Feature: A New Year, A New Latin American Strategy –

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

Both domestic and local private equity funds that invest in Latin America have shifted their focus yet again, according to a survey by KPMG produced at last month’s Third Annual Conference on Latin American Private Equity sponsored by The Economist. This time it’s away from general Internet investing and toward country-focused investment.

The Internet became last year’s hot button thanks to excitement generated by the initial public offerings of Starmedia and ElSitio, 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 the fourth quarter of 1999 and the Nasdaq crash. Everybody jumped on the bandwagon. In fact, last year 63% of respondents to this survey said Internet and e-business would be their primary investment focus through 2003. No longer.

This year, aside from a few presentations of successful Internet models, such as Officenet.com and Laborum.com, the word Internet was hardly uttered, and survey respondents have switched to a country focus instead, settings their sights on Brazil, Mexico and Argentina.

Brazil garnered the preference of 60% of respondents when asked where they would be focusing over the next two years, while 37% said they would focus on Mexico. Argentina received the remaining 3% of the vote.

This geographic shift 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 represent 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 crises throughout the region in the 1990s, Latin America has also seen vigorous growth, which has been spurred by privatizations of formerly government-regulated industries, capital markets reforms and ADR offerings. However, each country presents its own set of 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, and 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 of an effect the economic slowdown in the U.S. will have on its neighbor. Since NAFTA came into effect in 1994, the Mexican economy has become more reliant on exports to America. An economic slowdown in the U.S. could reverse the trend and create a deficit, pushing the peso down and spuring 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 are manifold, and include the fact that there are few dedicated full-time local teams; funds have limited experience working with the Mexican business community and the business community has limited knowledge about the benefits of private equity investment; and there is a dearth of industry and company information. As a consequence, he said, corporations have been taking the place of the private equity funds, even keeping the best deals for themselves. As a percentage of gross domestic product, 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. CVC Latin America 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 with 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 money is being put to work. Primary investments by industry include 19% in telecommunications; 17% in food and beverages; 15% in financial services; 13% in media and entertainment; 9% in retail; 5% in construction; 1% in information technology; 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 do 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 [small to medium enterprises] 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 the Mexican Congress beginning this spring, including fiscal reform meant to lower the government’s dependence on oil income, which currently provides about a third of government income, 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 main stated mantras among investors. Over and over again, investors 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. “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 with 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,” with 65% of the vote. As a result, 50% of investors are doing fewer, but more strategic, deals, and 74% are performing ever more due diligence, always a major issue in places with a lack of transparency and historical record-keeping, in place as a safeguard.

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 Economist 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 the general macroeconomic situation improves and interest rates continue to drop, spurring entrepreneurial activity.

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

Despite the greater number of deals, the amount invested dropped 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,” said Gonzalvez. Two factors should be closely monitored going forward in assessing the scenario for private equity in Brazil this year, he said. These are the increasing presence of players not affiliated with financial institutions and the tendency toward small to medium-sized investments. These SME investments will replace the privatizations in 1997-’98 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% to 19% of investments; and only 3% had divested 40% or more. Of the firms who had exited investments, 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 risk Advent often contacts potential buyers before closing a deal. Advent also reviews exit plans against others it has made; compares expected performance to similar deals, and focuses on Brazil, Argentina and Mexico. Most M&A activity occurs in the three big Latin American economies, and exit opportunities are greater from the start. Perhaps going against the grain, Advent invests in middle market companies, those with revenues of between $20 million and $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.”