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Growth Capitalism: Lessons from the Last Downturn: Preparing Your Portfolio Companies

21 September 2011

By Patrick McGinnis

Even as the United States and Europe struggle with ongoing economic challenges, Latin America remains resilient. Yet, as any investor who has been working in Latin America since the 1990’s knows, the region’s economies are not immune to external shocks or business cycles. The secular trend looks good, but there will be bouts of outsized volatility. As a result, it’s worthwhile to think about what a downturn will look like for private equity investors.

Over the last few years, the private equity and venture capital markets in Latin America have changed. There’s significantly more local money than in the past. Valuations have soared, especially in markets like Peru and Colombia, where more dollars (or soles or pesos) are chasing deals. Most recently, US or Europe-based PE investors are opening offices or flying in teams to look at large and expensive deals. In 2010, Apax completed one of the largest Latin American investments on record with its $500m stake in Tivit, which was the firm’s first deal in the region.

Given all of this activity, an economic slowdown in the region will have interesting implications for private equity. There will be significant capital sitting on the sidelines. Investors will need to work through challenges in their portfolios. More significantly, some investors will find themselves holding illiquid investments in companies that were acquired at high entry multiples. As one of my PE mentors used to say, if you get valuation right on a deal, most other sins are forgiven. But if you overpay, a downturn will result in significant numbers of write-downs.

Of course, many of the main players in Latin American private equity have lived through volatility and economic contraction in the past. Anyone who was investing the late 1990’s survived the devaluation of the real in 1999. A few years later, early stage investors managed through the blowback from the global technology bust. Then there’s the case of Argentina: the country was arguably the hottest PE market in Latin America during the second half of the 1990’s when investors, led by aggressive players like the Exxel Group, went on a debt fueled buying binge. Many of these investments, especially those in the consumer sector, were seriously affected when the Argentine crisis erupted.

Having lived through that period, I thought I’d put together a list of lessons for PE investors from the last downturn.

1. Cash Is King
I still remember the sinking feeling I got when my portfolio companies in the early 2000’s, several of which were internet companies, could no longer raise follow-on rounds of capital. All of the sudden, these companies were forced to switch from growth mode to a mentality of cash conservation. Admittedly, some of these companies were poor concepts. Heavy consumers of cash like Gratis1, Latin America’s largest free Internet service, were tough investment cases even before the crash. Without the ability to raise fresh capital, they were unsustainable. MercadoLibre, which raised a new round of capital before the market peak, rode out the storm thanks to strong execution, great management, and a healthy pile of cash its the balance sheet. Today, MELI is listed on the Nasdaq and has a market capitalization of nearly $3 billion. If MercadoLibre hadn’t had a solid balance sheet, it might have been forced to sell out to a strategic player like eBay at an unfavorable valuation. Instead, it negotiated from a position of strength when it sold a 19.5% stake to eBay in 2001.

2. Find a Good Controller
In the adverse environment of the early 2000’s, I came to believe that one of the most important people in a company – perhaps the most important person in some instances – is the controller. Yes, the unheralded controller. I saw this clearly through an investment in Mexican call center player Hispanic Teleservices Corporation (HTC). JPMorgan Partners and CVC invested in HTC, then an early stage business, in a series B in 2001. The company used the proceeds of the round to build-out additional capacity and a focus on cash was paramount. I spent a considerable amount of time working with management to find an excellent controller and then making sure that he was fluent providing in the types of information and controls that were essential to the Board. We always knew exactly how much cash we had in the bank and how we were going to use it, and this allowed management and the board to take informed decisions and to focus on the value drivers of the business. From my perspective, it’s hard to beat the ROI on an effective controller’s salary.

3. Walk the Halls at Your Portfolio Companies
If the markets turn, teams at PE firms will spend a lot less time working on new deals. Firms should use that extra time and capacity to spend some quality time with their portfolio companies’ management teams. I would suggest not just talking to the C-suite, but also getting to know employees at all levels. Even if you are in regular contact with your portfolio companies, spending time walking the halls of a business can be enlightening. You may be surprised at what you learn. For example, you might find out that a company has spent thousands of dollars building a bridge between the two buildings that constitute his company’s Peru office because the country manager didn’t feel like walking downstairs and crossing a courtyard to go between them. You might also learn that the CEO and CFO of one of your portfolio companies aren’t on speaking terms. I hate to admit it, but those are examples of the types of things that I was surprised to learn.

4. Consider Consolidation Opportunities
In any market, there are usually several players seeking to dominate a niche. In a downturn, it’s likely that consolidation will follow, especially when considering start-ups. Not only will the combined company gain market share, but it can also build a best-in-industry management team while bringing together a deeper investor consortium. That’s why MercadoLibre acquired DeRemate. That was also the driver behind the merger of Despegar and Since these deals were done in a down market, valuation expectations were reasonable. These companies are now the leading players in their niches and they were able to eliminate competition and consolidate their market positions in a relatively low cost fashion.

5. Beware the LBwOes
One of the principal differences between the PE environment today and the one that existed ten years ago is the wide availability of debt to fund buyouts. If there is a downturn, it’s unclear how lenders will react. Local banks will face pressure throughout their portfolios due to strong concentration in their home markets. Global banks will seek to de-risk their portfolios and minimize their exposure to unattractive markets. Investors in leveraged deals should seek defensive capital structures today while terms are still attractive.

6. Buy in the Trough to Drive High Returns During the Next Booms
A downturn creates opportunities to invest in great companies at attractive valuations. Moreover, it affords investors the opportunity to make bets on dislocations and to pursue deals where the risks are too high for other PE shops. A great example of this dynamic is AIG Capital’s investment in GOL airlines in 2003. The deal came together in the post-September 11 environment when airlines were out of favor. At the same time, there was a significant ebb in private equity activity in Latin America. AIG Capital decided that this was the right time to double down on two unloved segments. A few years passed, and GOL went public on the NYSE to generate a fantastic return for its shareholders. What changed? In just a few years, GOL had become the dominant low-cost carrier in Brazil while, at the same time, public market investors were growing receptive to the Brazil growth story.

7. Cash is King
Because I can’t say this enough.

We’re living in exciting and interesting times in Latin America. While it’s now rare to hear a skeptic comment that “Brazil is the country of the future and always will be,” I’m not yet convinced that “Deus é brasileiro.” No matter where you stand, however, there’s one thing of which I’m certain: you can’t blame God if the company for which you paid 13X EBITDA calls you one Monday to tell you that it’s running out of cash.

Growth Capitalism is a regular column in the Latin America PE/VC Report from Patrick McGinnis. McGinnis has been a private equity investor in Latin America and the emerging markets for over a decade, first at Chase Capital Partners/JPMorgan Partners and later at AIG Capital Partners (now PineBridge Investments). Presently, he sits on the Board of Directors of The Resource Group, a global BPO company, and is a co-founder of Real Influence. Fluent in Spanish and Portuguese and an avid traveler, he blogs about travel at He can be reached at [email protected]