Reduce, re-use and recycle

Distressed deals have evolved to the next level in Latin America, with a new generation of funds picking up assets from strategic investors leaving the region. By Judy Kuan.

As a number of key strategic investors divest their holdings in Latin America, private equity firms are eyeing assets at a discount. The corporate exit has left in its wake a set of undervalued and in many cases financially troubled assets, many of which are looking attractive to local private equity funds. What is more, as the region's economy recovers, companies with solid balance sheets are becoming more expensive, making turnaround deals appear all the more appealing to specialist investors.

Financially distressed companies – particularly those within the energy, consumer-based retail and banking and finance industries – have caught the attention of a handful of fund managers who have chosen to deviate from the traditional private equity approach. These investors prefer to specialise in undervalued businesses that are in some form of distress, in exchange for accepting a greater degree of risk.

What is significant about this eclectic group is that their investments are among the largest transactions made in Latin America thus far in 2005.

The largest investment made so far this year is Washington DC-based private equity firm Acon Investment's purchase of Brazilian grocer GBarbosa from troubled Dutch food retailer Royal Ahold for an estimated $110 million.

Following close behind is Buenos Aires-based private equity fund manager Grupo Dolphin's pending acquisition of Edenor – which is responsible for 95 percent of the power distribution taking place in Argentina – for $100 million from French utility company Electricité de France.

Grupo Dolphin has drawn the attention of the region's private equity industry, with its aggressive pursuit of key power assets in Argentina that include Transener, the country's main power transmission company, and Hidroneuquen, the holding company for Argentina's largest private power generation plant.

Pegasus Venture Capital and Southern Cross Group have also established themselves as contenders for distressed asset deals in Latin America. Although Buenos Aires-based Pegasus has competed with Acon and Grupo Dolphin for investments, the deals actually closed by Pegasus have tended to be smaller in scale. In the last two years, Pegasus has ramped up its investment activities and co-invested with corporate investors in financially troubled companies throughout the region. Rather than investing from a fund, Pegasus calls for capital from its LPs on a deal by deal basis.

Meanwhile, Southern Cross Group – headquartered in Greenwich, CT – is most well known for restructuring Chilean retailer La Polar and taking the company public on the Santiago Stock Exchange in 2003. Southern Cross is now in the process of investing the $217 million in its new fund, which closed at the end of 2004.

SUCCEEDING THE STRATEGIC INVESTORS
To be sure, interest in turnaround deals in Latin America is not new. Private equity firms such as Acon Investments and CSFB's DLJ Merchant Banking platform have actively invested in the region since the mid-1990s, when the first cycle of Latin American private equity was in full swing.

However, there is a key point differentiating the current wave of distressed deals from those of the past: whereas private equity firms and other private investors previously engaged in acquiring distressed holdings from local governments through the sell-off of state-owned property, today's distressed specialists are buying from large international players that are scaling back their businesses in Latin America. Consequently, the strategies adopted by distressed asset investors have evolved as well.

Reverse leveraged buyouts – the most extreme approach – became very popular in Argentina at the height of the country's economic crisis in 2001.

“Local players would buy companies that were highly leveraged with worthless equity, and then go and tell the companies' creditors, ‘We don't have any money, so we're here to extract some equity value.’ It was basically extortion,” says a fund manager active in the region, who asked to remain anonymous.

The source also observes: “This is obviously a type of deal that high-profile international investors cannot do because they cannot go to creditors with claims that they do not have money. Of course these reverse LBOs require a lot of moral flexibility, but examples continue to happen, particularly in Argentina.”

The more moderate approach towards distressed investing is that of purchasing companies that are highly leveraged, and then repaying part of the debt using equity capital. For instance, this structure was adopted by a number of private equity firms to acquire the assets of Royal Ahold as it exited from Latin America, which, in addition to Brazil's GBarbosa, included Ahold's Santa Isabel and Disco chains in Peru and Argentina.

LOOK BUT DON'T TOUCH
Enabling oneself to invest in distressed deals is a challenging process, and while some private equity fund managers in the region have examined such deals, the majority has not yet taken the plunge.

Many of the region's private equity groups choose to counter the higher prices asked for potential acquisitions in ways other than resorting to turnaround investments. According to Carlos Sales, the Mexico City-based managing director of Protego Asesores and the Discovery I private equity fund targeting mid-sized companies in Mexico, his firm responds to the “rising valuations of potential acquisitions by allocating more time and effort toward finding suitable investment targets.”

Varel Freeman, the New York-based managing director of Baring Latin America Partners, says that for Baring: “Distressed assets and turnarounds became a significant part of our business when we took over the management of a fund with portfolio difficulties from other fund managers. However, we have not made our own investments nor raised a fund dedicated to those types of assets.”

Meanwhile, global private equity firm The Carlyle Group, which recently acquired its first Mexican portfolio company, plans to stay strictly away from distressed asset investments. “We think that there are plenty of opportunities in nondistressed assets in Mexico,” says Luis Téllez, co-head and managing director of Carlyle's Mexico City office. “Distressed companies – particularly in Mexico – are difficult to deal with due to local legislation and regulations.”

DEALING IN DISTRESSEDA snapshot of private equity firms specialising in distressed or turnaround investments in Latin America.

Private equity Head office Current fund Investments in Latin Acquisition strategy Representative Latin
firm America American turnaround
deals
Acon Investments Washington, DC Acon: no dedicated Brazil, Colombia, Undervalued or GBarbosa, 2005
fund distressed mid-sized (Brazilian supermarket)
companies
Carulla Vivero,
1998-1999
(Colombian super-
market)
Dolphin Fund Buenos Aires, Dolphin: D. Opp Fund Venezuela, El Distressed investing, Transener, 2004
Management Argentina LP, $70 million, 2003 Salvador particularly during (power transporter)
Argentina political or economic
crises Hidroneuquen, 2004
(power generator)
Edenor, 2005
(power distributor)
Pegasus Capital Buenos Aires, Pegasus: no dedicated Argentina, Mexico Turnaround deals, Heladerias Freddo,
Argentina fund traditional private 2004
equity, early stage (ice cream parlor
growth capital chain)
Grupo Alvher, 2004
(packaging manufac-
turer) Musimundo, 2003
(music and entertain-
ment retailer)
Southern Cross Greenwich, Southern Cross: Argentina, Chile, Restructurings and La Polar, IPO held
Group Connecticut Southern Cross Latin Brazil, Mexico turnarounds of com- 2003
America Fund II, panies with underly- (department store
$217 million, 2004 ing value chain)