compass Capital Fund, which just closed in May, has yet to make an exit.

Advent’s Bachrach agrees that a strategic buyer is probably the best option. But as the sale will likely be to another foreign investor, determining whether a company will be an attractive sale in a few years means not only analyzing industry trends in Latin America, but also in the U.S. and Europe.

He also says that what started off as a boom of funding in Internet deals in Latin America seems to be “a balloon that’s been burst by a lack of access to an IPO market.”

Another option is finding a company – most likely in technology – that will be strong enough to go public on the U.S. market, says Fred Smith at CSFB Private Equity. “We now are more particular with industrial companies, or really any kind of company, thinking of investing in those companies which basically you have more than one way out,” he says.

Keeping It Real

LBO firms have to be cautious about who they are dealing with also. “The real issue in emerging markets is disclosure, disclosure, disclosure,” says DLJ’s Crocker.

Several investors mention that it is important to carefully examine the accounting books of target companies, as tax evasion and skimming is more prevalent than in the U.S.

“The quality of information [in Latin American deals] is not on par with the U.S. or Europe in terms of the management accounts, management information that one finds in mid-size private companies,” says Bachrach. “I think also audit standards are different than they are elsewhere.”

Smith says they have not found disclosure to be a problem. However, CSFB Private Equity tends to work with large professionally run companies, as opposed to smaller family-owned businesses, and prior to each investment, the firm hires accountants to audit the company and its books.

Of course, all these hazards mean one thing to the cautious investor – more due diligence and therefore more time, making patience not only a virtue, but a necessity.

As in any foreign market, a local presence is key also, sources say. It not only minimizes any hesitancy to work with outside investors, it creates a stronger network which will help with disclosure issues. “The only way you can tiptoe around the minefields is if you have someone who knows what that culture’s all about, is plugged into the local networks and that’s simply because disclosure isn’t necessarily adequate,” says Crocker.

Also, John Verbic, managing director and global co-head of ING Barings Private Equity Finance Group, which is responsible for placement agent services to domestic and international investment firms, has found that many limited partners prefer to invest with experienced general partners that have an established track record and strategy in the region.

Coming Soon

While many investors are content to invest their capital into Latin American markets, there is still a sense of uncertainty as to who the winners and losers will be in this game.

Private equity is a relatively new phenomenon in Latin America – only about fifteen years old. And the first wave of Latin America funds are just beginning to be fully committed, so the impact of the exit deficiency has not been fully evaluated yet.

It remains to be seen whether LBO firms will continue to fund Internet businesses with a questionable future, or whether they will shift to more infrastructure-type technology deals, Bachrach says.

As can be seen in Paraguay and Argentina, privatization continues. The growing telecommunications and technology sector is creating increasing room for consolidation.

“Really fundamentals have been improving across the board,” says Carballo, “Independence of central banks, banking systems that are more solid, more foreign banks participating in them, better fiscal development, opening economies, and development of pension fund systems – I think that, in general, you can see across the board that things have been improving. In some countries faster than others, but clearly the trend has been [established].”