Faith in the consumer

Opportunities created by demographics, the nature of family-owned businesses and even positive economic growth are catching the eyes of investors in Latin America.

“I was somewhat surprised and encouraged attending meetings with our fund managers lately that there is no sense of panic,” says Umberto Pisoni ofWashington DC-based development institution the International Finance Corporation.

Private equity executives throughout Latin America are to an extent ambivalent about the economic crisis. There is a view that the problems stem from developed markets and nothing is fundamentally broken at home. For the most part, financial institutions are fundamentally sound, private equity deals have involved modest amounts of leverage and companies were not bought at inflated valuations – with the possible exception of Brazil.

Much private equity investment in Latin America over recent years has been motivated by the growing middle class, which provides an ever-increasing customer base for goods and services. Although the rising affluence of this middle class may have slowed, there is still confidence in its purchasing power.

Investors which targeted only the middle class may struggle because the middle class is the part of the population that usually sees it spending power dip most in a crisis, according to Joaquin Avila, head of the Carlyle Group's $134 million Carlyle Mexico fund. However, the general feeling is that the middle class will continue to be a significant driver of growth.

“For the most part emerging markets grow because of the expansion of the middle class,” says Marjorie Magner, managing partner of Brysam Global Partners, which recently invested $98 million in a Colombian consumer bank. “The middle class is what emerges and it's not going to go backwards.”

Although the middle class continues to be an important economic driver, some investors have turned to the “base of the pyramid”, or low-income sector, for attractive returns.

In Mexico, half the population is close to the poverty line. “If you have a business in which you help that market in a profitable way, you have a huge marketplace in which usually the players are usually not well organised,” says Avila.

Basic services like healthcare, education and housing all come high on the list of family priorities in terms of spending and are thus resilient sectors, says Michael Chu, founder of social venture firm Ignia, which specialises in base of the pyramid investing in Latin America.

Demand for certain non-discretionary goods is also expected to remain strong among this population. “People will stop buying fancy clothes – nevertheless, they will continue to buy tortillas,” says Avila.

Incomes in the base of the pyramid are more decoupled from the global economy since they rely less heavily on the global markets, Chu adds.

In the Mexican market, the consumer base is expanding due to the aging population. Ten years ago, half the country's population was less than 15 years old, creating a surge of individuals now entering the workforce, earning a wage and demanding goods, according to Avila. Not only is this shift attractive for private equity firms but also for the strategic buyers that are the main source of exits in Latin American private equity.

Mexico is experiencing little to no GDP growth at present but the sheer size of the population means that investments in fast-growing sectors can become dominant businesses in a private equity portfolio, says Erik Peterson, regional director for Latin America at emerging markets private equity firmAureos Capital.

“We see slower growth throughout the region, with countries like Peru and Colombia less affected than countries that are more dependent on US trade, like Mexico and some of the Central American countries,” says Peterson.

However, even with reduced GDP projections, some countries are expecting continued growth. Projections for next year are 6 percent growth for Peru and 3 percent in Colombia, says Peterson.

The vast majority of targets for private equity in Latin America are family-run businesses, many of which struggle with changing market conditions. Theoretically, this should lead to an opportunity to buy distressed companies at attractive valuations.

Some family-owned companies have solid balance sheets and are not willing to sell at discounted prices despite issues such as family succession disputes, says Avila. Others are strong operationally but have problems with their balance sheets due to overleveraging and low growth. It is this second category of businesses that has found itself in need of private equity capital.

Avila says: “The pipeline we're seeing now is 100 percent bigger than four or five months ago. We see more opportunities in different sectors. Many of these family-owned businesses will really need to refocus their strategy and accept the value creation that a private equity firm can offer.” The last couple of months have seen an extremely busy pipeline of M&A, SPAC and private equity transactions, according to Pedro Seraphim of Brazilian law firm TozziniFreire.

But whether struggling companies are actually sold remains to be seen. Private equity deals should be able to command decent pricing but the truth is that people are very reluctant to sell their business at a steep discount, argues Duncan Littlejohn, head of private equity secondary investing for Paul Capital's Brazil office.

“In actual fact, what happens is the whole system gets frozen. They consider the pricing from the private equity industry to be offensive, so deals don't get done,” says Littlejohn.

With the impact of global turmoil just beginning to hit emerging markets in earnest, expectations are optimistic for deal flow. Whether that optimism is justified depends in large part on how effectively Latin American businesses can weather the storm.

“The IPO market is shut now in Brazil. Private equity firms acknowledge this and are essentially putting their exit plans on hold because this is coupled with a drying up of strategic investors' interest in the country so I think the short-term impact is going to be a period where managers wait and see and hope that market conditions improve.”

Umberto Pisoni, International Finance Corporation

“In downturns, we know that lower-income segments are much more resilient than the market in general and the formal economy. One reason is that people that work in the informal sector can change very quickly from how they conduct business and their line of business.”

Michael Chu, Ignia (left)

“Public markets have never really existed in Mexico for exiting. The size of the transactions we're looking for are tailor-made to acquire the company, fix the company, make it grow and eventually make it appealing for a strategic buyer.”

Joaquin Avila, CarlyleMexico (right)

“Our investors from outside the region prefer to see local investors, like pension funds, in the funds that we invest in the region. They see that as a validation of the general investment strategy of the fund.”

Erik Peterson, Aureos Capital

“This may be the first time everyone really does believe in the globalisation of the world's economies… what's different from previous crises in Latin America is there was an anticipation and a response.”

MarjorieMagner, Brysam Global Partners