To gain exposure to the domestic story, investors need to dig below the global LBO activity that has dominated the region, finds Joseph Mariathasan

A decade ago, the stereotypical view of Latin America, as Cate Ambrose, president of the Latin American Venture Capital Association (LAVCA), admits, was of hyper-inflation and political instability. But over the intervening period there have been fundamental changes that, combined with low levels of debt, have left Latin America looking like an attractive investment destination.

"Countries such as Brazil after Lula [President Lula da Silva] are looking very stable, very democratic," says Ambrose. "Peru, like Brazil, elected a leftist leader, who looks as though he will move to the centre. Columbia has been a success story and former president Alvaro Uribe did a good job cleaning up the drug dealers."

The growth in the region generally, like that of Asia, comes mainly from expanding domestic demand, a theme that private equity investors have very much taken on board - resulting in returns less dependent on the stuttering economies of the developed world.

Trend
This trend is underpinned by favourable demographics. According to Karin Hallin, who heads the São Paulo office of Partners Group, in 2010, more than 50% of the continent's population was below the age of 30 and close to 50m people are forecast to join the economically active population by 2020. This would lead to higher demand for a wide range of consumer products.

While GDP growth in Latin America is supported by the growth of domestic demand, this is not reflected in the composition of the public equity markets, which are dominated by commodity companies. As Hallin points out, 46% of Brazil's Bovespa index market capitalisation is commodity-related, but this is the case for only 12% of Brazil's real economy. The listed markets are also highly concentrated, with the 10 largest companies in Mexico accounting for 75% of the public equity index, for example. Private equity investments can offer much purer exposure to domestic consumption growth.

But while Latin America might be a convenient geographic designation, it masks a huge variation in investment opportunities - Brazil at one end represents a self-contained, dynamic universe for private equity investors, while at the other, Cuba, Venezuela, Bolivia and a host of others do not register at all.

Brazil itself is a relatively closed economy: "Brazil's exports account for 10% of GDP versus China at 29% and India at 18%, which means that the economy is driven by internal demand and less dependent on global growth," says Hallin. And while the sheer size of Brazil's economy and population makes it stand out, that, as well as its Portuguese language, renders it quite separate from opportunities elsewhere in the region.

"Brazil has such enormous opportunities that Brazilian private equity firms are completely focused domestically, while Brazilian pension funds are investing large amounts into private equity," Ambrose notes.

The local pension funds have played an active role in the development of the private equity industry over the past decade, although Ambrose points out that their requirement for a seat on general partners' (GPs) investment committees has created a governance conflict and acted as a deterrent to international limited partners (LPs) investing with Brazilian managers that have pension fund commitments.

Inevitably there is some interplay between Brazil and its neighbours. Alvaro Goncalves, CEO of Brazilian private equity firm Stratus and a LAVCA board member, points to one fund in Colombia that specialises in investing in companies expanding from Colombia into Brazil.

"In the mid-market space, many Argentinian agricultural companies are moving to Brazil," he adds. "Grain companies in Argentina are more professionally run, as ownership of land is usually separate from the management of the companies. In consumer goods, we see movement in the opposite direction as Brazilian companies move to Argentina, Colombia and Mexico."

Ambrose notes that many global firms are looking for regional opportunities, as this gives access to deals flowing across multiple countries and offers portfolio companies the ability to develop across a wider geographic region.

Ambrose picks out Mexico, Peru, Colombia and Chile as the major ex-Brazil private equity markets, with Argentina, Costa Rica and Uruguay making up a second tier. Many investors prefer Mexico over Brazil because its markets have not overheated - security issues have clearly frightened off some investors. She also likes Costa Rica, despite it being dragged down by drug traffickers.

Promising
The annual LAVCA Scorecard ranks business environments for private equity and venture capital activity of 12 countries in Latin America based on indicators including taxation, minority shareholder rights, restrictions on institutional investors, entrepreneurship and capital markets development.

Chile, Brazil and Mexico lead the 2011 rankings. The other major economy, Argentina, continues to struggle to develop a viable private equity or venture industry, despite its strong entrepreneurial community and increased interest from global investors. It ranks tenth in the region, tied with El Salvador and is above only the Dominican Republic.
The LAVCA indicates the industry in Argentina will continue to be constrained due to the perception of high political risk, legal uncertainty and a complex, high tax environment. The lack of a specific regulatory framework for private equity and underdeveloped capital markets are also significant hurdles.

Among GPs, Partners Group considers Chile and Colombia as the most promising investment destinations after Brazil, with the outlook for Peru dependent on political and economic continuity after president Humala's election. In the longer term, its also likes the potential in Mexico.

So what kind of deals get done in the region? Unlike in developed markets, financial engineering has had little impact on private equity in Latin America, primarily because debt was not readily available and is generally too expensive in the region. Despite this, fund-raising has been dominated by global firms financing large buyouts, according to Goncalves.

"There has been a mismatch between the fundraising and the opportunities, which are predominantly in the small and mid-market sector," he says. "As a result, the deal activity has been low, with capital sitting on the sidelines."

Brazil, in particular, has attracted too much capital for large buyouts, he says, whereas in Colombia some mid-market firms have been raising capital in an organised manner. "This helps the ecosystem as it is very difficult if you only have one extreme, says Goncalves."

Local private equity firms are more focused on the small and mid-market sectors, with the primary driving force being the operational improvements that private equity firms have been able to add to often family-owned businesses as they grew beyond the capabilities of the initial founders. That is very much the strategy for Brazilian firm GP Investimentos, for example. Similarly, global emerging markets specialist Aureos Capital focuses on companies smaller than $100m (€75m), investing up to $10m in the first round of financing.

"Typically we are buying a minority stake in a family-owned business which the founder has run in an informal manner to take it to a certain stage," as Erik Peterson, managing partner for Aureos Latin America, explains. "At some stage, he wants to monetise his equity and get the business to run more professionally. We introduce better corporate governance with a board of directors receiving timely information. Then, on a strategic level, we help the firms to expand rapidly through thinking of ways to find financing, and so on."

Goncalves agrees that a company founder is the engine and visionary of a firm, but also often a "limitation on its growth". Private equity firms can help dilute the position of the founder in a friendly manner, as well as dealing with generational succession in family-owned firms.

Aggressive
And the exit routes? For Aureos, the initial strategy for exit is invariably a strategic sale. This used to be sales to large US or European companies, but is increasingly shifting to local strategic purchasers. There are also some companies with the growth potential to enable them to become large enough to list publicly - predominantly in Mexico and the Andean region of Chile, Colombia and Peru, according to Peterson.

At the larger end of the market, private equity firms can help a company to grow large enough to list. Goncalves says this consists of two steps. "We first complement the management teams, fine tune the business plans and implement corporate governance. The second stage is the implementation of the business plan through adding on acquisitions, for example. Often the non-availability of capital has prevented consolidation in the industry."

As an example, Stratus took a $40m investment in Brazilian polyester fibre firm Unnafibras in August 2010, with a clear mandate of getting the company ready for IPO within 12-24 months. Despite being the largest player in its industry it still has only 15% of the Brazilian market. Stratus worked with Unnafibras to develop a five-year strategic plan aimed at boosting its position in the marketplace, both by doubling production capacity with two new recycling plants and by identifying potential acquisitions of direct competitors, as well as businesses with different niches.

GP Investimentos goes even further in its approach to helping management, in some cases installing one of its partners as part of the management team, according to director of investor relations Raymond Trad.

One example was BRMalls, one of the largest integrated shopping malls in Brazil. GP installed one of its partners as CEO and implemented an aggressive M&A strategy, increasing ownership from seven to 32 malls and administration from 24 to 25, transforming the firm into the largest player in the sector within a year. Six months after the deal, the company went public at an implied valuation of 2.5 times the initial investment.

Asia might still be delivering higher GDP growth than any other region in the world but Hallin points out that Latin America should post a superior growth performance to the developed economies.

The IMF expects Latin America to grow by 4.5% and 4% in 2011 and 2012 respectively. Private equity investment is well positioned to take advantage of that, providing funds focus on the growth of domestic demand and are not reliant on exports to an increasingly risky developed world.