Private Equity Funds and Institutional Investors in M&A
This is an Insight article, written by a selected partner as part of Latin Lawyer's co-published content. Read more on Insight
Private equity funds and institutional investors have become increasingly prominent in Latin American M&A activity. From 2009 to 2019, the portion of annual M&A activity in Latin America involving capital invested by private equity funds and institutional investors has grown from approximately 2.5 per cent to 25.8 per cent. This significant increase is fuelled in part by factors that have propelled the global growth of private equity. But this shift also reflects the increasing acceptance in Latin America that private equity can accelerate the growth of businesses with expansion potential and, in the case of infrastructure, provide essential long-term funding. More broadly, private equity funds and institutional investors offer: much needed capital to finance promising enterprises; business practices and models that enable local companies to leverage strategies already road tested in other markets; and advanced corporate governance practices that strengthen the transparency and durability of local enterprises.
The impressive market penetration that private equity funds and institutional investors have achieved in the region is even more remarkable considering the many economic and legal obstacles they face in Latin America. Because of these obstacles, private equity funds and institutional investors have had to tailor to Latin America their traditional approach of looking for undervalued businesses that can deliver steady cash flows, if not spectacular growth. These local circumstances, which we will discuss next, have shaped an approach to private equity deal-making that focuses on identifying targets with significant growth potential and then negotiating contractual terms calibrated to provide some protection against the many unexpected developments that seem to occur frequently. As explored in the balance of the chapter, this approach is reflected in: the sectors that private equity funds and institutional investors target; the emphasis on flexible contractual protections that allow private equity and institutional investors to ‘roll with the punches’; and the valuation and exit approaches used by private equity and institutional investors in Latin America.
Overcoming intrinsic challenges
The most noteworthy economic challenge that foreign private equity and institutional investors confront in Latin America is the dramatic volatility of many local currencies. For example, over the past two decades, since the adoption of the floating exchange rate regime, the currencies of the two most important economies in the region (Brazil and Mexico) have fluctuated in a manner that has impacted the investment process in various ways. Exchange rate volatility makes valuations at entry more difficult given uncertainties in valuing future cash flows. It also creates the need to allocate exchange rate volatility risk between signing and closing, which could take up to several months depending on the closing clearances required. Exchange rate volatility also can impede an exit where a seller needs to monetise an investment during a period of local currency devaluation. Since hedging extremely volatile currencies is not economically viable, investments in Latin America by foreign private equity funds and institutional investors must be made in spite of foreign exchange risks. However, this risk is not necessarily a concern for domestic private equity funds and institutional investors funded primarily in local currencies and that likewise report their results in local currencies. As domestic private equity funds and institutional investors grow, we would expect that they will be able to leverage their ‘currency advantage’ in auctions.
The second most significant economic obstacle to private equity investments in Latin America – which domestic players share with their foreign counterparts – is the limited availability and cost of leverage as a key private equity strategy. For reasons including the limited availability of credit to finance buyouts and minority investments, as well as competition from cheaper sources of financing including from state-owned financial institutions, private equity investments in Latin America rarely involve additional leverage as a key strategy to boost returns.
In addition to foreign-exchange risk and limitations in available leverage, private equity funds and institutional investors in Latin America also must contend with:
- corrupt practices that have appeared to be endemic in some geographies and industries;
- the political volatility of most countries in the region;
- the vulnerability of commodity-driven economies to cyclical external shocks coming from China, the United States or Europe;
- in certain jurisdictions, concerns about ‘piercing the veil’ and directors’ exposure to personal liability;
- transparency issues in the due diligence process;
- markets in which there are few (if any) generally accepted and publicly shared contractual terms for M&A deals, resulting in lengthier negotiations requiring more commitment of the investment team’s time;
- tax complexities;
- burdensome labour practices; and
- delayed exits due to currency, economic or political factors.
Notwithstanding these challenges, private equity funds and institutional investors have achieved important successes in Latin America. They have done so by deploying mitigating strategies aimed at: (1) concentrating on robust and resilient sectors of the economy expected to grow over time, such as infrastructure, technology, consumer products and life sciences; (2) proactively addressing difficulties through pricing and contractual terms; and (3) leveraging their operating expertise to improve both the bottom line and overall performance of the companies in which they invest. These strategic imperatives have been key factors in shaping private equity investments in the region. Indeed, the many past successes of private equity investments in Latin America demonstrate that savvy and astute deal-makers are aware of these risks and have developed sophisticated strategies to mitigate them.
While the pandemic’s impact on the economies of the region will pose additional novel challenges, private equity funds and institutional investors appear to be well prepared to ride out even this unique storm. Past experiences have honed their skills at managing businesses through unexpected developments. In this regard, grappling with tough scenarios has been and probably will continue to be normal ordinary course of business for private funds and institutional investors active in Latin America. As discussed below, the business and legal approaches that private equity investors have developed for this region are designed expressly to navigate through radically uncertain scenarios that are hard to quantify and therefore price.
Mitigating risks through contractual rights
A critical element of this risk mitigation involves negotiating contractual rights that support an investment thesis and address the idiosyncratic challenges faced in Latin America. In our experience, particularly in the case of acquiring minority stakes, the most significant such contractual protection relates to the target’s business plan and deviations from such plan. Given that management of unexpected developments is a principal concern of private equity and institutional investors in Latin America, it can be safely assumed that any plan beats no plan when carrying out a successful acquisition.
Developing with the controlling shareholder a shared business strategy is often the first order of business in protecting the investment thesis of a private equity investment. Typically, private equity and institutional investors begin developing an economic narrative for their proposed investment during the due diligence exercise. In this phase of trying to understand ‘what is going on here,’ investors often come up with approaches to encourage and upgrade winning strategies while trying to discourage and control business approaches perceived as counterproductive.
Many businesses in Latin America, particularly family-run businesses, are still used to operating in fairly unstructured and informal manners. For this reason, the introduction of formal planning and, even more importantly, the acceptance by the target’s management of processes and procedures calibrated to ensure adhesion to a business plan can sometimes be challenging. In particular, they may require behavioural changes that the controlling shareholder and management resist. This is one of the principal reasons why many of the international private equity and institutional investors that have been most successful in the region have a local team capable of bridging the gap between business cultures. A local team can be critical inasmuch as ‘boots on the ground’ help overcome deviations from the plan and the nearly inevitable mid-course adjustments.
In order to protect a proposed investment’s economic rationale, other significant factors include:
- ensuring that the investor gains a seat on the target’s board and sometimes a senior position (or more than one) on the executive team;
- obtaining a sensible package of veto rights over the most material decisions of target, such as fundamental changes in the scope of its business or business plan, new acquisitions, large capital investments, changes in dividend policy and material borrowings; and
- negotiating a fulsome set of information rights that will enable the investor to adequately and timely monitor the performance of the target and fulfil its reporting obligations in compliance with fund documents and regulatory requirements.
Although the inclusion of such contractual provisions is critically important, building a close relationship with the controlling shareholder and the target’s management is perhaps even more important, as that is the principal path to ensure that the private equity investor can influence effectively the implementation of the agreed business plan.
Compliance considerations also feature prominently in formulating appropriate minority protection rights. We live in an era of aggressive anti-corruption enforcement, including in Latin America, and compliance violations can impact materially the ultimate valuation of an investment. It is therefore imperative that the package of covenants protecting the economic deal of the investor includes the commitment by the target and controlling shareholder to comply with relevant laws and to implement or otherwise maintain a risk-based compliance program and system of adequate internal controls. Perhaps most importantly, a minority investor must ensure that appropriate steps are taken to remediate any wrongdoing or deficiencies uncovered during due diligence or otherwise identified during the course of the investment. This may include a specific covenant by the target and controlling shareholder, appropriate monitoring by the investor and sometimes review by external advisers.
Private equity and institutional investors in Latin America also are increasingly focused on broader environmental, social and governance (ESG) considerations in negotiating minority protection rights, at least partly under the influence of their limited partners and public opinion. To ensure that investments are environmentally sustainable and have a positive social impact, investors often seek to promote portfolio companies’ adoption of more advanced corporate governance practices. This is consistent with the idea that invested companies may benefit from experiences and know-how developed in other markets.
Mitigating strategies through transfer restrictions
Private equity funds and institutional investors typically seek to negotiate transfer restrictions that may include:
- a lockup for some limited period following the investment;
- rights of first offer or rights of first refusal depending on the investment and the controlling shareholder’s profile;
- covenants not to transfer shares to sanctioned persons or competitors; and
- tag-along rights that may result in having to accept being subject to drag-along rights.
Investors in Latin America seek such restrictions for the usual reasons that motivate investors in other markets, principally ensuring that new shareholders are reputable and preferably not competitors. But certain reasons are specific to circumstances in Latin America. As discussed above, the timing of an exit is often complicated by currency volatility and the long stretches of recessions experienced by these markets. For this reason, private equity investors often are extremely leery of having additional investment partners, particularly local investors with different priorities and investment horizons. Finally, private equity investors use transfer restrictions as a mechanism to screen out potential partners that could be tainted by corruption or other compliance misdeeds.
Valuation challenges and competition with strategic players
For various reasons, valuing a target in Latin America is often significantly more challenging than valuing a similar business in a developed market. To begin, public data on comparable companies is typically unavailable owing to the shallowness of the local capital markets. As a result, private equity players at times resort to using developed-market multiples for companies in the same industries and then, somewhat arbitrarily, adjusting these multiples for ‘local risk’.
Valuing Latin American targets by modelling discounted cash flows is just as fraught with difficulties. The robustness and reliability of the financial information available on targets remains less than perfect as many family-controlled companies operate in an informal manner. Developing projections based on weak historical information is a bit of an exercise in educated guesswork. The cycles of booms and busts that have characterised the macroeconomic picture of Latin American countries further complicates this analysis, including determination of an appropriate discount rate. To address these issues, some private equity investors look to invest in infrastructure targets that may offer the stability and certainty of contracted revenues or companies in the technology sector that are asset-light and tend to generate higher rates of growth.
It is not unusual for private equity funds and institutional investors in Latin America to find themselves in heated competitive auctions that involve local and international strategic players. This can turn out to be challenging for private equity funds and institutional investors because strategic players may be prepared to pay generously for assets that offer them unique synergies or allow them to defend market positions.
Talent challenges in buyouts
Private equity funds and institutional investors focusing on buyouts rather than partial acquisitions previously have faced talent challenges. While private equity funds in more developed markets have recruited managerial talent kept on standby and poised to be deployed in portfolio companies, this practice has not yet taken hold in Latin America.
As a result, for a private equity fund to launch a buyout with a view toward improving a target’s business performance, the fund must engage in the ad hoc recruitment of superior new management. Although this has been difficult in the past, the breadth and strength of the new business class in Latin America could bring about a change. Domestic private equity funds and institutional investors and their foreign counterparts with local offices may be best positioned to tap into the local talent pool and engage in a larger number of buyouts in the future.
Pooling with other investors
To date in Latin America, there have been few instances in which private equity funds have combined with strategic investors to pursue acquisitions together. It has happened where the strategic investor brought special industry expertise relevant to the proposed transaction. More of these transactions seem likely in the future.
‘Club deals’ involving multiple private equity investors are also relatively rare in Latin America, except for very large privatisations of infrastructure assets. When these transactions involve investors based in and out of the region, participants need to find a consortium equilibrium that reconciles financial objectives and contractual priorities, which often are not perfectly aligned. Since large infrastructure projects are likely to figure prominently in future M&A activity in Latin America, a growing number of club deals likely will occur, including participants that over time will develop a shared approach to such transactions.
On the other hand, co-investments between foreign private equity funds and sovereign wealth funds have been pursued with increased frequency and with some success in recent years. Typically, one of the thorniest issues posed by these combinations flows from differences in investment horizons and, consequently, misaligned preferences regarding liquidity and exit arrangements. The market has developed some creative solutions to address this misalignment involving separate windows for exit. The important takeaway is that sovereign wealth funds have greater flexibility in investing in Latin America, because the limited windows for exit available in these markets typically matter less to such investors.
Although a detailed discussion of the complex tax issues that private equity and institutional investors confront in Latin America is beyond the scope of this chapter, it is nevertheless worth reviewing some of the key considerations.
Tax first arises during the due diligence process, as an investor assesses the target’s historic tax compliance and material exposures. In many countries in Latin America, of which Brazil is perhaps the most notable example, ongoing tax disputes between companies and revenue authorities are extremely common. An investor ‘learning the ropes’ in the region may be surprised, or dismayed, at the extent of a potential target’s tax disputes, as compared to other regions. In purchases from creditworthy strategic sellers, historic exposures often can be addressed through a pre-closing tax indemnity. However, many deals involve purchases from a founding family group, or from a financially distressed seller, where obtaining such an indemnity can be more challenging and potentially have more limited value. In these cases, it is important to look beyond the nominal exposures to understand context. To what extent do the exposures indicate fundamental compliance issues or unduly aggressive tax planning? Or are they common audit disputes that similarly situated companies are likely to face? Private equity and institutional investors need high quality advisers who can not just identify and quantify exposures, but can assess commercially whether the risks are reasonable or justify greater contractual or other protections.
The second key area involving tax is investment structuring. As most private equity and institutional players in the region are investing cross-border, their objectives often include reducing the local taxes payable on dividends and exit gains, as local taxes reduce returns and are unlikely to be of use as a credit to the majority of fund investors that are not taxpayers. Across the region, different structures have been used that vary from country to country.
Of particular note, Brazil has a private-equity tax regime (the FIP regime) that enables offshore investors to avoid tax on exit gains so long as certain requirements are met. In recent years, the Brazilian tax authorities have challenged the eligibility of non-resident investors to the FIP exemption, including by arguing that the jurisdiction of the beneficial owners of such investors (and not just that of the investing vehicles themselves) should be considered in assessing whether the domicile requirement is met. In December 2019, the Brazilian tax authorities issued an acknowledgement that the investing vehicles’ jurisdiction is the one that should matter, except for a sham or fraudulent circumstances. Although this has been viewed as a positive development, it appears that tax authorities (as well as the local FIP administrators responsible for ensuring payment of withholding taxes by FIPs) have continued to scrutinise indirect beneficial ownership. As a result, many private equity sponsors investing in Brazil have scrambled to restructure offshore fund structures from the Cayman Islands or other blacklisted jurisdictions. These restructurings raise significant legal, tax, administrative and potentially investor relations issues that require meaningful time and attention, and should be addressed well ahead of portfolio company exits.
In most other countries, investors may utilise a holding company organised in a country having a tax treaty with the local country (Spain, Netherlands and Luxembourg are among the most common) to reduce or eliminate exit taxes. Some countries do not have a treaty network; in these cases, the future tax liability must be factored into the returns for purposes of the investment thesis. Here again, quality advice is essential, as the tax laws (and the enforcement posture) of Latin American countries frequently change, and structures that worked for previous investments may no longer work in the future.
The challenges discussed thus far are serious, but can pale in comparison with the issues that private equity funds and institutional investors face when it comes to finding a path to monetise and exit their original investment.
Private equity investors in developed markets typically exit their investments in one of five ways (or, more rarely, a combination of these approaches):
- perhaps most commonly, a public offer of the portfolio company shares in which the investor sells its shares immediately or over time;
- next most popular, a trade sale or an acquisition by a suitable strategic company interested in acquiring a complementary business;
- a secondary sale to another private equity investor (which may become appealing if the original investor needs to monetise the investment while the business continues to require funding);
- a repurchase of the private equity stake by the original shareholders or management; or
- the least successful approach, a liquidation that happens if the investment fails.
In Latin America, each of the foregoing successful exit paths presents some ‘bumps in the road’. Public offerings of shares in Latin American companies are challenging because local capital markets are not deep and the window for launching them opens only infrequently and often closes fast. When the markets finally open (as, for example, they seemed to be in Brazil during the third quarter of 2020), there is a mad scramble to list and a strong sense that it is crucial not to miss this unique opportunity. Of course, the problem is that the ‘feast or famine’ character of local markets makes it difficult to predict upfront, at the time of investment, whether an exit through an IPO is a likely option. The feasibility of a public offering of the shares of a Latin American company in New York or in another international market also is uncertain due to the volatility of the currencies involved. Private equity investors need to consider whether there will be appetite for this additional risk and how this risk will affect the exit price.
Trade sales are a great option for private equity in Latin America if a strategic with deep pockets can be identified. While there are a few examples of successful trade sales, this strategy seems to be less common than in developed markets. Similarly, the market for secondary sales of portfolio companies to other private equity investors appears to be growing in Latin America. The most likely buyers of these private equity stakes, at least in the infrastructure sector, seem to be sovereign wealth funds. Finally, we have not observed too many instances in which a successful exit was achieved through a repurchase of the portfolio company stake by the original shareholder.
On balance, private equity players in Latin America have reasons to hope that the future of exits may be characterised by increased liquidity as the local capital markets should develop and deepen to match the size and strength of the continent’s economies.
When we wrote this chapter in the summer of 2020, the future looked extremely uncertain due to the pandemic and its economic impact. Many observers are currently quite bearish on the near-term outlook for the economies of Latin America. Perhaps they are right; perhaps they are not.
Despite not possessing a crystal ball, we remain optimistic for four main reasons about the long-term future of private equity and institutional investors in Latin America.
First, we would expect that, as the local economies mature, the size of the deals will grow and the capital invested by private equity and institutional investors in Latin America will grow significantly.
Second, in time, the local capital markets in Latin America should grow and mature to provide a better path to exit private equity investments.
Third, private equity funds worldwide have plenty of cash ready to invest and will be looking for opportunities, including in Latin America.
And last, we believe that private equity funds and institutional investors in Latin America have developed the tools and skills necessary to operate in a highly uncertain environment, as discussed in this chapter.
There inevitably may be some issues with many investment targets in Latin America, but there are also terrific growth opportunities. As Leonard Cohen once wrote: ‘There is a crack in everything; that’s how the light gets in.’
 Maurizio Levi-Minzi, Peter A Furci, Andrew M Levine and Jonathan Adler are partners at Debevoise & Plimpton LLP.
 See Chapters 5 and 12 of this guide.
 See Chapter 1 of this guide.
 Kay, John & King, Mervyn, Radical Uncertainty: Decision-Making Beyond the Numbers (2020).
 Geithner, Timothy F, Stress Test: Reflections on Financial Crises (2015).
 See Chapter 5 of this guide.
 One recent successful case was the joint bid by Engie and Caisse de dépôt et placement du Québec (CDPQ) for Petrobras’s stake in the Brazilian natural gas pipeline company Transportadora Associada de Gás (TAG) (source: ‘Engie-CDPQ Consortium concludes purchase of Petrobras’ 10 per cent stake in TAG’, Lavca (7 July 2020), https://lavca.org/2020/07/20/engie-cdpq-consortium-concludes-purchase-of-petrobras-10-stake-in-tag).
 One example is the acquisition of 40 per cent of the shares of Mexican infrastructure operator Impulsora del Desarrollo y el Empleo en América Latina (IDEAL) by Canada Pension Plan Investment Board (CPPIB) and Ontario Teachers’ Pension Plan Board (OTPP) (source: ‘CPPIB and OTPP finalize purchase of 40 per cent stake in Mexican infrastructure operator IDEAL’, Lavca (16 April 2020), https://lavca.org/2020/04/16/cppib-and-otpp-finalize-purchase-of-40-stake-in-mexican-infrastructure-operator-ideal).
 By way of example, Brookfield Infrastructure acquired a controlling stake in Nova Transportadora do Sudeste S.A. in consortium with CIC Capital Corporation, GIC Private Limited and others. ‘Brookfield Infrastructure Announces Closing of South American Natural Gas Transmission Utility Transaction’, Brookfield (4 April 2017), https://bip.brookfield.com/press-releases/2017/04-04-2017-230208159.
 See Chapter 14 of this guide.
 The rule is available at: http://normas.receita.fazenda.gov.br/sijut2consulta/link.action?idAto=105652&visao=compilado.
 Alternatively, a distressed M&A transaction may be attempted. See Chapter 8 of this guide.
 In a recent example, Advent International agreed to sell its stake in Brazil-based digital investment platform Easynvest to Brazilian fintech Nubank. ‘Advent International agrees to sell its stake in Easynvest and become an investor in Nubank’, https:/adventinternational.com.
 ‘Sovereign Funds: Latin America’s Hidden Investment Potential’, World Crunch (9 May 2019), https://worldcrunch.com/business-finance/sovereign-funds-latin-america39s-hidden-investment-potential.