LAVCA in the News
The Quiet American Fund
9 February 2005
More than anywhere, Latin America has stood out as a black hole for private equity, a place where capital goes to die. In the 1990s, elite U.S. and European private equity firms, seduced by the region’s muscular if uneven economic growth, began wagering, and squandering, billions in the region. In the end, a rash of fiscal collapses and currency crises, most recently in Argentina in 2001 and 2002, induced many of the wounded to scale back activities or pull out of Latin America altogether. That turbulent backdrop makes the resilience of Darby Overseas Investments Ltd. all the more remarkable.
06:14 PM EST, Jan-21-2005 — More than anywhere, Latin America has stood out as a black hole for private equity, a place where capital goes to die. In the 1990s, elite U.S. and European private equity firms, seduced by the region’s muscular if uneven economic growth, began wagering, and squandering, billions in the region. The biggest and boldest, Dallas-based Hicks Muse Tate & Furst Inc., tossed away the majority of a $1 billion Latin American fund it raised in 1997 on bad Argentine media and Internet deals. Losses even threatened to kill off Latin America’s mightiest homegrown private equity house, Buenos Aires’ Exxel Group.
In the end, a rash of fiscal collapses and currency crises, most recently in Argentina in 2001 and 2002, induced many of the wounded to scale back activities or pull out of Latin America altogether.
That turbulent backdrop makes the resilience of Darby Overseas Investments Ltd. all the more remarkable. Despite an impeccable pedigree — “Darby” is a scrambled version of the surname of its founder chairman, former Treasury Secretary Nicholas Brady — the boutique has kept a low profile while it has maintained a remarkably sturdy performance record in the region.
Indeed, industry sources expect Darby’s first, $148 million private equity fund — raised in 1994 and now winding down — to deliver a compound, annual internal rate of return in the midteens. While hardly remarkable by U.S. or European standards, given Latin America’s macroeconomic booby traps and legacy of casualties, that is exemplary. It’s a performance that Darby CEO and managing partner Richard Frank ascribes to skill, and luck, at navigating the region’s volatility, at crafting forgiving, unleveraged deal structures and at picking astute, local co-investors and operating managers.
“The U.S. buyout model of taking control of companies, changing management and jacking up their leverage is the wrong approach for Latin America,” he says. “A key for us has been to pick good companies in growth sectors and align ourselves with business executives who can deal with and even thrive with volatility. We’ve been willing to look through the macroeconomic volatility and the difficult times which scare off a lot of other capital.”
Hair-raising times are a recurring hazard. Since 1994, the region’s three biggest economies, Mexico, Brazil and Argentina, have each been roiled by fiscal or debt crises and drastic currency devaluations. These, in turn, have spawned waves of bankruptcies — particularly of companies that take in revenue in reals or pesos but are laden with hard-currency debt. That lethal combination ravaged Argentine businesses backed by Hicks Muse and Exxel. The chaos set in suddenly and was all the more dumbfounding given Argentina’s stature, at the time, as the gold standard for Latin American economic reform.
From the start, Darby pushed into Latin America with open eyes. Brady, who as treasury secretary in 1989 led a U.S. government-sponsored effort, known as the Brady Plan, to ease Third World countries’ debt, surrounded himself with seasoned Latin American pros led by Frank, a former top World Bank official. The firm, which now presides over $1 billion in assets in six investment funds, including an Asian mezzanine fund and two emerging markets fixed-income funds, is angling eventually to extend its reach to all major emerging markets.
To date, however, Latin America has gotten the bulk of its capital. In addition to the 1994 fund, which invested in 11 Latin American companies, Darby has raised $155 million for a second that has backed another four companies. Darby also runs a $195 million fund it bills as the world’s only mezzanine finance vehicle dedicated solely to Latin America. (In October 2003, Brady and his partners sold Darby to Franklin Resources Inc., a San Mateo, Calif.-based mutual fund giant, for $76 million.)
In one key area, according to Frank, the region has an unbeatable appeal — acquisition multiples.
“People ask me why we’re in this with all the volatility,” says Frank, 63, whose round, sunny visage suggests a beardless Saint Nick. “Valuations are why. We really don’t look seriously at anything priced north of three or four times cash flow.” In fact, he says, the region’s risks and the dearth of competition for assets — a byproduct of the turbulence — ensure that prices stay low. “There are half as many private equity players in Latin America as five, six years ago,” he says.
On the other hand, Latin America doesn’t abound in blue-chip acquisition opportunities. Many of the most desirable Latin American enterprises are controlled by families, few of whom hanker to sell. Often they tap private equity simply to fill short-term capital shortfalls, in exchange for minority stakes.
And, while buying cheaply is easy, exiting with a satisfactory profit is another matter.
Darby’s corporate private equity chief, Julio Lastres, 52, who joined from the International Finance Corp. in 1998, says that, at first, Darby counted on being able to exit investments via IPOs in the Latin American markets. But the markets seized up in the mid-1990s, forcing Darby to shift course.
“We had to reposition companies for trade sales,” says Lastres. “That meant renegotiating shareholder agreements. It created some tension with our investment partners.”
In one such sale, of Brazilian packager Dixie Toga SA to Bemis Co. early this month, Darby absorbed a loss. While the company was financially sound, Brazil’s currency devaluations eroded Darby’s return in dollars.
In its worst deal, Darby dropped nearly its entire $11 million investment in Morgan Impresores, a Chilean printing business mauled by price wars and a fall in export sales to Brazil, Argentina and Asia.
But Darby’s main funds sidestepped Argentina almost entirely, so it could absorb a few losses without plunging into the red overall. (“We had a suspicion [trouble] was coming but nothing as bad as eventually happened,” says Lastres. “But we looked at more than 50 Argentine deals and never saw eye to eye with people there on valuation.”)
The firm also posted some very handsome gains. One has been in a Colombian company that not only had to cope with routine Latin America hazards but also operates in a place wracked by rebel attacks and drug-linked violence. For “security” reasons, Lastres asked that the company not be named.
That business ranks as one of Darby’s two best-performing deals. From it, Darby has earned back more than twice its $17 million investment in distributions, he says, and it still retains a stake.
The firm’s most lucrative deal ever, a $26 million minority investment in a publicly traded Mexican bank, Grupo Financiero Banorte SA de CV, shows how the chaos translates into opportunity.
Darby first sank $11 million into Banorte in 1996, in the wake of Mexico’s 1994-95 debt and currency crisis. Many of the country’s banks went belly up; others, still solvent, needed booster shots of capital. Banorte, then the country’s 11th-largest commercial bank and profitable, was one of the latter.
In a deal Brady negotiated personally, Darby joined an investor group led by Mexican businessman Roberto Gonzalez, Banorte’s biggest stockholder, which recapitalized the bank. Darby initially invested $11 million for about a 3% interest. Over time, it boosted the investment to $26 million and its stake to about 5%.
Banorte, meanwhile, absorbed three smaller rival banks while continuing to boost profitability. Over time, Banorte’s net worth more than quadrupled and rose in rank to become Mexico’s fourth-largest bank. On Sept. 28, 2004, Darby sold the investment via a block trade of stock, scoring about a 300% gain.
Darby’s portfolio currently includes Grupo Viz SA de CV, Mexico’s largest beef producer, in which Darby invested $10 million; a $15 million investment in Atlantica Hotels International, a Brazilian hotel management concern; and Grupo Empresarial Metropolitano SA, a builder of housing for low-income families in Mexico City.
“We’ve had a couple of major successes, two or three average ones, some where devaluations delayed our exit and some very big mistakes,” says Lastres.
Just now he is high on a Darby 2003 investment in Border Media Partners LLC, a Houston-based radio station operator catering to Hispanics in the U.S. He says Darby will target more companies that serve the booming U.S. Hispanic marketplace.
Notwithstanding the fact that many U.S. buyout firms have decamped in despair from the region, Lastres says that the investment climate in Mexico and Brazil, Latin America’s two largest economies, has grown increasingly stable. Mexico, in particular, has done a superb job of rebuilding its financial house.
“Mexico is ahead of the pack,” says Lastres. “It has a stable currency, stable interest rates and stable inflation that is converging with the U.S. inflation rate.” And in Brazil, the market-based policies of president Luiz Inácio Lula da Silva, a former socialist who took office two years ago, have been an encouraging surprise. Brazil has reined in inflation, shored up its currency and become a world-class exporter. “The volatility hasn’t gone away in Brazil — the country still has a heavy debt burden,” Lastres says. “But market forces are working.”
That evolution suggests that Latin America is bound to become ever more fertile ground for investors, like Darby, astute enough to capitalize on opportunity while dodging the gravest perils.
Says Lastres: “Latin America is at a crossroads, where I think demand for private equity will be on the uptick. I believe you’ll be seeing more deals there and also more buyouts.”
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