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Implications of the Current Business Environment for the Nascent PE Industry in Colombia Colombian Private Equity & Venture Capital Seminar Andrés Cadena, McKinsey & Company MAIN MESSAGES • Leading up to mid-2007, the growth of the PE market was fueled by a flood of capital and easy lending standards. However, liquidity dried up following the credit crisis, causing the buyout markets to collapse • General Partners will concentrate in the short term in turning around troubled portfolios and in taking advantage of distressed assets. In the mid term the industry will return to fundamental-based deals (smaller, less leveraged, longer holding periods) • The nascent PE industry in Colombia could take advantage of the current market conditions to leapfrog other economies. However, it is critical to take immediate actions on regulation, infrastructure and, moreover, education of both GPs and LPs. 1 IN THE PAST YEARS THE PE INDUSTRY EXPERIENCED UNPRECEDENTED GROWTH Global buyout assets under management (AUM)* $ bn Global funds raised $ bn CAGR % 918 58 195 61 164 +33% 667 39 275 146 27 117 ROW** 387 14 Europe 135 465 26 107 228 “Global PE fund-raising in Q1 2008 reached $163.5bn, the second highest in the history of PE” – PreQin 2008 173 584 35 400 U.S. 238 266 2004 2005 2006 2007 * Funds raised in the previous five-year period, by vintage year ** Rest of the world Sources: Private Equity Intelligence; PreQin, press search; team analysis Q1 Q2 Q3 2007 Q4 Q1 2008 2 FUELED BY A FALLING COST OF CREDIT High-yield spread over swap rates* Basis points 700 639 basis points 650 600 550 500 450 400 184 basis points 350 300 250 200 150 1995 ’96 ’97 ’98 ’99 2000 ’01 * Spread denotes industrial B-rated bond index over swap rates Sources: Bloomberg; team analysis ’02 ’03 ’04 ’05 ’06 2007 3 PRIVATE EQUITY BECAME EXTREMELY LEVERAGED Hedge funds and private equity firms control ~$2.5 trillion of equity but borrowed several times this amount to fund their investments Private equity leverage multiples* Estimated hedge fund leverage** 6.2x 5.3x 4.6x 1,1 3,5 Leverage through derivative positions Total leveraged assets 5.4x 4.8x 0,9 4.0x 1,5 2002 2003 2004 2005 2006 * Source: Morgan Stanley, September 2008 ** Source: McKinsey, October 2007 2007 Assets under management Leverage through debt 4 HOWEVER, JULY 2007 BROUGHT A REVERSAL OF THE CREDIT AND LIQUIDITY GROWTH Global CDO issuance $bn Crisis onset July 2007 60 Credit and liquidity growth 50 Credit and liquidity crisis and contagion 40 30 20 10 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Main drivers of liquidity growth • Growth in financial assets (e.g., equity, private and government debt, bank deposits) • Increasing importance of private capital • Entry of new investors in the market through innovative financial products (e.g., CDOs) Sources:Dealogic; team analysis Triggers of liquidity crisis • Complexity and opacity of subprime/CDO risk • Mispricing of risk • Aggressive pursuit of yield Areas of contagion • Mortgage-backed securities • Wholesale funding market • Hedge funds • Private equity 5 RESULTING IN AN 80% DECREASE IN GLOBAL BUYOUT DEALS Total value* of announced global buyout deals $ Billions 186 Mega Deals (over $2bn) 73 611 Announced global buyout deals Number of deals 213 38 55 46 401 401 372 663 444 2005 2006 2007 Q1 Q Avg. Q Avg. Q Avg. Avg. deal size** $ Millions 164 304 321 * Total deal value includes both equity and debt ** Average taken of disclosed deal values. May exaggerate actual average since deals with undisclosed value tend to be small Source: Capital IQ Q2 Q3 2008 118 6 AN IN A DRAMATIC CAPITAL OVERHANG ($400 BILLION) THAT NEEDS TO BE INVESTED Private Equity capital raised and invested $bn 278 Buyout Investments* 284 245 244 Buyout Fundraising 219 Capital overhang (cumulative since 2003)** 188 $393 billion overhang 156 101 76 48 81 97 53 5 2003 46 10 2004 2005 2006 2007 2008*** * Assuming a 2:1 debt:equity ratio ** EVCA (most accurate) figures for Europe not yet available. Alternative source used but this may understate the global total *** Cumulative uninvested capital since 2003, capital committed pre-2003 is unlikely to be invested at this point; assumes that 1/3 of capital on the road will close in Q4 NOTE: Overhang = Uninvested Capital 7 Sources: Private Equity Analyst, EVCA, AVCJ, Venture Expert. McKinsey analysis, PE Intelligence RAISING NEW CAPITAL WILL BE THOUGH AS PENSION PENSION FUNDS WILL NEED TO REBALANCE PORTFOLIOS Typical LP allocation to PE Percent of total portfolio ILLUSTRATIVE New allocations fall 50% to keep PE within target range 11.5 1,0 PE target allocation range PE share of portfolio rises following collapse in stock values 12.0 0,5 1,5 PE allocations rise due to fewer distributions 9.0 9.0 Limited exit opportunities reduce distributions 10.0 2,0 1,0 2,0 Start of 2007 Cash back 2,0 Cash called 8.0 Start of 2008 * Footnote Source: Press search, McKinsey analysis Cash back Cash called Prestock crash Denom- Start inator of effect 2009 Cash back Cash called Start of 2010 8 MAIN MESSAGES • Leading up to mid-2007, the growth of the PE market was fueled by a flood of capital and easy lending standards. However, liquidity dried up following the credit crisis, causing the buyout markets to collapse • General Partners will concentrate in the short term in turning around troubled portfolios and in taking advantage of distressed assets. In the mid term the industry will return to fundamental-based deals (smaller, less leveraged, longer holding periods) • The nascent PE industry in Colombia could take advantage of the current market conditions to leapfrog other economies. However, it is critical to take immediate actions on regulation, infrastructure and, moreover, education of both GPs and LPs. 9 DEALS WILL BE SMALLER Private equity deals are smaller Average deal size* $ millions 519 Credit crisis 422 294 251 171 155 143 134 97 2006 Q3 2006 Q4 2007 Q1 2007 Q2 2007Q3 2007 Q4 2008 Q1 2008 Q2 2008 Q3 * Source: Dealogic 10 THE CAPITAL STRUCTURE WILL REVERSE TO EQUITY LIKES Private equity deals involve more equity - average equity contribution % of purchase price 40% 38% 36% Credit crisis 34% 32% 30% 28% 26% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H08 2Q08 11 AND COST OF CAPITAL WILL RETURN TO LONG TERM LEVELS Private equity deals involve less favorable debt terms Average spread of leveraged buyout loans* Vs Libor 450 400 Credit crisis 350 300 250 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H08 2Q08 Source: Standard & Poor’s 12 MAIN MESSAGES • Leading up to mid-2007, the growth of the PE market was fueled by a flood of capital and easy lending standards. However, liquidity dried up following the credit crisis, causing the buyout markets to collapse • General Partners will concentrate in the short term in turning around troubled portfolios and in taking advantage of distressed assets. In the mid term the industry will return to fundamental-based deals (smaller, less leveraged, longer holding periods) • The nascent PE industry in Colombia could take advantage of the current market conditions to leapfrog other economies. However, it is critical to take immediate actions on regulation, infrastructure and, moreover, education of both GPs and LPs. 13 FOLLOWING THE CRISIS, BUYOUT ACQUISITIONS SHIFTED TOWARD EMERGING MARKETS Announced global buyout deals, by region %, $ bn 100% = 282 ROW 8 720 169 371 97 75 6 10 10 10 12 37 Europe Buyout investments in emerging markets $ bn 31 39 18 26 100% = 17 Middle East 5 1 Africa 12 Other 35 22 3 5 24 45 7 4 7 8 2 73 1 16 35 20 31 49 7 25 57 0 51 17 Asia 56 N.A. 60 83 82 64 69 56 61 57 43 48 30 2005 ’06 Q1 ’07 Q2 ’07 Q3 ’07 Sources: Capital IQ; Asian Venture Capital Journal (AVCJ) Q4 ’07 30 Q1 2008 2003 ’04 ’05 ’06 2007 2008 14 WILLINGNESS TO INVEST IN EMERGING MARKETS GREW DUE TO HIGHER RETURNS AND FALLING RISK PREMIUMS Returns have increased in all emerging markets … IRR 10-year returns 3-year returns 57 Avg. U.S. PE returns range Most LPs expect to invest in emerging-market PE by 2013 % of LPs who expect to invest in emerging regions 39 30 25 2006 2008 2013 68 Asia 83 19 89 0 Latin America CEE* + Russia 8 12 Emerging Asia All emerging regions 43 … and PE risk premiums** over U.S. investments have fallen % 2006 2008 CEE+ Russia 57 75 5 Middle East 11 35 9,0 5,8 5,9 6,5 6,4 8,9 8,0 6,7 6,7 5,0 20 Latin America 40 65 4 Emerging Asia CEE+ Russia Middle East * Central Eastern Europe ** LPs set the risk hurdle for U.S. PE investments at 16.3% Source: Emerging Markets Private Equity Association (EMPEA) Latin America Africa Africa 30 52 15 RECENTLY, CAPITAL FOR EMERGING MARKETS HAS FROZEN AS VOLATILITY IS HUGE AND CRISIS IMPACT IS UNKNOWN CEE Current Account Deficits* -4.9 Lat. Am. Fiscal Balances Pro-Forma for Commodity Prices at 10 Yr Avg.** 8.7 -5.3 1.8 1.1 -13.7 -2.6 2007 Pro-Forma -5.0 -22.0 Bulgaria Baltic States 2007 actual -2.0 -18.2 1.7 -8.1 Romania Hungary United States Argentina Brazil Chile Peru • Eastern European account deficits and Latin American commodity dependency are key vulnerabilities – Certain CEE countries will experience credit contractions, reduced investment, and slower growth – Latin American governments may have to raise taxes or cut spending as commodity related revenues fall * Economist Intelligence Unit, 13 October 2008 ** Morgan Stanley, 30 September 2008. 16 IF COLOMBIA MANAGES TO NAVIGATE THE CRISIS, IT COULD BE IN A STRONG POSITION TO RECEIVE PE FLOWS %, Change 2007 Δ Private consumption Δ Government consumption Δ Gross fixed investment 2008 (Forecast) 4,4 1,7 1,1 0,6 5,1 Δ Stock building 1,9 0 Δ Exports 0,6 1,9 Δ Imports Δ GDP • How exposed are our exports to a slowdown in the US? In Venezuela? 4,8 7,7 * Forecast Source: DIAN-DANE; The Economist’s Inteligence Unit©, Oct 22th, 2008. 1,5 3,0 3,4 • Which investments will hold? • energy? • mining? • Industrial? • Infrastructure? • What role could PE play in holding current investment rates? What has to be done to facilitate these deals? 17 WHAT ACTIONS SHOULD BE TAKEN IMMEDIATELY? NON EXHAUSTIVE Can we create a more competitive tax structure for GPs and LPs? • Carryforwards • Retefuente • Ganancia ocasional • Doble tributación Should the government incentive the industry? • Cómo LP? • Cómo GP? • A través de políticas industriales? • Articulando inversionistas? • Generando economía de escala? • Predefiniendo proyectos infraestructura? Can we strengthen the regulation (articulo 2175) to facilitate/stimulate investments from pension funds and insurance companies? • Flexibilidad en clases de activos • Desregulación vs. Lavado de activos • Condiciones de contratación pública Is it feasible to accelerate the creation of top quality GPs? • Co-inversiones • Definición de conflictos de interés • Gobierno Corporativo • Procesos operativos claros • Certificados para GPs 18