Building a Critical Mass of Sustainable Emerging-Market SMEsThe Role of Private Equity

Noah Beckwith, Partner, Aureos Advisers Limited, LondonTBLI Europe 2007, Paris

1)The Myths of Investing in Emerging-Market SMEs…

SMEs are inordinately riskyManagement and governance are poor, financial discipline is lacking / non-existent Contractual arrangements cannot be enforcedSMEs are not scaleableSMEs cannot compete owing to:

Dis-economies of scale Oligopolistic market structures Un-level playing fields

Capital growth is insufficient to generate returnsRisk-return reward is unattractiveExits are difficult or impossible due to:

Lack of investor demand Market illiquidity

The private equity model is inappropriate for SME investment in emerging markets

2)…The Myths Debunked

• Illiquidity is not the problem – IPOs, buy-backs, trade sales, other exits all possible• Exit strategies require careful planning from ex ante

Exits

• Track record in SME private equity is misleading• Risks of investing in private equity can be mitigated

Risk-reward unattractive

• The traditional private equity model must be modified• A portfolio approach to investing is vital to the sustainability of the model

Private equity modelInappropriate for SMEs

• Absolutely – reliance on capital growth, alone, is dangerous• A portfolio approach is critical – capital growth, income, income/growth transactions

Capital growth prospects are limited

• Market structures often disadvantage SMEs• Competitiveness must derive from tailored growth and strategic development plans

SMEs are uncompetitive

• Scalability is achievable but requires context-specific strategies• Regional growth strategies are vital

Scalability

• Often poor, although not always – a critical part of the investors’ value proposition• Alignment, deal structures and rights are key

Management, governance, financial controls

• Local professionals, local presence, established networks• Early stage / venture capital versus late stage – a crucial distinction

SME Risk Profile

Towards a reformulated SME investment strategyR

even

ue /

Prof

it

Time

Embryonic Growing

Expansion

Seed

Start-Up

Maturing

MBO/MBI

Roll outs/consolidationsReplacement Capital

Aureos Regional Funds – Product Types• Regional investment strategies:

• De-risk SME funds• Generate deals and exits

• Domestic demand assumptions are vital

• Investment ranges are critical

• Geared equity structures enhance viability

• Good transactions attract liquidity

• Maintain strategic focus

• Relationships are key – capital is ubiquitous

Transaction Structuring: A Cash Flow Focus is Key

Deal structures that generate a high proportion of returns through ‘cash flow’, reducing the reliance on the equity multiple

Fund Managers targeting at least 40% cash flow based deals.

Cash Flow StructureEnhances Returns – income and capitalLess reliance on ‘equity’ multiples (where volatile markets cannot guarantee exit through IPO's / trade sales) Enhances our controlsProtects in downside scenarios

Benefits

Preferred Common Stock - higher ranking ordinary shares, with investor rights (e.g. preferential dividends; exit and control rights) Self-Liquidating instruments - returning a combination of capital and yield throughout the holding period

Core Instruments

Provide a head start to achieve target returns and reduce the overall risk of the Fund

Sample Transactions – Avance Ingenieros

Brief description: Leading homebuilder in ES targeting mid/high income buyers

Investment Thesis:

Opportunity to invest with leading player in a homebuilding sector with strong demand driven by long term financing, remittances from abroad and recent conversion to dollarPoor bottom line visibility led to an investment structure where fee was tied to top line performance

Outcome:

Receive in excess of 40% yield on equity investment. Have lent company an additional $4m in 2006 which was mostly repaid.

Amount Invested: US$ 4 million initially, with an additional $4m after prepayment of initial $3m loan

Current Valuation (Mar 07): US$ 5 million

Expected Return (Mar 07): 29.9%

Avance Ingenieros

TBLI Thesis•Extensive consultation with local communities•Environmental best practice competitive advantage•Social best practice competitive advantage

TBLI Thesis•Risk mitigation strategies reflect social capital •Price premium through reputational advantage

Sample Transactions – Aluminios de Panamá

Brief description:ALPAN: Leading Aluminum Extruder in Panama, SD&W: Window frames manufacturer

Investment Thesis:

Production bottlenecks and limited working capital restricting production to 32% of capacity despite strong demand for its productsBoom in construction sector in Panama driving local demandConstruction and hurricanes in Southern US driving international growth

Outcome:

Local demand stronger and more than offsetting weaker int’l (less hurricanes in ’06)Company on schedule for CAPEX expansionHave already been approached by two interested buyers

Amount Invested: US$ 3.05 million ($5m committed)

Aluminios de Panamá

TBLI Thesis•Reducing macro-risk by investing in domestic producer•Environmental leadership helps to capture market share

TBLI Thesis•Environmental best practice enhances brand

The Aureos Latin America Fund:Building Critical Mass in Emerging Market SMEs

Andean companies looking northwards

Central America companies positioning themselves as intra-regional conduits

Mexican companies moving southwards

Winners will be companies best able to adapt to new competitive factors

Outsourcing of products and services with a “near shore” advantage

Aging populations in US & Canada demand for products and services

Remittances / returning migrants drivers of local consumption

FTAs to drive consolidation and cross border expansion as companies adjust to

new competitive environment

Not just about opportunities in USA

Demographic Trends

Beyond geographical competitive advantage

Free Trade Agreements

Domestic and regional markets as

growth drivers

Andean companies looking northwards

Central America companies positioning themselves as intra-regional conduits

Mexican companies moving southwards

Winners will be companies best able to adapt to new competitive factors

Outsourcing of products and services with a “near shore” advantage

Aging populations in US & Canada demand for products and services

Remittances / returning migrants drivers of local consumption

FTAs to drive consolidation and cross border expansion as companies adjust to

new competitive environment

Not just about opportunities in USA

Domestic and regional markets as

growth drivers

Conclusion

Why private equity?– SMEs require ‘patient capital’– Financing is available – SMEs require ‘financing plus’– The whole capitalisation structure must be taken into account

Why SMEs?– An ‘under-served’ market segment– The lifeblood of the emerging markets– Today’s S’s are tomorrow’s Ms and the future’s Ls

Why a TBLI thesis?– Ignore social and environmental criteria at your peril!– The triple bottom line nexus is even tighter at the SME level