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LAVCA in the News

Pension Fund Liberation To Boost Nascent Sector

1 October 2007

Americas – Latin American Private Equity:
Pension Fund Liberation To Boost Nascent Sector

A Relaxation Of Pension Funds Allocation Rules In Latin America Will Hugely Benefit Regional Private Equity Investment – But governments Must Keep Better Tallies

October 1, 2007 | FT Business — Even as developed market private equity suffers from the pain of the financial crisis, the Latin American private equity (PE) industry is taking off as Brazil, Mexico, Colombia and Peru make it easier for domestic pension funds to invest in the asset class.

According to the Emerging Markets Private Equity Association, Latam PE funds raised $1.35bn in the first half of 2007 and are set to beat last year’s total of $2.66bn with major funds having been raised in July. Brazil captured 82% of all private equity invested in the region last year. The peak year for PE investment in Latin America was 1998 at $3.7bn.

Experts say that the private equity industry in the US only started to expand rapidly after local pension funds were allowed to invest in it. Brazil, Mexico, Colombia and Peru could be about to follow the US’s lead as they relax allocation rules for pension funds.

Cate Ambrose, executive director of Latin American Venture Capital Association (Lavca), says: “In the US, a change in the regulatory interpretation by federal pension authorities in the 1970s led pension funds to become the single most important source for US venture funds, providing about half of all such funding over the past 20 years.

“In Latin America, involvement of pension funds would inject needed local capital and also encourage European and US pension funds to invest in PE in the region and give the industry a big impetus.

“Brazil and Chile already allow pensions funds to invest in PE/venture capital. Peru and Colombia have recently made their rules more flexible. In Mexico and Argentina, pension fund investing into venture capital is not allowed.”

One of the most important restrictions in Colombia and Peru is that domestic pension funds cannot invest in private equity funds that are domiciled abroad, unless the PE funds are greater than $10bn.

PE restrictions

In Brazil’s case, domestic pension funds cannot invest in any private equity funds domiciled outside the country. In the case of Mexico and Argentina, pension funds cannot invest in private equity at all.

Jose Brazuna, manager of funds at Brazil’s National Association of Investment Banks, says: “Pension funds still cannot invest abroad but we believe that this will change in the short to medium term.

“Recently, Comissao de Valores Mobiliarios, Brazil’s regulator, allowed mutual funds to invest abroad, with a limited percentage of 10% to 20%. So, in some cases, pension funds, indirectly, will be investing abroad, if they invest in those mutual funds.”

Noah Beckwith, a partner at Aureos Capital, a London-based private equity fund manager specialising in the emerging markets, says: “The Colombian and Peruvian regulatory authorities are aware that this is a significant hindrance to private pensions’ investment in international PE.

“They are committed to modernising the law to facilitate investment into international funds and so that there is more optimal use of domestic capital in local and international markets.”

However, experts say they do not expect Colombia or Peru, whose pension funds have $25bn and $20bn under management respectively, to make the change until next year.

In Colombia, currently domestic pension funds can invest up to 30% of their value in private equity funds managed in the country (called sociedad administradora de inversion) but cannot invest more than 5% in any specific fund. In Peru’s case, there are no restrictions for pension funds investing in PE funds managed in the country, as long as they are registered as sociedad administradora de fondos de inversion.

In Brazil, private equity and venture capital fall under variable income rules which specify that not more than 50% of a pension fund can be allocated to variable income. Furthermore, there is a specific rule that not more than 20% of a pension fund can be invested in private equity.

The 50% restriction is creating huge problems for pension fund managers in Brazil because of the country’s rising stock market. The Bovespa is now at more than 58,000 points, against 44,000 at the end of December last year, 33,000 at the end of 2005, and 26,000 at the end of 2004.

Many funds have already exceeded the 50% allocation, making it even harder for them to increase their investment in PE.

Ricardo Malavazi, investments director of Petros, a retirement fund run by Brazilian oil giant Petrobras, says: “Today, if I wished to invest in private equity, I would have to reduce the overall equities allocation. It is necessary to create an alternative category for private equity.”

In the US, 7% of pensions funds’ assets are invested in PE, while in Brazil – where total pensions funds amount to $212bn – the proportion is just 1%.

Previ, Brazil’s biggest pension fund with more than $60bn under management, has 1.8% of its assets in PE.

Joao Santos, an audit partner at PricewaterhouseCoopers in Sao Paulo, says: “Last year, the Brazilian tax authorities waived capital gains tax for foreign companies that invest in PE funds managed in Brazil. This has encouraged some multilateral institutions to invest in Brazilian PE funds.

“What’s happening now is seen as the second wave of PE investments in Brazil.

The first one was between 1996 and 1998, but now it seems much more consistent because the economic fundamentals are better.”

In June, the Colombian authorities introduced new rules that spelt out the roles of limited and general partners in a PE fund, the functions of the investment committee, minimum individual contributions limits, and how to establish a fund.

Andres Correal Gutierrez, coordinator of private equity funds at Colombia Capital, part of the Colombian Stock Exchange, says: “Their effect is positive, as they make it easier to establish private equity funds in our country. They provide this nascent industry with a clearer regulatory framework, which previously did not exist.

“There were no specific rules concerning private equity in place before this decree was issued.”

Rule loosening

In Mexico, the pension funds supervisory body, Comision Nacional del Sistema de Ahorro para el Retiro, recently issued a directive – which will come into effect at the start of August – allowing private pension funds – which manage $70bn – to invest in domestic or foreign variable income through share indices, in Fibras (fiduciary funds similar to US real estate investment trusts), and in companies and private projects through structured notes with guaranteed principal.

Luis Perezcano, managing partner of the Nafta Fund, a Mexico-based PE fund, says: “The directive does not include explicitly private equity funds. The Mexican Private Equity Association [Amexcap], is lobbying the authorities to make minor changes to the directive’s text so that funds that meet certain requirements of transparency can be invested in by [PE funds].”

He thinks the changes could be extended to PE investment by the end of this year.

This year, Colombia introduced capital controls mostly directed at speculative capital inflows or hot money. Any international portfolio investment is required to leave 40% of the total at the Central Bank for six months at zero interest or pay a penalty close to 9.5% upfront.

These restrictions have little impact on PE investment, as this kind of investment normally lasts several years, but commentators say the controls can send the wrong signal to foreign investors.

Corporate citizenship

Michael Mortimore, head of the investment and business strategy unit at Santiago-based think tank Economic Commission for Latin America and the Caribbean, says: “The controls are not directed at PE investment but they can lead to a kind of ideological battle in which countries with the controls are not seen by the international financial community as good ‘corporate citizens’. That can affect the view of PE investors. This was the case in Chile and it had to remove the controls.”

He says that big private equity investment inflows in the region could present some countries with other problems. “I think one of the issues is that we do not have a very clear picture of the total size of private equity flows into Latin America. There are no reliable statistics collected by government agencies.

“Many of the investments seem to be for the short term and, at the first sign of difficulty, the money could exit the country. I think some countries must consider carefully whether the flows make their economies more vulnerable to external shocks. Other countries could put more extensive capital controls in place if there was a crisis.”

A relaxation of the pension funds allocation rules in Latin America will be highly beneficial to private equity investment in the region, but governments in the region need to introduce new mechanisms to keep a better tally on the amount of private equity coming in.