As buy-out funds decline, SME funds attract greater attention

Operating well beneath the radar of most traditional private equity industry players for many years, a new class of venture funds is emerging as the fastest growing segment in the asset class.

Latin America's private equity industry has mainly developed out of an interest by US banks and buy-out groups to use traditional control and minority style investing on the region's middle-market companies and projects. However, a surge of interest in companies operating on a much smaller size is advancing as the wave of buyouts retreats.

Using venture capital to finance small and mid-sized companies, known as SMEs, has existed as least since the mid-1990s when the Inter-American Development Bank's Multilateral Investment Fund (MIF) began backing funds that targeted the sector. At the same time, Mexico's Nacional Financiera S.A., the development bank, was trying to rescue what remained of the open-ended venture capital funds it had supported prior to the banking crisis of late 1994 and early 1995.

However, it was at the end of the 1990s and early into this century when several forces contributed to create what today can be seen as a dynamic sub-group of the venture capital asset class in Latin America.

The proof that the asset class has taken a life of its own lies in the fact that several fund initiatives have been able to attract private capital, says Sandra Darville, who heads the fund investment program for the MIF.

'We have been pleasantly surprised that even throughout the difficult market conditions…domestic private investors have become interested in the segment and are getting their feet wet,' says Ms. Darville.

The MIF or other agencies, such as Mexico's Nacional Financiera, Brazil's BNDES and Finep, Chile's Corfo and even the Inter-American Investment Corp., another unit of the Inter-American Development Bank, usually commit up to one-quarter of a fund's total capital. Managers must be able to raise the rest from other agencies or from private investors.

In Mexico, investors have included state governments, individuals and business groups. Nacional Financiera is even backing one fund initiative that hopes to draw interest from Mexican emigrants living outside of the country.

In Brazil, private pension funds and corporations have pitched in.

In Central America, SME fund backers include CDC Group, London, and Norfund, the Norwegian development agency.

An energy services fund organized by FondElec Group, Stamford, Conn., brought in Japan's Tokyo Electric Power Company and Sumitomo Corp.

Government interest around the region has been another positive development for the sector. 'They are working actively and in a focused way to really assess what the environment (for this kind of investing) is and what their role should be in changing it,' she adds.

The governments of Brazil, Chile, Mexico, Peru and other countries are looking carefully at the regulatory structure and what sort of incentives - tax or otherwise - could be appropriate.

Fund management competency is improving as well, says Ms. Darville. There are now several cases of fund managers that have gone on to launch multiple funds, and are able to apply lessons learned from the first time around going forward.

Brazil's CRP Companhia de Participaçoes, Porto Alegre, has launched its fifth venture fund, for example. The latest three, called RSTec, SCTec and SPTec, are practically franchise operations, as the firm hones its niche in backing technology companies operating in specific regions: Rio Grande do Sul, Santa Catarina and São Paulo.

The crossover between managers of larger, more traditional private equity or venture capital funds and SME funds is becoming more frequent as well.

A recent MIF commitment to LatinTech Ventures illustrates how managers of venture capital funds, in this case LatinTech Capital Inc. of  Rio de Janeiro, can turn their sights to the SME segment for a new twist on their work.

Some larger private equity firms are even carving out a portion of their funds to use for SME investments. ZN Mexico Capital Management LLC, New York and Mexico City, has committed to using a portion of its $90 million ZN Mexico Trust II (final target is $150 million) for SME deals.

Jamaica-based Caribbean Equity Partners also pledged a portion of its $50 million Caribbean Investment Fund, L.P. to SMEs and, according to Ms. Darville, the first deals it closed were mainly in the SME segment rather than with larger companies.

The 'M' in SME

Several fund managers admit that one new trend in SME funds is to favor mid-sized companies over the truly small ones. 'Given the cost of administering each investment, including posting a dedicated investment executive, over time we've felt the need to focus on larger deals,' says CDC Group's Ian Weetman.

Despite the trend towards relatively larger deals with bigger investee companies, the kinds of companies these funds are used to back are still very small compared to regular private equity fare.

In general, SME funds are used to back companies that have less than $10 million in annual sales, although many funds have a maximum size of under $5 million in sales. Deal sizes are usually less than $1 million, although Mr. Weetman says the new Aureos Central America fund, a joint effort between CDC and Norfund, will likely include deals up to $5 million in size.

The universe of potential investee companies is huge. In Mexico, Nacional Financiera estimates that 98 percent of all Mexican companies fall within the SME and micro-enterprise categories. In the rest of the region the numbers are likely the same.

All small companies in the region are characteristically denied access to public capital markets because of their size, and are unable to obtain long-term financing at affordable rates from commercial banks. Even if banks are willing to lend money, they often demand collateral that the companies are unable to provide. Often, a company will have put up so much collateral for one loan that it has nothing left to pledge against further financing, says Eduardo Mapes, who oversees Nacional Financiera's venture fund division.

The wide gap between the supply of and demand for capital creates the opportunity for SME venture funds. However, the number of eligible investee companies drops considerably as investment criteria are applied.

The company must have very high growth potential, which is usually made possible by operating in a niche market that it can dominate, or because it has some comparative advantage to exploit. The business must be scaleable, says John Bays, general director of Arlington, Va.-based Small Enterprise Assistance Fund's (SEAF) Bolivian chapter.

Injecting equity capital or a combination of debt and equity into a company that is starved for growth capital can unleash this growth.

For example, Fondo Capital Activo, the SME fund for Bolivia organized by SEAF, backed a wood-flooring manufacturer whose sales in August 2001 were at $800,000. By March of this year, sales had ballooned to $3.5 million.

Such growth potential demonstrates how SME investing can generate returns beyond the developmental benefits of backing small companies. 'Targeted investments in SMEs will always outperform the country's economy,' says Mr. Bays. SEAF operates SME funds in Asia and Central and Eastern Europe as well as South America.

However, SME venture funds face more obstacles than just the gap between the number of companies that need financing and the number of suitable ones.

One such obstacle is the lack of understanding on the part of entrepreneurs and family owners. Venture investing in this segment calls for evangelization, says Mr. Bays.

'We are still educating entrepreneurs,' says SEAF General Director José Garcia in Peru. A typical question, well into negotiations, is still 'What's your rate?' as entrepreneurs fail to understand the venture capitalist isn't trying to give them a loan. Mexico's Mr. Mapes echoes the same concern.

Some family owners have trouble accepting that they will have to dramatically alter the way the way they run their business once outside investors are involved.

However, the understanding that one needs to open up a company in order to prosper and grow is increasing all the time, says CDC's Mr. Weetman.

Copyright © VE-LA 2002

VE-LA Publications tracks the deals, funds and people in the world of Latin American private equity and venture capital investing. Its biweekly newsletter, Venture Equity Latin America, is delivered vi email as a PDF. The website, www.ve-la.com. Is an industry resource, with sample articles and statistics posted in a timely fashion. VE-LA Publications' first mid-year report brings fundraising and deals data for 2002 as well as for past years and discusses trends in investing. For details, see www.Ve-la.com/midyear2002.html