Keeping the faith

Private equity professionals based in Latin America are honest about the problems facing the region – in some cases, brutally so. It is hard to maintain unfettered optimism in an area where the largest economy, Brazil, has just entered recession, and seen the value of its currency, the real, plunge – abruptly reducing the dollar value of exits that can be achieved by private equity funds.

But although they acknowledge the challenges, private equity staff energetically put the case for keeping faith in Latin America, and, in particular, in the economic power of its growing middle class.

“Brazil is going through temporary political and economic problems, but if you are a long-term investor you have to look at the long-term fundamentals,” says Patrick Ledoux, co-head of Latin America at Actis in São Paulo.

Ledoux is honest about the deep-seated nature of the problems facing Brazil. He sees little prospect of economic growth in the country until Dilma Rousseff’s term as president comes to an end in 2018.

This sense of crisis is reflected in the numbers for fundraising and exits. In the year to 14 September only $1.5 billion was raised for Latin America, compared with $6.2 billion last year, according to PEI’s Research & Analytics team.

Only $548 million was raised for Brazil, compared with $3.4 billion in 2014. Latin America has seen only $200 million in exits in 2015, down from $2.9 billion last year, according to data from Preqin.

Whether exits present a problem or not depends partly on the life cycle of individual funds. Ledoux cites the Actis Global 4 Fund, which closed in 2012. In this case, “Am I worried? No.”

The fund’s first two Brazilian deals were at the end of 2014, when there were about 2.7 reals to the dollar. At the time of speaking it had fallen to 3.8 to the dollar. Despite this, Ledoux believes the fund can still achieve its targeted return – 20 percent-plus a year in dollar terms over an investment horizon of three to five years.

The depreciation is, however, still greater since Actis Emerging Markets 3, Actis’ predecessor private equity fund raised in 2008, bought into Brazilian companies. For Brazilian deals made by this fund, which became fully invested three years ago, Ledoux believes a 25-35 percent local currency return is achievable. This translates into a “high single digit to low teens” dollar return after allowing for the fall in the real.

He regards this a respectable outcome, though some investors are likely to deem such returns as disappointing by the
standards expected of emerging markets.

Even in Mexico, where the blow caused by falling commodity prices has been softened by strong ties to the resilient US economy, GPs are frustrated. Roberto Terrazas, managing director at Nexxus Capital, a Santa Fe, Mexico-based general partner, is positive in the long term about the government’s reform programme, which aims to boost GDP growth.

However, in the medium term, “domestic consumption has been affected – this has been a frustration. The main reason is tax reform, which has had a large impact on the pockets of the Mexican middle class”.

Terrazas thinks the slowdown has made life harder for its Fund VI, which closed in November 2013 with commitments of $550 million to the country. Over the past 17 years Nexxus has done an average of about two deals a year. Since November 2013 it has done only one.

Terrazas blames this largely on “a gap in valuations, between our expectations and those of the sellers”.

“For most companies that we’ve looked at, EBITDA has fallen since 2013. But many owners say next year will be better. They want us to value the company based on forward-looking numbers which are quite different from ours.”

This gulf between sellers’ and buyers’ valuations is an oft-observed phenomenon during emerging market slowdowns, but it has not frozen deal activity completely. Figures for Latin America show that the value of transactions, at $2 billion so far this year, has already equalled 2014, though it remains below the 2010 peak of $7.2 billion.

Mexico’s devaluation has been less severe than Brazil’s, but it remains a problem for GPs. They have responded with a wait-and-see approach, but only up to a point.

“We don’t have any exits planned for the rest of 2015, but from the summer of 2016 we have to become more active,” says Miguel Olea, partner and regional head for Latin America at The Abraaj Group in Mexico City – referring to the firm’s 2008 Latin America fund ALAF I, which became fully invested in 2012. “Some exits might be delayed a bit, other deals will exit at lower valuations than expected when translated into foreign currency, and others might do well. It depends on how everything evolves in the next six to 12 months.”

Olea says that the firm creates a “cushion”, which allows for a currency devaluation of 5-10 percent over the life of the investment. He acknowledges that the Mexican peso, down about 20 percent on the year, has gone beyond that cushion. However, he expects a recovery in the currency.

In the eyes of the private equity industry, those investors happy to wait stand a greater chance of reaping the long-term rewards offered by Latin America. As well as the growth of the middle class, this includes the economic efficiencies generated by the Pacific Alliance, a trade bloc consisting of Chile, Colombia, Mexico and Peru.

One such investor is General Atlantic, the growth investment firm. Its average holding time is five to seven years. However, because it lacks the fund structure of conventional private equity firms, it is under less pressure to exit according to a strict timetable. The firm is willing to stay with companies for seven to 10 years if necessary, says Luis Cervantes, head of its Mexico City office. “Over that time period we’re still very confident,” he says. “The fundamentals show that Mexico will grow.”

Cervantes cites an example of a recent General Atlantic investment that will tap into both the growth of Latin America’s middle class and the promise of the Pacific Alliance: its 2014 purchase of a minority stake in Sanfer, Mexico’s largest manufacturer of generic pharmaceutical drugs.

Sanfer benefits not only from growing spending by higher-income Mexicans on medicine, but also from recent agreements that make it easier for drugs already approved in one Pacific Alliance country to be given the green light in another. “The Pacific Alliance is a strong catalyst for many industries,” says Cervantes.