Green light for the pensions

Mexico's sleepy private equity market may be about to shake off its siesta, thanks to recent regulatory changes.

The country has historically had fairly low private equity penetration levels, notably lagging behind that oft-lauded Latin American emerging market, Brazil. Private equity and venture capital investment in 2009, as a percentage of gross domestic product, is just 0.045 percent in Mexico, compared with 0.146 percent in Brazil, according to recent statistics from the Latin American Venture Capital Association. As points of reference, the figure is about 0.85 percent in the UK and 0.30 percent in Spain.

There are numerous reasons why Mexico has traditionally been left out of BRIC frenzy, including SMEs' difficulty in accessing equity markets, outdated bankruptcy laws and institutional investors' inability to invest in private equity.

The lack of private equity activity in the country, by extension, has meant local companies and entrepreneurs are not familiar with the asset class and how it operates, says Miguel Olea, head of the Mexico City office for emerging marketsfocused Aureos Capital. “There is a need to educate managers in the advantages of private equity as a lever to foster growth and expansion,” he says.

The situation looks set to improve, however, thanks to one significant change.

In July, Mexico's banking and securities regulator made it possible for the managers of Mexico's private retirement funds (Administradoras de fondos para el retiro, or Afores) to invest in publicly listed private equity and infrastructure vehicles.

Structured as a certificado de capital de desarollo (CCD), the vehicles enable Mexico's institutional investors to invest directly in alternative assets for the first time.

“We have been working for almost two years on opening up the framework so these pension funds can invest in alternative assets,” says Jose Contreras, managing partner of Mexico City-based WAMEX Private Equity Management. “The way we were able to do it was to create a public trust,” from which the manager can draw down capital. “The regulatory bodies wanted to have corporate governance and full disclosure and the only way [they felt appropriate] to do that was through the stock exchange.”

WAMEX, which estimates the Afores control nearly $100 billion in assets, raised and listed the first such private equityfocused vehicle in October this year. It collected $55 million from five institutional investors for a Mexican Stock Exchangelisted vehicle that will invest alongside a traditional private equity fund, the two together aiming to raise a total of $120 million for lower mid-market deals.

Contreras expects many local and regional private equity fund managers to follow suit, regardless of investment strategy.

Aureos, for example, is busy investing a $185 million regional fund closed in June, roughly half of which is allocated for Mexican SME investments. Olea estimates the Mexico City team will have invested $40 million by the end of 2009, leaving it another $45 million to invest next year.

“We will probably have to begin raising a new fund by the second semester of 2011,” he says. “And we would certainly raise money from Mexican pension funds. Some Mexican pension funds have made clear to us that they might be interested in investing” in a vehicle running parallel to the current fund “as early as next year”.

Darby Overseas Investments, another global emerging markets player investing in Mexico from a regional fund, also thinks CCDs will present an interesting opportunity. “We have been looking at the possibility of raising a local, country-specific fund and that opportunity has opened up lately through the Afores wanting to expand their activities,” says Julio Lastres, senior managing director and director of Darby's Latin American operations.

If the Afores' foray into private equity goes well, it will help “generate employment for Mexico and will generate an industry that doesn't exist today”, says Joaquin Avila, managing partner of EMX Capital, a Mexico City-based fund that recently spun out from The Carlyle Group.

Avila anticipates the Afores will invest from $6 billion to $8 billion in CCDs, most of which he expects to focus on infrastructure projects crucial for the country's development (the first CCD raised and listed, for example, was by Goldman Sachs and ICA, who were behind the FARAC toll road concession). Macquarie and other infrastructure groups have also been mentioned in local press as interested in raising CCDs.

“Perhaps something like $500 million or $1 billion at the most will be invested in true private equity/leveraged finance, and I think that makes a tremendous amount of sense because it's an industry that still needs to be developed,” Avila says. “It will not happen overnight, and if it happens overnight, it will be wrong.”

He points to the progress of the private equity industry in the US, which took off exponentially once the asset class gained ground with pensions. “It took a while to develop and that's exactly what will happen in Mexico. We need to develop gatekeepers, different asset managers, to train Afores in how to invest or not invest in a team… nobody can expect that it's going to be an instant success.”

The advantage the market's GPs and LPs have, however, is the ability to visit more established private equity markets and learn from their successes and failures, Avila notes.

As Afores move more confidently into private equity, advisers and other affiliates will spring up, strengthening the infrastructure needed to support a fully formed and active private equity industry on the ground.

Their support is necessary for a host of fund managers to take part in the anticipated surge in deal activity, as “traditional” sources of capital – for Mexico, mainly development finance institutions – are not expected to start writing more or bigger tickets anytime soon.

But it's not just capital that that these local institutional investors deliver to Mexico's private equity market. They also bestow a legitimacy that should attract even more domestic LPs.

Couple this with the longer-term impact of positive outcomes for pensioners, as well as a broader spectrum of investee companies (not just prominent corporations, but SMEs, too) and the asset class should become better understood and embraced by local regulators, politicians and the public at large – all of which is necessary to incorporate private equity successfully into a market's economic DNA.

Julio Lastres (left),senior managing director, Darby Overseas Investments “The deepening capital markets process now being underpinned by one of the fastest growing pension fund systems in the world will accelerate further. This is already proving to be very promising for the expansion of the local PE market and long-term funding for infrastructure and other key sectors of the economy. One would also imagine that a more robust IPO market will emerge.”

Jose Contreras,managing partner, WAMEX Private Equity Management “The best scenario is that the CCD vehicle takes off and a domestic industry builds gradually on past successes to a size relative to Brazilian private equity. It would be a rather slow process where investors gain confidence in the asset class and authorities simultaneously recognise the critical role of PE in bringing life to the public market and proactively optimise the vehicle.”

Joaquin Avila (right),managing partner, EMX Capital “I see that PE in Mexico will grow significantly. There should be at least five more funds doing the sort of LBO that we do, and the asset class will become a way to differentiate the returns of local fund managers. More or less, with all proportions kept, [we will see in Mexico] what happened in the US 20 years ago.”

Miguel Olea,partner, Aureos Mexico “The multiplier effect of opening the possibility of pension funds to invest in this asset class should ignite a growth stage in PE presence in the Mexican market…If five percent of pension fund money flows to PE funds in five years …we could think of a scenario of more than $15bn deployed in Mexico in the next five years. Interesting? Not precisely what you find in developed economies, but it is a good first step.”