The pandemic hit harshly most Latin American countries, especially given underlying structural, political and economic factors that exacerbated the crisis’s impact. Beyond the pandemic, companies and investors in the region have grappled with considerable depreciation in some key currencies, fueled in part by foreign investors’ risk aversion, trade tensions and political volatility. For example, the Brazilian Real declined against the U.S. Dollar from an annual average of approximately 3.9 Reais per USD in 2019 to over 5.6 Reais per USD in October 2020, with year-to-date devaluation nearing 30%. These adverse developments help explain the International Monetary Fund’s recent forecast that combined regional GDP in 2020 will decline by 8.1%.
Although overall M&A activity in the region in terms of deal value has decreased by more than 50%1 during the first half of 2020 compared to the same period last year, private equity investors in Latin America have remained busy pursuing USD 5.1 billion worth of exits, primarily through the equity capital markets.2 In Brazil, the market for public equities expanded as retail investors moved their savings away from debt instruments, now less remunerative due to consistently lower interest rates. In the meantime, exits through strategic dispositions have been much more challenging as potential buyers constrained by lack of liquidity are demanding unattractive deferred payment mechanisms and tending to value assets more conservatively.
On the buy-side, most of the interest is in sectors perceived as more COVID-resilient. These include technology, particularly mature startups seeking large rounds of funding from an increasingly active regional venture capital industry, including Fintech as a tool to bypass the region’s expensive payment systems and reach the unbanked population; healthcare; education; and infrastructure, including logistics, especially with an upcoming privatization wave in Brazil. Investments in quasi-equity debt instruments of distressed entities likewise have been active and are likely to find fruitful ground as the economic effects of the crisis continue to unfold. Regarding deal volume by country, Brazil remains the frontrunner with more than half of all regional M&A activity, followed by Mexico and Chile.3 Interestingly, while fundraising increased 30% year-over-year during the same period, much of the new money flowing into these funds seemingly does not come from abroad but rather from local investors searching for higher yields.4
Some pessimism about the near term future of the regional economies persists among LPs and GPs, particularly with respect to 2021. Looking ahead, the International Monetary Fund does not expect any growth in the region through 2025. But is this a case of it’s always darkest before dawn? Does this negative sentiment actually offer good opportunities to foreign investors willing to adopt a contrarian view on the region’s future and to take advantage of low valuations and favorable exchange rates? Experienced investors in the region believe that these opportunities indeed could materialize, particularly if the business-friendly legal reforms, privatizations, and partnerships with the private sector being launched by regional governments succeed.
For example, Brazil has adopted important reforms over the last two years involving the country’s expensive pension system and complex labor legislation. In addition, last year, Brazil enacted Law No. 13,874, an Economic Freedom Act aimed at reducing government intervention in business activity. And the Brazilian Congress now has approved a simplified legal framework to draw investments to its sanitation sector and amended the Bankruptcy Code to, among other things, facilitate distressed investments. The federal government’s executive branch, in turn, has promised auctions of dozens of state-owned assets by year end, as well as tax and administrative reforms in 2021.
Especially significant to private equity investors is Brazil’s recent clarification of its private-equity tax regime for FIPs (Fundos de Investimento em Participações), which exempts offshore investors from paying taxes on exit gains. In recent years, the Brazilian tax authorities have challenged the eligibility of non-resident investors to the FIP exemption. This has included asserting that the jurisdiction of such investors’ beneficial owners—and not just that of the investing vehicles—should be considered in assessing their tax domicile. In December 2019, however, the Brazilian tax authorities acknowledged that the investing vehicles’ jurisdiction should be operative, except for sham or fraudulent circumstances.
Other reforms aimed at attracting investments are occurring across the region. Colombia, for instance, recently issued new regulations deferring income from private equity or collective investment funds, as well as rules on permanent establishments. And Chile has enacted new tax legislation allowing tax amortization of all intangibles acquired from June 2020 to December 2022.
The third-quarter business headlines provide anecdotal support for a more optimistic view, with: (1) a large global sponsor raising a USD 2 billion Latin American-focused fund; (2) the Brazilian IPO market on track to a record year since 2007, and deal activity giving signs of a rebound; and (3) stiff competition for large Brazilian assets (e.g. Localiza, StoneCo and Laureate Education).
Overall, the pandemic’s difficulties have created an impetus from local governments to attract foreign capital to help jumpstart the region’s economies. If some of these reforms succeed, and the third quarter’s positive outlook continues, their impact—together with low valuations and cheap currencies— could increase private equity activity. But to the extent new interest in Latin American targets indeed materializes, investors still will have to continue focusing on the other risks that comprise the regional landscape.
Of particular relevance, compliance risk persists as a significant consideration in PE deal-making, only exacerbated by the COVID-19 pandemic and associated challenges. The anti-corruption enforcement revolution that began several years ago in Brazil has continued reverberating throughout the region, notwithstanding various difficulties encountered along the way. Because compliance risk can materially impact the value and appropriateness of a potential investment, PE firms in Latin America and beyond are increasingly mindful of such risk when screening, managing and exiting their investments. Against this backdrop of institutional development on the compliance front, other contemporary legal concerns are incrementally making their way into the region’s legislative agendas and business practices, with an increased focus on data privacy being particularly noteworthy in Brazil and beyond.
The near-term outlook for private equity in Latin America remains quite uncertain. Nevertheless, given that private equity investments as a percentage of GDP are, according to the Emerging Markets Private Equity Association, less than 0.3% across the region as compared to more than 1.5% in the United States, there still appears to be significant potential for growth in the region.
The Private Equity Report Fall 2020, Vol 20, No 3