FORUM: Private equity investment in Latin America
September 2016 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
Cate Ambrose at LAVCA moderates a discussion on private equity investment in Latin America between Julio C. Martínez at Fondo de Fondos, Kelly Tubman Hardy at Hogan Lovells, John Crespo at King & Spalding, Sergio A. Urías at Kirkland & Ellis LLP, and Luiz Filipe Aranha at Koury Lopes Advogados.
Ambrose: In broad terms, how would you characterise recent private equity activity across Latin America?
Hardy: In general, the last year or so has seen a decrease in the amount of capital raised in the region but an increase in funds invested. However, in order to discuss private equity activity in Latin America, it is important to understand that the region is not a uniform, homogenous market. On the contrary, there is great variation from country to country and the region-wide numbers mask significant and sometimes offsetting movements. 2015 saw the rise of Mexico – a trend that is continuing in 2016 – and a significant decrease in fundraising and investing in the Brazilian market. Some of the smaller Latin American markets such as Colombia, Peru and Chile have seen dramatic increases in private equity investment, but they are dwarfed by Mexican and Brazilian activity. Overall, the entrepreneurial environment in many countries and the decreased valuations in Brazil have created conditions that are full of opportunity for investors.
Aranha: Private equity and venture capital funds are waiting for the economic and political situation to calm down in order to further invest in their portfolio companies or new ventures. Divestment is also not a good option now since the real has devalued in relation to the US dollar.
Crespo: Latin America continues to make important progress in fomenting an attractive regulatory environment for private equity investment. Additional progress is needed, but recent developments in some of the major economies, such as Mexico, are a positive sign that private equity will drive economic activity in the region going forward. Despite the economic cycles, the embedded corruption and the usual risks associated with the region, investors have consistently looked for opportunities in Latin America over the last few years. Many funds are allocating increasing percentages of their committed capital to Latin America, many in the 25 percent to 35 percent range. There are also entire funds that are region specific, especially in the real estate, energy and infrastructure sectors, something that was nonexistent decades ago. In 2015, these region-dedicated funds were able to raise over U$10bn, which evidences the commitment of international and domestic investors in the region. Going forward, certain countries in the region will continue to offer attractive investment opportunities for fund managers. Taking Brazil’s recent struggles aside, major economies such as Mexico have experienced tremendous growth in their middle class. This growth has made Latin America an attractive destination for private equity focused on consumer stables.
Martínez: Uncertainty has increased around the region, which has resulted in a slower investing space. This uncertainty can be explained by the slowdown in economic growth, particularly as Brazil has an important level of PE-investment penetration. Political factors, such as the election of new governing parties in several countries, as well as changing economic policies in Peru and Argentina, have also had an effect. In other economies with a more stable macroeconomic environment, such as Mexico, external factors like the US presidential election, which could potentially affect free trade in the NAFTA region, has also had an impact. Another important factor is the foreign exchange depreciation against US dollar and its deep impact not only on the profitability of mid-term LPs, but also on the track record of the funds. Not only is confidence low in the investment space, it is becoming harder to raise capital, particularly for second-time funds. That is why we are seeing quite a concentration of the PE market in bigger funds, at least in Latin America.
Urías: We have seen slightly lower activity compared to 2014 and 2015, but prospects are stable. Most of the activity has been concentrated in Brazil and Mexico, although many PE funds are also looking at opportunities in Chile, Colombia and Peru. Argentina still needs to overcome some economic trials, but it is re-emerging in the scene as investors receive positive signals from the current administration. Consistent with their long term expectations, we are seeing large international PE firms opening local offices in Latin America or partnering with local fund managers to get access to local know-how and source investment opportunities. Most of the deals are small to mid-market buyouts. Leveraged buyouts are less frequent as a result of weak local debt markets and regulatory restrictions. High volatility and currency depreciation is pushing the investment horizon to 10 to 12 years as managers look for flexibility. As a result, hedging activity or creative fund formation structures that use local currency based return measurements may also be expected.
Ambrose: What factors are driving PE investment in the region? Which countries and sectors seem to be of particular interest to foreign firms?
Crespo: The most important drivers for private equity investments in Latin America are strong and consistent economic growth, predictable investment conditions and appropriate government actions with respect to the promotion of investments. Mexico and Brazil remain the most active private equity destinations. Recently, in part due to its economic struggles, Brazil has become relatively less attractive and investors have started shifting more and more toward Mexico. Mexican regulations have encouraged this transition by implementing legal and regulatory frameworks in favour of private equity, including allowing the pension funds to invest up to 10 percent of their assets in private equity investments.
Urías: Depreciation of local currency and low commodities prices are making targets relatively cheap for foreign investors, although high volatility also demands caution and carefully planned exit strategies. Companies with debt denominated in US dollars are also motivating PE activity in the region. There is a renewed interest in Argentina even though investors are taking a cautious approach to deploying capital. Mexico will continue to attract strong PE activity. Recent regulatory reforms and commercial maturity all suggest that Mexico is on an upward trajectory, in contrast with Brazil, where activity has experienced a downturn driven by political instability and corruption scandals. Healthcare, oil & gas, energy, information technology and consumer/retail will continue to be active sectors. We expect activity to remain stable during 2016 and 2017 given the large amount of ‘dry powder’ existing after a record 2014 in terms of fundraising.
Aranha: We have noticed a search for companies in the education sector and also online payment and banking solutions. The healthcare sector also seems to be a good bet in the Brazilian market, due to the new regulation allowing foreign investments in companies that provides healthcare services.
Hardy: In some jurisdictions, the government has played a significant role in promoting PE investment by strengthening the regulatory and legal frameworks that affect the PE sector and the industries in which PE funds invest. A relatively newfound appreciation for how PE can positively affect the economy, lead to job creation and promote overall growth seems to be at the root of this trend. Mexico is a good example. Its momentum has been driven by constitutional changes to its energy, financial and telecommunications sectors, as well as the passage of regulations that permit domestic pension funds to make limited PE investments. In terms of foreign interest in Latin America, Mexico has emerged as a new regional powerhouse, displacing Brazil as the most attractive market for PE fundraising. Brazil continues to generate significant private equity interest despite the political and economic crisis the country is currently facing. There is hope that Argentina’s more business-friendly administration will make it an attractive jurisdiction. Colombia has also been pegged by many as a new market to watch, and some significant transactions have occurred in Peru and Chile. Across the region, sectors like infrastructure, healthcare, energy, logistics and real estate have been important.
Martínez: Mexico and the Andean region – comprising Chile, Peru and Colombia – are attractive markets. They have executed microeconomic reforms in key sectors and private consumption is growing faster than traditional sectors involving commodities production, which is a sign of the transition to consumption-based economies with a solid development of the middle class. Furthermore, these countries have an attractive demographic structure that will boost the private services sector. Brazil remains in the background; though it is attractive in terms of valuation, it is awaiting a ramping up in the national economy as well as some degree of political stability. Even though there is a positive perception developing around Latin America, we have to be patient in light of new episodes of volatility in the short term.
Ambrose: Have any high-profile private equity investments caught your attention in recent months? What trends have you identified from these investments and what impact have they had on local markets?
Martínez: Three economic sectors look attractive, especially in the Mexican market: consumer goods and services, energy and telecommunications. Besides the direct investment opportunities, there are infrastructure and credit facilities related to these sectors which need to be financed. The consolidation of the middle class and demographic trends are favouring private consumption significantly. In Mexico, the energy sector presents various attractive opportunities. This includes, in the short term, the development of the power grid and transportation infrastructure for natural gas. In the mid-term, oil production and exploration show great potential based on low costs of around US$12 per barrel. Finally, reforms in the telecommunications sector have presented good opportunities for new business models with more competitive fees and also financing infrastructure projects for coverage solutions.
Aranha: Worth noting is the recent merger between Brazil’s biggest education operator, Kroton Eudacional S.A., and Estácio Participacões S.A., the country’s second-largest for-profit firm in the sector. This transaction will probably influence a consolidation movement in the education sector, as other companies take on the huge player resulting from the merger. In 2015, BTG Pactual and the Moll family jointly sold a 15 percent stake in hospital chain Rede D’Or to Singapore sovereign wealth fund GIC. Also in 2015, the US-based private equity firm The Carlyle Group, acquired an 8.3 percent stake in Brazilian hospital chain Rede D’Or São Luiz, through a capital increase. The expected effect of these transactions is to give confidence to players in the healthcare area to follow in the footsteps of GIC and Carlyle, increasing investors’ appetite in this sector.
Crespo: What has caught our attention has been the interest of private equity in the Mexican energy reform. This has effectively opened up a new private sector for private equity in Mexico. We are seeing a lot of private equity interest in the midstream as well as in the energy renewable space. Going forward, we anticipate that as the upstream section of the Mexican energy reform is developed, it will create additional private equity investment opportunities by way of oilfield services companies.
Urías: Last year The Carlyle Group acquired a minority stake in Rede D’Or São Luiz. This transaction was the first major investment since the Brazilian government allowed foreign ownership in healthcare companies. We expect this transaction to pave the way for similar deals in the near term. The transaction was innovatively structured, as The Carlyle Group acquired the equity interest via a capital increase, diluting the Moll family who were the existing controlling shareholders, as well as BTG Pactual. This confirms what we perceive as a trend: investors partnering with or acting as financial sponsors of local companies to leverage local experience. The complex structure of this transaction demonstrates that parties need to be creative in terms of ‘deal certainty’ and risk allocation.
Hardy: Much of the recent PE activity has been in the energy sector. This is particularly true in Mexico, where KKR, First Reserve and BlackRock have all made investments in the past year. These transactions are significant in that they are an indication that the reforms beginning in 2012 have had an impact. KKR’s $1.2bn sale-leaseback agreement with Pemex was particularly interesting in that it represented a new way for PE to partner with a sovereign to provide a financing solution. We can expect to see continued investment in this sector. Another transaction that drew a lot of attention last year was Carlyle Group’s investment in Rio de Janeiro-based healthcare firm Rede D’Or. The transaction, reported to be Carlyle Group’s second largest in the country, was evidence that private equity investors are finding opportunities in lower valuations caused by the economic downturn.
Ambrose: How would you describe regulatory frameworks in Latin America as they apply to the private equity industry? How do they influence investment decisions, as well as ongoing fund management, tax decisions, exits and returns?
Urías: In terms of policy regulation affecting PE investors in Latin America, while each country is different, there have been notable efforts by local regulators to foster a stable climate for investment. These changes include bolstering investor protection, adopting international financial reporting standards, creating tax incentives, allowing pension funds to invest more freely in the PE industry, eliminating prohibitions in industries that were restricted to foreign investments, and enabling restructuring in bankruptcy or distressed scenarios. That being said, certain regulations still need improvement and stronger enforcement is also required to avoid expensive and time consuming disputes, sometimes with unpredictable outcomes. These problems may result in deal uncertainty, disproportionate risk allocation and potential loss of value. Therefore, we strongly advise PE sponsors to retain lawyers, accountants and consultants that have experience in Latin America to help structure a deal in a way that is tax efficient, protects the investment, properly allocates risk and plans for future exits.
Hardy: The development of the legal and regulatory frameworks affecting the private equity industry in Latin America varies greatly from one country to another. Although the overall framework remains underdeveloped in the region as a whole, some countries have actively improved their regulatory environments. Some Latin American countries have taken steps to make the investment environment more hospitable. For example, in recent years Mexico has passed anticorruption, competition, energy, tax and telecommunications reforms, as well as laws aimed at increasing the rights of minority investors and facilitating investments by domestic pension funds. Brazil has a strong regulatory framework for fund formation and has strong accounting standards that are favourable for ongoing fund management. Chile is also viewed as investor-friendly. In Colombia, policymakers have expressed a commitment to the development of a national private equity industry by revising and simplifying complex fund operation rules. Countries committed to growing a private equity industry must take similar steps to positively influence PE investment decisions.
Aranha: Particularly in relation to Brazil the regulatory framework is favourable since the entrance and exit of money is easy and not restricted, with a simple registration with the Central Bank. Tax is also a good perspective since dividends are free of tax and so far the income tax on capital gains is not so high. Taxes on the operations of portfolio companies are more complex and particularly high in Brazil, taking in ICMS, PIS, COFINS, IOF and so on. Again, the new rules applicable to foreign investments in healthcare are a good example of how the recent regulatory framework may expand the opportunities for investments in Brazil.
Martínez: In Mexico, there has been a breakthrough in the last two years, mainly in fiscal terms, like the product of joint efforts between Amexcap, which is the Mexican PE and VC Association, and institutional investors. The authorities changing the tax framework in order to consider the nature of PE and VC investments has become quite common, and this has mainly occurred in exit-sales that have created a gap between income and cash flows. Another area which has seen great progress is the creation of legal vehicles for structuring funds, with the creation of the CERPIs, which are very similar instruments to Canadian Limited Partnerships, to formalise private equity investments. Having their own legal figures to comply with international standards generally offers great certainty and impetus to new local funds; however, there is still plenty of work to be done in terms of legal certainty.
Crespo: Latin America has always been a tale of two regions; a region divided between countries that foment investor-friendly policies and countries that are protectionist. Consequently, the regulatory framework for private equity across the region is highly uneven. Those that have sought to attract investment have implemented favourable private equity regulations. Among these countries are Brazil, Chile and Mexico. Chile is likely the most advanced from a regulatory standpoint, but since it is a relatively small economy lacking a fulsome capital market, the opportunities to exit fund investments are limited. Brazil also has a favourable system in place, though not as favourable as that of Chile. With respect to Mexico, over the last few years Mexico has shortened the distance with the most favourable systems in Latin America, focusing on the promotion of the private funds. Mexico is a good example of the positive impact of an appropriate private equity framework, and how it can help the economy and the creation of jobs.
Ambrose: What advice can you offer to PE firms when it comes to structuring and negotiating a private equity deal in the region? What due diligence and risk management considerations should be part of the process?
Martínez: It is important to see a solid investment thesis and a coherent pipeline in a fund. However, it is also crucial that the incentive structure is aligned with operating performance. It is appropriate to see LPs agreements where the general partners invest a portion of their patrimony in the fund, and also guarantee good cost control and a reasonable management fees basis. Nevertheless, management discipline is essential, with no rent extraction against the investors’ profitability, via commissions or payments to related parties, for instance. Lately, the complexity of corporate structures created to limit the liability of GPs over the life of the investments has negatively affected profitability in fiscal terms.
Aranha: It is important to perform a complete due diligence process, including compliance due diligence. The main issues will be tax, labour and corporate governance related, particularly on the hiring of entities instead of employees and family owned targets.
Hardy: It is crucial to understand the local investment culture of the country that is the subject of the private equity investment. In addition to financial diligence concerns, common diligence concerns include security, corruption risk, political and economic instability and institutional uncertainty. The process of structuring and negotiating private deals in Latin America can be drawn out, and it is important to recognise that due diligence materials, particularly those that must be obtained from public registries, may be dispersed and not readily available. Having a full appreciation of risk measures and risk management mechanisms, as they apply to emerging markets, is necessary for any private equity firm considering investment in the region.
Urías: PE sponsors need to think creatively when structuring deals in Latin America. Depending on the circumstances, we regularly advice structuring the transaction as a ‘US-style acquisition’, governed by US law. Another tool is earn-outs provisions to bridge valuation gaps – contingent payments are especially helpful when the target is a family-owned business and the seller’s value expectations are not consistent with the expected performance of the business. Other tools include using representations and warranties insurance to shift risk to a third-party insurance carrier, using call/put provisions to help facilitate a future exit, and using equity incentive compensation schemes to align interests with management. In terms of due diligence, PE sponsors should pay special attention to tax and accounting matters, related-party transactions, compliance with anti-bribery and anti-money laundering laws, and should run background checks on management and business partners.
Crespo: The most important aspect is to know your partner and make sure there is alignment regarding growth strategies as well as an exit. Many of the private equity opportunities in the region rest with companies that have been owned by families for generations. In large part, this is not your typical portfolio company management team focused private equity investment. The second generation of these family-run businesses – largely US educated and trained – appears more closely aligned to the vision of private equity funds. In addition, it is important for the private equity funds to undertake a thorough due diligence of the business and identify any foreign corrupt practices issues that may expose them to US based penalties.
Ambrose: In your experience, how are PE firms building value within their portfolio companies and generating expected returns? What kinds of exit routes are proving popular in Latin America?
Hardy: In recent years, Latin America has consistently outperformed other developing regions in PE investments. Cultural affinity, relative geographical proximity to the US and an increasing appreciation of the value of professional management facilitate relationships and cooperation among investors and portfolio companies. However, with limited IPO activity, exit strategy remains a challenge in the region, with most exits involving mergers & acquisitions rather than capital markets transactions.
Urías: In our experience, PE firms have usually created value by providing access to relatively cheap sources of financing, maximising the companies’ capitalisation structure, giving strategic direction, identifying and incentivising talent within management, and facilitating access to a wide business network. Also, PE firms add value and accelerate growth by leveraging their experience in sourcing, planning and implementing ‘add-on’ acquisitions or strategic partnerships. In terms of exit routes, the most common continues to be a ‘sponsor-to-strategic’ sale. While some jurisdictions have implemented positive reforms to the capital markets regulations, IPOs in Latin America continue to be an expensive and burdensome process. While also not as frequent, other exit routes include ‘sponsor-to-sponsor’ sales, such as the Abraaj Group’s sale of Peru’s Condor Travel to The Carlyle Group. In any case, flexibility in the funds’ investment horizon and careful thought on exit strategies from the outset will usually result in achieving strong returns.
Aranha: Among the trends we are seeing are a search for angels and series B and C follow-on investments and professional management, family owned targets, and economies of scale with the help of the funds’ portfolio companies. IPOs are not really taking place, so the focus is on private sales to national or foreign funds looking to enter Brazil and strategic buyers looking for market consolidation.
Martínez: The most successful funds have a management team focused on operational monitoring and remain close to the needs of companies, not only in financing terms but also including corporate governance and market practices. At this point the professional background, experience and networking of general managers are crucial, giving a more solid basis to analysis and problem solution, from the identification of the situation to the recruitment of a top executive to solve it. With regard to exit strategies in the Mexican market, roughly 60 percent of all exits are made through strategic sales, 40 percent through funds sales with follow-on investments and the rest through IPOs on the stock exchange.
Crespo: The recipe for success is the same as in other regions of the globe. Value is built by increasing market share through efficient and targeted capital commitments. On the energy and infrastructure side, being able to capitalise on first mover advantage is more important. Exit routes in Latin America are not what they are in the United States or Europe. Often an exit via equity markets is not an option. Although Brazil and Mexico do provide examples of this type of exit, it does not occur with the same frequency as it does in the United States. In smaller markets such as Chile, Colombia and Peru, exit strategies are basically limited to the sale of the portfolio company.
Ambrose: Looking ahead, what are your expectations for future opportunities for PE investment in Latin America? Are there any particular developments you expect to see?
Aranha: E-commerce and services entities, mainly technology companies, need professional investors to educate on costs and at the same time respect the founders. Transactions in the healthcare sector should also see a significant change in the coming months and years, as a consolidation of the market – which is still largely dispersed in Brazil – is expected. The fact that the economic and political scenarios are becoming more stable and currency is still cheap creates a good opportunity for investors, considering that there are also many opportunities and assets on sale by companies involved in the recent corruption scandals.
Crespo: Investors have been active in the region for quite some time now, and we believe this is not going to change anytime soon, since it is still a good time to invest in Latin America. We expect Mexico to maintain its place as the most important destination for private equity investments and Brazil to continue to attract capital in the coming years but probably not at the level shown five years ago. The region should also continue to offer other attractive private equity destinations, such as Colombia and Peru, which have enjoyed about two decades of consistent economic growth and urgency for the development of infrastructure projects. With respect to the projects to be financed with private equity capital, we anticipate that infrastructure and energy projects should continue to present one of the most attractive private equity opportunities in Latin America.
Hardy: Private equity opportunities in Latin America will continue to grow. The region is an attractive market that has made significant gains in lifting people out of poverty, modernising infrastructure and improving its overall development in the last 15 years. The past several years have seen the entry of wider array of funds and the development of a deeper bench of fund managers in the region. Reforms in Mexico are bearing fruit, and investors have high hopes that new administrations in Argentina, Brazil and Peru will create additional business opportunities. Latin America has a strong entrepreneurial environment that is prime for PE capital investments.
Martínez: I am very optimistic about a robust recovery in Latin America’s main economies over the next three years. Right now there are a lot of attractive opportunities in terms of valuation that will see solid growth in the next five to six years, but a good selection of funds, with discipline in negotiations and operational management is crucial for an investment decision in this environment. I look for managers with experience and a solid track record but the most important fact is a focused investment thesis. I consider generalist funds to be too risky considering the high volatility that the market is reporting these days.
Urías: We expect a boost in activity in Mexico and we foresee energy, IT and consumer/retail as being active industries. Longer holding periods are also likely as funds look for flexibility to deal with the region’s volatility. Investment – and consequently prices – should escalate as a result of the large amounts of ‘dry powder’. Another trend we might see is family offices competing with conventional PE firms. Given the limited number of deals in Latin America, and the fact that family offices tend to have more flexibility and longer holding positions, we expect PE firms to fight hard to source deals and to invest at a reasonable price. Likewise, PE funds will continue to partner up with local players, either to invest in larger tickets – such as First Reserve and Blackrock’s minority-interest in Mexico’s Los Ramones II pipeline – or to leverage local experience and networks – such as Blackstone’s acquisition of 40 percent of Patria Investimentos.
Cate Ambrose is President and Executive Director of the Latin American Private Equity & Venture Capital Association (LAVCA). She speaks and writes regularly on a range of topics related to public policy and private investment in Latin America, and is a regular commentator on CNN En Español, Bloomberg, and Fox Business and a guest lecturer at The Wharton School. She can be contacted on +1 (646) 315 6735 or by email: firstname.lastname@example.org.
Julio César Martínez entered Fund of Funds as an Investment Manager in April 2015. During the four previous years, he served as a senior stock market analyst in Punto Casa de Bolsa, of Grupo Salinas, and was in charge of the sectors of petrochemicals, mining, steel, energy and industry groups, with investment recommendations ranked in the top places by Bloomberg. He won 4th place in the ranking of analysts in Mexico, published by the Inversionista magazine in 2014. He can be contacted on +52 55 4433 4500 or by email: email@example.com.
Kelly Hardy is skilled at recognising and explaining differences between legal frameworks and helping clients manage their global legal needs. She has represented clients on matters throughout the world and in a broad range of industries, including manufacturing, life sciences, education, government contracting and energy. Ms Hardy has 20 years’ experience advising US and global clients on mergers and acquisitions, joint ventures, strategic alliances, restructurings, post-merger integrations, corporate governance and compliance in established and emerging markets throughout the world. She can be contacted on +1 (410) 659 2782 or by email: firstname.lastname@example.org.
John P. Crespo is a partner in King & Spalding’s Houston office and a member of the firm’s Global Transactions Practice Group. Mr Crespo has a broad multidisciplinary practice that includes extensive experience in domestic and international transactions, including the formation and structuring of joint ventures, mergers and acquisitions, privatisations, development of infrastructure projects, and general corporate and contract matters. He can be contacted on +1 (713) 276 7324 or by email: email@example.com.
Sergio Urías is a partner in Kirkland & Ellis LLP’s New York office and a member of the firm’s Latin American Practice. Mr Urías represents a variety of clients in mergers, acquisitions, dispositions, private equity and other corporate matters, with special emphasis on cross-border and Latin American transactions. He is admitted to practice in Mexico and New York, and has been recognised in the M&A Advisor’s ‘40 under 40’ rankings of top professionals. He/She can be contacted on +1 (212) 446 5964 or by email: firstname.lastname@example.org.
Luiz Filipe Aranha is a corporate and M&A partner at KLA with extensive experience in private equity & venture capital. Mr Aranha has broad experience assisting international clients in complex matters. Admitted in Brazil in 2000, he received his LLB from the Universidade Presbiteriana Mackenzie Law School in 1999 and his LLM from the Benjamin N. Cardoso School of Law (New York) in 2002. Mr Aranha has specialisation in finance and corporate Law from Fundação Getúlio Vargas (2004). He can be contacted on +55 11 3799 8238 or by email: email@example.com.
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