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The Private Equity Landscape

In Colombia

FEB, 2013

By Rodrigo Boscolo, Ben Shephard and Wallrick Williams

A decade ago, Colombia was struggling with political and social instability, a weak economy and widespreadColombia violence. With foreign direct investment (FDI) hovering around US$2 billion from 1999 until 2003, it was clear that the international financial community was not looking at the country as a favorable place in which to invest capital. However, with the election of President Álvaro Uribe in 2002, Colombia began to resolve the issues of violence and national security and lay the foundation for the economic boom experienced over the last 10 years.

While in office, Uribe worked hard to change the international community's negative perception of Colombia by dramatically reducing violence and attacking the country's narco-trafficking problem. Where Colombia once led South and Central America in homicides per capita in 2002, recent United Nations (UN) statistics indicate a reduction of more than 50%. From an economic perspective, the country has also experienced explosive growth. Since 2002, Gross Domestic Product (GDP) has increased threefold, Gross National Income (GNI) has nearly tripled and FDI has grown sixfold.

At the same time, Colombia has also put in place the regulatory framework to help a formerly fledgling private equity (PE) industry become one of the most exciting industries in the region. According to Bancoldex Capital, 17 PE funds were raised in 2010, compared to only 2 funds just 5 years earlier. While challenges certainly lie ahead for the PE industry in Colombia, future prospects seem much brighter than they did just 10 years ago.

Colombia's First Private Equity Investment Cycle

Before Uribe's efforts to improve the country's economic and political stability, the PE industry was negligible in Colombia. As Hernán Cely of Advent International commented, "The period from 1997 through 2006 composed a lost decade for private equity in Colombia. International crises and domestic security issues hindered any private equity development." Prior to 2005, there were no government regulations regarding the establishment of PE firms, the legal structures needed to form them or protections for minority shareholder interests required for structuring noncontrolling equity investments.

Passed in 2005, Decree 964, among other things, established minority shareholder rights and created a framework for transparency that specified appropriate board-member composition, required the formation of audit committees and mandated the timely disclosure of financial information, according to the Latin American Law & Business Report. These changes put corporate governance practices in Colombia on par with international standards, enhancing the country's credibility with investors and essentially made traditional PE investments possible.

Despite all this, only a handful of parties were contemplating PE investments in Colombia at this time, according to Euromoney — namely, local search funds, high-net-worth families and international players such as AIG, Darby, Newbridge Capital and The Carlyle Group. It is important to note that since 2006, 2 local PE firms, Tribeca Partners and Altra Investments, raised their respective first funds and attracted the attention of other regional PE firms, such as Southern Cross Latin America, Linzor Capital, Mesoamérica and SEAF, which have been very active. Despite the momentum in the PE market in Colombia at that time, only a few deals were closed and not many details were made public.

A key piece of legislation in 2007 marked a major milestone for the PE industry in Colombia. Decree 2175 legally defined PE firms (Fondos de Capital Privado or FCPs) as closed-end funds that are, according to Euromonitor, "(i) created for the purpose of raising and managing cash or other assets; (ii) composed of contributions by more than one investor, each with a contribution of at least $150,000; and (iii) composed of funds which are collectively managed and whose profits are distributed pro-rata among the contributors." More importantly, this decree allowed Colombian pension funds to invest up to 5% of their assets in local PE funds. These changes signaled that the country was ready for PE investments and sparked a surge in the number of PE firms that were established. Between 2007 and 2010, more than 20 PE funds were raised compared to only 4 funds prior to 2007.

With new sources of funding, a well-developed regulatory framework, economic growth and mounting international attention, the Colombian PE industry has risen to a new level and is quickly becoming one of the most exciting markets in Latin America. In fact, according to the Latin American Venture Capital Association (LAVCA) scorecard, Colombia advanced from the 7th best country to invest in in 2007 to 4th in 2012.

Currently, more than 20 funds are operating in the Colombian market, including 5 with management from abroad, holding a total of US$2.2 billion in assets, according to Balcoldex Capital. The latest funds closed by local firms are much larger and now average US$200 million. At the end of 2010, Latin America Enterprise Fund Managers (LAEFM) closed its new Hydrocarbon Fund at US$350 million, and this year Altra Investments raised a new fund totaling US$164 million. According to LAVCA, 44% of the PE firms in Colombia are structuring new funds, and their combined fundraising targets could add as much as an additional US$2 billion to the market.

As these firms enter new fundraising cycles, local managers are starting to make good on their promises to seize opportunities and create value in Colombia through successful exits. In 2010, Tribeca made its first exit by selling Latco, an oil-drilling company, allowing its investors to realize an internal rate of return (IRR) of over 50%. Last year, Altra Investments made a highly visible and successful exit, showing a twofold profit from the sale of its stake in the Peruvian generic pharmaceutical company Corporación Infarmasa SA, which the fund had acquired in 2007.

While local fund managers seek to raise ever larger funds, pursuing not only local but also international funding, more international firms, including funds of funds, are dedicating additional resources to Colombia. In 2011, Advent, one of the world's leading global buyout firms, opened an office in Bogotá. The Carlyle Group and Southern Cross, other bulge bracket funds, are also paying close attention to the country. In order to attract investors, these groups counterbalance their newly appointed teams' lack of local experience with a more proven track record and the comfort of the franchise value their brands carry. Different approaches are apparent in sourcing deals between local funds and international funds. According to Hernán Cely of Advent International, "the sourcing of deals between local and international funds is very different. Local funds work their local connections, many [of whom] are ex-bankers. The international funds have a more structured and analytical approach that involves analysis by sector."

In connection with larger funds, PE firms are also looking at larger deals, as illustrated by SEAF. The firm's first fund invested on average just US$2.8 million per company, often in minority positions. However, its current fund is now targeting an average of US$10 million per investment, with a maximum of US$25 million in deals that include co-investors. Laura Lodoño, of Altra Investments, commented on this dramatic shift in investment sizes, saying that, "initially, most of the opportunities in our pipeline were from $15 million to $20 million; today, we are looking north of [between] $30 million and $50 million per transaction."

Even as PE firms increase their bets, the Colombian market still has a long way to go. Today, Colombia has only 2% of PE capital allocated to Latin America, and the continent's total asset base represents 2% of total global resources, according to figures compiled by Proexport Colombia. PE experts suggest that local pension funds should continue to be a major source of additional funding for future growth. In the last 5 years, compulsory and voluntary pension funds have grown by more than 25% a year, reaching a combined asset base of more than US$72 billion as of March 2012. Based on the present regulation, pension funds profiled as moderate or high risk may place up to 5% or 7%, respectively, of their total asset base into the PE asset class. Considering current assets under management, an additional US$1 billion could be allocated to PE investments.

The Investment Horizon: Riding the Wave of Growth

Given the relatively high growth rate and rapidly expanding middle class, it should come as no surprise that the demands for capital continue to increase, especially for industries that are more sensitive to consumer discretionary spending. In the near term, PE investors are finding several sectors particularly attractive — retail, education, health care, housing, tourism and entertainment. Established PE firms in Latin America have also continued to express interest in sectors that will benefit from the country's overall macroeconomic growth as well as in recent trade agreements that could lead to more exports. These sectors include mining, agriculture, business-process outsourcing, IT services and software, and education.

Investment opportunities are arising in more niche industries as well. One such example is Dynamo Capital, a firm that invests in television- and film-related projects. Over the past 5 years, Dynamo has bridged the capital need for a burgeoning film industry in Colombia. According to Alejandra Guzman, the firm's director of investments, these investments not only have been attractive from a financial point of view, but have also contributed to economic growth by providing jobs. Supported by government incentives to help promote job creation and spending in Colombia, these projects can be particularly profitable for local investors with specialized market knowledge, such as Dynamo. It is an example of the potential economic impact that small to medium PE firms can have in the coming years in terms of alleviating capital constraints and supporting job growth.

Meanwhile, no discussion about Colombia would be complete without addressing infrastructure projects. As the country continues to grow and place additional demands on its already stretched infrastructure, the private sector has become increasingly involved in funding projects to address the most critical infrastructure needs, including utilities and transportation systems. PE interest in infrastructure investments has continued to grow, and recent fundraising efforts have indicated that 27% of capital raised has been marked for this sector.

How PE firms deploy this capital has been, and will likely continue to be, segmented into 2 categories: primary investment in infrastructure projects and periphery investments in infrastructure service providers. Larger funds, such as Ashmore and Brookfield, have raised sizable amounts of capital designated primarily for investing directly in infrastructure projects. As an alternative approach, the lower and middle market-sized funds have expressed interest but have generally pursued a strategy centered around investments in outsourcing or service business that would benefit from the presumed growth of these projects. This strategy mitigates the timing risks that can be associated with the projects while still allowing these more generalist firms to participate in the seemingly inevitable growth that will come from the infrastructure sector in the coming years.

Risks and Challenges Ahead

Although the PE landscape in Colombia is broadening along with the country's rapidly growing economy, several challenges still loom on the horizon, including limited track records for funds, a sufficient number of sizable transactions, entrepreneur/manager awareness of PE, and exit opportunities in the future.

A primary challenge that PE firms will face is the task of raising capital for new funds in the absence of a clear returns profile. With both an increase in the number of funds raising capital and an increase in the average target fund size, the competition for capital fundraising will be more intense, and many fund managers will need to convince potential investors of their ability to succeed without a clear track record in the region. Those managers that are successful at fundraising may still face challenges in finding transactions of sufficient size and scale to deploy capital efficiently.

In addition, the industry must work to educate entrepreneurs about the existence of PE capital and the role this funding can play. Most Colombian business owners are just starting to become acquainted with PE and venture capital. The vast majority still do not know what these funds represent and how they can fit in their growth plans. The deal environment in a market such as Colombia is inherently different from other, more established PE markets. Contributing to the difference in the deal environment there is the fact that many of the more sizable businesses are family-owned enterprises, with owners reluctant to accept outside capital and/or relinquish control. As Guzman noted, "It can take a long time to cultivate relationships with these family-owned businesses, and when you do, how do you convince them that a PE investment was a good opportunity?"

Finally, there is the challenge of finding exit opportunities that allow firms to obtain the liquidity needed to provide returns to their investors. Initially, most PE managers see a strategic sale as the main exit route. However, with the influx of larger international funds willing to write bigger checks, sponsor-to-sponsor exits could become a realistic possibility in the near term, although this is still uncertain. The increased IPO activity in 2011 and the merger of stock exchanges in Colombia, Chile and Peru could also provide another path toward liquidity for PE investors. "The stock market has been rising dramatically recently, with 12 IPOs of mostly blue chips that have added up to more than $8.2 billion in the last 18 months — a historic record for Colombia," says Felipe Iragorri of Tribeca Management. "IPOs for midsize companies should be more of a reality in 2 to 4 years."

Colombia's PE industry will not become a globally significant market until it has established a track record of solid investor returns. Given the lack of this track record, the next investment cycle may prove to be make-or-break for the industry. If fund managers are unable to deliver on the promised economic opportunity, the PE industry in Colombia will struggle to grow at the same pace it has sustained since 2007. However, given the favorable economic conditions, political stability and relatively strong economic position in the region, fund managers up to the task should be able to realize gains that will spur continued PE investment interest in Colombia.

This article was written by Rodrigo Boscolo, Ben Shephard and Wallrick Williams, members of the Lauder Class of 2014 and republished with permission from Knowledge@Wharton the online research and business analysis journal of the Wharton School of the University of Pennsylvania.

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