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An Awkward Renaissance

The private equity industry is undergoing a rebirth around the world, but Latin America might not benefit from boom times in the business.

The private equity industry is undergoing a rebirth around the world, but Latin America might not benefit from boom times in the business.

Investors lined up to buy shares of Brazilian airline Gol.
Argentina's economic collapse of 2001-2002 was a catastrophic event for millions of ordinary Argentines, not to mention hundreds of thousands of bondholders around the world. It was also a disaster for the private equity industry. Investors had stampeded into the country in the late 1990s, snapping up everything from cable TV operations to ice cream parlors, in the belief that market reforms and a stable currency would deliver strong economic growth. But the crash turned these investments to dust long before they could be offloaded at a profit to deep-pocketed multinationals. Many of the private equity firms involved in these deals closed down or left Latin America.

Finding Value
That long winter is drawing to an end, although the focus of attention has shifted away from Argentina to Brazil and Mexico. And this time, investors say, nobody is taking leave of their senses by buying into weak companies at the top of the market. US-based private equity firm Advent International closed its Latin America Private Equity Fund III in October, easily hitting its $375 million target. In May, Washington-based emerging markets investment firm Darby Overseas Investments closed its $175 million Darby-BBVA Latin American Private Equity Fund, focusing principally on Mexico, Brazil and the US Hispanic market. In Brazil, São Paulo-based investment firm Stratus Investimentos is fundraising for a new private equity fund.

Firms are focusing instead on value, looking at resilient industries and concentrating on countries that are less likely to unravel than Argentina. Says Richard Frank, CEO at Darby Overseas Investments in Washington: "There is increased interest in private equity investing in the emerging markets, especially Asia and Latin America are benefiting from this. In the shakeout after 2001-2002, some investors were hit hard and they are coming back now. They are the survivors so there are a smaller number of [private equity] companies in business, but they are getting more attention now."

According to the Latin American Venture Capital Association, private equity funds raised $1 billion to invest in the region in 2004 – the best year for Latin America since 2000 – and that figure will likely be similar or slightly higher this year. Venture Equity Latin America, a specialist publication, says that in the first half of 2005, private equity and venture capital funds invested over $560 million, closed on over $441 million in fund raising and took in more than $720 million from sales of companies. The industry's performance in Latin America is so vigorous that dealmaking in the first half of the year came close to the totals for the entire year in 2003 and 2004.

Asian Tigers
Although the pace of private equity activity in Latin America is certainly picking up, its recovery pales in comparison with Asia. Investors' fascination with Asia, especially China, remains as intense as ever. Last year, private equity firms raised $2.8 billion to invest in Asia, or just more than half the total funds raised for the emerging markets, according to the Emerging Markets Private Equity Association (EMPEA). Investors have committed $8.9 billion for Asia, or three-quarters of the global total, for 2005. It's easy to see why: investments in Asia achieved $9.7 billion in net realized capital in the first half of 2005 and posted mean internal rates of return of 54%.

The Hunt for Yield
But Ernest Bachrach, who runs Advent's Latin American business, says Latin America has some important strengths that are obscured by the region's mediocre economic growth record. "Latin American service sector companies are growing in an environment where the macroeconomic scene is not really the whole story," he says. "It's not like Asia, where manufacturing is driving growth. Here it is services that have grown a lot, and that's been our story in the last 10 years."

Money is dribbling back to the region anyway because it is beginning to look more attractive. Years of rational economic policies are paying off with stronger currencies, lower interest rates and gradual if unspectacular growth. Above all, investors everywhere are hunting for yield, and exposure to medium-sized Latin American companies in growth sectors could pay off handsomely. However, Alvaro Gonçalves, partner and director at Stratus, says fundraising can still be a struggle. "International investors lost track of Brazil for a while and our first presentations on the new fund were more about changes in the investment environment," he says. "Since 2001, Brazil has introduced new corporate and bankruptcy laws, approved arbitration and the stock market has a corporate governance index and a new small-cap segment." Still, he reports increasing interest by investors who are starting to travel to Brazil scoping investment opportunities.

However, a survey by EMPEA says that investors still see Latin America as a far less attractive place to invest in than Asia or central and eastern Europe. EMPEA found that distance, instability and the difficulty of exiting investments are the main deterrents to investing in the region.

Playing it Safe
Those that do invest generally play safe. Advent focuses on service companies that can generate cashflow and revenue growth of 30%-40% annually. Stratus will focus on middle-market companies and hopes to post dollar returns of 30% a year. Since the collapse in Argentina, leveraged buy-outs have evaporated. Interest rates are still too high in most countries – especially Brazil – to justify LBOs, and refinancing risk remains very high. Investors, especially foreigners, often insist on control either by holding a majority of a company's shares or through a shareholders' agreement. On the whole, private equity firms prefer low-risk industries that may lack the allure of a high-tech venture, but can reliably generate substantial volumes of cash. Given the substantial risks of investing in a turbulent region, it makes little sense to double the risk by backing businesses with an uncertain future.

Advent, for instance, owns Central Lav, Brazil's largest industrial laundry. All its Mexican investments are in services, ranging from recently-acquired mortgage lender Hipotecaria Casa Mexicana to Dufry, the world's fourth-largest duty-free retailer. The latter asset is a nice fit with another Advent property, Inmobiliaria Fumisa, which controls the commercial operations at Mexico City's airport – the largest airport in Latin America. In July, Advent took over Nuevo Banco Comercial, Uruguay's largest commercial bank, at the head of a syndicate of co-investors that includes Morgan Stanley Alternative Investment Partners and two of Europe's largest development banks, FMO of the Netherlands and Germany's DEG. Advent did not disclose terms of the purchase.

Brazil's Role
Most of the excitement is in Brazil, both because it has the region's best-developed local private equity industry and because it has a wealth of promising but undercapitalized medium-sized businesses. A decade of market-oriented economic policies has convinced investors that an upheaval of Argentine proportions is becoming more improbable by the day. Brazil also has the region's best-developed stock market, which has allowed some private equity investors to exit through the public markets. This matters, because IPOs generally deliver better pricing than traditional trade sales to bigger competitors that know their markets well and are less prone to overpaying. Last year's launch of Gol Linhas Aéreas Inteligentes, a São Paulo airline, on the New York and São Paulo stock markets was Brazil's best-planned and most successful IPO in years. Gol has grown fast, and is now the country's second-largest airline. Its shares have doubled in price in dollar terms since the IPO.

GP Investimentos, Brazil's pioneering private equity firm, has taken companies such as online retailer Submarino and railroad operator ALL public in the last two years. Submarino raised approximately $175 million via an IPO on the São Paulo Stock Exchange's Novo Mercado, selling just less than half its equity in March. Credit Suisse First Boston lead managed the deal. Submarino was backed by such blue chip private equity firms as TH Lee Putnam Ventures, Goldman Sachs and Warburg Pincus, in addition to GP.

The São Paulo Stock Exchange's Ibovespa benchmark index is up 42% in dollar terms this year and trading volume has increased 60% to $750 million a day. Although Latin America's stock markets are among the most volatile in the world, even seasoned investors are considering more seriously using the public equity markets as an exit strategy. They say that while valuations and trading volumes are being driven up by the global liquidity glut – foreign stock investors are very active in São Paulo and Mexico City – there are major structural changes in the markets that will affect the private equity industry positively.

Darby's Frank says that the markets in Brazil and Mexico in particular have become less vulnerable to catastrophic crashes or unsustainable booms. "The domestic markets in Brazil and Mexico are gaining in depth. Portfolio managers there are driving this. An IPO in Mexico these days would be 50% foreign bought, but instead of waiting for a US listing, they will make a play on a Mexican company by going directly to the local markets."

Given the industry's past reputation for excess and overindulgence, it is perhaps encouraging that the big players still left over from the bust of 2000-2001 are playing it safe.

Making it Easier

Private equity investing is becoming less of a specialist pastime, and several new structures are emerging to meet the needs of generalist investors. In August Eccelera, a São Paulo-based private equity investment firm that is ultimately owned by Venezuela's Cisneros Group, created a receivables investment fund as a conduit for private-equity investments in mid-sized Brazilian companies. The structure is designed to reduce investors' risk of losing their money by using a portfolio of eight-year, zero-coupon debt instruments backed by receivables and carrying a local investment-grade rating from Moody's as collateral for their equity investments. Shareholders will invest an initial R$200 million ($90.4 million) in senior shares and a minimum of R$2.5 million in subordinated shares, and this money in turn will be invested in companies identified by Eccelera. Over the fund's eight-year life, the value of the collateral will grow to meet the value of shareholders' original investment. However, senior shareholders are not promised any interest payments. Eccelera Administracão de Fundos will manage the fund's private equity portfolio. São Paulo-based Banco Itaú will manage the collateral portfolio.
International funds of funds are becoming more common, which allow non-specialists to diversify risk and outsource investment decisions to experts. These funds offer diversification by investment class and by region, as well as across funds, for instance by including secondaries – funds that buy original investors' stakes in private equity funds. New York-based Siguler Guff recently launched its $350 million BRIC Opportunities Fund, named for the main emerging market countries it will invest in – Brazil, Russia, India and China. The Fund aims to recruit 15-20 partnerships experienced in consumer services, financial services, telecommunications and media. The firm expects to invest $20 million-$30 million in each fund. However, two-thirds of the money is earmarked for ventures in China and India.

So Near, Yet so Far

Progress in private equity in Mexico is disappointing given its considerable advantages as an investment destination. It has an investment grade rating, a stable currency and a free trade agreement with the US. Yet, Federico Patiño, deputy director general at Mexico's government-owned development bank Nafin, says that the lack of a clear policy supporting private equity investment, limited general knowledge within the country and limited number of specialists is a hindrance.
Investors complain that Mexico needs to strengthen minority investor rights. Plans to introduce a new corporate structure known as a Sociedad Anónima Promotora de Inversión (SAPI) is advancing slowly through Congress. SAPIs would offer stronger investor rights and allow them to go public without having to meet the stock exchange's full listing requirements for three years.
The country still lacks an appropriate US-style vehicle for limited partners to invest in private equity, which has forced funds to incorporate offshore – often in Canada – adding to the cost and complication of doing business in Mexico. Although government officials recognize this is a serious problem, they have yet to decide on a new structure for private equity funds in Mexico. Still, the government is planning to set up a fund of funds to consolidate its disparate private equity investments in a single semi-autonomous fund that would channel financing to privately managed private equity firms.
Mexico's pension funds barely invest in listed shares so it is no surprise that they spurn private equity, unlike Brazilian or Chilean funds that already hold a sliver of their portfolios in private equity vehicles. However, the government has ruled out any relaxation of rules limiting pension-fund investments in private equity.

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