Early stage and venture capital investing is expanding in Latin America, with cities such as  Florianopolis and Buenos Aires acting as hubs of venture activity in the region’s southern cone  of Argentina, Brazil, Chile and Uruguay. But an incipient VC industry is also emerging much farther north in Mexico, despite the inherent challenges the country has traditionally presented for entrepreneurs. Over the last 18 months, a combination of change drivers have contributed to an  improved ecosystem for entrepreneurs, angels investors and venture capital fund managers aiming to generate new businesses in Mexico.

Latin Idea Ventures, a local early stage/growth capital firm, has been looking for companies to back in Mexico since 2000, but recognizes a major change in the playing field in 2009, with increased opportunities on both the fundraising and deal flow fronts.

According to Managing Partner Alex Rossi, “deal flow is coming in at a record pace – we have made three investments already this year and are seeing new opportunities in IT, software, media and logistics. Market awareness of venture capital is at an all-time high, and as we prepare to raise our next investment fund we see heightened interest in the VC sector from local institutions and investors compared to our previous go-around four years ago.”

One positive for firms such as Latin Idea is the opportunity to exit investments by selling to a an increasing number of later-stage private equity funds seeking a deal pipeline in sectors such as education, health care services, software, business services, financial services, infrastructure and agribusinesses.

“Until recently, funds in Mexico were focused on private equity and non-technology segments, without much venture activity”, explains Erik Lopez, who heads Intel Capital’s efforts in Mexico. “It was a very niche industry and for years I would encounter the same small group of players. But in the past 18 months I have seen a resurgence of activity – now when I am asked if I know one fund or another, more often the answer is no.”

New public and private efforts are contributing to the change, driven by a new generation of entrepreneurial minded business leaders. Rogelio de los Santos, a serial entrepreneur with an 18-year track record and a string of successful exits including Xtreme Cinemas and workforce training company Dalus, describes an ongoing shift in Mexico’s business environment: “Traditionally, companies took advantage of public and private monopolies and the lack of a competitive environment, with employers dividing up territories and making pacts on prices. Typically, entrepreneurs were members of a family with an established business or part of a group in government that gave access to highly profitable concessions. This was compounded by a very shallow financial system, which effectively blocked entrepreneurs from accessing capital. Today in Mexico there is more competition and different public and private groups are interested in creating a new economic organization that promotes competitive investment.”

Mexico’s family business networks have dominated both early and later-stage deal flow opportunities for decades, often crowding out professional fund managers. So perhaps one of the most important developments for the VC industry is an incipient migration towards institutional investing among traditional family groups.  One example of this is Alonso Diaz, who since 1999 had been doing deals through an investment club of family offices. Among the club’s deals was Metroscubicos.com, a real estate website that delivered a 7.4x multiple and a 65% IRR in a strategic sale in 2007. This year Diaz and his partners created Gerbera Capital in order to ‘formalize’ their VC experience and track record.

“We set out to raise a fund so that we can invest a portfolio rather than taking advantage of one-off opportunities in single companies”, explains Diaz. “In VC there is no other way to invest if you want to mitigate risk long term. We were also looking to expand our investor base. Typically, VC activity in Mexico is dominated by family offices, some angel networks or large family owned businesses. These participants bring a lot to the table – local business experience, contacts, etc. – but they often lack the discipline and scale to create a successful VC portfolio that a fund with professional management can provide. So far, we have convinced three major business groups in Mexico to participate in our fund and take advantage of the many projects they come across but are not necessarily able to implement.”

The uptick in VC fund formation and deal flow has coincided with an extraordinarily tough macroeconomic environment in Mexico, as the country has suffered from the impact of the US recession and the effects of the H1N1 flu outbreak. But where many see short-term adversity, others see an opportunity to influence long-term changes. Paul Ahlstrom, the founder of Utah-based vSpring Capital, has made a major bet on Mexico, moving his family to Monterrey in September to start up Alta Ventures Mexico, an early-stage venture capital fund.

“Some people may think that now is not the best time to be making such a bold move as to start a venture fund in Mexico. But entrepreneurs follow the road less traveled, and a time of crisis can be a good time to invest and is always a good time to make a change.”

Mr. de los Santos met Ahlstrom at the 2008 LAVCA-AMEXCAP Summit in Mexico City, and was inspired by the idea that venture capital funds can democratize capital and empower entrepreneurs without relying on public and private power. Soon after, De los Santos and Ahlstrom teamed up on a seed fund program known as Kickstart Mexico, and to launch Alta Ventures Mexico.

Ahlstrom has been deeply impressed by the level of interest of government officials, who have invited him to comment on relevant regulatory frameworks and on public efforts to promote the competitiveness of Mexican business. “In our investment efforts we are partnering with key business, education and government ecosystem participants including leading Mexican companies and families, the Endeavor and Enlace mentor groups, Mexican and international institutional investors and corporations and the Tec de Monterrey University system.”

In fact, many of the agents contributing to an improved ecosystem for VC have been present for years. Chief among these is the Instituto Tecnologico y de Estudios Superiores de Monterrey (or ‘Tec de Monterrey’), a private university with campuses throughout Mexico that has long been the country’s epicenter of business incubation. The Tec de Monterrey system generates hundreds of new startup companies every year through dozens of business incubators and business parks, which one manager describes as the single most productive deal flow source in Mexico if not North America.

Following this lead, many of Mexico’s leading universities are now recognizing the importance of innovation and protecting intellectual property and are growing their entrepreneurial and technology commercialization programs.

Tec de Monterrey also hosts some of Mexico’s principal angel networks, and angel investing has been expanding rapidly over the last couple of years due to the growth of both formal and informal networks. Intel’s Lopez is encouraged by the increased angel activity and new entrepreneurship programs in private as well as public universities, “because it is an indicator of potential future activity, and the source of a sustainable pipeline.”

Some of the key formal angel networks active today include Angel Ventures Mexico, New Ventures Mexico (focused on clean tech), Red Mexicana de Inversiones, Club de Inversionistas del Tecnológico de Monterrey,  Bid Network, Fundación E,  Incubadora Universidad Panamericana, and Inversionistas Angeles NAFINSA.

As another long-term agent of change, Intel has studied weaknesses within the venture ecosystem and responded over the past several years by hosting seminars to raise awareness around angel investing, partnering with academic institutions to develop entrepreneurship curricula and programs, and creating the Premio Intel, a business plan competition which has now been scaled to the entire region.

Cisco Systems has also made Mexico a priority, and in May of this year CEO John Chambers took center stage with President Calderon to make a public commitment to invest $5 billion dollars in the country.

Public sector efforts to back private capital have been headed from within state development bank NAFINSA since about 1996, and in 2006 a private equity Fund of Funds was established. Managed by Eduardo Mapes, the vehicle has invested in dozens of local managers. At the same time, the Mexican Council for Science and Technology (CONACYT) has been providing grant funding for new ventures with a major innovation component.

Now NAFINSA is launching a new structure which will specifically target VC managers within the Mexican Capital Investment Corporation (CMIC), drawing on the experience of the current Fund of Funds. A new VC Fund of Funds will provide equity investments to early stage managers rather than loans or subsidies for innovation. CMIC is targetting to commit between $40m and $100m to the vehicle, and aims to invest in 60 enterprises through eight different VC funds.  Mr. Mapes and Adriana Tortajada of CONACYT are being tapped to drive the project.

The Mexican Private Capital Association (AMEXCAP) aims to act as the key coordinator among the different entities and individuals promoting VC in the country, through a new Venture Capital Committee which is being chaired by Alonso Diaz of Gerbera. “More participants require more coordination. We found that there were many efforts going on with limited results, so we gathered some of the most important players and convinced them that we needed to coordinate efforts in specific actions and programs,” explains Diaz.

Among the committee’s areas of focus is to contribute to policies and laws that will improve the regulatory environment for venture capital firms. The corporate structure known as SAPI (or Sociedad Promotora de Inversion) which came into effect in 2005 has been widely used by private equity firms active in the region, and will be an important vehicle for entrepreneurs venture capital managers as well. More recently, 2009 regulation allowing Mexico’s local pension funds, or AFORES, to invest in private equity and venture capital has the potential to detonate the country’s VC industry going forward (see related article).