Interaction Model of Private Equity and Venture Capital Developing
Factors in Chile and Latin America
By
~MASSXAUSETT,-S
OF TECH' OL
Angel Sevil Esteban
MBA, Pontificia Universidad Cat6lica de Chile, 2005
Industrial Engineer, Universidad de Zaragoza, 2000
SUBMITTED TO THE MIT SLOAN SCHOOL OF
MANAGEMENT IN PARTIAL FUFILLMENT OF THE
REQUIREMENTS FOR THE DEGREE OF
JUN
ARCHIVES
JUNE 2012
C 2012 Angel Sevil Esteban. All Rights Reserved.
The author hereby grants to MIT permission to reproduce and to
distribute publicly paper and electronic copies of this thesis document
in whole or in part in any medium now known or hereafter created.
////,0"
Signature of Author:
/
MIT Sloan School of Management
May 11, 2012
Certified By:
Robert C
Stewart C. Myers
erton (1970) Professor of Financial Economics
Thesis Supervisor
A4
Accepted By:
U
Michael Cusumano
SMR Distinguished Professor of Management
Program Director, M.S. in Management Studies Program
MIT Sloan School of Management
1
"";. j;§
LIBRARIES
MASTER OF SCIENCE IN MANAGEMENT STUDIES
AT THE
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
zll/
iNTTT
Interaction Model of Private Equity and Venture Capital Developing
Factors in Chile and Latin America
By
Angel Sevil Esteban
Submitted to the MIT Sloan School of Management on May 11,
2012, in partial fulfillment of the requirements for the Degree of
Master of Science in Management Studies
ABSTRACT
Private equity and venture capital (PE/VC) are efficient resource allocation systems that provide
equity capital to selected entrepreneurs, industries or firms that contribute to advance the economic
welfare of society. Private equity and venture capital firms act as a catalyst for initiating, consolidating,
professionalizing, growing and globalizing their portfolio companies, and in doing so, they increase
their competitiveness and expand their operations in regional and global markets. They create an
invaluable ecosystem based on innovation, entrepreneurship and the detection of business
opportunities, building local talent and setting up the pillars of new growing industries diversifying
countries' economies.
From 1999 to 2005 the internet bubble and several economic crises impacted Latin America,
collapsing private equity and venture capital activity. Moreover, the confidence of limited partners (LPs)
in the fund managers (GPs, general partners) sank. Thanks to the fast growing internal demand of
Brazil and the low economy cycle in developed countries, the appetite for private equity assets in
emerging markets and in Latin America raised, creating the opportunity for successful exits. However,
few success cases have been seen outside Brazil.
Why the number of exits in Chile has been limited? What are the drivers of success? How is it
possible to accelerate the development of PE/VC given the benefits they provide to the economy and
the society? This document answers these questions identifying the most important factors affecting the
development of private equity and venture capital. All the factors are linked together and form part of
an ecosystem; they are not independent parts that can be studied separately. This ecosystem is modeled
be mean of a framework, where the interactions among these factors are defined and their impact is
explained in detail.
Through the analysis of the model of private equity and venture capital developing factors two
main conclusions are extracted: first, the development of PE/VC is a continuous learning process;
positive actions implemented now will have a visible impact in the medium or long term. Second,
success is the main driver of the PE/VC development as it has a positive amplifying effect in the whole
ecosystem. However, success is one of many other factors, and all of them must be considered since all
are interconnected. The more positive actions are put into action from all the different factors, the
more success cases will be created and as a consequence, the development will be accelerated, creating a
synergic reinforcing loop.
Thesis Supervisor: Stewart C. Myers
Title: Robert C. Merton (1970) Professor of Financial Economics
3
[Page intentionally left blank]
4
ACKNOWLEDGEMENTS
First, I would like to thank Professor Stewart Myers for his advice and guidance in this intellectual
journey. Thanks to HBS Professors Richard S. Ruback and Royce Yudkoff; they sowed the seeds of
this thesis and boosted my interest in private equity.
Thanks to all the individuals who spent their time with my interviews and provided me invaluable
insights and information.
I am also grateful for the support of all my fellow MS in Management Studies classmates,
especially thankful to Luis Caballero and Marco Terdn, for their sincere friendship. My appreciation
also goes to Chanh Phan, Julia Sargeaunt and Alex Caracuzzo, for their kind help.
This thesis is ultimately dedicated to Alejandra and our sons, Gabriel, Daniel and Rub6n, my
source of energy and inspiration.
5
TABLE OF CONTENTS
CH A PTE R 1: IN T R OD U CT IO N ...................................................................................................................
8
1.1 M ethodology, O bjectives & Scope............................................................................................
8
1.2 Defining Risk Capital ("Capital de riesgo").............................................................................9
1.3 Private Equity Global Outlook.................................................................................................
10
1.4 V enture Capital G lobal O utlook ............................................................................................
18
1.5 Why the Development of Venture capital and Private Equity is Important?.................21
CHAPTER 2. PRIVATE EQUITY AND VENTURE CAPITAL IN LATIN AMERICA: AN
INDUSTRY OVERLOOK ..................................................................................................
23
2.1 Recent History of Venture Capital and Private Equity in Latin America........................23
2.2 Market Overview ............................................................................................................................
25
2.3 Why Invest in Latin A m erica?.................................................................................................
29
2.4 Latin American Funds Performance.......................................................................................32
CHAPTER 3. PRIVATE EQUITY AND VENTURE CAPITAL IN CHILE ............
3.1 Development of Private Equity and Venture Capital in Chile .........................................
34
34
3.2 Fundraising, Investments and Exits in Chile........................................................................41
3.3 Regulatory Framework for Private Equity and Venture Capital in Chile ........................
45
3.4 The Chilean Pension Funds in the Latin America Context...............................................
47
3.5 The V enture Capital Ecosystem ..............................................................................................
51
CHAPTER 4. THE INTERACTION MODEL OF VENTURE CAPITAL AND PRIVATE
EQUITY DEVELOPING FACTORS.............................................................................54
4.1 Private Equity and Venture Capital Developing Factors....................................................54
4.2 Introduction to Causal Loop Diagrams................................................................................
57
4.3 The V enture Capital M odel.....................................................................................................
58
4.3.1 V C s Experience ........................................................................................................
59
4.3.2 LPs Confidence in Venture Capital......................................................................60
4.3.3 Entrepreneurs' Motivation.....................................................................................
61
4.3.4 V enture Capital N etw ork.......................................................................................
63
4.3.5 N umber of V C Funds ...........................................................................................
64
4.3.6 Entrepreneur's Network & Experience...............................................................65
4.3.7 Impact of Socioeconomic Environment in Venture Capital ...........................
6
66
4.3.8 Men torin g ......................................................................................................................
4.4 The Private Equity Model........................................................................................................
67
68
4.4.1 Experience of Private Equity Firms (GPs) ..........................................................
69
4.4.2 LPs Confidence in Private Equity Firms.............................................................
71
4.4.3 G Ps Network ................................................................................................................
73
4.4.4 Awareness of Private Equity ..................................................................................
73
4.4.5 Number and Size of PE Funds ..............................................................................
75
4.4.6 Impact of Socioeconomic Environment in Private Equity...............................76
4.4.7 Impact of External Financing Sources................................................................
78
4.5 U sing th e Models............................................................................................................................79
CHAPTER 5: CONCLUSIONS.....................................................................................................................80
REFERE N CES ......................................................................................................................................................
83
LIST O F EXHIB IT S .............................................................................................................................................
88
APPENDIX 1: INTERVIEWS CONDUCTED IN THE RESEARCH ...................................................
90
APPENDIX 2: TAXES APPLICABLE IN EUROPE AND US DEPENDING ON THE
91
..............................................................................................
INVESTMENT
7
CHAPTER 1: INTRODUCTION
1.1 Methodology, Objectives & Scope
Part of this study is based on 35 interviews and chats with experts on the topic of venture capital
and private equity in Chile and South America. All the interviews have been conducted face to face
between January 16 and March 30, 2012 in Santiago de Chile. In order to assure treating the
information completely confidential, no reference to the interviews will appear in this document.
However, all the comments received from the interviewees have been considered and deeply influenced
this work.
The final goal of this thesis is to help the development of private equity and venture capital in the
region in terms of increasing the number of local experienced fund managers and the number and
amount of local investments by foreign or local investors. The following question arises: Why is this
goal important? I believe that private equity and venture capital are two extraordinary tools that help
the organic growth of the economy, developing the local talent and providing an open door to
knowledge generation, innovation, new technologies and businesses and opportunities development.
In addition, private equity and venture capital are the instruments needed to support
entrepreneurship and wealth creation. A well cultivated ecosystem of entrepreneurship is one of the
most valuable assets of a country, especially in downturns, since it provides jobs, opportunities and very
important, a successful local example transmitting confidence and energy; a reference to follow.
To achieve the goal of this thesis, it has been divided in five chapters. The first chapter offers an
introductory update on global private equity (PE) and venture capital (VC). The second chapter
describes briefly the evolution and outlook of the industry in Latin America. The third one analyzes in
depth the most influencing factors in the development of PE/VC in Chile. The forth chapter develops
extensively the interactions among all relevant factors affecting PE/VC, building visual and
comprehensive models. And finally, the fifth chapter presents the conclusions.
Through my research I conclude that Chile and Latin America have still a long way to reach a
mature PE/VC market. However, from the last seven years there has been a fast progress, in terms of
local entrepreneurs and managers gaining experience in the PE/VC field with a global action scope and
network. Getting a continuous support from governmental policies in investing in small or startup
companies is key for the survival of PE/VC in this early stage of development. In Chile regulations
regarding investments from institutional investors should be eased and the benchmark methodology on
pension funds should be changed to improve the efficiency of their investment decisions. The final
objective of public policies should be the creation of a local expert ecosystem that provides confidence
to foreign investors and international PE firms; the seed to success.
8
Success is identified in this work as the most important factor affecting the development of private
equity and venture capital. The generation of success cases would accelerate the learning process of the
whole system, increasing the experience of all the agents involved (entrepreneurs, fund managers,
business men, etc.), improving the confidence of investors in the managers and breaking down cultural
a synergic,
c
p
where t
eAxi
dealo
the main lever.
In this world most of the resources are limited and/or replaceable. Some economies such as Chile,
and in general in all Latin America, are enjoying the positive economic cycle because of the high
demand of natural resources. We just need to look backwards to see that good times do not last forever
(for example, the history of Chilean saltpeter in 1930), and realize that the history can repeat again.
Now it is time to invest in our future.
1.2 Defining Risk Capital ("Capital de riesgo")
In Latin America private equity and venture capital are embraced in a unique concept: risk capital
(in Spanish, "capital de riesgo"). It is noticeable that the words risk capital have a negative connotation
whereas venture capital or private equity generate more positive feelings. It indicates a higher risk
aversion of the Latin culture compared with the US culture.
Private equity is a broad term that includes all kind of transactions of illiquid, private held assets.
Under this definition venture capital (VC) is one type of private equity. We define venture capital as a
transaction of equity in a new or early stage growth business providing financing, advising and strategy
through partial control of the company.
In this document, the term private equity (PE) will be used in a narrower sense, considering all
private equity transactions except those related to start-ups (venture capital). Private equity transactions
can be divided in three main groups: first, growth equity, which involves investing in companies with
high growth opportunities, usually taking a minority stake in the company keeping the management and
financing the expansion; second, buyouts, the most traditional form of private equity generally using
financial leverage, taking full control of the company and replacing the management, and third,
distressed private equity, used to restructure companies in turnaround situations.
Even if the legal entities are not completely equivalents in US and in Latin America, the term
General Partner (GP) will be used to refer to the fund managers, and the term Limited Partner (LP) to
the investors committing capital in the fund.
Both PE and VC investments are intended to be held for a limited period of time with the
expectation that there will be substantial growth in equity value followed by sale. It is important to
remark that family offices and investment holdings, direct competitors of PE/VC firms for deals in all
Latin America, usually have long term investment horizon, following a different investment strategy.
9
1.3 Private Equity Global Outlook
North America, especially the US, continues to be the most active region, with higher growth rate
than Europe and Asia Pacific (Exhibit 1.1). However, the total value of the deals is still low compared
with those in the years before the credit crisis. Since the '80s the private equity industry has had ups and
downs in cycles of 10 years. Arguably the industry is now at the bottom of the cycle, so higher volume
of transactions is expected in the future. A total recovery could last several years since the levels of
leverage are now significantly lower than in 2006-2007. Since 2009 investment activity concentrated the
buyouts in mid-market deals valued between $500 million and $5 billion (Bain 2012).
Exhibit 1.1 Global Investment Activity (US$B)
696
666
600
400
(10-11)
109-11)I
Rest of world
-13%
70%
Aso-Pocific
32%
41%
297
246
200
0
32""
95
96
54
2
97
M-
99
00
01
U Europe
f
**f
98
U
72
68
65
184 184
186
-
142
I1I11""
112 98
30
M
-"
02
03
04
05
06
07
08
09
l
10
North America
-2%
58%
-5%
67%
11
irnsocons
Noes: Exdudes
addns, loo-own
andacquislions of banrupt asse;s
based
onannouncement
daie;
geographybasedonOhelocaion of targets
orpendingwih data subled to change;
announced
deals#iat arecompleted
includes
Source: Bain Global Private Equity Report 2012. Figure 1.2.
One of the consequences of the credit crisis is that more control and scrutiny has been imposed to
private equity. In the US the Dodd-Frank legislation in 2010 requires funds with assets over US$150m
to register with the Securities and Exchange Commission (SEC). In addition to registration, funds have
to name a chief compliance officer who will be responsible for establishing and maintaining a
compliance program.
Another Dodd-Frank provision, termed the "Volcker Rule," contains restrictions on the ability of
financial institutions to engage in PE investing. In Europe, the Alternative Investment Fund Managers
Directive aims to increase transparency and disclosure and, as such, requires firms to provide
information on funds' financial positions and risk profiles. It also requires any firm, regardless of where
it is based, looking to raise capital from European investors to apply for a passport.
10
Exhibit 1.2 Global Private Equity Dry Power
1.071
1.064
1005
1,000
992
927
801
750
561
500
403
406
2003
2004
250
0-
2005
2007
2006
2008
2010
2009
20
II
As of year-end
I
Buyout
N Realestate
U Distressed PE
E Venture
Other
Mezzanine
and urnrond fwd
Note Diswessed
PEincludes distessed debtspeciol situahton
Source: Bain Global Private Equity Report 2012. Figure 1.6.
In 2011 general partners continued to feel pressure to invest because of the high levels of
committed uninvested capital, also called dry powder, reaching more than US$900 billion globally
(Exhibit 1.2). GPs faced the increasingly urgent need to find investments to absorb the capital and to
avoid the costs of opportunity of missed carried interest. With so much buyout capital to deploy, and
considering the free cash flow of many US corporations, competition for attractive assets is intense.
Many GPs placed heightened focus on deal origination, uncovering proprietary opportunities. Other
GPs have worked to strengthen their relationships with company owners and intermediaries, such as
banks and advisers, building brand awareness and trying to catch external opportunities right at the
time they are originated.
Exhibit 1.3 Add-on Deals as Percentage of Buyout Deals in US
SS5
2,soo
2,000
1.500
11000
450A
40'
38
359A
3096
0
2001
2002
2003
2004
2005
2006
mAdd-on mNon Add -on
Source: PitchBook Private Equity Trends 1Q 2012
11
2007
2008
2009
Add-On % of Buyout
2010
2011
Add-on or consolidation strategy represented a significant 50% of the US deals in 2011 (Exhibit
1.3). Successful GPs focused on assembling many small businesses that fit well into the company's core
strategy. They took time to assess the strategic rationale for each add-on, recognizing that achieving the
program's full scale can take years and the true synergies of scale.
According to PitchBook, The US median buyout size in 2011 was US$130 million and the median
size growth equity was US$23 million. The average leverage used in deals above US$1B was 61%,
whereas the average leverage used in deals under US$1B was 46%, the lowest in the last 10 years.
During the second half of 2011 the number of deals declined severely, due to the tightened credit
conditions and the fears about a sovereign debt crisis in Europe. This fact highlights a still strong
dependency of PE in leverage through high junk bonds or leveraged loans. The importance of debt in
buyouts is reflected in the EBTDA multiples (Exhibit 1.4).
Exhibit 1.4 EBITDA Multiples of Buyout Transactions in US
lx
9.5
8.2
S.9
6x
Sx
4x
3x
2x
Ix
Ox
2002
2003
2004
Debt / EBITDA
2005
2006
2007
Equity/ EBITDA
-Total
2008
2009
2010
2011
Deal Size / EBITDA
Source: PitchBook Private Equity Trends 1Q 2012
Financing for leveraged buyouts (LBOs) is probably to be limited during the following years, as
CLOs (collateralized loan obligations) reinvestment periods expire. In 2011 they represented 40/6 of
the total debt supporting LBOs, down from 60% in 2006.
Lower leverage and lower economic growth has caused a shift in the focus of many PE firms,
from financing leverage and the search of growing markets or industries to a focus on internal growth,
margin improvement and operational strategy. The value must be created by taking advantage of rapid
shifts in economic value chains.
Even supposedly at the bottom of a private equity cycle, the number of funds is globally increasing
(Exhibit 1.5). The increased competition among GP's worldwide, from strategic investors and from
sovereign wealth funds, has pushed EBITDA multiples up.
12
Sovereign wealth funds (SWFs) are emerging as a potential source of capital to help bridge the
fund-raising gap. Contrary to conventional industry thinking, SWFs are eager to partner with a wide
range of PE firms provided GPs understand how to work with them. Middle East countries and fast
growing economies of Asia are looking to deploy assets in high return alternative investments.
Exhibit 1.5
Number and Target Value of Active Funds by GP Location
Aggregate fund-raising
target value
Number of PEfunds by GP location
on the fund-raising rood
$1.0008
2.000
800
1,00
600
1000
400
500
0
200
Jon
06
Jon
07
08
I
Jon
09
North Americo
Jul
09
Apr
09
0 Europe
Oct
09
Jon
10
Apr
Jul
10
10
Rest of world
K Asia
Jon
11
Oct
10
-
Apr
11
Ju
11
0
lct
O
11
Jon
12
Aggregate target value
Source: Bain Global Private Equity Report 2012. Figure 1.16.
The aggregate target value increased in 2011 reaching US$900 billion (Exhibit 1.5). From the 141
funds closed in the US, 30% were new GPs entering the private equity industry. Experience and track
record are still important, but dedication, passion, and new ideas are also been welcome by LPs.
However, new relationships that won LP commitments in 2011 were often the result of a courtship
lasting months or years.
The average time to close a US PE fund was 16 months, and the average fund size was US$777
million. The total holding period of investments in 2011 increased, resulting in a median time from
buyout to exit of 4.81 years, the highest in the last 10 years (PitchBook 2011). Longer holding periods
have a negative impact on the IRR.
Since LPs are more and more exigent and it is more difficult to build a track record because of the
increased competition and market volatility, it is getting harder to launch new PE firms. The number of
PE firms decreased slightly in the last quarter 2011 (Exhibit 1.5) and a declining trend in the number
of PE firms and in the number of funds is expected in following years.
13
Exhibit 1.6 Global Exit Activity
Global buyout-backed exits
Value by chonnel
Total count
$1508
400
1 9
113
300
100
220
H
0
01
02
03
2007
04
01
02
03
04
2008
1 Strategic
13
4a10
01 02
03
04
01
2009
U
Sponsor-kponsor
Q2
03
04
2010
IPO
-
01
02
03
04
2011
Toka count
Notes Excludes
bankupi; IPO value rprwnts off*( omount
Source: Bain Global Private Equity Report 2012. Figure 1.14.
Secondary buyouts are becoming more and more important, representing in the US a 35% of all
the exit volume in 2011 (Exhibit 1.6). However, strategic buyers are the most common way of exits.
IPO's represented in the US a barely 9% of the exits (US$), and corporate acquisitions represented
more than half of the deals. IPOs represented the preferred exit route for PE-backed companies in
China since China's regulatory environment is not very conducive to trade sales, particularly those
involving foreigners.
It is interesting to observe the correlation between performance and fund size (Exhibit 1.7). In
the US, there is a significant difference in IRR depending on the fund size. Bigger funds, higher returns,
and funds under US$100 million, consistently underperform. Through the interviews it was found that
a similar pattern is observable in Latin America, where funds over US$150 million have IRR over 25%
whereas small funds can barely reach a 1 0% IRR. Of course the factor to consider it is not the size of
the fund itself but the size of the investments.
However, IFC recently shared their experience in 313 exits showing average IRR of 18% for
investment sizes over $US2 million. The number of write-offs was significant for investments of size
below US$30 million.
14
Exhibit 1.7 US Private Equity Horizon IRR by Fund Size
30%
25%
--- $58+
-$1B-$5
15%
....
10%
10%
11
7%
$500M-$1B
--$250M-$500M
-----$1OOM-$250M
-Under
$10OM
5%
0%
1 Year
3 Years
-5%
Source: PitchBook Private Equity Trends 1Q 2012
Another factor that affects the IRR is the number of simultaneous investments. According to a
research in 7,453 investments made in eighty-one countries by 254 PE firms between 1971 and 2005,
Lopez de Silanes, Phalippou and Gottschalg (2010) affirm that as the number of simultaneous
investments made by a GP increases, returns fall. The explanation is that diseconomies of scale are
linked to firm structure: independent firms, less hierarchical exhibit better returns. High-performing
firms restrict their size to remain top performers (Kaplan and Schoar 2005).
15
Limited partners have become increasingly demanding and vocal, asking for lower management
fees and even doing due diligence to GPs' internal procedures. They also try to find top quartile GPs to
guarantee the profitability of their investments. However, even if track record is maybe the factor that
better predicts the future fund's performance, it is not absolutely certain. Exhibit 1.8 shows that at
least 10% of top quartile funds perform worse the next year.
Hedge funds are also looking for opportunities in the private equity area, but more as debt
providers, minimizing the risk: if the company performs well, they can get a 15% return based on
interest payments, and if the company performs bad warrants are activated so they can get at least
partial control of the company.
Exhibit 1.8 Performance Quartile Distribution of Successor Fund to Top Quartile Funds
100%
80
60
40
_ _ in topquartile
persistence
20
0
Predecessor fund vintage
Predecessor fund vintage
2000 and earier
2001 andlter
Notes: Analysis includes
buyout funds
of US-based
GPs;inclides 271 fundpairings with thepredecessor
fnd,
vintage 2000 andeoder, and 119 fundpairings with thepredecessor
fund,vintage
2001 andlater
Source: Bain Global Private Equity Report 2012. Figure 2.26
Having the control or influence in the operations of the firm is a key issue for most of GPs since it
minimizes the risks. Nevertheless, it does not mean that minority positions cannot be taken. IMIinority
positions, distinctive of growth equity, should be secured through partnerships that provide access to
transactions, influence in the company direction and influence in the exit, i.e., being actively advising
and hand holding based in the GP's experience. Data from 61 majority positions and 251 minority
positions from IFC invested funds shows that minority positions have led to good performance in all
forms of exit, indicating that the risks associated with minority positions can be managed effectively
(Exhibit 1.9).
16
According to Matt Cole from North Bay Equity Partners, in the last years more firms taking
minority positions entered the market, especially in Brazil, which also is a sign there's a lot of
confidence in economic growth, management teams, and local partners.
Exhibit 1.9 IFC Investments IRR per by Exit
Mean Performance by Exit lime,
Majority versus Minority Investmens
Mediar Performance by Exit Time,
Majority versus Minority Investments
0.5
0.6
Minority
Majority
0.4-
Minority
0.5
Majority
OA
0.3
0.3
0.2
0.
0.1
0.0
0.1
iPO
0.0
Trade sale
MBO
Structured Exit
Sample of 61 rm;Jonty positions and 251
IPO
Trade sale
MBO
Structured Exit
Samplie of 61 majontty oositions and 231 rninority
positiois from IFCinvested funds
rninorry
positions from IFCinvested funcs
Source: IFC World Bank 2010
17
WU
1.4 Venture Capital Global Outlook
Venture capital hit the bottom globally in 2009. That year in the US there were just 3,065 deals
with a value of US$19.7 billion. Since then it has had a slow recovery in terms of capital invested, IRR
and number of firms in existence but still far from the levels pre-internet bubble (Exhibits 1.10 &
1.11). According to PricewaterhouseCoopers, in 2011 the total venture capital deals in US were 3,673,
amounting more than US$28 billion. This represents an increase of 22% respect the capital invested in
2010.
Exhibit 1.10 Venture Capital Investments in the US
6ntre MICapnal
Mo nrested (SWaims)
-.-
Funded byVenture Capital
Companes
0
00
3845
3383
3152
2688
2655
V2486
3398
2752
;
2554
1000
93
SA.1
7.
314
o
1970 198
0
$.40wa
1I90
19%
lI
2000
2001
2002
20)
2004
20k5
2006
2007
2008
200
2 1t
Source: Venture Impact 2011
There is currently a consolidation process in the venture capital industry. In some cases this
consolidation is not visible since it takes place at the level of the general partners. The number of funds
and VC firms remain the same but they are controlled by the same individuals.
Exhibit 1.11 US Venture Capital under Management
No. of VC Firms in Existence
VC Funds in Existence
No.4ofPoesinl
No. of First Time VC Fund s Raised
No. of VC Funds Raising Moe his Year
VC Capital Raised This Year ($B)
384
716
,66
13.0
86.0
3.2
861
1,701
791
104.0
791
1,3
6,328
649.0
104.8
157.0
12.3
Avg VC Capital Under Mgt per Fiirn ($M)
Avg VC Fund Size to Date ($M)
Avg VC Fund Size Raised This Year ($M)
LargestVC Fund Raisedto Date ($M)
73.7
36.5
37.2
1,775
255.9
88.0
161.5
5,000
223.4
107.8
78.3
6,300
No. of
Source NVCA Yearbook 2011
18
44.0
A global trend is that many institutional and private investors have turned their back to venture
capital in the last years. In Europe there has been an important shift in terms of the LP support: private
individuals have almost disappeared while governments have increased considerably their participation
(Exhibit 1.12).
Exhibit 1.12 LPs Distribution in European Venture Capital
2011
2007
Government
9.9 --------
l
Other
12.9
Private
individuals
-7.7
Banks&
capital markets
12.9
-21.3
Private
individuals
20.6 ---
Source European Venture Capital Association
Investors are trying to minimize risks investing in early and later stages rather than providing seed
capital (Exhibit 1.13).
US Venture Capital Investments by Stage of Development
Exhibit 1.13
DUas0
1,000
3000
2000
,000
5000
6,000
7,000
8,000
s.1
Later Stage
-
Startup/Seed
Grand Total
10,000
9,000
Expansion
-
-
9
- -jA
- --
$
3$28.42300
2010
2011
Sourr: PWC MoneyTree Report, Full Year 2011
In 2011 the volume of exits increased 48% to US$32 billion, being M&A the most important exit
vehicle with 429 transactions, representing 70% of the total volume. 52 IPOs were registered, a increase
of 30% (US$) compared with the last year (Exhibit 1.14).
19
Exhibit 1.14 US Ventured Backed Exits
Number of IPOs
M&A Deals
$ inmilions
Sinmiaions
10009
9000
2000s
1000
1000
50
1000
ouarter
Number Of
M&Adeafs
01
02
0s
04 01
(65)
(85)
(69)
(74) (122)
04
04
02
os
01
os
(99) (113) (97) (129) (90) (118S) (92)
o2
0ure 10
Numbe Of MP~
(0)
(3
(4)
(10)
(17)
(14)
s0
10
so
10
s0
(5)
(34) (14)
(22)
(5)
Source PWC MoneyTree Report, Full Year 2011
Venture capital returns improved in 2011, another sign of the VC recovery (Exhibit 1.15).
Although the returns in the third quarter of 2011 was marginally negative due to volatility in the IPO
market, total projected returns for the whole calendar year 2011 are positive and marked performance
improvement in 2012 is expected.
Exhibit 1.15 US Venture Capital Index End to End Returns
Ending Period
Septemnber 30, 2011
June 30, 2011
March 31,2011
December 31, 2011
US VtrCpital Early Stage Indiex
US. Venture Capital Late & Expansion Stage Index
US. Venture Capital MultiStage Stage index
DJIA
NASDAQ ComposIte
S&P 500
i--
3 Years
5 Years
4.9
4.3
2
-0.2
6.7
7.4
5.9
5.7
-0.7
7
5
8.4
:i
20.9
26.3
18.5
13.5
.
-0.7
21.9
4.4
6.
1.1
-1.3
-11.5
-12.9
-13.9
25.6
17.7
3.8
2
1.1
12.7
2.9
3.2
4.9
1.2
12.9
5
1.4
1.4
-1.2
20
31.7
30.9
343
34.
27.3
27.4
26.5
26.3
36
25.6
Q
431
31.5
6.7
4.5
4.7
4.9
2.8
13.1
29.5
6.5
4A6
5.2
21.4
24.4
9.2
7.9
7.6
-4.
The Cambridge Associates LLCUS.Verture Capital Idex* Is an end-to-end calculation based on data compiled
from 1.327 U.S.venture capital funds (876earIly stage, 171 late & expansion stage, 277 multi-stage and 3 venture
debt funds), includng fully liquidated partnerships, formed between 2981 and 2011.
Pooled end-to-end return, net of fees, expenses, and carried Interest.
Source: Cambridge Associates LLC
26
1.3
-0.1
-2
(11)
1.5 Why the Development of Venture capital and Private Equity is Important?
After ten years of poor returns, the number of LPs willing to invest in venture capital has been
reduced dramatically. In Europe governments have reacted by increasing the committed capital in
venture capital funds. The reason of this highly welcomed interest is the fact that venture capital is the
catalyst of innovation and entrepreneurship into wealth and positive social and economic impact.
Venture capital not only generates value in terms on new jobs and revenues creation (Exhibit
1.16), but it is also a source of new companies, technologies and innovation. Throughout its history,
venture capital investment has built entire industry sectors by funding ground breaking innovations.
From biotechnology to information technology to clean technology, thousands of startups have been
brought to life, improving the way we live and work each day. Among the most known examples are
Apple, Cisco, Starbucks, FedEx, Microsoft, Amazon, Home Depot, Skype, Facebook and others.
Exhibit 1.16 Impact of Venture Capital in Economic & Social Factors in UK
Indexed turnover trends
260
Indexed employee trends
200
indces, 2006(7 - 100
Indices, 2006/7 a 100
240
180 VC-backed companies
1
220
-
Non VC-backed companies
VC-backed companies
-
200
Non VC-backed
companies
160
180
140
160
140
120
120
100
100
80'
80
2006/7
2007/8
2008/9
2009/10
200617
2010/11
Indexed gross profit trends
260
2007/8
2008/9
2009/10
2010/11
200910
201011
Indexed productivity trends
Indices, 2006/7 - 100
170 -
240 -
-- VC-backed companies
160
220
-m Non VC-backed companies
150 -
200
Indces, 2006f7
in
-
140
180
- 100
VCbacked companies
Non VC-backed companies
130
160
120
140
110
120
100
100
90-
80
2006/7
2007/8
2008/9
2009/10
2010/11
Source British Venture Capital Association, 2012
21
2006/7
2007/8
2008/9
VC is also crucial for the development of a culture that rewards innovation, value creation and
entrepreneurship. Good ideas and businesses have support: finance source, implementation of good
corporate governance practices, management and industry advice, etc. Venture capital provides money
and at the same time they are the pillar that supports the efforts of the entrepreneurs through strategic
advice and guidance, sharing their valuable experience in other start ups and providing a huge network
of contacts to help in recruiting talent or in marketing and selling products. And even more important,
venture capital supports Schumpeterian innovations that establish the basis of new firms and new
industries (Kenney, Han and Tanaka 2002).
Although venture capital is by far a more common asset class in developed countries, emerging
countries are seriously considering venture capital as an important part of their future GDP growth. In
Israel venture capital investments contribute directly over 1% to the country's GDP and the technology
sector represents 25% of the GDP.
In other countries outside the US and UK there has been little study of the benefits of the venture
capital and private equity industry to the entire economy, but in Taiwan many of the Taiwanese
computer-related success stories received venture capital funding. For Israel, in 2000 high-technology
industry accounted for approximately 25 percent of the entire GDP, and venture capital investing has
been an important support for the high-technology environment there (Kenney, Han, Tanaka 2002).
Private equity capital is critical creating competitive, profitable, high growth companies. PE could
be defined as one of the instruments countries have to adapt their economy to the rapid world changes.
Private equity facilitates strong sustainable growth, capital into starving economies, improvements in
corporate governance, fresh operational and strategic thinking, access to a global network
(internationalization), and creating new jobs. It is also a way to reinvest wealth and attract investors
from outside to augment it.
Another reason of the importance of venture capital and private equity especially important in
emerging markets is that it creates social equality through a wider and more efficient allocation of
resources. In Latin America the concentration of the economic power increases the probability of
supporting not the best projects but the projects where the decision makers know the entrepreneurs,
restricting the investment opportunities. Consequently, private equity and venture capital can play an
important role as a social factor, uncovering opportunities that otherwise would stay untapped.
Like many other countries in Latin America, Chile depends strongly from natural resources,
especially from copper and cellulose. For these countries venture capital and private equity is an
efficient solution to support the talent and innovation, diversifying the sources of wealth generation.
However governments must be aware that the outcomes of the implemented policies have long term
returns and not give up in their efforts looking at the short term results.
Just recently, in April 2012, the president Obama signed into law the Jumpstart Our Business
Startups Act or JOBS Act, a law intended to encourage funding of United States small businesses by
easing various securities regulations. This fact highlights the importance of a continuous support to
entrepreneurship and small businesses, even in developed countries.
22
CHAPTER 2. PRIVATE EQUITY AND VENTURE CAPITAL IN
LATIN AMERICA: AN INDUSTRY OVERLOOK
2.1 Recent History of Venture Capital and Private Equity in Latin America
Private equity funds proliferated in the mid 90s. By the end of 1999, there were more than 100
Latin American funds, most of them had not existed earlier in the decade. Between 1992 and 1997, the
value of new private equity capital grew by 114% annually, from just over US$100 million to over US$5
billion. The private equity expansion was strongly supported by bilateral development institutions such
as the IFC (International Finance Corporation) and the European Bank for Reconstruction and
Development. Their participation was critical in the earlier years to convince private investors to
commit capital (Leeds and Sunderland 2003).
However funds didn't perform well. Of 227 Latin American private equity investments between
1995 and mid-2000 only 15 investments had been exited, and returns were in single digits or lower.
Investors turned away and funds raised in 2004 were the lowest since 1993 (Exhibit 2.1). as a
consequence, the majority of current Latin America funds are very young, being founded beyond 2005.
Exhibit 2.1 PE/VC Investments and Fundraising Evolution in Latin America
11.0~
10.09.0-
10.3
9.2
8.0 7.06.0.
8.1
6.5
6.4
5.7
5.0 4.0 - 3.
3.0
2.0-10
5.0
3.6
3.
3.7
2.62.8
0.0
07
n0.
0
0.8 0.70.6 .
1.31.0
.
0.0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Fundraising (US$B)
Investments (US$B)
Source: LAVCA Industry Data 2012
Apart from the disadvantageous economic conditions in the late '90s and early 2000s with the
devaluation of Brazilian real in 1999 and Argentinean peso in 2002, high unemployment levels in
Argentina and Chile and hyperinflation and high interest rates in Argentina and Brazil, there are
intrinsic causes of underperformance. First, there were very low standards of corporate governance in
terms of the quality of information required to make investment decisions and monitor performance
once the investments have been made. Second, the legal systems were weak enforcing contracts and
protecting the investors. And third, the lack of deepness of domestic equity markets.
23
Exhibit 2.2 PE Investments in most Relevant Emerging Markets
100%
90%
80%
70%-
7
60% -
South Africa
Russia
U India
0 China
50%
40%
Brazil
30%
20%
10%
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Sourcre EMPEA, 2011
In 2011 Brazil was the destination of 12% of the US$21 billion invested in PE in emerging
economies (Exhibit 2.2). That amount represented over 76%(US$) of the deals in Latin America.
Nevertheless, other countries like Peru and Colombia are on an upward trajectory in terms of opening
up to private investment and GDP growth, so they are also attracting increasing interest. In addition,
regulatory initiatives in Mexico such as the introduction of CKDs (Certifcados de Capital de Desarollo)
may accelerate the development of a more active private equity market. Chile is also an interesting
country where to invest because of its political and economic stability, but its more limited size and
internal growth.
Conversely, there has been a decrease in activity in Argentina lately, partly as a result of various
interventionist initiatives by the current government. Due to the overheated Brazilian market more and
more LPs look beyond Brazil to frontier markets in search of less competition, better valuations and
more opportunities to generate proprietary deal flow in these countries.
In contrast to the positive private equity trends in Latin America, the evolution of venture capital,
though positive, has not been significant yet. Besides the different paths of development, both private
equity and venture capital are still in a very early stage. The main reasons for this poor development are
explained in detail in Chapter 4.
The future looks much more promising than the past, and LPs are looking to Latin America as a
very attractive market (Coller 2011), especially Brazil (Exhibit 2.3).
24
Exhibit 2.3 Weighted Attractiveness Score for Investments over the Next Year, LPs View
Brazil
China
Other Emerging Asia
Latin America (Ex Brazil)
India
Turkey
Sub-Saharan Africa
Central & Eastern Europe
MENA
Russia/CIS
0
10
20
30
40
U 2011Survey
50
60
70
80
90 100
V 2010 Survey
Source- EMPEA, Coller Capital Survey 2011
2.2 Market Overview
Latin America is a wide geographical area, comprising twenty different countries. Nevertheless, the
total size of the Latin American economy is still small, with a lot of room for future growth. The GDP
of the target market in Latin America is half the size of the GDP of Developing Asia, although it would
be higher if China is excluded.
Latin American countries are far from being homogeneous from an investment point of view. We
can currently divide the region in two main groups considering two main factors, the political and
economic stability. Brazil, Chile, Mexico, Peru, Uruguay, Colombia, Panama and Costa Rica form the
group where most of the PE/VC opportunities are, and the rest of Latin American countries will form
the second group where investment opportunities are more difficult to assess because of the high level
of uncertainty involved in business decisions. Even considering the opportunity group, a countryspecific approach is needed to valuate investments since each country entails a unique set of
opportunities and advantages.
Brazil continues to be the frontrunner of the region. Several factors are impacting the impressive
investment in Brazil: strong market fundamentals (7.5% and 2.9% GDP growth rate in 2010 and 2011
respectively), high population of more than 200 million people and solid middle class growth that has
been fueling the internal demand, infrastructure development projects needed to host the FIFA World
Cup in 2014 and the Olympics in 2016, and the extraction projects of the recently discovered oil
reserves. Brazil also represents the most important economy in Latin America in terms of GDP (Total
Latin America GDP in 2010: US$4.67 trillion, Exhibit 2.4).
25
Exhibit 2.4 Latin America GDP 2010 by Country (JS$)
Peru Other
6%
Chile 3%
5%
Colombia
Brazil
44%
Venezuela
6%
Argentina
8%
Source: IMF
Brazil is not the country with the best environment for PE/VC. According to LAVCA Scorecard
2011, Chile is the Latin American country with the best environment, followed closely by Brazil
(Exhibit 2.5). Nevertheless, both countries still have a lot of room to improve in all the investment
criteria defined by LAVCA: Laws in PE/VC fund formation and operation, tax treatment of PE/VC
funds and investments, protection of minority shareholder rights, restrictions on local institutional
investors investing in PE/VC, protection of intellectual property rights, bankruptcy procedures and
partners liability, capital markets development and feasibility of exits, registration requirements on
inward investments, corporate governance requirements, strength of the judicial system, perceived
corruption, quality of local accounting ,and entrepreneurship.
Exhibit 2.5 LAVCA Scorecard 2011
5
S
7
S
*
10
1
12
|
Uruguay
Trinidad & Tobago
Costa Rica
Panama
Peru
Argentina
El Salvador
Dominican Republic
-
-
Source: LAVCA
26
57
56
54
47
47
43
43
38
Private-equity firms' involvement in Latin America, especially in Brazil, has increased sharply over
the last five years, fueled by the following factors (Meerkatt, Liechtenstein 2010): significantly higher
net returns since 2000, and greater resilience to the current financial crisis. However, prices have sky
rocketed in Brazil, probably slowing the path of new investments in the future and pushing fund
managers to look for investment opportunities outside Brazil, targeting Colombian, Mexican and
Peruvian markets.
One incontestable indication that Latin America's private equity and venture capital market is back
in fashion is the level of fundraising. Capital levels continued to soar in 2011, amounting to a total of
US$10.5 billion (LAVCA Industry Data 2012), the highest capital level seen in the region in 18 years.
Brazil accounted for 79.2% of the total fundraising. The majority of the capital raised for Latin
American private equity firms came from investors in US, Europe, Asia and the Middle East.
Regional fundraising in 2011 was only US$1.18 billion, in contrast with almost US$4 billion raised
along 2010, when about half of total fundraising activity pertained to regional funds, mainly driven by
two funds: the fourth fund of The Southern Cross Group with capital commitments of US$1.68 billion
and Advent International's LAPEF V with US$1.65 billion in commitments (VELA 2010 Year end
report). The most important regional funds raised in 2011 were from The Carlyle Group (US$776
million) and from Linzor Capital Partners (US$465 million).
Conversely to fund raising there was a notably large number of exits in 2011, with 46 strategic
sales and seven IPO's, reaching a total of US$10.5 billion (LAVCA Industry Data 2012, Exhibit 2.6).
Exhibit 2.6 Trends on Fundraising, Investment and Exits (US$M)
11,000-
10,582
10,270
10,0009,0008,05
8,000 7,000-
7,205
6,390
2008
2009
,504
*2010
6,0004,000
2011
4,591
5,0003,63
,273
3,000
2,555
1,78
2,000
1,0000
FUNDRAISING
INVESTMENTS
EXITS
Source LAVCA Industry Data 2012
GP's aim of scaling their business and having access to an increased deal flow with better exits
expectations on one hand and the lack of deepness in Latin American markets (Brazil could be
considered an exception) on the other hand, predicts a more integrated regional Latin American
private equity market in the future. In 2011 there were 48 deals in growth equity, a 19% down from
2010, but the total amount invested increased a 3% up to US$2.9 billion. Still buyouts account for 44%
(US$2.8 billion) of the investments in 27 deals, representing a 14% of the total number of deals.
27
Exhibit 2.7 2011 Investments by Country (JS$) and by Stage (US$)
Chile
gentina
-L Ishhhh.,1%
Development
6%
Project Finance
Mezzanine 1%
;
Expansion Stage \.Early Stage
1%
2%
Source: LAVCA Industry Data 2012
Investments in 2011 were down 10% from the previous year, with US$6.5 billion committed in
173 deals (Exhibit 2.7). The decrease is probably due to the increasing assets' values in Brazil. 19 deals
were over US$100 million, with most of the transactions within the $1 million - $25 million range.
Energy and services were the sectors where the most important transactions were registered.
Exhibit 2.8 2011 Exits by Country (US$) and by Sector (JS$)
Renewable
Energy6%
Health/ Life
Sciences3%
Other
information
7%
Technology
Source LAVCA Industry Data 2012
The biggest source of exits in Latin America has been selling to foreign strategic buyers, mainly
multinational companies looking at emerging markets for growth. In addition, some local companies
are expanding in their home market or buying companies in neighboring Latin American countries
(Exhibit 2.8).
28
PE-backed sales reported in 2011 reached 53 exits of $8.9 billion (37 reported exits), including
seven initial public offerings. The most relevant was the blockbuster IPO of Arcos Dorados, the Latin
American franchise of McDonalds wich raised US$1.25 billion on the NYSE. Just the disvestment of
Ashmore Energy International represented $4.4 billion. An observed trend has also been the increasing
number of local strategic buyers.
In most part of Latin America the development of the industry is still at an early stage, but there is
a sense of enthusiasm. This feeling must become real in the form of demonstrable returns. Outside
Brazil, those local fund managers with sometimes short but successful track record are mainly panregional fund managers like Advent International, Victoria Capital Partners, Linzor Capital and The
Southern Cross Group. The relative large size of their funds compared with local funds (ranging from
US$180 million to US$1.7 billion) and the managing experience of their teams allow them to invest in a
wide range of opportunities, usually larger investments with better exit opportunities (local and
multinational strategic buyers and IPO's).
2.3 Why Invest in Latin America?
Latin America has stronger economy fundamentals than developed regions such as US or EU. A
higher and sustained GDP growth (Exhibit 2.9), surging young population, emerging middle class,
increasing disposable income of the population, and an increasing internal demand makes emerging
markets in general, including Latin America, the new heaven for capital investment.
Exhibit 2.9 Latin American average annual real GDP growth rates (/o)
S.
. .
2,1
3.0
3.1
4.4
3.0
3.6
1.7
6.4
3.3
3.7
4.7
4.8
3.4
2.9
4.0
4.5
2.4
0.6
3.5
3.2
1.8
5.1
3.9
6.4
Source IMF 2011
The IMF expects Latin America to grow by 3.6% and 3.9% in 2012 and 2013 respectively. Private
equity investments are well positioned to take advantage of that, providing that funds focus on the
growth of domestic demand and are not reliant on exports to an increasingly risky developed world.
Looking at the current account of Latin American countries, there is a significant exposure to other
5
emerging market economies: Brazilian exports to Asia and the rest of Latin America account for 0%
the total trade (MDIC, 2012), and Chilean exports to Asia account for more than 45% of the the total
(Prochile, 2012).
29
Conversely to China, Latin America, has enough natural resources to sustain the projected growth,
with abundance of water, agriculture, commodities and other natural resources. In fact, and according
to JP Morgan, in 2011 aproximately half of the M&A transactions in South America were originated by
Chinese and Japanese buyers looking for natural resources.
Most Latin American countries have faced cyclical challenges such as inflationary pressures and
high sensitivity to commodity prices. Furthermore, their financial markets are also prone to suffer from
inevitable bouts of global risk aversion. However, the cleaner balance sheets and growing self-reliance
of these emerging economies will prove to be key advantages in a world in which developed
economies' growth capabilities will be burdened for years to come by the need to address excessive
government debt and daunting pension liabilities caused by adverse demographics.
The lower risk perception of Latin America to GPs and LPs has increased the attractiveness of the
projects. Lower perceived risk and lower leverage have led as a consequence to lower discount rates.
According to Conduit Capital Partners, in green energy projects some LP's are applying 7% and 5%
discount rates while just five years ago they were considering 18%. In fact, Standard & Poor's is
currently assigning investment grade to eight Latin American countries: Chile, Mexico, Brazil,
Colombia, Peru, Uruguay, Panama and Costa Rica. A growing domestic demand also makes the
terminal value of the projects more attractive.
Another reason to invest in Latin America is portfolio diversification. Investors looking for risk
diversification may find Latin America a good market for hedging and diversification strategies
(Exhibit 2.10).
Exhibit 2.10 Brazilian Equity Markets Correlation Matrix
brail
CorelaIOn Coeflident
Feb-2005 to 0eC-2011
Index
Brazil 10mm plus Volume Index
taril 5-10mm Volume Inex
9raril 1-5mm Volume Index
MSO brail ndex
MSCEmerging Madms Index
MO Wodd Index
Russe 2000 Index
S&P 500 index
-0ep
BoMpW
Index
1000
0.937
043
.
0.786
0.949
0.886
0.792
0.650
0.719
10mm plus
Volume Idex
1.000
0.897
0.828
0.895
0.875
0.782
0.655
0.705
Brail
ta
1-5mm
MSO Bra6l M50Emwing
5-10mm
Index
MaWees iex
Uolunse index Volume Index
MSO
Russell
Wodd
nde
2000
Index
1.000
0.897
0.971
1.000
0.933
SP 500
Inde
1000
0153
0.774
01.790
0.719
0.600
0.64
1.000
0.744
0.751
0.680
0.515
0587_
1,000
0.909
0.792
0.653
0.711
1.000
0.900
0.772
0.823
1.000
Source: Bloomberg
Private equity in most countries in Latin america is often the only alternative to invest in a wide
variety of equities since most public equities are related to commodities, natural resources, financial
services, utilities or telecom. In addition, Latin American public equity markets are heavily
concentrated, not representing the country's real economy (Exhibit 2.11). For example, in June 2011,
the ten largest Brazilian companies accounted for 47 % of the market capitalization of Bovespa, the
Brazilian equity index. The picture looks similar in other Latin American countries. In Mexico, the ten
largest companies accounted for 75% of the public equity index and for 63% in the case of Chile. In
contrast, private equity generally offers a broadly diversified exposure directly linked to the real
economy (Partners Group, 2011).
30
Exhibit 2.11 MSCI Brazil Index by Sector (Nov. 2010) vs. GDP Composition
Index breakdown
GDP breakdown
Consumer
14%
Other
Consumer
Other
39%
38%
52%
Energy
23%
Financials
Financials
7o,
25%
Energy
2%
Source: JP Morgan Asset Management
Another point of consideration is the low penetration of private equity penetration in Latin
America, not only compared with US or European countries, but also compared to other emerging
markets, so there is still growth opportunities, especially for other Latin American countries than Brazil;
for example, Chile (Exhibit 2.12). However, Bain&Company recently found that a better indicator of
the potential to absorb PE investments could be the number of large companies operating in the
country. In fact, this is quite logical since deeper and larger markets have statistically more potential
targets than small markets.
Exhibit 2.12 Global Private Equity Penetration
2,50
2,05
2,00
1,70
1,50
C
n2010
I
2011
1,29
E
1,00
wU
CL
0,50
0,380,33
0,22
0,140,14
0,12
0,01-
0,10
0,01
South
Africa
Turkey
0,1000"
0,060,04
0,030,02
Russia
South
Korea
Chile
0,00
Israel
United
States
United
Kingdom
India
China
Source EMPEA & LAVCA Scorecard 2011
31
Brazil
2.4 Latin American Funds Performance
Due mainly to major macro-economic events in the late '90s and early '00s the performance of the
funds investing in Latin America has been truly disappointing in the past. Since 2006 new funds were
created and there is a lot of expectation about their outcome. The increasing capital committed by LPs
year after year in different funds from the same GPs could be a positive sign. However, the
performance of the funds depends on many factors and it is not possible to obtain an absolute value
until the fund is closed or mostly disinvested.
Expected returns by GPs for private equity funds in Latin America are in the range of 20%-35%
IRR for funds over US$100 million. For smaller funds expected IRR is in the 15%-25% range, so there
is a significant cap on the upside compared to larger funds. For venture capital firms, surprisingly
expected returns are in the same range than the larger funds, probably internalizing all the constraints
on the upside that currently Latin American capitalists have (reduced or null option to IPOs, small
markets, lower valuations, etc.).
As stated by IFC data (Exhibit 1.9), the mean IRR of all their funds since 1990 has been 43% for
IPO exits with majority positions and 8% for the rest of exits in majority positions. David Wilton from
IFC affirms that private equity returns on emerging markets are driven by growth and efficiency rather
than leverage or multiple expansions. Higher growth and lower leverage makes the source of risk in
emerging markets less cyclical and more operational (Exhibit 2.13).
Exhibit 2.13 Drivers of Return in IFC funds
Margin
Improvovement
Leverage
25%
30%
55%
6
6%
0%
5%
5
Multiple Expansion
25%
75%
10%
14%
0%
5%
5
Growth
25%
75%
10%
6
6
6
6%
20%
5%
5
6%
0%
30%
5
Efficiency
25%
75%
85%
Source. IFC World Bank 2012
According to the 39 funds included in the Latin American and Caribbean PE & VC Index from
Cambridge Associates, the return from the last 5 years (up to September 2011) was 13.57%, whereas
the last year performance was only 2.59% (Exhibit 2.14).
Exhibit 2.14 End to End returns by Region (as of 30 September 2011)
Index
Emerging Markets PE & VC
Emerging Asia PE & VC(
CEE & Russia PE & VC
Latin America & Caribb ean PE & VC
MSCI Emerging Marke ts
us VC
US PE
Western Europe PE
S&P 500
__
One Year
9.48
10.92
14.00
2.59
-15.89
20.93
13,76
13 13
114
Three Year
11.90
14.51
1 41
10.35
6.59
4.93
7.32
3.37
1.23
Source: Cambridge Associates
32
Five Year
12.11
13.43
7.36
13.57
5.17
6.72
8.11
7.99
-1.18
Ten Year
10.62
11.19
14,84
4.30
16.41
2.59
1155
17 50
2 82
Expected returns by LPs for investments in emerging markets are higher than those for their
global portfolios (Exhibit 2.15). Approximately one in four (23%) LPs anticipate annual net returns of
21% or more from their EM (Emerging Markets) PE portfolios over the next 3-5 years. Just 9% of
investors have similar expectations for their global PE portfolios.
Exhibit 2.15 LPs Annual Net Return Expectations over 3-5 Years
60
50
40
U,
30
C
0
CL
cc
20
10
0
-F-
0-5%
6-10%
11-15%
16-20%
21-25%
Annual Net PE Return Expectations
Source: EMPEA, Coller Capital Survey 2011
33
>25%
CHAPTER 3. PRIVATE EQUITY AND VENTURE CAPITAL IN
CHILE
3.1 Development of Private Equity and Venture Capital in Chile
In Chile the venture capital and private equity history starts with the enactment of the 18.815
Investment Funds Law in 1989. The purpose was to allow the Chilean pension funds, recently created
in 1980, to invest in new alternative instruments. In 1990 the pension funds were authorized to invest
up to 5% of its assets under management in public investment funds. Between 1992 and 1995 eight
private equity funds were created, for a total committed capital of US$ 179 million.
At the same time, during the dot-com bubble four venture capital funds were born, committing
US$ 57 million of capital. These early stage funds were not successful, mainly because the low quality of
the projects and scarce experience of the entrepreneurs (Echecopar and Rogers 2011), and the interest
of investing in venture capital disappeared.
From that experience the Chilean government decided to support the development of an
entrepreneurship ecosystem through CORFO (Chilean Economic Development Agency), a public
institution overseeing a variety of programs aiming the economic development of Chile. Some of the
first programs implemented involved the support of incubators in universities and the supply of seed
capital to innovative ideas. Additionally, private initiatives like Endeavor Chile in 1998 and angel
investor networks generally attached to some universities were born, all of them providing support to
entrepreneurs.
In 1998 Ventana Global Capital, a US venture capital firm was the first to land into the Chilean
market. The Ventana fund comprised US$30 million. Increased startup activity began in late summer of
1999 but only a small number of startups were created, most of them based in Internet development.
One result of this slow Internet activity in Chile is also the almost complete lack of entrepreneurial
success in the country. Bazuca and Laborum are probably the most renowned Internet startup still
active in Chile together with Gemelo.com and SeNegocia. Bazuca is one of the very few Internet
startups in the country to have completed three rounds of financing, raising a total of US$6.5 million.
The development of the investment community was correspondingly slow, and only a dozen or so
private venture capital funds were set up during this period. Ventana Global and Latinvalley are two
examples for venture capital funds in Santiago. Ventana Global set up a fund that operated as a FIDE
(Business Development Investment Fund) and targeted investments in the range of US$500,000 to
US$3 million in small, privately held Chilean ventures. Also, Ericsson set up a venture capital fund
called MiFactory that focused exclusively on mobile Internet solutions (Baltin and Bell 2001).
34
Due to a lack of results, from 2005 the Chilean government decided to support directly
investments in venture capital and private equity providing leverage (long term debt) through the F2,
F3 (2006) and K1 (2008) financing programs (F1 was created in 1997). F2 and F3 programs had one
main restriction: investment in companies up to US$ 4 million. Up to now, pension funds and
insurance companies have nor committed capital in venture capital investments, and most of LPs invest
not only looking for high future returns but also because there is a desire to transcend, to build a better
society. For them, participating in a venture capital fund is a form of philanthropy.
Because of the limitation in the size of the target companies, the role of funds that subscribed
CORFO leverage programs was to invest in small or medium size companies. Since 1998 35 funds have
been created (CORFO 2011), investing more than US$342 million. However, this number is small
compared to the transactions made in Chile by other local agents or international funds. Yet it is
remarkable that only in 2011 more than US$60 million were invested (the highest yearly investment
since its creation) by CORFO backed local funds (Exhibit 3.1).
In 2011 CORFO launched a new financing program: The Fenix Fund, providing leverage
exclusively for mining development projects. Up to january 2012, 6 funds were created using the Fenix
financing program (Exhibit 3.2).
Exhibit 3.1 PE/VC Funds Supported by CORFO Financing Programs
# Progra
Dat
Fund Manager
Fnd Name
o
(
netet
VC/PE
Numrtof
Status
Companies
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
EEM
F1
F1
F1
F1
P1
F2
F2
F2
F2
F2
F2
F3
F3
F3
F3
F3
F3
F3
F3
F3
F3
F3
F3
F3
F3
F3
K1
Inversiones Incured S.A.
Incuredl
Chiletech S.A.API
Chiletech
Choshuenco APISA.
Columba
Negocios Regionales S.A.
Negocios Regionales,
ITManagement S.A.
Mifactory
Halcon
Econsult APIS.A.
Gerens Capital SA.
Precursor
Econsult APIS.A.
Halcon Il
IT Management S.A.
Mifactory 11
Sembrador Capital de Riesgo SA.
Crecimiento Agricola
Independencla S.A. API
Expertus
Ecus Private Equity SA.
AXA Capital Chile
PICapital de Riesgo S.A.
PI Capital
Inv Empresas Innovador Inversiones Innovadoras S.A.
lfincorp S.A.
Emprendedor I
ASCapital SA.
AS Capital
Patagonia S.A.
Patagonia
Austral Capital Partners SA.
Austral
Cruz del Sur AGF S.A.
Copec-UC
Zeus Capital SA.
Tridente
Equitas Management Partners S.A.
Medlo Ambiente I
EPGPartners S.A.
IGCapital
Gerens Capital S.A.
Precursor il
Chile Innovation Fund I Equitas Management Partners S.A.
Sembrador Capital de Rlesgo S.A.
Agrodesarrollo
IM Trust SA. AGF
IM Trust
W3
Aurus SA.AFI
Aurus Bios FIP
Aurus Tecnologia FIP Aurus SA. API
Mater SA.
Mater
1998
1998
1999
2002
2003
2005
2005
2005
2005
2005
2006
2006
2006
2006
2006
2007
2008
2008
2008
2008
2009
2009
2010
2010
2010
2010
2010
2010
8.8
9.1
10.5
3.6
12.5
18.3
21.8
19.6
9.2
21.8
27.5
11.1
2.9
13.1
10.9
11.9
31.2
8.7
16.6
26.2
17.4
17.4
17.4
14.3
17.4
11.2
11.2
16.6
419.1
TOTAL:
Soura: CORFO 2012
35
33.2
10.9
31.3
1.6
9.5
25.5
14.1
0.0
VC
VC
VC
VC
VC
VC
VC
VC
13
9
11
2
4
8
2
Active
Closed
Active
Closed
Closed
Active
Closed
Closed
10.3
VC
6
Active
28.2
23.6
11.0
2.3
8.1
8.4
3.9
28.8
4.7
14.0
16.7
9.9
3.6
5.3
9.6
9.9
7.1
10.7
VC
PE
VC
VC
VC
VC
VC
VC
VC
VC
VC
PE
VC
VC
VC
VC
VC
VC
VC
8
4
4
5
4
2
1
11
3
3
4
3
2
3
S
4
8
2
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
Active
342.1
131
Exhibit 3.2 PE Mining Specific Funds Supported by CORFO Fenix Program
Fund
Fund Manager
Creatio Date
CORFO Debt
_(US.$m illio n)
Investments
(US$ milio n
IMT Exploracon Minera
IM Trust SA. AGF
Celfin Capital SA.
6/1/2012
6/1/2012
4/1/2012
5/1/2012
6/1/2012
12/21/2011
15.3
16.1
15.8
13.1
18
13.5
0
0
0
0
0
0
91.7
0
FIP Mining
Asset Chie Exploracion Minera
Asset SA.
FtP Mining Equity
Zeus Capital S.A.
FIP EPG Exploraclon Minera
FIP Lantanidos
Inversiones Mineras S.A.
EPG Partners S.A.
TOTAL:
Source: CORFO 2012
In 2012 FT and FC replaced F1, F2, F3 and K1 financing programs. FT is the Early Stage Fund
program (Fondo Etapas Tempranas), designed to support venture capital funds, and FC is the Growth
Fund program (Fondo de Desarrollo y Crecimiento) created to support growth equity capital.
Exhibit 3.3 summarizes the three active CORFO financing programs.
Exhibit 3.3 PE/VC Active CORFO Financing Programs
CORFO Financing
Program
Fei
ud
FT
FC
(Venture Capital)
(Growth Equity)
Creation Year
2011
Leverage (Debt/Capital)
2:1
2:1, up to 3:1
1:1, up to 2:1
Maximum CORFO Debt
(US$ million)
17.6
15.4
24.2
25% of Carried
Interest
25% of Carried
Interest
25% of Carried
Interest
Up to 8.8
Up to 4.6
up to 9.68
Investment Maturity
10 years
10 years
10 years
Beneficiary Funds (as of
January 2012)
6
0
-0
Debt Interest Cap
Size of Investments (U$
Soura:e CORFO 2012
36
One important feature of CORFO financing programs is that they permit the funds to invest in
foreign companies provided that the foreign company invests those funds in a small or medium
business legally constituted in Chile. This is a tremendous opportunity for the development of the
venture capital industry in Chile, since it allows the GPs and entrepreneurs to complement the local
talent with foreign talent, to take advantage of foreign VC/angels networks for fund raising and for GP
expertise (Sillicon Valley, Boston area or New York) or to become closer to deeper capital markets (US)
with better exit potential whether it is through an strategic acquisition or an IPO.
According to ACAFI (Chilean Investment Fund Managers Association), there are 21 active local
venture capital funds, two of them public (Chiletec and Trident) and the rest public. However, even if
those funds are classified as venture capital funds, many of them invest in growth equity or small cap
buyouts. There are also 16 local private equity funds (Exhibit 3.4). All VC funds use CORFO leverage
programs but only two PE funds use them because of the size of the investment constrains. The total
PE/VC active capital invested in Chile by local funds is estimated in US$845.8 million; from that 48%
(US$) allocated is venture capital and 52% private equity. Local funds using CORFO leverage programs
represent 54% of the industry (US$).
Exhibit 3.4 Private Equity Funds in Chile
#U
Fund Name
Local Fund siz
I
AXA Capital Chile
25,
2
Cein Private
Equity - KKR
19,9
4
Feeder
KKR SA Master Fund, L.P.
4
Celfin Private
Equity
29,6
3
Feeder
Southern cross Latin America
celfin Private
Equity IV
Equity Ii
Direct / Feeder
4
6
Feeder
14,3
1
Feeder
6
celfin Private
Equity IV
112,0
0
Feeder
7
IGcapital
25,2
3
Direct
Feeder
IM Trust Private
Equity -PG Direct
9
LIalma
9,2
10
Proa 1i
12,0
11
Penta Capital de
I
1
Private Equity Fund ii
Southern cross Latin America
Private Equity Fund IV
Private Equity Fund III
Southern Cross Latin America
Private Equity Fund IV
Investment /
liquidation
Public
investment /
liquidation
Direct
4
Direct
Public
Public
investment /
liquidation
Public
-
Uiquidation
Private
Partners Group Direct
investment 2009, LP.
investment /
liquidation
Public
Direct
1
Public
Public
Liquidation
-
Private
-LUquidation
Blackstone Capital Partners VI
Public
Fund Raising
Fund Raising
Pubic
Public
0
Feeder
Linzor BICE priat
Equity 1i
0
Feeder
Quilvest Private
Equity
0
Feeder
QP PEP 2010, Inc
Fund Raising
Public
0
Feeder
Harviour Vest Partners
Fund Raising
Public
0
Feeder
Lexington Partners
Fund Raising
Public
12
Larrain Vial BcP VI
13
14
16
48,0
Private
Direct
140,3
8
Master Fundstg
compass Group
164
47
Source: ACAFI, VC/PE Report 2010-2011, EMPEA 2011
37
tinzor Capital Partners Fund 11, FndRing
L.P.
Pbc
Private investment funds differ from public funds mainly because they do public offering of its
securities and therefore are not audited by the SVS (Superintendencia de Valores y Seguros, SEC
equivalent in Chile).
During the last year it has been an explosion of big international funds raising funds in Chile. As a
result of that, a large number of funds known as Funds of Funds or Feeder Funds has been created.
Those funds come from regional Master Funds administered by major foreign private equity managers
(Blackstone, KKR, Linzor, Quilvest, Southern Cross, Exhibit 3.4).
Management fees are in the range of 2% to 3% for direct funds, and from 0.3% to 1% for feeder
funds. These fees are usually charged on committed capital, even if it has not paid out completely.
Foreign funds can also be legally constituted in Chile under the form of two different entities:
Foreign Capital Investment Funds (FICE) or Foreign Risk Capital Investment Funds (FICER). These
are mainly characterized by having an equity contribution made by foreign natural or legal persons and
whose administration is left to an investment fund manager (AFI) or a general manager of funds (AGF)
regulated by the SVS (Superintendencia de Valores y Seguros, SEC equivalent in Chile).
The distinction between both entities is mainly for the purpose of investment. The FICE invests
primarily in securities listed on stock exchanges and the FICER is authorized to invest in companies
not listed on the stock exchange. Both FICER and FICE must be audited by an auditing firm registered
with SVS. According to recent information from the SVS there are five FICER funds with assets
totaling U.S. $ 123.6 million (Exhibit 3.5).
Exhibit 3.5 Foreign Risk Capital Investment Funds (FICER)
EGI-VSRt L LC.
FHC Holding Lirited
KRC Chile Investment Fund LL C
Matignon Developpement 3
Celfin Ca pitalI Adm. De F.I.C.E. S.A.
IM Trust S.A. Adm. GeneralI de Fondos
IM Trust S.A. Adm. General de Fondos
Ecus Private Equity SA.
TOTAL
9,8
60,6
31,8
6,9
123,6
Sour: ACAFI, VC/PE Report 2010-2011
But not only private equity firms invest in private equity. Chilean family offices and holdings are
direct competitors for hot PE deals. Chilean holdings like Quifienco, AntarChile or Dersa have been
investing long time ago in real assets. There are two important differences between private equity
companies and family offices and holdings. First, they don't have a limited investment horizon. Family
offices and holdings follow a Warren Buffet approach, maximizing return with no limit in the
investment horizon, exiting when there is an opportunity. Second, family offices and holdings act
directly; they are not agents, so there is a complete alignment between LPs and GPs.
38
In Chile the family office phenomenon took off in 2001, when the family office Megeve was
established, although previously the investments of the very wealthy did not go unnoticed. In those
years it was usually the same owner who took over his personal investment decisions using the same
structure of his companies to deploy capital. But today, all that is run by a professional in the family
office. It is estimated to be about 150 family offices in operation in Chile, which together manage more
than US$30 billion (Capital 2011) of which 95% are Single Family Offices (SFO), the remainder MultiFamily Office (MFO). Some of the most relevant SFO apart from Megeve are Bancard (it belongs to
the current Chilean president Sebastian Pinera), Drake, Bethia, Corso, Costaverde, Porto Seguro, Mar
Adentro and Inversiones Liguria. According to Alejandro Hirmas, between 25% and 30% of the family
offices' portfolio of investments are illiquid assets (hedge funds, private equity), and 70% to 75% is
placed in public equities (stocks, stock funds) and bonds (Treasury bonds, corporate bonds or emerging
country bonds). 40% of investments are made in Chile, and the rest abroad.
Family offices are going to be more and more important in the future. According to Federico
Muxi, partner and managing director of The Boston Consulting Group in Chile (Qu6 Pasa 2011),
family offices growth rate wealth is 8% to 12%, higher than that of Brazil. Wealth in Chile is not equally
distributed: 1,000 families have liquid assets over US$ 1 million, and 30 to 35 families in the country
have individually more than US$100 million in investable liquid assets.
When a single family does not have sufficient resources to set up an office for itself (US$5 million
to US$50 million), a solution is the multi-family office (MFO). The MFO manages the assets of several
families at the same time. The following are among the best known Chilean MFO firms: AD Capital,
Capital Advisors, Addwise, Alcala Inversiones, Picton Investments, Alikanto and Stars Investments.
Exhibit 3.6 Domestic Funds Comparison by Size, Target's Development Stage and Ticket Size
120
0
Fund Size
105-----
Southern Cross IV
90
--- Southern CrossIll
------ - - - - - - - -- ----------------90- - - 75- ----
45 --- ---30o4-15 -----
ja
-----
-----
-
-
-
-
-
--
-
--
-
1
2
3
Development Stage
Source: Own Calculations, 2009 SII Data
39
Linzor il
-
-
---
--
-
ft
. 06**I" go*
0
-
-
--
--
#Linzor
4
I
-
-
5
There is no doubt that venture capital and private equity are emerging in Chile. However the
efforts are not equally distributed. Representing the 34 most relevant funds by size, ticket size and
development stage of the target companies being one early stage and five the most mature companies,
it is possible to observe how there is an important gap between small funds with ticket sizes of less than
US$4 million and bigger funds with average ticket sizes of US$50 million or higher (Exhibit 3.6.).
According to the interviews, there is an opportunity to invest in companies valued over US$5 million;
especially attractive are ticket sizes over US$10 million. In that range between US$10-US$25 million
there is less competition, more targets, better buying multiples and more exit options. Family offices
have similar criteria too. Their minimum ticket size for a deal is US$15-US$25 million, with an average
deal target in the range of US$30 million-US$80 million.
Through the field research it came out that smaller funds usually strive to get real returns over 5%.
This is in line with what have been observed in the US for the last 5 years, where funds under US$100
million consistently underperformed.
There are some factors that could explain these results. First, it is difficult to find the right
management for a small company, since managing a small firm does not offer the same recognition
than a bigger one, the resources to pay the management team are constrained, and few managers are
willing to work under the typical compensation scheme of private equity where most of the
compensation comes at the exit. Second, financing a small firm is more expensive and harder to get
than for a bigger firm. Third, from the GP perspective an investment in a small firm requires the same
or even higher dedication than an investment in a bigger one due to the more limited resources of the
managing team. And fourth, there are a higher number of exit options for medium-large companies
than for smaller ones. Nevertheless, it is important to remark that the top quartile small funds can
outperform the top quartile big funds. US private equity firms Gemini Investors and Abry Partners
have consistently outperformed the market with IRRs over 30% investing in small caps with a deep
understanding of specific industries, being disciplined in the due diligence, asking the seller to share the
risk in the form of minority equity participations or earn outs, and never paying more than 5x EBITDA
in any transaction.
The future for venture capital and private equity in Chile looks promising. On the one hand, and
after several years of improvement, the government is providing leverage to venture capital funds and
giving them the opportunity to market and sell their products, raise money and expand their business in
foreign countries. Because of the size of Chile this should be the right direction to follow: to develop
local talent and ideas and make them global.
On the other hand, local private equity funds have been gaining experience and building a track
record, in some cases, through a rough journey. As long as the developed experience is not lost, that
experience should be the seed for larger funds (and deals) and better returns in the future. To the extent
that positive returns and success stories occur, venture capital and private equity will naturally
experience rapid growth.
40
Finally, it is also important to highlight that the development of venture capital and private equity
is a long process, therefore a long term and sustained support by the government (CORFO) is needed.
In the US specialized modem venture capital industry is considered to be born in 1978 (Fairchild
Semiconductors, Genentech), 20 years after the creation of one of the major development programs in
the industry, the Small Business Investment Companies (SBICs) in 1958, and almost 80 years after the
first government efforts in this area.
3.2 Fundraising, Investments and Exits in Chile
International private equity funds took a leading role in fundraising last year, and probably they
will continue to take it in 2012. KKR was one of the first US PE firms to land in Chile in 2010, but
later on many others arrived: Blackstone, Partners Group, Lexington, Harvour Vest, Quilvest and
Altamar Private Equity, raising an estimated amount of US$500 million in Chile from local pension
funds, insurance companies and wealthy individuals. In 2010 Southern Cross, a regional fund
committed US$1.7 billion for its IV Latin America PE fund, and in 2011 Linzor Capital, a Chilean PE
firm, successfully raised US$465 million for its second fund. It is also remarkable the committed capital
of almost US$100 million for early stage mining projects using the help of CORFO's Fenix financing
program.
In 2011 estimated total investments in Chile were US$42 million (LAVCA 2012). Exhibit 3.8
shows all the investments registered in Chile by Thomson One and ACAFI from 2002. The reported
investments to LAVCA in 2011 showed that an important number of investments were made in
information technology and agriculture sectors, being the last one the sector where more capital was
deployed (Exhibit 3.7). A large number of transactions were early stage, project finance or seed capital,
but most of the resources were probably invested as growth equity (Exhibit 3.9).
Exhibit 3.7 Investments in Chile by Sector (2011)
Investments by Sector
Investments by Sector ($)
(N. of Deals)
Source LAVCA Industry Data 2012
41
Exhibit 3.8 Reported Investments in Chile from 2002
CopnaeInvestment
PENVC Firm Name
Fund Type
Pesquera Apiao
St. Andrews
Andes Biotechnologies S.A.
-
-
A5 Capital
A5 Capital S.A.
Aurus Bios/Austral Capital
Junar
Splitcast
-
Aurus Tecnologla
-
Venture
Aurus Tecnologla
Venture
Aurus Tecnologia
Venture
Aurus Tecnologla/Equitas
Austral Capital
-_Austral Capital
Austral Capital
Austral Capital
Austral Capital
Austral Capital
Austral Capital-Axa Capital Chile/Ecus Private Equity
Axa Capital Chile/Ecus Private Equity
Axa Capital Chile/Ecus Private Equity
Axa Capital Chile/Ecus Private Equity Fund of
Axa Capital Chile/Ecus Private Equity Fund of
Brookfield Asset Management
Real Estate
Brookfield Asset Management
Chiletech
Chiletech
Chiletech
Chiletech
Citi Venture Capital international
Citi Venture Capital international
Citi Venture Capital international
Buyout
Clairvest Group, Inc.
Buyout
Clairvest Group, Inc.
Buyout
Clairvest Group, Inc.
CMB-PrimeS.A.
Venture
Copec-UC
Venture
Copec-UC/Austral Capital
Venture
EconsultS.A.
EconsultS.A.
Equitas
Equitas
Equitas
Equita_
Fonds de Solidarite des Travailleurs du Generalist
Gerens Capital
Gerens Capital
Gerens Capital
-Gerens Capital
Gerens Capital
Gerens Capital
Generalist
Global Environment Fund
lfincorp SA.
Ifincorp S.A.
Ifincorp SA.
Ifincorp S.A
Independencia S.A. AIndependencia S.A. AFI
Independencia S.A. AFI
Independencia S.A. AFI
Independencia S.A. AFI
Zpped
Clickmagic
Bio Architecture Labs (BAL)
Green Pacific Biological
Multicaja
Paperless
Producto Protegido S.A.
Scanntech
Scopix
Central Frenos
Loginsa
Vitamina
S&K Lavanderias y Servicios
Servicios Hospitalarios S.A.
Transelec
Sociedad Concesionaria Vespucio Norte Express S.
Eneria Latina
Termocandelaria
TPL Chile
Vendomitica
Empresa Electrica Rucatayo
Moller y P6rez Cotapos
Dream S.A.
Casino Marina del Sol
Latin Gaming S.A.
Casino Sol Calama
Invertec Foods SA
SIRVE S.A.
Atacama Labs S.A.
PC Book
Sero
Tiaxa
Aguamarina
Buuteeg Inc.
Reinvent
ForAction Chili, Inc.
Dimacofi Servicios Avanzados S.A.
Energlas Coyanco S.A.
Metanoia Chile S.A.
Wisetrack Chile S.A.
Alimentos Puerto Varas
Tubopck
Monte Alto Forestal
Fabrics
Papa John's
Publisistemas
Transportes Buen Destino
Soc. Educ. Colegio Los Alpes
Soc. Educ. Colegio Rengo S.A.
ioSan
Dieg
Soc. Educ. Coleg
Soc. Educ. Colegio San SebastiAn
Soc. Educ. Colegio Santa M6nica
-
-
-
-
2007
2007
2006
2011
-
-
2004
2007
2008
2008
2008
2010
-
2002
2003
-
2008
-
42
Da
au
-
-
-
-
-
-
Venture
-
-
-
-
2.01
20.00
-
-
-
-
is~onaa
b.A
Ecopellets S.A.
Neosylva S.A.
FBlanco yNegro SA
Hoyts Cinemas Chile SA
Corporaci6n Santo Tombs
CruzBlanca SA
[David del Curto
Sociedad Austral de Electricidad SA (SAESA)
Alto Atacama
El Almendro S.A.
Empresas CEM
EPC S.A.
_
Frutlcola Angol S.A.
Boulder Institute of Microfinance, The
Legal Publishing Group SA
Hortifrut
Agricola Mercedario Limitada
Soltec
Masterland S.A.
PH la s
Plesticos Burgos
PI Berries S.A.
PI Lecteos S.A.
§jTapsi Soluciones Y Servicios IT, Lda.
Sociedad Agricola El Retomo
Arenal
Pan de Azocar
Arendanos del Sur S.A.
Campo Cauquenes
Fruticola Porvenir S.A.
San Pablo
Tres Vlas
Chilesat Corporation SA
Campanario Generacion SA
Campanario Tierra Amarilla
Essbio SA
GasAtacama Generacion SA
Project Eagle
Bigger
Supermercado Keymarket Ltda
Supermercados DIPROC
Supermercados FullFresh
Supermercados Munoz Hermanos
Supermercados Tucapel Ltda
Aguas Nuevas SA
Ubicuo
Autopista Central Motorway
PC Factory Ltda.
China Ocean Bio-Tech (Holdings)
Busco S.A.
Endurance S.A.
Industrial Tecpipe S.A.
Novsa
TecPipe
2003
-
Intel capital
venture
-
Inversiones Innovadoras S.A.
Inversiones Innovadoras S.A.
Larrain Vial SA
Linzor Capital Partners, L.P.
Linzor Capital Partners, L.P.
Linzor Capital Partners, L.P.
Moneda S.A.
Morgan Stanley Private Equity
Negocios Regionales S.A.
Negocos Regionales S.A.
Negocios Regionales SA.
Negocios Regionales S.A.
Negocios Regionales S.A.
Omidyar Network
Palmfund Management LLC
Patagonia Adrinistradora S.A
Penta Capital de Riesgo
Penta Capital de Riesgo
Penta Capital de Riesgo
Penta Capital deRiesgo
Penta Capital de Riesgo
PI Capital de Riesgo S.A.
P Capital de Riesgo S.A.
Riverwood Capital LLC
Sembrador Capital de Riesgo
Sembrador Capital de Riesgo S.A.
Sembrador Capital de Riesgo S.A.
Sembrador Capital de Riesgo S.A
Sembrador Capital de Riesgo S.A.
-
Sembrador Capital de Riesgo S.A.
-
2002
2006
2006
Sembrador Capital de Riesgo S.A.
Sembrador Capital deResS
Southern Cross Group
Southern Cross Group
Southern Cross Group
Bu-out
2006
Southern Cross Group
Buyout
2007
2007
2008
2008
2008
2008
2008
2008
2009
2009
2010
2012
2005
Southe CGroup
Southern Cross Group
Southern Cross Group
Southern Cross Group
Southern Cross Group
Southern Cross Group
Southern Cross Group
Southern Cross Group
Undisclosed Firm
Undisclosed Firm
Undisclosed Firm
Undisclosed Firm
Wl Harper Group
Zeus Capital
Zeus Capital
Zeus Capital
Zeus Capital S.A.
Zeus Capital S.A.
Buyout-
-
2010
2007
2009
2010
2008
-
2007
2008
-
006
006
-
010
-
-
-
Source: Venture Expert Thomson One data as of April 2012, ACAFI 2010
43
-
Buyout
Buyout
-
Buyout
1,287.00
Other
-
-
Generalist
Buyout
52.00
Buyout
-
Buyout
Buyout
Buyout
Buyout
Buyout
Buyout
Buyout
Buyout
Buyout
Venture
Venture
Buyout
Venture
-
___
-
81.00
160.00
9.00
71.00
59.00
39.00
877.91
60.00
-
-
-
-
-
Exhibit 3.9 Investments in Chile by Stage (2011)
Investments by Stage
(N. of Deals)
Investments by Stage
($)
other
Source: LAVCA Industry Data 2012
The exits in Chile have been scarce, and since most of the deals are done under confidentiality
agreements, almost no information is revealed. According to LAVCA, five exits were reported in
energy, retail, information technology, health/life sciences and other sectors. One of the most recent
exits has probably been the sale of Cine Hoyts to Cinemundo.
One interesting issue is that in Latin America buyers usually require the PE firm to stay on board
after selling the company, so exits are sometimes more progressive and not so immediate.
IPO is an exit option in Chile, but up to now only for large and established companies. In Chile,
the Capital Market Reform of 2002 (MKI) created the "Emerging Stock Market". However, in the last
10 years no "emerging" company has been listed, only mature firms. The reason is that
emerging companies in Chile do not have the sufficient size to obtain financing in the stock market. To
justify the IPO, the market capitalization should be at least $ 20 million, but emerging
companies issuing that amount would lose the control of the company. While tax incentives for
investors (three years exemption of capital gain taxes) applied to stocks listed in the "Emerging Stock
Market" can help, the effect is marginal.
In the last ten years there has been 23 IPOs, including Azul Azul the IPO with the lowest market
capitalization of US$18.2 million (not PE/VC backed). The average IPO market cap from 2002 to 2012
was US$126 million, and the median US$91 million.
A remarkable initiative to increase public equity transactions and IPOs has been the creation of
the "Mercado Integrado Latinoamericano", or MILA, an integration of Colombia, Chile and Peru stock
exchanges with the potential to become the second largest stock market in Latin America, after the
BOVESPA stock exchange in Brazil. It is also a response to the huge gap between the Brazilian stock
market and the rest of Latin American stock markets. However, due to different regulatory and tax
policies among the three countries, and the lack of free float of the companies listed, the project has
not yet taken off.
44
With the exception of Brazil, IPO markets hardly will play an important role in Latin America in
the short term. The focus should be on exits to strategic buyers. Since it is important to plan the exit
strategy in advance, co-investing with strategic buyers is an alternative. Additionally, multinational
companies can bring in a private equity firm to help finance a deal considering that more often than
not the cost of capital is generally lower for a multinational than for a private equity fund, or at least the
expectations for returns are lower.
3.3 Regulatory Framework for Private Equity and Venture Capital in Chile
The first Law for private equity and venture capital in Chile was enacted in September 1987 (Law
18.657), authorizing the creation of two different entities: Foreign Capital Investment Funds (FICE)
and Foreign Risk Capital Investment Funds (FICER). These are mainly characterized by having an
equity contribution made by foreign natural or legal persons and whose administration is left to an
investment fund manager (AFI) or a general manager of funds (AGF) regulated by the SVS
(Superintendencia de Valores y Seguros, SEC equivalent in Chile). The FICE invests primarily in
securities listed on stock exchanges and the FICER is authorized to invest in companies not listed on
the stock exchange. FICER funds are the only ones that don't pay VAT on management fees.
In 1989 a real legal frame was created by Law 18.815, defining the rights and responsibilities of
two independent entities: fund and fund manager. The fund manager must be a corporation supervised
by the SVS (Superintendencia de Valores y Seguros, SEC equivalent), the investors are represented by
an Investors Assembly and an Advisory Committee.
In 1994 and 1995 laws 19,301 and 19,389 were enacted, changing the law 18,815, easing
regulations and encouraging the creation of Business Development Investment Funds (FIDES). In
1997 CORFO introduced the first financing program consisting in offering long-term loans to
investment funds governed by Law 18,815.
In 2000 the OPAS Law 19.705 created a new entity: private investment funds, that differs from
public funds mainly because they do not do public offering of its securities and therefore they are not
audited by the SVS. The number of investors in private funds is limited to 49. Previously to the
enactment of this Law investors could only invest through public funds. The minimum number of
investors needed to qualify as a public fund was reduced from 50 to 25.
The Capital Market Reform of 2002 (MKI) created "the emerging stock market", reduced the tax
on international financial transactions and strengthened the rights of minority shareholders.
Nevertheless, MKI didn't have a significant effect in the support of venture capital.
In 2007 the second Capital Market Reform (MKII) was approved by the senate after four years of
discussion, and it included the following rules (Cortes, Echecopar, 2008):
1. Tax benefits on capital gains from the sale of shares of companies backed by venture capital
funds. This incentive is aimed at both entrepreneurs and investors. However, because of the
restrictive law requirements, it is difficult to impossible to access in practice
2.
CORFO is authorized to invest directly in venture capital and private equity funds
45
3.
4.
5.
6.
Banks are authorized to invest, through subsidiaries, up to 1% of its assets in venture capital
and private equity
A new more flexible limited liability corporate structure is created: SpA (Sociedad por
Acciones)
The term of the tax benefit for the Emerging Stock Market is extended for eight additional
years
The only tax rate applied to capital gains of Foreign Risk Capital Investment Funds (FICER)
is 10%, instead of 35%.
In 2010 the capital market reform MKIII was created under Law 20.448. It introduced a series of
reforms with regard to liquidity, financial innovation and integration of the Chilean capital
market. However, the MKIII did not include significant improvements in the investment funds. A new
capital market reform called MKB (Mercado de Capitales Bicentenario) is currently being discussed by
the senate.
In Chile investors have the right to fire the fund manager in case of bad performance. For private
funds the conditions to do it shall previously be defined in the rules of procedure commonly agreed
between the fund manager and investors. The fund manager has vote rights if its participation in the
fund is over 25%. Investors in public funds have the right to change the fund manager if there is
quorum in a vote. The fund manager cannot vote if it has participation over 25%. In both public and
private funds the fund manager cannot have participation in the fund over 40%.
In Chile local investors
taxes in concept of dividends
be paid only at an individual
through Foreign Risk Capital
of investment funds do not pay corporate taxes, this is, they do not pay
or capital gains at the fund level; the fund is a tax pass through. Taxes will
level. Conversely foreign investors must pay 35% taxes unless they invest
Investment Funds (FICER).
International funds doing business in Latin America usually create offshore tax efficient structures.
For example, all Advent Latin American private equity funds (LAPEFs) have been set up as Caymans
limited partnerships. Some others register their funds in British Virgin Islands, the Bahamas or
Bermuda. However, due to certain restrictions for institutional investors in some countries like Chile,
where one of the conditions to allow capital allocation is that the country where the fund is set up
should have investment grade, some funds have chosen alternatives like an Ontario Limited
Partnership, used by Aureos Capital and other firms.
Because there has not been a single focus in developing a legal frame for the venture capital and
private equity industry, but the problems have been addressed inside broader global capital market
reforms, and because the number of initiatives and their impact has been very limited, is that the legal
frame has had a low and incomplete development.
46
3.4 The Chilean Pension Funds in the Latin America Contekt
In Europe and in North America pension funds played an important role in the development of
venture capital and private equity. Nevertheless, in Latin America, with the exception of Brazil, pension
funds are far from being actively investing in alternative assets. This has a negative impact in the local
PE/VC industry since pension funds are among the biggest sources of capital and their investment
horizon fits well within the private equity model.
In 1978, the U.S. Employment Retirement Income Security Act (ERISA) guidelines were
reformed to allow pension funds to invest in private equity under the 'prudent man rule,' enabling
investments at the LP's discretion provided that they do not endanger the entire portfolio. As of
September 2011, big public-employee pensions had about $220 billion invested in private equity
(Exhibit 3.10), or 1 1 % of their assets, according to Wilshire Trust Universe Comparison Service, which
tracks the holdings of pensions, foundations and endowments. In 2003, the European Union adopted a
Directive embracing the "prudent man rule", stating that member states should not prevent pension
funds from investing in private equity and venture capital. As a result, Europe's pension funds are now
among the leading investors in private equity.
Exhibit 3.10 PE Spending at 10 Large Public Pension Funds in US (Dec. 31, 2010)
Tota
Asets
(bilo)
Actual Allocation
in PE Assets ($
billion)
% Effective
Allocation in PE
Assets
California Public Employees' Retirement System (CalPERS)
228
32.2
14.1%
14%
California State Teachers' Retirement System
Florida Retirement System Plan
New York City Retirement Systems
Ontario Teachers' Pension Plan
Teacher Retirement System of Texas
150
124.2
115
111.5
105.3
20
5.1
6.7
12.4
9.4
13.3%12
4.1%
5.8%
11.1%
8.9%
N/A
N/A
N/A
10%
Pension Fund
Washington State Investment Board
Tre
Alcto
se
nP
79.4
14.7
18.5%
N/A
New Jersey State Investment Council
72.6
4.6
6.3%
N/A
Oregon Public Employees' Retirement System
57.7
12
20.8%
16%
Massachusetts Pension Reserves Investment Management
48.3
5.1
10.6%
10%
__._
Source: Buyouts, April 2011
Exhibit 3.11 Latin American Pension Fund AUM (US$B)
$700
US$6388
$600
US$550B
$500
US$362B
._ $400
i
US$282B
$300
$200
$200
US$1268
$100
$0
2000
a Brazil
2005
2008
a Mexico
U Chile
Source EMPEA 2011
47
2009
U Colombia
2010
a Peru
2
Today, assets under management (AUM) at private and public pension funds in Brazil, Mexico,
Chile, Peru and Colombia total US$638 billion (Exhibit 3.11), and a fund of funds in the region
estimates medium-term potential investments in private equity at US$20-US$25 billion.
Latin American pension assets are expected to grow at double-digit rates for the foreseeable
future, among the highest pension industry growth rates in the world (Exhibit 3.12).
Exhibit 3.12 Latin American Pension Fund Assets Growth
Chile
15%
Peru
27%
Colombia
31%
Source EMPEA 2011
In Mexico, two local PE firms, EMX and WAMEX closed commitments in 2011 from local
pension fund Afores on US$130 million and US$60 million respectively. In Peru, Enfoca Inversiones
secured commitments from the local pension funds, and in Colombia country's pension funds have
backed new funds from local managers over the last years: LAEFM, Teka Capital and Access SEAF
(2011 LAVCA Mid Year), investing 5% of their assets in local funds.
In Brazil local pension funds have been active investors in PE/VC for more than ten years,
investing up to 10% of reserves in PE/VC. Investors are free to choose where to put their money.
Brazil's 400 or so pension funds, with assets of around US$342 billion, have been allowed to place
money more freely with alternative-investment firms since 2009. Pensions now account for around
22% of investments in private equity and venture capital, according to Claudio Furtado of Fundasio
Getulio Vargas. Valia, the US$6.8 billion pension fund of Vale has increased its allocation to private
equity from 1% of assets three years ago to 6% in 2011 (The Economist, February 2011).
In contrast, and even if Chile has the oldest pension fund system of Latin America created in 1980
with total assets of US$153 billion, the support of Chilean pension funds to local private equity funds
(currently Chilean pension funds have no investments in venture capital) is marginal, less than 1% of
the total assets, compared with that of local pension funds of Brazil, Mexico, Colombia and Peru, and
most of the assets have been committed to leading U.S. private equity firms, not local GP's (Exhibit
3.13).
Not only pension funds are investing in private equity. Other institutional investors like the
insurance companies are looking for opportunities in this asset class. Chilean insurance companies are
beginning to make commitments to international private equity funds through the local feeder funds,
committing US$60 million to Southern Cross Fund III in 2006, US$32 million to Southern Cross Fund
IV in 2010 and US$20 million to BCP VI in 2011.
48
Given that the development of PE/VC industry depends heavily on capital provided by local
institutional investors, it is key to determine the causes of this situation and the potential changes that
could reverse this situation back. The following causes were identified:
1.
Risk aversion. Latin American pension funds developed an aversion to alternative assets after
the downward cycle of the late 90's and the devaluation of the Brazilian real in 1999 and the
Argentinean peso in 2002. In 1996 several Chilean pension funds lost more than US$ 8
million after have invested in the company IsaCruz, increasing the aversion to new investment
instruments. This risk aversion is encouraged through a strong negative media exposure in
case of any adverse event (La Polar case).
2. Limited experience of pension funds teams investing in alternative assets. Since there is
no team dedicated specifically to manage alternative assets, and most of the decisions are
taken by the top executives, there is almost no inner learning process. This has two
consequences: more risk aversion because of a lack of confidence and understanding and less
interest in that asset class.
3. Fierce competition from big multinational PE funds. In the last two years there has been
an invasion of big foreign funds that realized of the weaknesses and needs of the Chilean
pension funds. Smaller local funds will have to invest a huge amount of time to convince
Chilean pension funds to be their LPs.
4. Regulatory limitation of 35% maximum investment per instrument. Chilean pension
funds cannot own more than 35% of any company. It means that if one pension fund wants
to invest directly in a PE deal, it must find a majority partner or at least two additional pension
funds willing to take the deal. Because of the reduced number of pension funds in Chile, this
is a great barrier especially for small local funds.
5. Small size of local funds. Pension funds have an average minimum ticket of US$10 million.
That means that because of the 35% maximum investment limitation, the minimum deal size
interesting for pension funds is US$30 million. The AUM (Assets Under Management) of
most local funds is smaller than US$30 million.
6. Lack of GP's experience and track record. The VC and PE industry is young, and most
local funds have not enough experience and/or track record. Sometimes there is track record
at an individual level but not as a team.
7. Lack of efficacy of the performance benchmark. Relative metrics of minimum returns
based on 36 months industry average returns are very generous and creates a non desired
effect: all pension funds tend to invest in the same assets. Brazil requires a 6 % minimum real
return. Colombia in 2010 implemented a similar system than Chile. In Mexico there are not
minimum return requirements, and in Peru each pension fund should have their own
reference indicators, previously approved by SBS (Superintendency of Banks and Insurance).
8.
9.
Lack of competition. In 1996 there were 26 pension funds in Chile (Solimano 2009). Now
there are only 7. This situation creates a lack of appetite for risk and higher returns.
Lack of regulatory framework incentives to invest locally. Unlike other countries like
Colombia or Mexico, there is no incentive to invest locally (Exhibit 3.13)
49
The regulatory limitation of 3 5% maximum investment per instrument, the lack of competition
and the benchmark performance against one another creates a "herd effect": most of the pension funds
take the same decisions. The problem for the workers and employees that are contributing to the funds
is that they are getting approximately (it depends on the fund risk profile) the same return than the
S&P500 less an average 2% fee. It would be more efficient to invest directly in the S&P500 Index.
Exhibit 3.13 Overview of Pension Funds Regulation for PE Investments (as of May 2011)
(an Invest in Private Equity
International
Domestic
Brazil
Cap on PEAllocation (%of AUM)
Total Domestic
Ys1
Chile
-
Total International
Details
10%
While Brazilian pension funds may invest up to 10% of
international assets-including public equity,
in equity
AUM
private
and fixed income-most funds have internal
restrictions on such investments
See Details
Chilean AFPs may invest up to 0.5% of their AUM in each
feeder fund, but the cumulative investment limit across all
feeder funds isnot directly regulated
Colombia
5%
5%
Colombian AFPs may invest up to 5%of AUM into
domestic private equity and an additional 5% into
international private equity
Mexico
10%
0%
The 10% cap isinclusive of real estate and infrastructue funds
Peru
Peru
There isno cap on investment in domestic PE,each of
the AFP's three fund options has a limit on allocation to
variable income securities (which includes PE).There isa
3%cap on all foreign alternative assets.
-
Source: EMPEA 2011
In conclusion, the regulatory frame is one of the main causes of a reduced investment of pension
funds in local private equity and venture capital firms. In order to improve the current system I
mention the following recommendations:
1.
2.
3.
4.
Allow investments up to 80% or 100% of the instrument. It would not be necessary any
more to find at least two other LPs to take a deal. Pension funds could invest in smaller deals.
Allow pension funds to invest directly in private equity. In a first stage it would not help
much because of the lack of expertise in the asset class, but in the future it would be a new
investment alternative with high potential returns. Additionally, it would be the best way to
build in site local experience teams.
Change the performance benchmark. Since setting a soft and relative benchmark has no
impact in the behavior of the pension funds, a possible solution would be that they would
make public their own benchmark policy, following the US example. This system could create
the incentives for a pension fund to market an aggressive target and attract more employees
and workers if they succeed. With the current system there is no opportunity and no incentive
to any pension fund to do something different from the rest of the system.
Implement incentives to invest in PE/VC locally. Colombia is a good example to followit could be possible to set a minimum target allocation of private equity assets locally and the
excess could be invested abroad.
50
3.5 The Venture Capital Ecosystem
Venture Capital ecosystem is closely linked to the entrepreneurial ecosystem. However, there is an
important difference: while the entrepreneurial ecosystem focuses in creating the environment to foster
innovation, creativity and entrepreneurship, the venture capital ecosystem is centered in the process of
creating value, it is the catalyst that makes possible the implementation of the entrepreneurial idea.
Seven factors need to be considered to analyze the venture capital ecosystem: angel investors,
entrepreneurs, service providers, entrepreneurship centers, investment in R&D, government and
financial support (Exhibit 3.14).
The existence of an ecosystem has a multiplier effect in the generation of business opportunities.
Yet the whole ecosystem requires of a process to be formed, so the results rarely will be visible in the
short, medium term.
Exhibit 3.14 Venture Capital Ecosystem
Entrepreneurs
Service Providers
Entrepreneurship
Centers
Angel InvestorsVetrCail
Investment in R&D
Financial Support
Government
Source: Adapted from Castile Ventures
Angel Investors: Angel investment is incipient in Chile and predominantly dependent on private
initiatives, usually coming from universities. In 2006 CORFO started a program supporting the creation
of angel networks to promote this activity. Currently, there are seven angel investor networks working
in Chile. Southern Angels was the first, created in Santiago in 2005 and previously linked to the Adolfo
Ibaiez University. Other angel networks are: Incured, Angeles de Chile, Angeles del Sur, Chile Global
Angels, Angeles Dictuc and Proyecta Chile. The estimated capital invested by angels in the last seven
years was US$13 million.
51
According to the angel investors, only 3 % of the screened projects is finally supported. The main
problems detected are first, the lack of quality of the ideas and projects presented and second, that the
entrepreneurs don't have the abilities or skills to implement the project.
Entrepreneurs: Entrepreneurs are the blood of the venture capital ecosystem. According to the
2010 GEM report, a high percentage of the Chilean population (3 8 % ) has the intention to start a
business, but most of them are necessity-based entrepreneurs (those that do not have better options to
work than being self-employed), not opportunity-based entrepreneurs, who have several employment
possibilities . The culture of entrepreneurship is mostly taught and learned at the universities, not from
the cradle like in the US, so the impact is more limited. It is very difficult to change the mentality of the
people right away at the age of 18 if entrepreneurial attitudes have not been fostered previously. In
order to provide high quality entrepreneurships two barriers need to be broken down in the Chilean
culture: the fear to fail, and the non-trespassing borders mentality.
Additionally, from listening to angel investors and VCs, it is clear that many Chilean entrepreneurs
lack the abilities and skills to communicate, develop and implement correctly their ideas.
Service Providers: The creation and maintenance of any business involves the need for additional
services like auditing, accounting and law firms. Law firms are without any doubt the most critical
service provider in developing countries. Since venture capital is a nascent activity in Chile, there is just
a handful of law firms specialized in term sheets and creation of SpA firms (Sociedad por Acciones).
Most of them have learned at the same time than their clients. Ideally there should be lawyers
specialized in entrepreneurs advice and others in venture capital firms advice, but due to the fact that
the volume of venture capital activity is still low it is not the case yet in Chile.
Entrepreneurship Centers: Nowadays there are more than 30 incubators in Chile and the
number is still growing thanks to government supported programs. But entrepreneurship center is a
concept that goes beyond incubators, comprising also learning and diffusion programs of
entrepreneurship and other private supported initiatives. Most of the learning and diffusion programs
are supported by universities, although there are private entities like mining companies or professional
associations that also offer pro-entrepreneurial programs. In addition to those initiatives, Endeavor
Chile, a nonprofit organization created in 1998 has its own entrepreneurship supportive model.
Endeavor selects and supports potential entrepreneurs with already demonstrated capabilities, not only
providing financing help, but also offering counsel, mentorship and immersing the entrepreneurs into a
wide contact network of more than 2,400 business executives and 600 entrepreneurs.
Investment in R&D: The R&D investment in Chile is still low, only 0.67% of GDP (UNESCO,
2010), where business expenditures accounted for 46% of the total. The rest is primarily carried out in
the universities and few governmental institutions. In recent years, the Chilean government has put in
place a framework aimed at improving scientific and technological development. The two key agencies
are the Chilean Economic Development Agency (CORFO) and the National Scientific and
Technological Research Commission (CONICYT).
52
Exhibit 3.15 R&D Profile of Chile
GERD
as%of GDP
-
BERDas % of GDP
% of population aged 25-64 with tertiary degree
Science and engineering degrees
as %of all new degrees
-------
Chile
Average
Triadic patents per million
population
Researchers per thousand total
Scientific articles per million
employment
population
\
% of GERD
financed byabroad
% of firms with new-to-market
product innovations (as %of all firms)
% of firms undertaking non-technological
innovation (as %of all firms)
%offirms collaborating (as % of all firms)
Patents with foreign co-inventors
Source: OECD 2010
Government: The government
in Chile has played and active role promoting both
entrepreneurship and venture capital. In Chile, there are currently 22 government-backed institutions
promoting new businesses either directly or indirectly through different financial instruments. These
programs are divided into areas such as technical assistance, export promotion, innovative
entrepreneurship, training, and access to financing, and are predominantly directed towards micro,
small and medium firms. Many of these public programs are sector-specific and aim to develop
productive clusters in activities such as agriculture, fishing and mining.
CORFO (Chilean Economic Development Agency), stands out as the public organization that has
developed the widest range of financing programs. Innova Chile committee was created in March 2005
and is the public institution in charge of enhancing the Chilean national innovation system,
competitiveness and entrepreneurial activity. The Innova Chile budget has gradually increased from
USD 35 million in 2005 to USD 148 million in 2011, and is channeled into five areas, which cover
different sources of innovation and entrepreneurship: innovation in enterprises, entrepreneurship,
innovation environment, technology transfer and diffusion and international programs. The main
financing instruments of the entrepreneurship area in Innova Chile are business incubators, seed
capital, technological support and angel investor networks.
In addition to the entrepreneurship and innovation programs the government supports
educational programs, research (R+D) programs and financing programs providing leverage for
venture capital.
Financial Support: For high impact entrepreneurships the financial support is given primarily by
angel investors or venture capital firms with or without government leverage. Only 1% of the presented
projects to VC firms are finally backed according to the conducted interviews. The nonprofit
organization Endeavor also provides growth capital once the company has a short track record. Private
equity firms should play an important role too providing capital for growth, expansion and
consolidation stages.
53
CHAPTER 4.
THE INTERACTION MODEL OF VENTURE
CAPITAL AND PRIVATE EQUITY DEVELOPING FACTORS
4.1 Private Equity and Venture Capital Developing Factors
In the previous chapters I presented a global, Latin American and Chilean private equity and
venture capital outlook, identifying the most relevant factors. My goal is not just to describe what the
hot trends in PE/VC are, but to prioritize those factors considering the impact they have in the
development of the PE/VC in Chile and Latin America and to establish a model where the interactions
among them are clearly defined and understood.
I developed two models, one for venture capital and the other for private equity. Even if they are
different, the essence is the same. The only reason why I could not merge them in just one model is the
importance of the entrepreneur in the venture capital model, a variable that it is not present in private
equity.
Exhibit 4.1 The Three Factor Categories affecting PE/VC Development
Socioeconomic and Regulatory Environment
pucs
All the factors can be divided in three main categories: enabling factors, adaptive factors and
leverage factors (Exhibit 4.1). These categories are distributed in layers. The external layer, the
socioeconomic and regulatory environment, includes all the enabling factors that are necessary to create
an adequate PE/VC climate. However, these factors have low or null leverage power to develop private
equity and venture capital in a significant way.
54
Without the enabling factors it is very unlikely that private equity and venture capital could even
spark. Enabling factors are usually static and not time dependant. They affect the rest of the factors but
they are not affected by the behavior of the system; they are seldom involved in learning processes
(causal loops).
The middle layer represents the adaptive factors. Once the enabling factors have been created,
culture and experience must be developed. The adaptive layer involves continuous feedback and an
adaptation process. The length of this process will depend on the quality of the enabling factors, the
initial capabilities of the resources involved (GPs' initial knowledge, open mentality of entrepreneurs,
etc.) and the amount of resources applied (talent hiring, entrepreneurship education, etc.).
The third and the most important category in terms of the impact on the development of private
equity and venture capital is success, the leverage factor. Success has the power to boost the PE/VC
ecosystem, creating positive emotions and perception to all the agents involved in the PE/VC
development. As the number of success cases multiplies, entrepreneurs are more motivated, increasing
the number of people willing to start a business, LPs are more confident and commit more capital,
there are more PE/VC firms raising and managing funds, etc. Success has an amplifying effect in the
whole PE/VC ecosystem.
A caveat: it is important to be aware that as any other kind of leverage, this factor has risks.
Success can also work in the opposite direction, this is, if instead of success cases failure cases are
observed, the opposite effect is created: the whole ecosystem will be discouraged to be involved in
PE/VC. This is what happened in Latin America in the early 2000s. It took almost ten years to recover
from the downturn.
In order to develop private equity and venture capital it is not enough to remove barriers (create
enabling factors), but it is also needed to introduce positive factors to move forward the learning
process that leads to success. That would allow PE/VC to attract more fund managers, entrepreneurs,
investors and businesses. The higher the number of positive factors, the greater the deal flows.
It is important to highlight that success cases must be spread out and communicated; otherwise
they have no effect at all. Consequently local media plays a crucial role in the development of the
PE/VC ecosystem. In the case of Chile, CORFO understood this need two years ago when they started
a promotional campaign supporting entrepreneurship based in small success cases.
What are the characteristics of the most successful venture capital and private equity firms? Even
if there are systemic factors affecting success like socioeconomic environment or experience and ability
of entrepreneurs, there are intrinsic characteristics to PE/VC firms that have a critical impact in the
GPs' performance. I identified the following built-in success factors:
1.
Due diligence process is key. An exhaustive list of questions should be developed by the
due diligence team. There should not be any blind side, evaluating carefully all the risks. In
Latin America the quality of the information is of poorer quality than in US or EU, so in
general, more due diligence work is needed for tax, labor, environmental liabilities and
corporate governance.
55
2. A constant and active search of opportunities. Middle market GPs screen 100 companies
3.
to invest in 1.
Build an internal repeatable model, based in adaptable procedures, embedded in the
culture of the company. Institutionalize the decision process, so the responsibility, experience
knowledge and relationship with investors is shared. Successful firms define creative value
creation strategies and specific first year initiatives from a team, avoiding superstars. They
define policies to strengthen and professionalize the organization retaining and motivating the
best people. A mix of entrepreneurs, financiers and operating professionals who want the
challenge of transforming businesses is needed to spot opportunities and develop highly
attractive sustainable businesses from a wide variety of situations.
4. Plan the exit from the start. This factor is even more important in developing countries
given the extraordinary challenges of creating a viable exit opportunity. True sector expertise
engaging a network of advisers that includes senior industry executives and operating partners
5.
6.
7.
is the basis to identify growth opportunities others don't see.
The company management shall understand and commit to the strategy from the
beginning. Forging a strong and early partnership with the company's management team on
a value-creation plan is essential for achieving growth expectations. GPs should play a handson role, actively monitoring the performance of the company.
Develop an adaptive investment strategy built on core strengths and big enough to
support an investment team. The strategy should also be linked to the value creation levers
(Revenue growth, margin expansion, leverage or multiple expansion). Industry expertise is key
to make the right investment decisions. Smaller investments consume the same or more
resources than bigger investments.
Reduce the risk. There should be a continuous focus on reducing the risk, in the due
diligence process and during all the investment period, financially and operationally.
56
4.2 Introduction to Causal Loop Diagrams
The models have been created using causal loop diagrams. These diagrams allow to see all the
interactions among all the agents comprising a system, in this case, the venture capital or the private
equity ecosystem. The interactions are defined by circles of causality, also called feedback loops.
Feedback loops can be reinforcing (amplifying) or balancing (stabilizing). Reinforcing feedback
processes are engines of growth or also accelerators of a decline, while balancing loops stabilize the
system at a certain goal. The arrows link the different variables or factors in the system, indicating with
a sign if the impact of the previous variable is positive (+) or negative.
Exhibit 4.2 Causal Loop Diagram
External Financing
Sources
+
Financing
Nuber of
Successful
Exits
Number ofNew
Entrepreneurships
Funded
In Exhibit 4.2 an example of a reinforcing causal or feedback loop diagram is represented. The
"R" identifies it as a reinforcing loop, and it is called "Financing". How to read the diagram? We can
choose any diagram variable to start reading the diagram. Choosing "Number of Successful Exits" as
the starting variable, the diagram would be interpreted as follows: As the number of successful exits
increase, the number of available financing sources increases (since the perceived business risk by banks
and other facilitating credit institutions diminishes). As there is more financing sources, the number of
new entrepreneurships funded raises. As the number of new entrepreneurships increases, there are
more successful exits (considering that the probability of success does not change). In summary, an
increase in success cases has an amplifying effect when considering the impact in financing sources and
the number of entrepreneurships funded.
In some diagrams this arrow appears:
+
It means that there is not a direct
connection between the two variables; they are connected through one or several other factors that are
not relevant for the analysis of current loop, and therefore those interconnecting factors are omitted.
57
4.3 The Venture Capital Model
Exhibit 4.3 The Venture Capital Model
Pro-Entrepreneurial
Governmental Economic
Policies
+
Governmental
Innovation,
Educational &
Quality of
Socioeconomic
Environment
n
+
Cultural Barriers
+
-Entrepreneur
Motivation
R3A
Number of
Entrepreneurs
+
Motivation
+
+
R
Number ofNew
Nunber of VC
Entrepreneurships
Funded
+
Size & Number of
VC Funds
4
Better Governmental
+
Regulations for Institutional
Funds
+
Ivestors
Govermental
Governmental
olicies to Facilitate
reign Investnent
Governmental
Leverage
Program
\
+
Mentoring
Performance
(odMentoring
LUs Conflidence
+
+
&
Advising
LPs Committed +(R1
+
Capital
+
+ +
VCs Experience
+
<Quality of
Socioeconomic
Vgs Experience
Envfi-rnment>
The core of the venture capital model is the leverage factor: Success. Every single feedback loop
has success as one of the variables. Around the leverage factor are located most of the adaptive
feedback loops: motivation, network, experience, mentoring, LPs confidence, etc. The enabling factors
usually don't affect directly the causal loops. They form part of the system and influence adaptive
factors, but they are not affected by the rest of the variables.
58
One important observation is that the model is based only on postive (reinforcing loops). This
happens because I consider that the venture capital ecosystem is in an early stage of development and
therefore it is possible to omit stabilizing factors like competition, high prices and limits to grow
(number of VC companies, etc.).
The most relevant reinforcing loops in the venture capital model are:
R1:
R2:
R3:
R4:
R5:
VCs Experience
LPs Confidence
Motivation
VC Network
Number of VC Funds
Since the model is extensive, I will analyze loop by loop, simplifying the diagrams.
4.3.1 VCs Experience
The experience of venture capital firms is a key adaptive factor in the VC development.
Experience is needed to raise funds, to make the right investment decisions in terms of selection and
business structure and to manage the investment portfolio.
According to the model (Exhibit 4.4), as the number of entrepreneurships funded by VCs raises,
the experience is also increased. Experience is a learning process that allows VC firms to make better
decisions, leading to a higher success rate. At the same time, success increases the motivation and the
number of entrepreneurs and as a consequence, the number of potential entrepreneurships to be
funded by a VC firm, closing the reinforcing loops.
Exhibit 4.4 The VCs Experience Reinforcing Loop
Number of
Successful
+
Number ofNew
Entrepreneurships
Funded
RExits
VCs Experience
+
VCs Experience
The reduced experience of local VC firms and professionals and a lack of successful cases has
generated a different behavior between Latin America and US venture capital firms: In the US the VC
firms try to maximize the success probabilities, pushing the entrepreneur to fly, investing in the
development and growth of the business, whereas in Latin America VC firms try to minimize the
probability of failure, putting more control on the entrepreneur, sometimes limiting the use of capital.
59
Another difference found in my research is that the term sheet conditions imposed by some local
VC are really unfavorable for entrepreneurs. For example, in some cases VCs request 50% or more of
company's equity upfront.
Why this happens? The fear to fail makes VCs to focus on risk control. Additionally a lack of
experience can lead to a sub-optimal interaction among all the agents (LP's, VC, entrepreneurs) and to
an implementation of the wrong corporate governance policies in their portfolio of managed
companies. Lastly, the agency problem is a high concern in developing countries. In Chile only 13% of
the population expresses high trust in their fellow citizens (OECD 2011), much less than the OECD
average of 59%.
VCs experience is one of the most important variables of the model because it is not only an
adaptive factor, but also an enabling factor that has strong influence in mentoring entrepreneurs,
building the network and convincing LPs to commit capital (fundraising). Moreover, experience for a
VC firm has a huge impact in its prestige and brand name and therefore, providing a better and wider
access to more and better entrepreneurs, this is, to more and better investment opportunities. This
issue is crucial for the long term sustainability and profitability of the venture capital firm.
4.3.2 LPs Confidence in Venture Capital
The assumption implicit in the model is that the main factor involved in gaining confidence from
investors is performance. Performance refers to the average internal rate of return (IRR) or end-to-end
return of all the local funds. Interpreting the LPs confidence reinforcing loop (Exhibit 4.5), as the
number of successful exits increases, the performance improves so it does the VC's track record and
their ability to raise more funds. As more capital is committed by LPs, the number and size of VCs
increases, funding more entrepreneurships and therefore increasing the number of success cases.
Exhibit 4.5 The LPs Confidence Reinforcing Loop in the VC Model
Number ofNew
Entrepreneurships
Funded.
Number of
Successful Exits.
(
Size &Number of
VCs.
Better Governmental
+
Ls Confidence
Regulations for Institutional
Performance.
LPs Committed
+
Capital.
+
Governmental Policies to
Facilitate Foreign
Investme.Quality of
Socioecononne
Envionment.
60
+
VCs Experience.
Govenmental
Leverage Programs.
Building a successful track record is key to build confidence with the LPs. The ability to create
success cases is the basis to generate confidence among the LPs and raise funds. The scope of this
reinforcing effect expands beyond the successful funds; it spreads all around, at a country or even
regional level.
Up to now, in Chile and in Latin America, exits have had lower upside compared with those in
developed markets so the performance has been poorer. This is due to earlier exits with lower exit
multiples and to more limited opportunities of the small local market (Chile). To address these issues, it
is key that VCs develop their own expertise assessing appropriately the right moment to exit and that
they expand their network beyond the country borders, widening the range of potential buyers.
In Exhibit 4.5 it is possible to observe how the enabling factors "Better Governmental
Regulations for institutional Investors", "Governmental Policies to Facilitate Foreign Investment" ,
"Quality of Socioeconomic Environment" and "Governmental Leverage Programs" affect the
committed capital by LPs.
As I already mentioned in Chapter three, current governmental regulations for pension funds in
Chile do not support the development of local venture capital and private equity. At least, the
benchmark system to control the performance and the ban to participate in any investment over 35%
should be changed.
Finally, even if high IRR is probably the main factor when building confidence with LPs, it is not
the only one. Having a stable and experienced team, being consistent in the investment strategy and
aligning interests between GPs and LPs are also important factors to be considered. In the research it
was found out that some GPs co-invest in a significant way (up to 3 0%).
4.3.3 Entrepreneurs' Motivation
According to the opinion of angel investors and VCs stated in Chapter three, the projects
presented by entrepreneurs lack quality, and entrepreneurs, in general, are not enough prepared to run a
business. How could it be possible to increase the number of entrepreneurs and the quality of their
projects? The motivation loop gives us the solution: as the number of success cases increases,
entrepreneurs' motivation increases, breaking down cultural barriers that impede the proliferation of
more entrepreneurs. As the number of entrepreneurs increases, the number of new entrepreneurships
funded by VCs grows, and it does the number successful exits (Exhibit 4.6).
61
Exhibit 4.6 The Entrepreneurs Motivation Reinforcing Loop
Investmient in+
R&D.
Governmental
Innovation, Educational
-&
Development
Cultural
Programs.
Barriers.
Entrepreneur
Motivation.
Number of
Entrereneurs.
++
Motivation
Number ofNew
Entrepreneurships
Funded.
+
*
+
Number of
ucer of
Successful Exits.
Cultural barriers are the main obstacle to the generation of new entrepreneurs. The creation of
entrepreneurial idols based on local success cases could boost the number of opportunity-based
Chilean entrepreneurs willing to start a business. The following are the main cultural barriers I
identified in Chile:
1.
2.
Risk aversion. Chilean attitude is more risk-averse and conservative than in its neighboring
countries.
"Island mentality". Due to the geographical isolation of Chile (surrounded by the Pacific
Ocean and the Andes Mountains) the general thinking is local, not global. It is necessary to
break that mental isolation thus, a more open "go beyond" mentality can be established,
trespassing borders and thinking big. These attitudes are the basis of successful entrepreneurs.
3. Stigma of Failure. Failing to succeed in Chile has not only personal consequences, but also
social rejection. There is a double punishment: personal and social. A failed entrepreneur will
assume risks with regard to his family, society, and his financial position. Only success cases
can change this perception.
4. Cost of opportunity. Entrepreneurs have little or no management experience, and it is
uncommon for an employee to leave a stable job to start an independent business. There are
economic reasons (well prepared people have high wages in Chile) and social reasons:
developing a career in a multinational company is well regarded, it offers social prestige,
whereas being an entrepreneur has no social acceptance.
Two enabling factors considered in the motivation loop are "Governmental Innovation,
Educational & Development Programs" and "Investment in R&D". The Chilean government has
implemented programs to foster innovation and increase the number of scientists, trying at the same
time to reduce the technological gap between the universities (research) and the industry. Since having a
global vision is a must for nowadays entrepreneurs, internationalization programs have also been
deployed: International university collaborations (For example Misti-MIT), attracting international
entrepreneurial talent with the Start-up program, or offering the opportunity to study abroad through
Conicyt. However, even if the efforts from the government have been significant, some metrics of
research development are still far behind those of developed countries like the number of registered
patents.
62
4.3.4 Venture Capital Network
VCs not only provide capital but also advice, mentoring to entrepreneurs, experience, business
expertise and a network. Access to local and international networks is a requisite for the success of an
entrepreneurship and a VC firm, be it for strategic partnerships, development of prototypes, talent
hiring, financing, exiting or access to new opportunities. Considering the access to markets and given
that Chile is a small an isolated market, networking is significantly relevant, as it is stated in the model
(Exhibit 4.7): As the number of successful exits increases, it does the number of new
entrepreneurships funded by VCs, so the experience of VCs grows, expanding at the same time their
network, having a better and wider access to markets, and therefore increasing the number of success
cases.
Exhibit 4.7 The Venture Capital Network Reinforcing Loop
Number of
Successful Exits.
Number ofNew
Entrepreneurships
Funded.
0
(Access
R4
& Market
Knowledge.
VCNetwork+
Network.
VCs Experience.
Because of the small market size of most of the South American markets (like Chile), any
company covering a specific sector has to be regional in order to have a critical mass (better exit
opportunities). When moving to broad markets like US, the challenge is to define the right niche
strategy. Moreover, when exploring new markets, the company must respond to local characteristics,
i.e. different regulatory and legal frameworks, requiring a profound knowledge of each market.
Networking is essential supporting a global or an international strategy.
Chilean government offers financing leverage programs for PE/VC funds. These programs offer
the option to create a subsidiary abroad. This is a great opportunity to develop local VC with a global
scope. The only option of a small country like Chile to scale its potential is being global.
63
4.3.5 Number of VC Funds
At early stages of VC development a growing number of VCs is beneficial for the ecosystem. In a
more mature stage of development could be debatable whether more competition is good or bad, but
this is not the case. As the number of successful exits grows, the number of VC funds and funds' size
increases, leading to a higher number of entrepreneurships funded and therefore increasing the number
of success cases (Exhibit 4.8).
Exhibit 4.8 The Number of VC Fundss Reinforcing Loop
+ Number of
Successful Exits.
Number ofNew
Entrepreneurships
Funded.
k
Number of VCs
Size & Number of
VCs.
LPs Committed
Capital.
While increasing the fund size in private equity is critical for the profitability and performance of
the GP, in venture capital in developing countries it is not main factor: the projects presented by local
entrepreneurs require moderate amounts of capital.
However, if the capital to invest it is not constrained by the size of the project and the risk is
under control, higher investments would arguably more convenient and therefore the size of the funds.
From the point of view of the GP, a larger fund provides a higher management fee (in absolute terms),
but more important, the resources needed to manage a portfolio of small investments are the same than
those needed to manage a portfolio of larger companies. An additional point is that businesses valued
over US$10-US$15 million are more attractive for strategic buyers. Under the LPs perspective larger
funds would allow institutional investors to commit capital once the risk is accepted.
64
4.3.6 Entrepreneur's Network & Experience
VCs network and experience is an invaluable asset for any start up. Nevertheless, entrepreneurs
cannot rely only on VCs network and experience, they must build their own capabilities. First, from
success (and failure) entrepreneurs' experience grows. At the same time he experience contributes to
the development of more successful exits (Exhibit 4.9). As the entrepreneur's experience increases, the
entrepreneur's network expands, providing more and better opportunities to access to markets,
ultimately leading to more success cases.
Success has a multiplier effect in entrepreneurs' inspiration. Additionally, successful entrepreneurs
create a network that inspire, mentor and invest in new entrepreneurships, increasing the number of
entrepreneurships.
There are different causes why the entrepreneurs are interested to develop a network. First, they
want to pitch their ideas to leading local and global VCs. Second, they want to raise regional and
international profile, making contacts all over the world, exchanging ideas and finding the right
partnerships. Third, Broader access to smart, sector specific, local and global VCs.
Exhibit 4.9 The Entrepreneur's Network & Experience Reinforcing Loops
etwork.
Access & Markekt
R7+
Knowledge.
Entmpreneur
VCs
Network
Experience.
Quality of
Socioeconomic
+
Environment.
Number of
Successful Exits.
Entrepreneur
ernce
+uEntrepreneur
Experience & +
Abilities.
Mentoring &
Advisig.
According to angel investors and VCs, in general, entrepreneurs in Chile lack previous
entrepreneurial and professional experience. This means that they didn't develop a network before
starting a business. The lack of experience and knowledge of what is venture capital and how it works is
also a barrier preventing more angel or VC investments, since a lot of their time is spent in coaching
entrepreneurs how to pitch their idea and negotiate with interested investors. One example of the lack
of entrepreneurs' knowledge about venture capital is that few of them know the meaning of tag alone
or drag alone clauses that appear in all term sheets.
This lack of knowledge and experience does not only affect entrepreneurs, but also other
professionals involved like auditing, accounting and law firms. Most of them have learned or are still
learning at the same time than their clients.
65
4.3.7 Impact of Socioeconomic Environment in Venture Capital
Chile has always stood out from its neighboring countries in terms of economic and political
stability, and the quality of the socioeconomic environment is relatively good within the region.
However, a lower GDP growth rate and a much smaller internal demand could undermine this
privileged position.
The Chilean capital market is well developed (although not at the level of developed countries),
but due to the small size and heavily concentrated economy, it is difficult to sell a business at a
competitive price, limiting the options for local exit opportunities. Additionally, the stock market is
dominated by large companies and institutional investors, restricting the accessibility of IPOs for startups.
Another socioeconomic cause that restrains the development of venture capital in Chile and Latin
America is the underdevelopment of institutional norms compared with developed economies (Bruton,
Ahlstrom, Puky, 2009). This lack of norms and therefore expected behaviors creates a lack of
confidence between the two parts of a relationship, i.e. between the entrepreneur and the venture
capital firm. Moreover, in Latin America local economies are usually controlled by few economic
groups, usually attached to local families. These economic groups tend to privilege investment decisions
supporting companies inside their network, thus reducing the opportunities of getting capital for most
entrepreneurs.
Even if the socioeconomic environment could be seen as an external, enabling factor, in the
model it was consider an adaptive factor, that can be affected by the number of success cases: As the
number of successful exits increases, the perceived quality of the socioeconomic environment
improves, facilitating the access to the market, and therefore, increasing the number of success cases.
Of course, if the government puts in play pro-entrepreneurial economic policies, it will help to boost
the development of the venture capital ecosystem (Exhibit 4.10).
Economic determinants that increase the venture capital demand (the creativeness and expected
growth) and the venture capital supply (tax and legal environment for venture capital intermediation)
will increase domestic investments and cross-border inflows in the country.
Exhibit 4.10 The Socioeconomic Environment Reinforcing Loop in the VC Model
Quality of
+ Socioeconomic
Environment
Pro-Entrepreneurial
Governmental
Economic Policies
R8
.
.
Socioecononic
Access & Market
Knowledge
Environment
Number of
Successful
Exits
66
+
+
Network
4.3.8 Mentoring
Mentoring and strategic advice to entrepreneurs come mainly from centers of entrepreneurship
like incubators, nonprofit organizations like Endeavor and from venture capital firms. As the number
of successful exits increases, it does the number of new entrepreneurships funded by VCs, boosting
VC's experience. The experience from venture capital firms as well as the support from incubators
provide invaluable mentorship and advice, improving entrepreneur's knowledge and abilities, leading to
success (Exhibit 4.11).
Exhibit 4.11 The Mentoring Reinforcing Loop
Governmental Innovation,
Educational & Development
Programs.
Number of
Successful Exits.
Number of New
Entrepreneurships
Funded.
Entrepreneur
Experience & Abilities.
+
Mentoring
+
Incubators.
Mentoring &
+ Advising
VCs Experience.-
In Chile and in other Latin American countries the poor quality of education significantly reduces
the number of potential entrepreneurs. Alan Farcas, managing director of Endeavor Chile, estimates
that no more than 10% of the population has the skills and contacts necessary to develop a business.
While Chile's high-impact entrepreneurs total no more than a hundred, Israel, a much smaller country,
can call on almost 2,000 (Business Chile 2010). That lack of preparation is visible in the business
incubators, where some promising projects often spend up to three years by which time they are too
old, or too well-known, to be of interest. Mentorship is crucial to counteract the lack of skills.
67
4.4 The Private Equity Model
Exhibit 4.12 The Private Equity Model
Cultural
Barriers
Awareness ofPE
by Target
i11
C
Pro-Development
Governmental Economic
Policies
Quality of
)+
Environme
c1 -
External
PE
Awareness
Financing
R6)
Sources
R7
Financing
Socioeconomic
+
Environment
++
+
Number of PE
Deals
+
Number of
Successful
+
PE
PE Funds
+
Exits
Size & Number
of PE Funds
+
Performance
R2
LPs Confidence
Governmental Fund
Leverage Programs
R1
GP
+
Experi
LPs Cormitted
+
Capital
Y
+
Governmental Policies
Better Governmental
to Facilitate Foreign
Regulations for Institutional
Investors
Investment
In the same way that the venture capital model, the core of the private equity model is the leverage
factor: Success. Almost all feedback loops have success as one of the variables. Around the leverage
factor are located most of the adaptive feedback loops: GPs experience, network, PE awareness, LPs
confidence, etc. The enabling factors don't affect directly the causal loops, they form part of the system
and influence adaptive factors, but they are not affected by the rest of the variables.
68
One important observation is that the model is based only on postive (reinforcing loops). This
happens because I consider that the private equity ecosystem is in an early stage of development and
therefore it is possible to omit stabilizing factors like competition, high prices and limits to grow
(number of PE companies, etc.).
The reinforcing loops in the private equity model are:
R1:
R2:
R3:
R4:
GPs Experience
LPs Confidence
PE Network
PE Awareness
R5: Number of PE Funds
R6: Socioeconomic Environment
Next, I will analyze loop by loop, simplifying the diagrams.
4.4.1 Experience of Private Equity Firms (GPs)
Experience of GPs is the most important factor influencing the development of the private equity
ecosystem; in the '90s most failure causes were first time managers. Private equity is a relatively recent
asset classes in Latin America, so best practices in the industry including the optimal interaction and
alignment among all the agents (LPs, GPs, management of the target companies), are not completely
widespread.
Experience involves a learning process that takes time, moreover considering that private equity
investment cycles typically are in the range of four to seven years. Success is the spark that would allow
to accelerate the process: As the number of successful exits increases, it does the number of PE deals,
so the experience of GPs grows, improving the internal processes and decisions of the PE firms and as
a consequence, contributing to generate more success cases (Exhibit 4.13).
Exhibit 4.13 The GPs Experience Reinforcing Loop
Number of
Successful
Exits
GPs
Number ofPE
Deals
Experience
+
69
GPs
Experience
The fact that many fund managers have financial bckgrounds, often with investment banking
experience, gives them have the experience to manage the investment fund and to play the role as a
financial intermediary. However, the increasing speed of technology and economic changes demands to
the managers of funds in South America additional operational skills and the ability to look to the
future defining strategies and understanding the operations of the company. Operational growth is a
key factor of success in private equity.
David Wilton from IFC affirms that it is not possible to crystallize the opportunities without a
competent GP. IFC has huge quartile IRR gaps, this is, the difference between the best performing
fund and the worst is more than 30%; and one of the reasons they found that explain that behavior is
that the lack of experience increases the risk of failure. He also states that the differentiating factor in
fund quality is the manager's skill set. In general, the best deals are ones PE firms create. Good deals
must fit the skill set and industry knowledge (sector specific) of the fund manager, and offer identifiable
opportunities for enhancing value.
On the other hand, limited partners' traditional concerns about first-time funds are not necessarily
warranted in emerging markets like Latin America. 46.2 percent of the top-quartile IFC's performers
were first-time funds for the period from 2000 through 2006. Moreover, first-time funds achieved
approximately the same performance level that repeat funds did (Exhibit 4.14). Nevertheless,
experienced GPs offer more consistent and less volatile returns (Meerkatt, Liechtenstein 2010).
Exhibit 4.14 IFC's First Time and Non-First Time Funds IRR Comparative
Pre-crisis, 50% of
First Time Funds backed by
had IRRs above 20%
100%/
IFC
Post-crisis, return distributions
for First Time and Non-First
Time Funds were similar
80%
60%
40%
20%
0%
First Time
June 2008)
U
>20%
a 15-20%
Non-First Time
Oune 2008)
010-15%
Source IFC 2010
70
FirstTime
Oune 2009)
*0-10%
Non-First Time
Oune 2009)
a
<0%
4.4.2 LPs Confidence in Private Equity Firms
As in the venture capital model, performance has been considered the key decision factor taken
into account by LPs to commit capital. Performance is measured as the average internal rate of return
(IRR) or end-to-end return of all the local funds. Interpreting the LPs confidence reinforcing loop
(Exhibit 4.15), as the number of successful exits increases, the performance improves so it does the
PE's track record and their ability to raise more funds. As more capital is committed by LPs, the
number and size of PE firms increases, closing more deals and therefore increasing the number of
success cases.
Exhibit 4.15 The LPs Confidence Reinforcing Loop in the PE Model
Number of
Successful
Exits
0
Number of PE
Deals
f+
D
R
Size & Number
of PE Funds
Ps Committed
Capital
L
Better Govennental
Regulations for Institutional
+
+
+
-
4w+
Investors
Performance
LPs Confidence
+
GPs
Experience
Governmental Fund
Leverage Programs
Quality of Socioeconomic
Environment
Governnental Policies to
Facilitate Foreign
Investment
Building a successful track record is key to build confidence with the LPs. The ability to create
success cases is the basis to generate confidence among the LPs and raise funds. The scope of this
reinforcing effect expands beyond the successful funds; it spreads all around, at a country or even
regional level. Furthermore success cases can decrease the perceived risk of a country as a whole,
diminishing the discount rate applied by investors and encouraging the deployment of capital, another
reinforcing effect.
Again, please note that reinforcing loops also work in the opposite sense: from 1999 to 2006 Latin
America was seen as a risky place to invest. LPs demanded a larger for a risk premium in their
investments (higher IRR), it was harder and harder for GPs to raise capital. As a consequence,
investments plummeted.
According to IFC, in emerging markets, including Latin America, performance of top-quartile
funds is strongly driven by increases in the revenues of the portfolio companies, not by leverage. Lower
leverage has the advantage to reduce the exposure to macro and cyclical changes, but all the risk is
transferred to the execution in the form of operational risk.
71
Analyzing in depth the experience of IFC funds, two insights can be extracted: First, funds in
emerging markets with a strong local presence significantly outperform international funds without a
local presence. On average, the returns of domestic and international funds with local offices are more
than five times higher than the returns of international funds without local offices. Local offices not
only enable funds to plug into the local deal network but also provide the only way to understand the
cultural and socioeconomic differences that affect decisions and strategies (Meerkatt, Liechtenstein
2010). Second, while returns on IPO are higher, trade sales provide good returns too. GPs must be
aware of volatility in the exit window and be prepared to opportunistically exit even if it appears
premature.
In Exhibit 4.15 it is possible to observe how the enabling factors "Better Governmental
Regulations for institutional Investors", "Governmental Policies to Facilitate Foreign Investment" ,
"Quality of Socioeconomic Environment" and "Governmental Leverage Programs" influence the
committed capital by LPs.
Local institutional investors are investing a small percentage of their portfolio in private equity, but
mainly in funds managed by foreign GPs. In order to change this, the pension funds' regulation should
be modified, eliminating the benchmark system to control the pension funds' performance and
allowing them to invest without any limit in terms of their participation, giving them incentives to get
outstanding performances using their own independent criterion.
Finally, even if high IRR is probably the main factor when building confidence with LPs, it is not
the only one. Having a stable team and organization, being consistent in the investment strategy and
aligning interests between GPs and LPs are also important factors to be considered.
72
4.4.3 GPs Network
Access to local and international networks is a requisite for the success of a private equity firm, be
it for strategic partnerships, exiting or access to new opportunities As business networks are very tight
in South American countries, access is extremely difficult for outsiders. This peculiarity added to the
fact that Chile is a small country, leads to the conclusion that a local private equity firm with high
expectations should ideally have presence in different countries, or at least have built a strong network.
In the model the influence of the GPs' network is considered as follows: As the number of
successful exits increases, it does the number of deals, so the experience of GPs grows, expanding at
the same time their network, having a better and wider access to markets, and consequently increasing
the number of success cases (Exhibit 4.16).
Exhibit 4.16 The GPs Network Reinforcing Loop
Number of
Exits
Number ofPE
R3
Deals
Network
+
+
GPs
Experience
4.4.4 Awareness of Private Equity
The South American business community was widely unfamiliar with the concept of equity
participations in private companies. Private equity is seen as an alternative financing source rather than
a wealth opportunity, a chance to grow through a partnership that provides advice, experience,
management, ideas and strategy. Private equity helps companies to professionalize their management
and to introduce transparency, helping them to grow quickly and sustainably and identifying and
implementing internationally competitive practices (Meerkatt, Liechtenstein 2010).
In the Latin business culture there is an additional factor that it is not common in most developed
countries: emotions. Tradition and pride play an important role in the Latin American business culture,
more focused in the stability of the family rather than in the personal success. Latin businesses have a
lot of respect about their cultural traditions but also about the values inside of their own family, those
facts that represent the identity of the family. They feel proud of these distinctive principles, as they feel
proud of the sole ownership of their businesses because it is considered a legacy from older
generations. Those concepts, pride and tradition, joined with the endemic distrust, are incompatible
with the need of private equity companies to get control or influence positions inside the companies of
their portfolio.
73
Nevertheless, in the last years, Chilean and Latin American family-run businesses have become
more and more open to accept the convenience of a PE buyout or partnership for a variety of reasons.
They recognize that if they professionalize their businesses they will be more attractive acquisition
targets, domestically and internationally. They also recognize the amount of wealth that has been
creating for families partnered with PE companies in the last five years. Additionally, there is a
generational factor: as new younger family members get top executive positions, family owned
companies are more prone to consider alternative solutions like those offered by PE.
According to Jonathan Goldstein from TA Associates, growth equity investments are not possible
unless businesses are managed by a first generation entrepreneur with focus in the medium term
profitability through an exit and not in the creation of a business to support the next generations. As
mentioned before, the generational shift also creates opportunities to invest in growth equity.
The model takes into account all the factors previously mentioned: As the number of successful
exits increases, companies recognize the amount of wealth created by PE firms, increasing its awareness
of the benefits and advantages offered by PE, and therefore multiplying the potential number of deals
closed. As the number of deals increases, it does the number of success cases (Exhibit 4.17).
Exhibit 4.17 The PE Awareness Reinforcing Loop
Cultural
Barriers
Awareness of PE
by Target
Companies
+
+ PE
Awareness
Number of PE
Deals
Number of
+
74
Successful
Exits
4.4.5 Number and Size of PE Funds
In private equity the size of the investments (and as a consequence the size of the funds) is
correlated with the average performance. Under a certain investment size (US$2 million according to
IFC but more likely in the range of US$2-US$5 million), the probability to get lower returns is higher.
There are different sources backing this assessment: IFC data, Preqin and Pitchbook US data, and
proprietary research through interviews.
I identified the following factors causing this situation: First, it is difficult to find the right
management for a small company, since managing a small firm does not offer the same recognition
than a bigger one, the resources to pay the management team are constrained, and few managers are
willing to work under the typical compensation scheme of private equity where most of the
compensation comes at the exit. Second, financing a small firm is more expensive and harder to get
than for a bigger firm. Third, from the GP perspective an investment in a small firm requires the same
or even higher dedication than an investment in a bigger one due to the more limited resources of the
managing team. And fourth, there are a higher number of exit options for medium-large companies
than for smaller ones. Since 2011 a higher number of mighty strategic buyers from US (the 50 larger
non financial institutions in US have more than one trillion in cash) and especially from Europe, with
large amounts of cash in their balance sheets, started considering Latin America as a target in their
search for growth opportunities.
All that said, an experienced team and a deep understanding of specific industries can counteract
the risks of small investments, outperforming larger investments (larger funds). Additionally, there is a
larger number of small and medium companies, although their awareness of how PE works and the
business growth potential can be limited.
In Chile most of the small funds have investment constraints since they are using the financing
leverage programs offered by the government that allow investments up to US$4 million (F2 and F3
financing programs). Also because of their small size (US10-US40 million) is very unlikely that they
could raise capital from institutional investors, who need a minimum ticket size of US$50 million. One
option for these small funds is to invest in growth equity taking minority positions. But in order to
invest in growth equity properly, specific industry knowledge (added value to the owners) and complete
alignment of objectives (exit) with the majority shareholders are needed.
So, how can small Chilean funds grow? The most feasible solution is that they use the financing
leverage programs offered by the government to build their track record and the team, maximizing their
learning capabilities when facing all the challenges related with smaller investments. Once they get the
track record and the team is formed, the next challenge is to raise capital. Local general partners with a
solid track record and well-established local networks are likely to attract an increasing share of capital
commitments from local global limited partners. To preserve this competitive advantage relative to
global players, local general partners usually expand their funds. This is the case of Southern Cross and
Linzor Capital. However, big and fast changes in the fund sizes of a PE firm can be a warning signal to
LPs looking for stable and outstanding performance.
75
The model considers all the issues mentioned above in a simplified manner: As the number of
successful exits grows, the number of PE funds and funds' size increases, leading to a higher number of
deals and therefore increasing the number of success cases (Exhibit 4.18).
Exhibit 4.18 The Number of PE Funds Reinforcing Loop
Number of PE
Deals
Number of
Successful
Exits
Number of PE
Funds
Size & Number
of PE Funds
+
LPs Committed
Capital
4.4.6 Impact of Socioeconomic Environment in Private Equity
The scale of the opportunity for private equity in emerging markets is determined by the size of
each country's economy. However it is the relative sophistication of the countries' socioeconomic
environments that will decide whether private-equity firms will be able to unlock the full scale of this
opportunity (Meerkatt, Liechtenstein 2010).
Based on the Global Venture Capital and Private Equity Country Attractiveness Index published
by IESE, the following factors were considered as indicators of Chile's socioeconomic environment
quality:
1.
Economic activity. Chile's GDP growth has been significant, under a continuous political
stability, despite the impact of the earthquake in 2010. However, infrastructure needs further
development.
The
depth of the capital market. Chile has a developed capital market, but due to the small
2.
size of the economy and wealth concentration it is not deep enough yet to recall an important
number of private equity transactions in the short term. The level of market capitalization is
low limiting accessibility of IPOs for the majority of SMEs. The lack of deep markets is a
characteristic of all Latin American countries except Brazil.
3. Taxation. Chile has double taxation for foreign investors from most countries. There is no
unique tax structure to minimize the taxes, including VAT (Value Added Tax) and CGT
(Capital Gains Tax) on management fees, carried interest or gains for GPs and LPs. In the
Appendix 2 is attached a comparative of different structures in Europe and US and the general
taxation rules applied.
76
4.
5.
6.
Investor protection and corporate governance. Chile has a transparent and clearly defined
legislation concerning foreign investment: foreign investors enjoy the same rights as nationals
and are able to operate in all but a few restricted areas. However, the judicial system is slowcourt proceedings can be subject to long delays, and high costs remain a barrier to pursuing
legal actions.
The human and social environment. Chile has low levels of corruption: ranked 21 of 178
countries in Transparency International's 2010 Corruption Perceptions Index.
Entrepreneurial dynamism. There is an increasing entrepreneurial dynamism in Chile, but
still far from the desirable levels.
The Exhibit 4.19 shows the plot of Chile's overall attractiveness for private equity, relative to its
socioeconomic environment, based on 2011 country GDP data from the Economist Intelligence Unit.
Exhibit 4.19 Chile's Overall Attractiveness for Private Equity
Economic
Activity
125
Entrepr.
Culture and
Deal
Opportunities
100
75
Depth of
Capital Market
Human and
Social
Environment
Taxation
-Chile
Investor
Protection and
Corporate
Governance
----
Latin America
United States a100 Points
Source: Economist Intelligent Unit 2011
According to the model, as the number of successful exits increases, it does the quality of the
socioeconomic environment and therefore, acting as a catalyst, increasing the number of success cases
(Exhibit 4.20). Pro-development governmental economic policies is an enabling factor that impacts
positively in the quality of the socioeconomic environment.
77
Exhibit 4.20 The Socioeconomic Environment Reinforcing Loop in the PE Model
Pro-Development
Governmental Economic
Policies
+ Quality of
Socioeconomic
+ Environment
Socioecononic
Environmwnt
Number of
Successful
Exits
4.4.7 Impact of External Financing Sources
The main role of private equity firms is to provide capital. However, there is one type of private
equity that needs additional capital to get the deal done: leveraged buyouts (LBOs). In leveraged
buyouts PE firms borrow money, generally by means of syndicated bank loans or junk bonds, to
provide the capital needed for the transaction. In Chile and in Latin America in general banks have not
been very actively involved in leveraged buyouts, probably because a lack of expertise, and also, a lack
of opportunities.
According to the model (Exhibit 4.21), as the number of success cases increases, external
financing sources are more willing to lend money, increasing the number of deals, and consequently,
the number of successful exits grows.
Exhibit 4.21 The Financing Reinforcing Loop
External
Financing
Sources
+
Financing
Number of PE
Deals
Number of
Successful
Exits
78
4.5 Using the Models
The principal purpose of the models is to explain conceptually the dynamics of private equity and
venture capital in a graphic and simple way, representing the most important factors influencing the
development of the industry, highlighting that all the factors are interconnected, forming an ecosystem,
and ultimately analyzing their impact individually.
I defined three main classes of factors: first, enabling factors, that are necessary but not sufficient,
usually defined by governmental policies, and therefore, not affected or barely affected by the dynamics
of the system (they don't change). Second, adaptive factors, that are the basis of the ecosystem,
embedded in a continuous learning process, and affected by all kind of variables, including the enabling
factors (governmental policies). Third, success, the core of the ecosystem, the leveraging factor that
boosts the development of PE/VC.
The models can be used as a tool for:
1.
Providing a global perspective to GPs and LPs. The models are wide and general, but the
analysis of the factors is deep enough in most cases to be considered by fund managers and
investors. However I acknowledge that from the point of view of the PE/VC firm, an internal
model considering all the interactions and processes inside their own firm and with suppliers
and clients could be more compelling.
2.
Analysis of public policies' impact. The models are a good instrument to analyze in a
methodic and disciplined way the potential impact of any public policy related to the private
equity and venture capital. The procedure would be to evaluate the influence of any policy one
by one factor, taking the model provided in this thesis as a basis, but adapting it to the new
potential variables to be considered, and therefore, creating a new framework able to explain
all the relevant relationships affected by the new policy and to evaluate its impact.
3.
Introduction to private equity and venture capital in Chile and Latin America. Because
of the high visual content, models are appropriate to be used as an introduction to PE/VC in
Chile and Latin America. They provide a description of the main agents involved in the
industry and how they interact with a profusion of details.
One of the limitations of the models is that they are not quantitative, just conceptual. An
interesting future extension of this research is the calibration of the model through the development of
mathematical equations defining the interactions of the factors. It would allow a more accurate
prediction of the outcome and the quantification of each factor's impact.
79
CHAPTER 5: CONCLUSIONS
Worldwide, private equity and venture capital have been affected by the recent financial crisis.
Venture capital has had, in general, a bad performance during the last decade since the dot-com bubble
exploded. The industry is passing through a consolidation stage, where the number of funds and VC
firms is shrinking. Institutional investors are moving out of this asset class and governments are
expected to play a more important role in coming years. However, in 2011 there were signs of a slow
but continuous recovery, since a higher number of deals was seen and performance improved. Top
quartile VC firms continued to outperform significantly its peers mainly due to a privileged access to
entrepreneurs and opportunities, experienced and stable teams and refined internal processes.
Private equity is also evolving rapidly globally. General partners have shifted their efforts from
chasing market opportunities (beta) to the development of operational strategies supporting company's
growth and efficiency (alpha). Sovereign wealth funds are emerging as a new source of capital, with
investment thesis well aligned with the long term horizon and illiquidity of private equity. Competition
is expanding the time needed to close a fund, the holding period of investments, and therefore
decreasing IRR. Financing for leveraged buyouts (LBOs) is expected to diminish during the following
years, as CLOs (collateralized loan obligations) reinvestment periods expire. Summing up, competition
is increasing, opportunities are getting scarce, and the ability to adapt to changes and the creativity in
the definition of proprietary value creation strategies will make the difference between successful and
bad performing GPs.
Chile and Latin America have still a long way to reach a mature PE/VC market. Nevertheless,
from the last seven years there has been a fast development, especially in Brazil because of its market
size and fast growing internal demand. In addition to Brazil, most Latin American countries have
attractive growth GDP rates, what, from the point of view of private equity and venture capital, make
them more attractive to invest than most developed (and post crisis depressed) countries.
Chile has to continue developing its strengths: in the VC field, the ability to leverage local
entrepreneur talent and ideas and spread them globally, getting rid of the size constraints of the local
market. But local talent refers not only to entrepreneurs, but also to Chilean VC managers. In this
sense, there is a huge opportunity to develop experienced and talented Chilean managers able to close
deals globally, through an expanded network.
In the PE arena, Chile should increase its capacity to build local expertise and experience at GP
and LP levels, making a more flexible regulation on institutional investments and continuing the
governmental leverage programs that support investing in small companies. The goal is to create a
local expert ecosystem that provides confidence to foreign investors and international PE firms,
converting the country in a regional financial hub, a PE management reference backed by success cases.
80
To achieve this goal local PE companies in South America must set up a minimum fund size
(investment size) that would allow them to hire the best professionals for the PE firm (enough
management fees) and the best professionals managing their portfolio companies (enough EBITDA
generation). Other critical issues to take into account by local PE companies are deep understanding of
specific industries, the need to build an experienced management team, and disciplined due diligence
processes.
How is it possible to create successful exits and increase the deal flow? First, by being aware of all
the factors involved in the development of private equity and venture capital. Second, by implementing
positive actions through all those factors targeting the creation of success cases. The generation of
success cases will accelerate the learning process of the whole system, increasing the experience of all
the agents involved, improving the confidence of investors in the managers and breaking down cultural
barriers. Success is a powerful invigorating factor that has the might to leverage the development of
private equity and venture capital ecosystems in a meaningful way.
We are living in a fast changing world where technology is becoming omnipresent and there is no
sustainable competitive advantage except for the learning capabilities of the organizations (Senge,
1994). Venture capital and private equity are catalysts of innovation, entrepreneurship and continuous
wealth creation in the country. It takes time and effort to build the PE/VC ecosystem, but once it is
created, since its strength is based on the accumulated learning capabilities (experience and expertise), it
becomes a smart system able to solve the difficulties and detect the opportunities that will make the
difference when facing the coming world socioeconomic challenges.
81
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82
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87
LIST OF EXHIBITS
10
Exhibit 1.1 Global Investment Activity (US$B) .........................................................................................
Exhibit 1.2 Global Private Equity Dry Power............................................................................................11
11
Exhibit 1.3 Add-on Deals as Percentage of Buyout Deals in US...........................................................
12
Exhibit 1.4 EBITDA Multiples of Buyout Transactions in US ..............................................................
13
Exhibit 1.5 Number and Target Value of Active Funds by GP Location............................................
14
Exhibit 1.6 Global Exit A ctivity .......................................................................................................................
15
Exhibit 1.7 US Private Equity Horizon IRR by Fund Size ......................................................................
Exhibit 1.8 Performance quartile distribution of successor fund to top quartile funds......................16
17
Exhibit 1.9 IFC Investments IRR per by Exit ............................................................................................
Exhibit 1.10 Venture Capital Investments in the US..................................................................................18
Exhibit 1.11 US Venture Capital under Management................................................................................18
Exhibit 1.12 LPs Distribution in European Venture Capital....................................................................19
Exhibit 1.13 US Venture Capital Investments by Stage of Development...............................................19
20
Exhibit 1.14 US Ventured Backed Exits .....................................................................................................
20
Exhibit 1.15 US Venture Capital Index IRR...............................................................................................
21
in
UK....................................
Factors
&
Social
in
Economic
Capital
of
Venture
Impact
1.16
Exhibit
23
................................
America
in
Latin
Evolution
Exhibit 2.1 PE/VC Investments and Fundraising
24
Exhibit 2.2 PE Investments in most Relevant Emerging Markets ........................................................
Exhibit 2.3 Weighted Attractiveness Score for Investments over the Next Year, LPs View............25
26
Exhibit 2.4 Latin America GDP 2010 by Country (US$)......................................................................
26
Exhibit 2.5 LAVCA Scorecard 2011..........................................................................................................
27
Exhibit 2.6 Trends on Fundraising, Investment and Exits....................................................................
Exhibit 2.7 2011 Investments by Country (US$) and by Stage (US$)...................................................28
28
Exhibit 2.8 2011 Exits by Country (US$) and by Sector (US$).............................................................
Exhibit 2.9
Latin American average annual real GDP growth rates (o)..............................................29
Exhibit 2.10
Exhibit 2.11
Exhibit 2.12
Exhibit 2.13
Exhibit 2.14
Exhibit 2.15
Exhibit 3.1
Exhibit 3.2
Exhibit 3.3
Exhibit 3.4
Exhibit 3.5
Exhibit 3.6
Exhibit 3.7
Exhibit 3.8
Exhibit 3.9
Exhibit 3.10
Exhibit 3.11
Exhibit 3.12
Exhibit 3.13
Exhibit 3.14
Exhibit 3.15
Exhibit 4.1
Exhibit 4.2
Exhibit 4.3
30
Brazilian Equity Markets Correlation Matrix......................................................................
vs.
GDP
Composition...................................31
(Nov.
2010)
by
Sector
MSCI Brazil Index
Global Private Equity Penetration..........................................................................................31
32
Drivers of Return in IFC funds ..............................................................................................
32
End to End returns by Region (as of 30 September 2011) ................................................
33
LPs Annual Net Return Expectations over 3-5 Years ........................................................
35
PE/VC Funds Supported by CORFO Financing Programs............................................
PE Mining Specific Funds Supported by CORFO Fenix Program................36
PE/VC Active CORFO Financing Programs..........................................................................36
37
Private Equity Funds in Chile ................................................................................................
Foreign Risk Capital Investment Funds (FICER)...............................................................38
Domestic Funds Comparison by Size, Target's Development Stage and Ticket Size.......39
Investments in Chile by Stage (2010).....................................................................................41
Reported Investments in Chile from 2002................................................................................42
Investments in Chile by Stage (2010).....................................................................................44
47
PE Spending at 10 Large Public Pension Funds in US (Dec. 31, 2010) .........................
47
Latin American Pension Fund Assets Under Management (US$B)................................
48
Latin American Pension Fund Assets Growth....................................................................
Overview of Pension Funds Regulation for PE Investments (as of May 2011).............50
Venture Capital Ecosystem......................................................................................................51
R&D Profile of C hile....................................................................................................................53
54
The Three Factor Categories to PE/VC Development .....................................................
57
C ausal Loop Diagram ...................................................................................................................
The Venture Capital Model.....................................................................................................58
88
Exhibit 4.4
Exhibit 4.5
Exhibit 4.6
Exhibit 4.7
Exhibit 4.8
Exhibit 4.9
Exhibit 4.10
Exhibit 4.11
Exhibit 4.12
Exhibit 4.13
Exhibit 4.14
Exhibit 4.15
Exhibit 4.16
Exhibit 4.17
Exhibit 4.18
Exhibit 4.19
Exhibit 4.20
The VC Experience Reinforcing Loop..................................................................................59
The LPs Confidence Reinforcing Loop in the VC Model.................................................60
The Entrepreneurs Motivation Reinforcing Loop .............................................................
62
The Venture Capital Network Reinforcing Loop...............................................................63
The Number of VC Fundss Reinforcing Loop....................................................................64
The Entrepreneur's Network & Experience Reinforcing Loops..................65
The Socioeconomic Environment Reinforcing Loop in the VC Model..........................66
The M entoring Reinforcing Loop .........................................................................................
67
The Private E quity M odel........................................................................................................
68
The GPs Experience Reinforcing Loop ................................................................................
69
IFC's First Time and Non-First Time Funds IRR Comparative......................................70
The LPs Confidence Reinforcing Loop in the PE Model.................................................71
The GPs Network Reinforcing Loop .....................................................................................
73
The PE Awareness Reinforcing Loop ..................................................................................
74
76
The Number of PE Funds Reinforcing Loop....................................................................
Chile's Overall Attractiveness for Private Equity................................................................77
The Socioeconomic Environment Reinforcing Loop in the PE Model.........................78
89
APPENDIX 1: INTERVIEWS CONDUCTED IN THE RESEARCH
I conducted interviews with the twenty nine key players within private equity and venture capital
sectors in Chile and Latin America:
#
Company
AFP Provida
Name of Interviewee
Cristian Norambuena
Job Position
Sector
Webpage
Director Alternative
www.bbvaprovida.cl
lIements
Limited Partner, Pension
____Fund
2
Altamar Private Equity
Alvaro Gonzalez
Investment Director
Private Equity Firm
www.altamarcapital.com
3
Aurus
Alex Seelenberger
Managing Director
Venture Capital Firm
www.aurus.cl
4
Austral Capital Chile
Felipe Camposano
Partner
Venture Capital Firm
www.australcap.com
5
6
Capital advisors
Celfin
Marcos Garcia
Enrique Perez
Investment Bank / Real
Managing Director
Chief Finance Officer
Chief Private Equity
Private Equity / Investment
Bank
Private Equity / Investment
Bnk
Private Equity/
Infraestructure
www.capitaladvisors.cl
www.celfin.com
7
Celfin
Gast6n Angdlico
8
CMB-Prime
Juan Eduardo Vargas
CEO, Managing Director
9
Compass Group
Pablo Diaz
Product Manager
Fund Management
www.compass.cl
10
CORFO
Patricio Pastorelli
Investment Manager
Public Institution
www.corfo.cl
CORFO
Victor Besoaln
Chief Investment Manager
Public Institution
www.corfo.cl
Econsult
Alfonso Salas
CEO, Managing Director
12
13
Endeavor
Dobromir Parushev
Strategic Alliance
Fund Management /
Entrepreneurial Nonprofit
Caggt
www.celfin.com
www.cmbprime.cl
www.econsult.cl
www.endeavor.d
EPGPartners
Rodrigo Mendez
Partner
Private Equity / Real Estate
/Fund Management
Equitas Capital SpA
Cristin Shea
Founder, Chairman & CEO
Venture Capital Firm
www.equitas.d
16
Fondo Copec-UC
Enrique Pizarro
Managing Director
Venture Capital Firm
www.fondocopecuc.cl
[17
Larrain Vial -Activa
Jose Antonio Jimenez
Managing Director
Private Equity Firm
www.larrainvial.com
18
Unzor Capital Partners
Matias Gutidrrez
Principal
Private Equity Firm
www.linzorcapital.com
Investment Bank
www.mba-lazard.com
Family Office
14
19
Mba-Lazard
Cristian Bulnes
CEO, Managing Director
.....
Chile
_
20
Megeve
Dieter Heuser
CEO,Managing Director
21
Megeve
Nicolds Manlao
Chief Private Equity
22
Metlife
Mario Cortds
23
Moneda Asset
Alejandro Rogers
__Management
InvestrnenttUs
www.epgpartners.c
Family Office
_
_______
Director Latin American
Investments
Business Development
Manager
Limited Partner, Insurance
Company
Fund Management /
Private Equit
www.metlife.com
www.moneda.cl
24
Neorentas
Carlos Fell
Founder & Partner
Private Equity / Real Estate
25
Penta Capital de Riesgo
Patricio Visquez
Managing Director
Private Equity / Family
www.empresaspenta.c
26
Quinienco
Diego Bacigalupo
Business Development
Deputy Manager
Holding
www.quinenco.cl
27
Southern Cross Group
Gonzalo Dulanto
Managing Director
Private Equity Firm
www.southerncrossgroup.com
28 Universidad Adolfo lbhiez
Germn Echecopar
29 Universidad Adolfo Ibnez
Santiago Mingo
enter for Innovation and University, Business School
Professor
90
University, Business School
www.ua.c
www.ual.cl
APPENDIX 2: TAXES APPLICABLE IN EUROPE
DEPENDING ON THE INVESTMENT STRUCTURE
AND
US
Ability to preen
Tax transparent
for domestic
nvestor?
Ability to
Incorporate a
permn
establisment capita inyvestrt/ minirnis VAT
on management
incentiv for
for intemtional
investor?
fund managers?
Abiit to
Minimse VAT Fredom I
on carrW iedundue a
chares?
interest?
on inv a
Austriaf)
Yf)
Y
Y
Y0
Y()
Y
Belium (Lmited Company ot Private Privak)
N(O
n/a
Y
N(")
Y
N(3
N
Y
N
Y
Y
Y(3
Y
V()
Y(3
Y(8)
Y
Y(3
Y(3
Y
Y(3
Y
Y
Y
Y
Y
Y
Yf(
Y
N
Yfl)
Y(")
Y
N
Y
Y
Y
Czech Republic
Denmark
Finland (imited Patnership)
France (FCPR)
Germany (Limited Partnership)
Y
Ireland
Y(3
Y
Y
Y
Y()
Y
Y(9
Y
Y(")
Y
Itay ondo Chiso)
N(i
Y
Y
Y
Y
Luxembourg (SICAR
Nethrland (imited Partnershi)
Y
Y
Y
N(1)
Y
Y
Y
Y
Y
Y
Y
Y
Poland (prvate eqWty closed-end westment fund)
Pougal (VC (SC - CRFFC )
Y(X)
N
Y(i
n/a
Y
Y
Y
Y
YMi
N
Y()
N
N
N
Y
Y("
Y
Y()
N()
Y(9
Y
Y(A3
N()
Y
Y
N($
Y()
Y
Y(*)
Y
Y
Y
Y
Y(&)
Y(3
Y
Y(9)
Y()
Y
Y
Y
Y
Y
Y
Y
Hungary("
Slovak Repubic
Spain (SCF - FCR)
Sweden (Limited Patnership)
Switzerland(")(Limited Ptnership)
LK (Limited Ptnership)
USA(3 (Lmited Partnership)
Y
Y
N
Y
Source: EVCA Tax and Legal Committee. June 2010
(5) Applicable to the still prevailing fund structures. Currently, there is no prevailing structure for new
funds.
(6) Tax exemption.
(7) Depending on structure/clarification with fiscal authorities recommended.
(8) Depending on the structure.
(9) For tax benefits, restrictions have to be considered, although they can be avoided by using another,
less tax advantageous, structure.
(10) Note that investing through a Private Privak de facto might result in tax transparency.
(11) Under certain conditions, option is granted to avoid VAT on management charges (provided
falling within the scope of Director power as stated in the by-laws). Moreover, it is possible to
"reduce' the VAT cost by assuring that certain services can benefit from specific VAT exemptions
(e.g. transactions in shares). Finally, a particular exemption provision application to management
of investment funds (such as, for example, the Private Privak) could be applied provided certain
conditions are met.
(12) It should be noted that the Private Privak is subject to some restrictions on the type of investments
91
that can be made (for example, no direct participations in quoted companies).
(13) However, there are some restrictions relating to investments in specific sectors, such as the defense
sector.
(14) A limited partnership structure does, in general, not create a permanent establishment for foreign
investors, despite that the management company is Danish and has authority to act on behalf of
the LP.
(15) The VAT treatment of management charges depends on the services rendered. The services
rendered will partly be subject to VAT (ordinary management services) and VAT-exempt (services
related to acquisition and disposals of shares). If the services are VAT exempt they will instead be
subject to payroll tax. In many cases the vatable part of the management services amounts to
approximately 15-20%.
(16) Individuals fully taxable in Denmark are taxable of carried interest, with up to 56.5%
corresponding to the tax rate for salary income.
(17) Finnish limited partnership is not opaque in taxation and, thus, is basically tax transparent for
Finnish investors. A partnership is an accounting unit and its profits are taxed as income of the
partners.
(18) If the Finnish limited partnership Is engaged only in venture capital/private equity investments as
defined in Finnish tax laws and praxis, the limited nonresident partner is taxed for his share of the
profits of the partnership In Finland only to the extent that the income would be taxed In Finland
if the partner received it directly. The special treatment applies provided there is an applicable tax
treaty between Finland and the partner's state of residence and that the investments are made
through a Finnish limited partnership. It is possible that in situations where the actual investment
decisions are made in Finland or a foreign Investor permanently uses a related Finnish adviser, a
foreign venture capital fund or its Investor could be deemed to have a permanent establishment in
Finland.
(19) It is possible to structure the earned interest of the fund managers to be taxed at a proportional tax
rate instead of a progressive tax rate.
(20) The management company can choose not to charge VAT, but In that case it cannot itself deduct
VAT and has to pay a tax on the wages it pays out so that ultimately it needs to raise the amount
of management lee it asks from tie investors.
(21) Provided that the limited partnership is structured as a non-trading limited partnership.
(22) The use of a non-trading German limited partnership as a fund should generally not create a
permanent establishment In Germany.
(23) Hungarian fund vehicles regulated by domestic law are the Private Equity Fund and Investment
Fund, but in practice these are hardly used. Non-Hungarian investors usually prefer to use nonHungarian fund vehicles. Therefore, In the attached matrix, our comments relate to structures
involving non-Hungarian fund vehicles.
(24) The tax treatment of non-Hungarian vehicles will vary, but if treated as tax-transparent in their
Jurisdictions, then Hungary should in principle accept this approach.
(25) Usually these are non-Hungary-based.
(26) Depends on actual structure.
(27) Yes, if structured in a way that these retain the same character as the distribution that gave rise to
92
them (e.g. capital gains, dividends etc).
(28) Despite the fact that the Fondo Chiuso is not tax transparent, international investors from White
Countries benefit from the refund of the 12.5% tax on the yearly yield applied at fund level, which
in substance leads to the same results of tax transparency.
(29) Under regulatory provisions, certain restrictions on investments are provided and can be derogated
under certain conditions.
(30) The Luxembourg SICAR may be established under the form for fiscally transparent (SCS) or
fiscally opaque (SAP.L, SA, SCA and SCSA) undertakings.
(31) Each foreign investor will be considered to be engaged in the conduct of a business through a
Dutch permanent establishment to which the shares in the portfolio companies must be allocated.
In computing the taxable profit of the permanent establishment, however, the benefits (gain and
dividend) derived from the portfolio companies should generally be exempted under the
participation exemption. (32) Although the fund itself is not tax transparent, it may provide for tax
transparency effect. Namely, the fund is exempt from income tax in Poland. Tax is paid upon the
distribution of the profits of the fund to the investors. The rate of tax depends on the status of the
investor. Individuals and corporations being Polish tax residents are subject to 19% income tax.
Non-Polish residents can benefit from a lower rate of tax or even a full exemption on the
participation in profits of closed-end investment funds.
(33) Simply investing through the closed-end investment fund does not give rise to recognised
permanent establishment in Poland. The fund itself is exempt from income tax.
(34) Carried interest is understood as participation of the managers in the fund's profits once returns
are paid to the investors.
(35) Investments made by a closed-end investment fund are subject to several restrictions related, for
example, to the types of investments and level of commitment that result In diversity of Its
investments. All restrictions are in line with EU law.
(36) It should be noted that it is possible to "reduce" the VAT cost by localizing certain services outside
the EU (e.g. administrative services) or by assuring that certain services can benefit from specific
VAT exemptions (e.g. transactions regarding shares).
(37) The mere fact of investing through an SCR/FCR would not give rise per se to a permanent
establishment in Spain.
(38) The standard SCR/FCR current regulations do not easily allow the structuring of tax-efficient
carried interest for the promoters. However, depending on the specific circumstances, efficient
structures may be implemented.
(39) These management charges are usually VAT exempted in Spain. However, advisory fees charged
to the manager bear VAT, which is usually a cost for the manager.
(40) When a tax efficient carried interest structure can be implemented, VAT is typically avoided.
(41) Only partly, depending on the type of security.
(42) Depending on the activity.
(43) As long as it will be taxed as capital gain.
(44) Further to the entry in force on January 1, 2007 of a new legislation, Swiss private equity structures
93
are generally structured as limited partnership for collective Investments (SCPC: societe en
commandite de placements collectifs). As long as this investment vehicle does not own real estate,
it is not subject to income tax (tax transparency).
(45) Swiss domestic law does in principle not recognize any tax liability in Switzerland for foreign
investors.
(46) For domestic investors, a UK limited partnership is tax transparent for the purposes of income
and capital gains.
(47) Other than foreign financial traders, investors in a typical limited partnership private equity fund
managed in the UK should not have a taxable permanent establishment in the UK.
(48) VAT efficient structures can be put in place.
(49) Carried interest structured as a partnership interest should not be subject to VAT in the UK.
(50) To avoid a permanent establishment for non-US investors and to otherwise permit non-US
investors to obtain beneficial US federal income tax treatment, certain investments such as
investments In (i) real estate or real estate intensive companies, (ii) originated loans, or (iii)
operating companies formed as tax-transparent entities should be avoided.
94