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Is Private Equity Out of Control in Latin America?

The Impact of Structures on Private Equity Transactions in Latin America 1988-2007




is a vice president ar Endeavor's Center for High Impact Entrepreneurship ill New York, NY.

here are many reasons why some regions have underdeveloped private equity markets. The early literature on this topic focused on variables such as GDP growth, GDP per capita, and the depth of the local stock exchanges in order to explain the performance of the private equity markets.' In the recent past, most of the research on private transactions in general and private equity in particular has focused on the way private transactions are structured as a reaction to the existing legal institutions. This article will build on some of the findings performed on this topic but focuses exclusively on Latin America. There are several factors that should not be overlooked when trying to understand the performance of private equity in the region. For example, in Latin America there are particular aspects related to the industrial organization of each country that may inhibit private equity investments (from the existence of monopolies to the continued strengths of family-controlled business groups). This should be addressed in future articles. As referred to above, an important body of literature on private equity has focused on the development of financial markets and thtfir impact on the private equity cycle. Some authors have even proved the impact o an active stock market on the venture capital cycle.- However, little attention has been paid

to specific effects of the actual state of the stock markets in emerging markets. Instead of focusing only on the access to IPOs, some research should be performed regarding the impact of having fewer publicly traded companies on the exit of private equity portfolio companies. In other words, does having fewer publicly traded companies limit the exits for the private equity funds? This could be relevant in understanding the private equity environment in Latin America. There are other aspects that may impact the private equity cycle and that could be understood as cultural aspects. These probably have a twofold impact. First, an entrepreneur may perceive the equity of a company in Latin America as an extension of his or her family, which would generate barriers for possible external sources of equity. Second, entrepreneurial financing probably relies more strongly on family and friends than it does in other regions. Entrepreneurs may feel more comfortable relying on personal agreements than on legal contracts.* This could have an impact on the performance of private equity firms. As previously explained, this article focuses on the impact of the legal institutional framework on the private equity cycle. In order to do so, it would be wise to review some of the literature on this topic. In the late 1990s, La Porta et al. [1997, 1998] described how the legal origin of a country has an impact on its




financial markets. Their findings focused partly on the poor minority shareholder protections in French civil law countries compared to those of common law countries. Djankov et al. |2()()3j found that common law countries are able to enforce contracts better than countries with other legal origins. Lerneret al. [2O5[ found that in lowenforcement and French civil law nations, private equity groups rely on majority ownership rather than contractual provisions to protect their interests. Most ofthe literature compares the performance of transactions among groups of countries that do not have the same legal origin. However, little research has focused on the impact of different structures used in private transactions among countries with the same legal origins. Is there an indication that private transactions perform better by relying on contracts or on majority positions in countries with a French civil law origin? Do the different ways of structuring private equity deals in countries with similar legal infrastructure have an impact on their performance? This article specifically tbcuses on information on private equity transactions for the three leading economies in Latin America, all of which have a French civil law origin: Argentina, Brazil, and Mexico. The article also provides information for 22 other countries in the region. Not all of them have the same legal origin,'' but it is likely that the findings for the three largest economies in Latin America apply to the region's other countries as well. There are several variables that determine tbe strategy and structure of a transaction. This article focuses on the following three variables: equity ownership acquired by the private equity firm, post-money equity valuation ot the company receiving the private equity investment, and the amount invested by the private equity firm per transaction. Each variable will hold a specific hypothesis. lased on the underdeveloped legal structures in Latin America (including not only problems with the rule of law, but also the enforcement of laws and contracts as well as execution in the courthouses^), it would seem rational to target controlling stakes in order to protect the investments. If contracts could be enforced efficiently, minority ownership would be a reasonable investment strategy for a firm, as it could still protect its investors' interests. Even more important, the minority investor could still have control over certain decisions if it's agreed in a contract with the other owners. This hypothesis is in line with Lerner et al. [2005J findings on

majority ownership from private investors in emerging markets. Some initial findings of this article seem to contradict Lerner's finding: Brazil's private equity investments do not have majority controlling stakes in the portfolio companies. This would be material, as Brazil is a leading market for private equity investments in Latin America. However, an additional analysis for Brazil and Latin America seems to confirm a tendency of private equity investments to obtain controlling ownership. Investments in Latin America have a higher risk profile than investments in developed markets. The second hypothesis is that due to the additional risk associated with investing in emerging markets, the majority of private equity investments are focused on late-stage investments that reduce such additional risk, as earlystage investments would require an additional expected return. Post-money equity valuations should produce evidence regarding the late-stage focus of private equity investments in Latin America. The third hypothesis is that the equity investments have to be big enough to support a thorough due diligence process. This process should include but not be limited to legal, fiscal, and financial topics. It is likely that due to the underdeveloped legal structures and the difficulty of enforcing contracts in Latin America, the depth and sophistication of the due diligence process is more important than it is in developed economies, where representations and warranties can be signed. The depth ot the due diligence process may account for higher transaction costs per investment, which may inhibit investments or negatively impact the performance ofthe investments. In other words, smaller transactions are less likely because either the due diligence process accounts for a big percentage ofthe equity invested creating a negative impact on the performance ofthe investmentor private equity firms making smaller investments are not able to perform through due diligence analyses, which could have a negative impact on the performance ofthe transaction. Due to the lack of information about returns (cash on cash or internal rate of return) in Latin America, the analyses of this article are based on an important assumption: If a country has a larger amount of private equity inflows over time, it is a sign of positive performance for private equity investments. The idea is based on the following reasoning: if a fund is successful in its investments, it will be able to raise an additional fund. In the aggregate, a country in which the initial intlow




of private equity performs positively is more likely to attract additional investments from private equity funds, as a positive track record is created for that market.'' Tbe leading receptors ot private equity transactions in Latin America are Argentina and Brazil, while Mexico seems to be an underacbiever. These results were measured in three different ways by Charvel [2007]: first, total amount invested; second, by comparing the percentage of private equity going into a country as a percentage of total private equity investments in Latin America with the specit^ic country's CDP as a percentage of Latin America's total GDP; and third, calculating private equity inflows as a percentage of GDP of tbe country where the private equity transactions were performed and comparing those numbers witb tbose of the country's peers. This article compares data to prove or disprove tbe three hypotheses among Argentina, Brazil, and Mexico and determine what variables can explain differences in tbe performance of eacb country-specific industry. If the leading countries-such as Argentina and Brazilhave a different way of structuring transactions tban underperformers like Mexico, it may suggest tbat certain structures have a positive impact on the performance of private equity investments. Tbe positive performance would eventually lead to the raising of new funds, increasing the amount of private equity in a specific country. DATA DESCRIPTION Two databases were used for the analyses of this article. One is from Venture Equity Latin America (VELA), which was acquired recently by Thomson Reuters. This database is not public, but it is available tbrough a subscription. Up to now, VELA has the best and most comprehensive database for private equity transactions for Latin America. Its information goes back to 1988 and covers 25 countries: Argentina, Bahamas, Barbados, Belize. Bolivia, Costa Rica, Brazil, Chile, Colombia, Dominican Republic, Ecuador, Guatemala, Honduras, Jamaica, Mexico, Nicaragua, Panama, Peru, Puerto Rico, El Salvador, Santa Lucia, Suriname, Trinidad and Tobago, Uruguay, and Venezuela. The VELA database includes 1,403 transactions from 1988 to 2007. The second database, called Charvel in this article, has been built by tbe author during tbe last seven years. Tbe Charvel database is exclusively for Mexican transactions and was built tbrougb direct interviews with

fund managers, entrepreneurs, and institutional investors. Additionally, exhaustive news runs were performed in different search engines, newspapers {Reforma,
El Economista, El Financiero and El Universal) and magazines {Expansion, America Economia, and Poder y Negocios).

When possible, the information was cross-referenced witb VELA, LAVCA, Pablo Rion & Asociados newsletter, and Thomson Financial.^ Charvel has 359 transactions from 1990 to 2007. The main difference between tbese databases is that Charvel has significantly more informationmore transactions as well as greater depth of informationfor Mexico. For example, Charvel has ownership stakes for transactions dating back to 1990, while VELA goes back only to 2001 (except tor two transactions tor Mexico in 1995). Also, Cbarvel has information not only about tbe equity invested but also about the debt component of the deals. The principal variables tracked by both databases are: portfolio company, industry, amount invested (in US$), extent of control, country, and date of investment (year), among otbers. Both databases have incomplete information for many variables. For purposes ot this article, the most relevant variables relate to equity invested: ownership acquired and tbe post-money equity valuation of the firm receiving the private equity inflow. Both databases have incomplete information tor tbese variables. This means tbat both sources may have intormation about a transaction, but not necessarily about tbe equity invested; or they may show the equity invested, but not the percentage of shares acquired. Exhibit 1 shows the total number of transactions per variable with complete information. However, tbrougb combining tbese sources, there is enough information available to explore tbis article's hypothesis. Wben tbe information from VELA's Mexican data is compared to Charvel (which follows information only
EXHIBIT 1 Data Description VELA Charvel 25 1 1,403 359 906 201 124 341 271 268

Number of countries Total number of transactions Transactions with information on: Equity invested Extent of control or ownership Equity valuation of the firm




about Mexico), the latter seems to be a more robust source of information for the analyses. This could be explnined by the sources used to gather information. Charvel is a more reliable database as the information is gathered directly from institutional investors and fund managers rather than mainly relying on news runs." As stated in Charvel [2007], which uses the same two databases, if the information on Mexico in VELA is incomplete, it is very likely that the information for other countries in the database is incomplete as well, so information on Argentina and Brazil could be EXHIBIT 2

misrepresented. However, for purposes of this article, the author believes that while incomplete, both databases provide sufficient evidence of clear tendencies that explain strategies, structures, and performance among countries. WHAT REALLY GOES ON IN THE PRIVATE EQUITY INDUSTRY IN LATIN AMERICA? As per Exhibit 2, Argentina, Brazil, and Mexico are the three countries in the region that have attracted

Latin America Benchmark Analysis 1988-2007

Argentina 214 VELA Colombia Mexico Regional"' 37 82 198 276 Charvel Mexico 359

1. Total number of transactions 2. Investment analyses Amount invested Mill investment Max inveiitment Average investment Mode Median Transactions with complete information 3. Ownership analyses Min ownership Max ownership Average ownership Weighted average of ownership & investment Mode Median Correlationinvestment and % Transactions with complete information

Brazil 419


Other** 177

AU 1.403

{$11 7,157 ($) 13,381 ($) 1,373 (S) 728 (S) 3.353 (S) 5,695 ($) 2,116 (S) 33.803 (S) 5,946 0.03 0.15 0.20 0.38 0.22 0,25 0,20 0.03 0.01 740.00 1.000,00 320.00 160.00 317.00 1,400.00 200.00 1,400.00 228.00 49.36 54.84 21.12 21.40 22.81 39.82 16.53 37.31 14.63 10,00 10.00 10.00 25.00 20.00 15.00 10.00 10.00 20,00 15.60 18.45 9.00 15.00 15,00 15.00 7.70 13.00 5,50

7.0% 100.0% 56.5% 43.7% 100,0% 50,5% (0.20)

4,0% 100.0% 46.0% 66.9% 100.0% 34,2% 0.40

11,0% 100.0% 47.8% 54,4% 30.0% 40,0% 0.07


8.0% 100,0% 64,5% 58,3% 100,0% 65.0% (0.64)

7.0% 100.0% 47.7% 69,7% 100.0% 37.5% 0,37

15.0% 100.0% 48.1% 51.7% 100,0% 39.8% 0.34 16



10.0% 50,0% 33,0% 11,7% na 36.0% (0.94)

4,0% 100,0% 52,1% 60.4% 100.0% 49.0% 0.13 201

1,0% 100.0% 38.9% 45.7% 100,0% 29.4% 0,12 271






4. Company equitj' value analyses Min CO's equity value ($) 4,00 (S) 0.67 ($) 2.22 ($) 1.16 ($) 4.00 ($) 2.00 ($) 1.17 (S) 0,67 ($) 0.05 Max co's equity value 892.86 1.000,00 1,066.67 1.600.00 821.43 2,333.33 281.67 2,333.33 837.50 Average co's equity value 184.11 194.52 161.82 550,96 75.28 435.80 73.43 185.66 61.25 Weighted average of co's equity value & Inv. 335.24 505.70 510,83 1.463.11 83.73 1,633.80 231.16 822.60 201.19 Mode 400,00 317,86 na na 10.00 na 1.17 421.05 102.50 Median 94.50 142,86 40,67 51.72 29.42 111.11 26.36 68.75 17.35 Correlation^co's equity value and investment 0.75 0,78 0.86 1.00 0.84 0,97 0,96 0.81 0.68 Correlationco's equity value and % (0,59) (0,02) (0.34) (0,92) (0,64) 0.21 0.17 (0,20) (0.26) Transactions with complete infonnation 22 37 16 3 30 9 7 124 268 Notes: ^Regional investments include inrestmcnts in thcfolhwnig regions or set of countries: Argcntiwi-Brazil; Argentin-i-Brazi! and Chile; Argentina-Bra::il ''rui Colombia; Brazil-Bolivia; Brazil-Mexico: Central America; Central Ann-rica-Dominiuin Repuhhc and Mexk'o-U.S.;**T^^^ information of ihv following 20 countries: Bahamas. Barbados. Belize, Bolivia, Costa Rica, Dominican Republic, Ecuador, Guatemala, Honduras Jamaica, Nicaragua. Panama, Peru, Puerto Rico. El Salvador, Santa Lucia, Suriname. Trinidad and Tobago. Urugay and Venezuela.




the most private equity investment, with an aggregate 70.6% of the total invested in Latin America from 1988 to 2007 (VELA). Among the biggest countries in the region, Colombia and especially Chile seem to be under-represented in VELA. Those two countries represent only 119 transactions of the 1.403 in VELA, and just 19 have complete information. Apart from the three major recipients of private equity in Latin America, Regional transactions seem to be a fairly common strategy, accounting for 16.8% of all private equity invested in Latin America. In this article, "Regional transactions" means private equity investments performed in more than one country in Latin America. Usually these transactions include Argentina, Brazil, or both. Brazil, Argentina, Mexico, and Regional transactions combined account for 87.5% of all equity invested in the Latin America. Among the 906 transactions in VELA with information about the equity invested, there is a big range of investment sizes, from USS30,000 to US$1.40 billion. However, the average and median numbers describe a different story. The transaction size seems to be significantly smaller than similar investments in developed economies. The average equity investment is US$37.31 million and the median transaction is only USS 13.00 million (see Exhibit 2). There also seems to be a big difference among the ownership percentages targeted by the funds, varying from as low as 4% all the way up to 100% for the 201 transactions with complete information from VELA. It is noteworthy that VELA's information on private equity investments shows that on average funds have a majority ownership60.4%when investing in Latin American firins. The median ownership may even show a relative majority (49.0%) vis a vis the other investors or even the entrepreneurs (see Exhibit 2). Finally, after describing the amount invested per transaction and ownership structures, the last variable that this analysis focuses on is the post-money equity valuations of the companies receiving private equity investments. Similar to the variable tracking the amount invested, post-money equity valuations vary significantly, from US$0.67K to USS2.33B. However, on average the companies' equity valuations are US$185.66MM, and the median is US$68.75MM for the 124 transactions with complete information from VELA (see Exhibit 2).

WHAT ARE THE WINNING PRIVATE EQUITY INVESTMENT STRATEGIES IN LATIN AMERICA? In the first part of this article three hypotheses were formulated. The first one assumed that due to weak legal systems and infrastructure and the difficulty in enforcing private contracts, private equity firms should target controlling stakes in their investments. The second hypothesis was that private equity firms investing in Latin America should target later-stage investments due to the additional premium associated with earlier-stage investments in a region already perceived as risky. The third hypothesis, which is linked to the previous two, was that investments had to be larger rather than smaller to proportionally reduce the transaction cost basis of the investment. For purposes of this section, and as explained in the data description. VELA information will be used to describe patterns in Argentina, Brazil, and Latin America as a region, and Charvel will be used for information on Mexico. From Exhibit 2 information can be extracted to understand strategies followed by the private equity firms. As per the first hypothesis and based on the analysis in Exhibit 2, funds investing in both Brazil and Mexico are not obtaining a controlling stake in the companies they invest in. In a way this could say that having a controlling stake does not determine the success and amount of private equity invested in a country."* This finding would also go against the Lerner et al. 12005] finding regarding how private equity firms protect their interest when investing in countries with a French civil law origin by obtaining majority ownership. However, there is a simple test that could be performed on the data to prove otherwise. Even when both Brazil and Mexico have smaller ownership stakes in the private equity investments than the rest of the countries in the region, it would be important to review changes in strategy over time. If there is a shift to higher ownership shares, this could signal the growing importance of having a relative or absolute controlling stake when investing in Latin America. It can be seen in Exhibit 3 that investments have focused on increasing their extent of control through the region over time. This is also the case for both Brazil and Mexico independently. It could signal an adaptation process for the funds when structuring transactions in




EXHIBIT 3 Evolution of the Extent of Control in Private Equity Transactions in Latin America Brazil
I T * -

2000 Source: VELA. 1

0.9 0.8 0.7 -









0.6 ^ 0.5 - 0.4 -

0.3 - F 0.2 O.I H O 1990 1992 Source: Charvel.

; - , . Tt~TTTi-Ti-r1994 1996 1998

2000 2002 2004 2006




I 0.9 0.8 0.7

3 (continued)
Latin America

JL. %


0.5 0.4 H 0.3 0.2 -|


2001 2002 2003 2004 2005 2006 2007 strategies in Mexico are lagging behind those of its Latin American peers. The median investment in Argentina and Brazil seems to be two to three times larger than the median transaction in Mexico (when using Charvel's data). This is likely to have a direct impact on the performance ot the investment. Smaller transactions cannot support lengthy, deep, and expensive due diligence processes and structuring activities. If the due diligence and structuring of a deal costs USS lOOK, this represents 0.54% of the median deal in Brazil and 1.82% in Mexico (using Charvel's data). Mexican investments either have to wave some of the relevant cost associated with performing the investment and mitigating risks, or assume a cost situation that may directly and negatively impact the financial outcome. CONCLUDING REMARKS After describing three variables (ownership stake, company's equity valuation, and equity invested) among Argentina, Brazil, and Mexico, there are several takeaways regarding possible dominant strategies for private

2000 Source: VELA.

the region. Therefore, the findings could confirm the importance of having majority control when investing in Latin America. The second hypothesis of this article focuses on differences in equity valuations for companies receiving the private equity inflow among Argentina, Brazil, and Mexico. When using information both from VELA and Charvel, Mexican transactions seem to target significantly smaller average and median equity valuations when compared with transactions in Argentina and Brazil (see Exhibit 2).'" It is likely that Argentine and Brazilian investors are targeting later-stage companies, and in Mexico investors are funding smaller transactions. This could confirm the idea that private equity investments in emerging markets should focus on larger and more stable companies in order to minimize risks and obtain financial gains. The third hypothesis is based on possible differences in the amount of equity invested per transaction among Argentina, Brazil, and Mexico. It seems that the average and median equity investment in Argentina and Brazil are significantly larger than Mexican investment using either VELA or Charvel information for Mexico (see Exhibit 2)." Again, this suggests that investment




equity investments in the emerging markets of this

a better understanding of emerging-markets venture financing. ENDNOTES

The author thanks Alfredo Castellanos, Geort^ina Enthoven, and Fernando Fabre for their valuable comments. All errors or omissions are the author's own. 'See Gompers and Lerner |l'^98j. Black and Gilson [1999], Jcng and Wells (2000] and Balboa and Marti [2U01] for external variables to the private equity cycle. -See Black and Gilson [1999] for external variables to the private equity cycle. ^Allen and Qian [2005] analyze some of these aspects for Chinese entrepreneurs. ""For example Venezuela, Belize, and Trinidad and Tobago do not have a civil law origin. =Sec La Porta et al. |1998]. "See Charvel [2007]. 'For a detailed description, see Exhibit 3 in Charvel [2007]. ''Based on the possible issues with VELA's data, the information in Exhibit 2 may create some confusion. For example, if the median transaction in Latin America (using VELA) is USS13.0()MM and the median ownership stake acquired by the private equity fund is 49.0%, the post-money valuation of the private equity tirms receiving the investment should be USS26.53MM and not USS68.75MM as stated in the exhibit. This issue can be explained by the number of variables with complete information. VELA has 1.403 transactions of which 906 have the amount invested per deal. For the ownership variable there are only 201 transactions and just 124 for post-money equity valuation. The same analysis could be performed for Charvel with similar results based on the different number of observations per variable. However, in Charvel numbers seem to be relatively more consistent among the three variables. ''Investments in Argentina and Brazil seem to acquire larger ownership percentages than the ones performed in Mexico. This is apparent only when using the information for Mexico from Charvel. VELA's information is significantly different. It states that both Argentina and Mexico have larger ownership stakes per transaction than Brazil, a situation that would not be conclusive about the impact of ownership and control when performing private equity investments in Latin America. Mexico information in VELA includes only 47 transactions with complete information. Charvel has 271. Using Charvel, it seems likely that transactions performed in Argentina and Brazil are securing larger ownership percentages than investments performed in Mexico. In VELA, Mexican transactions have on average 58.3% of ownership

1. Based on the lack of development in legal institutions in the region (from poor rule of law to inefticient courthouses'-), having an absolute controlling stake would seem to be the winning strategy. While in legally advanced regions contracts such as shareholders' agreements are easier to enforce, doing this in Latin America could prove ditficult and expensive to monitor and implement.'-^ 2. Private equity investments in Latin America seem to do better when focusing on later-stage investments in medium to large companies. 3. Relatively larger investments seem to be a dominant strategy wben performing private equity investments in Latin America. 4. Future research should focus on the combination of some of these findings. For example, it seems that larger Argentine firms are willing to sell absolute control, wliile smaller Mexican companies are only interested in selling minority positions. Exhibit 2 may also provide information about diterences of business cultures and entrepreneurship in Latin America and shed light on which attitudes may provide better results for investors. 5. Tbe most important thing to be learned from this article may be that, apart from potential differences in tbe performance of private equity investments due to macroeconomic, entrepreneurial, cultural, or managerial variables, tbe way a transaction is structured in Latin American countries is a key determinant of the success of the investments. FUTURE RESEARCH This article singles out tbe legal institutional framework as a possible variable that could help explain the performance of private equity transactions. As stated in the beginning of the article, there are several other variables that need to be studied in order to understand the performance of private equity investments in emerging markets (i.e., specifics on industrial organization in tbe markets, underdevelopment of financial markets, and cultural aspects tbat impact entrepreneursbip and principal investment). Future research in addressing these variables needs to be performed in order to have

WINlEii. 2(109



and a median of 65.0%. Charvel's database suggests a different story: Mexican transactions seem to h;ive an ownership average of 45.7% and a median of 29.4%, in both cases below Latin America's numbers. '"The two databases seem to have differences for the Mexico numbers, but are not as drastic as the results in ownership participation. VELA has an average post-money equity valuation of US$83,73MM and a median of USS29.42MM. Charvel's database has US$61.25MM and US$17.35MM, respectively. "There seems to be a big variation between the VELA and Charvel databases. In VELA the average and median investments are US$22.81 and US$15.0()MM, while for Charvel the numbers are US$14.63 and US$5,50, respectively. VELA has 147 transactions and Charvel 341 for the same time period. '-See La Porta et al. [1997, 1998]. ''See Djankov et al. [2003].

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