Latin America Private Equity: In The Starting Block
Pauline Renaud, December 2009
Although Latin America has been dragged down by the worldwide financial crisis and the prolonged recovery in most countries, it is still considered as a region that offers attractive opportunities for private equity investors. Once local countries start emerging from their current difficulties, and buyout firms find it easier to obtain capital, the investment outlook for Latin America should brighten considerably. This revival of optimism will also be boosted by a number of recent legal and political developments in the region. Only time will tell how soon a sustained uptick will take hold, but in this rapidly-changing landscape, investors should put themselves in the starting blocks and prepare to seize potential opportunities and maximise returns.
Optimism following a difficult year
The financial crisis has indisputably had impact on private equity activity in many Latin American countries. In 2007, there were 38 announced buyouts worth $4.87bn, according to Dealogic.
Last year this figure plummeted to 18 deals with a total value of $1.25bn. And a recovery does not seem likely before the end of 2009, as only $391m worth of financial sponsor deals were announced to the end of October this year. Notable transaction in 2009 include Linzor Capital Partners’ $35m purchase of a 60 percent stake in Corporación Santo Tomás, a Chilean university, and the $4m acquisition of Peruvian importer of beauty products IasaCorp by Aureos Capital.
Despite lower deal values, local experts remain positive. They point out that the number of deals has remained relatively stable since the collapse of Lehman Brothers more than a year ago. They are also looking at the drivers of future activity, and suggest that the ability of buyout firms to attract limited partner commitments focusing on the region remains strong. “Even though Latin America experienced a decline in the value of deals and exits, statistics show an increase in fundraisings,” says Alejandro D. Fiuza, a partner at Marval, O’Farrell & Mairal. Fundraising is expected to continue rising as investors’ aversion to risk diminishes in the months ahead. Many fund managers believe limited partners will start committing to new funds in the region by the end of the year.
Presently, the level of investment activity varies substantially from one country to another. Private equity firms prepared to compromise historical returns for less risk have been selecting their investment destinations carefully. Brazil has emerged as the top target. Buyout houses are encouraged by the attractive prospects Brazil has to offer. The country is eager for investment in infrastructure and real estate; two crucial sectors of a growing economy with a developing middle class. In addition, Brazil is set to host the football World Cup in 2014, as well as the summer Olympic Games in Rio de Janeiro two years later. In the meantime, the country is exploring its massive deep water oil discoveries, as well as developing certain sectors such as tourism and agribusiness. Brazil has also enjoyed a resurgence of its local capital markets, where more certainty and liquidity has created a platform for exit strategies that were not viable in the past.
Other countries, such as Chile, Colombia, Peru and Mexico, are also attracting potential investors. The Latin American market is now more globalised than before, and is easily accessible to PE firms from Europe, North America and Asia, according to Sergio J. Galvis, head of the Latin American practice at Sullivan & Cromwell LLP. “A more recent and equally important development, however, has been the rise of a stable middle class in countries like Mexico, Brazil and Colombia,” he says. “As a result, investments in companies servicing domestic markets also are becoming increasingly attractive as the domestic client base becomes more established.” In addition, as the region has opened up to foreign injections of capital, it has benefitted from the expertise brought by overseas dealmakers. It has also been forced to adapt to their general expectations for a suitable regulatory framework that supports their investment methods. “Throughout Latin America, the problem of implementing regulation that will work in practice has been resolved through what is, in effect, a trial and error process, with fund managers educating local regulators on the asset class,” explains Francisco Acuña, chairman and CEO of InTrust Global Investments, LLC. “The Latin American Venture Capital Association (LAVCA) has played an active role on this front, with board members engaging with regulators in the policy revision process,” he adds.
In some countries – notably Brazil and Mexico, but more recently Argentina, Colombia and Chile – fund managers have formed trade associations aimed at promoting local private equity and venture capital industries, as well as obtaining support for structural regulatory reform. This initiative has been particularly successful in Brazil. Furthermore, the country has accelerated some regulatory provisions that benefit shareholders and creditors. “Recent legislation that modernises the country’s bankruptcy laws has provided better protection for minority investors, as well as improved corporate governance practices. Such developments have been encouraged by the Novo Mercado – a listing segment of the Sao Paulo Stock Exchange, known as Bovespa – and the confirmation by the Supreme Court that foreign arbitral awards would be recognised by Brazil’s courts,” says Marcello Hallake, a partner at Thompson & Knight LLP. Brazil has also introduced favourable tax treatment for private equity investments, taking in capital gains, income tax and double taxation. Colombia has taken similar steps to Brazil in order to address and reform minority protections through corporate law, an essential aspect of any private equity transaction.
ut legal change has not only affected investment. Fundraising is another key area of focus for countries in Latin America. A wave of regulatory change swept across the region, designed to draw limited partner commitments from local institutions and stimulate the growth of the domestic private equity industry, as well as allow participation in the global alternative asset class. “Following Brazil’s initiative, Colombia and Peru made advances on the regulation of pension funds in order to encourage local sources of institutional capital for private equity firms,” explains Adolfo R. Garcia, a partner at Ropes & Gray LLP. “In December 2008, Peru’s Banking and Insurance Superintendence allowed the country’s four private pension funds to diversify their private equity portfolios to international asset management firms,” he adds. But there have also been setbacks. Argentina recently decided to renationalise its pension fund system, consequently preventing public and private funds, as well as insurance companies, from investing in private equity.
Although it was intended to protect workers and retirees from the global turmoil in financial markets, some experts and investors fear this move may harm private equity opportunities in Argentina in the long term.
Efficient structures to seize opportunities
Latin America offers unique assets compared to other regions, notably due to its extensive natural resources. In a domino effect, investments in natural resources will necessarily require the development of related infrastructure projects, in order to transport goods from remote areas. Brazil in particular is a vast country in need of huge networks. In addition, a boom in certain sectors, such as ethanol, agribusiness, real estate and tourism, present opportunities for consolidation. By tapping into a wide spectrum of compelling sectors and companies, investors are able to diversify their portfolios in the region and spread the risk. “Moreover, although family-owned businesses still represent the majority of companies in the region, new generations of family-owned business are increasingly interested in private equity for expansion,” adds Mr Acuña. This greatly expands the number of potential target companies in the short term. In the long term, exit options are also enhanced by the region’s stock markets, which are now large enough to support significant IPOs.
But Latin America is not a one-dimensional playing field. Assumptions can quickly be shattered and forecasts that seemed reasonable may suddenly become wildly inaccurate. As a result, fund managers to be particularly careful when considering an investment in the region. “Investors may not be familiar with many of the risks involved, including currency exchange risk and, in some well-known countries, political risk,” confirms Mr Hallake. “It is very important for foreign investors to have reputable local partners in the region to guide them through the local environment.” A lack of transparency is often cited as one of the main risks when operating the region, hence the need to be meticulous in the due diligence process and draw on experienced advisers. Such advisers can help investors structure deals efficiently to maximise future returns and identify potential legal issues. “While political risk has decreased in many countries in the region, investors should continue to monitor legal developments and ensure that they take full advantage of legal regimes for the protection of foreign investments,” explains Mr Galvis. “For those investors interested in natural resources, environmental compliance should continue to be a focal point of any diligence process,” he adds.
As in any transaction, foreign private equity investors are urged to conduct thorough due diligence, with extra care due to the pitfalls of operating in an emerging markets. “Investors need to perform the necessary due diligence and properly structure their investments, notably in terms of dispute resolution mechanisms,” adds Mr Hallake. “In many cases it will be preferable to resort to international arbitration and to avoid local courts, which may be less predictable and often much slower at resolving disputes.” Corporate governance frameworks and exit rights are two other major issues to consider when executing a transaction. Experts explain that investors should ensure they are given a level of board representation proportional to their investment. They should also evaluate what type of veto rights, pre-emptive rights, rights of first refusal, and tag-along/drag-along rights would be appropriate for the investment considered.
Concerning exit options, investors need to carefully evaluate the planned duration of their investment. IPOs are no longer the most attractive exit route for portfolio companies, so buyout shops need to obtain appropriate rights in the initial deal structure, to be flexible with their exit route down the line. “In addition to carefully assessing the investment timetable, investors and their counsel will often consider requesting additional exit rights, including the ability to force the target company to be sold to a third party buyer, or for the investor to sell its shares back to the original shareholder,” says Mr Galvis. Taking such steps not only allows investors to avoid potential issues from impeding a future transaction, they can also make it possible to take advantage of new opportunities arising from a market recovery in the months ahead.
How close Latin America is to economic recovery is unclear. Most experts are prepared to be quite patient. “Our hope is that activity will pick up in the second half in 2010 and will lead the way to increased activity in 2011 and 2012,” says Mr Fiuza. But this recovery will not be homogenous across the region. High expectations are placed on Brazil, Colombia, Chile, Peru, and Mexico. “These countries are likely to see most of the activity in the region, although as investments begin to rise, other countries may accelerate reform efforts in a bid to attract foreign capital,” suggests Mr Galvis.
Some Central American countries may also spark an upturn in buyouts over the year to come, as they implement regulatory reforms to bring in foreign capital. However, the situation could remain difficult in Venezuela, Bolivia and Argentina, due to political factors. To be sure, when signs of the recovery do grow stronger, investors will not be deploying capital with the same appetite for risk as they did two or three years ago, and the top targets will be those with a solid track record of cash flow and a capable management team, operating in a sector that is structurally sound.