A VENTURE CAPITAL APPROACH

TO ECONOMIC GROWTH

IN EMERGING ECONOMIES –

WITH A SPECIAL FOCUS ON MEXICO

Background/Discussion PaperPrepared by

Andrew R. Horowitz

April 22, 2002 September 2002

TABLE OF CONTENTS

INTRODUCTION AND AN INVITATION TO DIALOGUE 3

SUCCESSFUL INVESTING IN EMERGING ECONOMIES 5

THE CASE OF ADVENT INTERNATIONAL 5

Strong Management Team 6 The Advent Network: Reliance on Local Partners 7 Attracting and Retaining Capital Investors 8 Diversified Investment Strategy 9 Opportunities in Latin America: Special Focus on Mexico 9 Key Lessons of the Advent Case 10

THE DEVELOPMENT OF AN INVESTMENT STRATEGYFOR EMERGING ECONOMIES – The Case of Mexico 11

STEP ONE: Learn about the Economic History of the Country 13

STEP TWO: Define and Assess Economic Markets, Competitive Strengths, and Strategic Opportunities 16 Identify New Avenues of Competitive Strength 18 Focus on Strategic Opportunities 19

STEP THREE: Develop Strategies for Managing Risky Assets 19

A Risk-Tolerant Investment Approach for the Financial Services Sector 22

STEP FOUR: Locate Capital Resources and Develop Harvesting Strategies 24

The Mexican Grupos 25 The Case of Grupo Bimbo 26

SUMMING UP AND LOOKING AHEAD 28

INTRODUCTION - AND AN INVITATION TO DIALOGUE

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On September 26-27, 2002, the Venture Finance Institute (VFI) of the Claremont Graduate University (CGU) and the Peter F. Drucker Graduate School of Management is conducting a conference on how U.S.-style venture financing can be used to stimulate financial independence and sustained economic growth in developing countries. The idea for this conference comes from Rev. Louis L. Knowles, a prominent proponent of economic initiatives in developing countries over the past 25 years. At the time that he proposed the idea, Rev. Knowles was serving as the U.S. liaison to American Protestant churches for Oikocredit, a consortium of 300 European Protestant churches that provides low interest loans to cooperative and community-based organizations in third world countries.

In a letter dated October 23, 2001, Rev. Knowles called for the convening of a conference of experts in the area of venture investing to explore new ways of promoting economic advancement in developing countries. While a myriad of organizations and great amounts of human effort have been expended for decades seeking to advance the economic plight of the developing world, Knowles asserted that newer approaches were needed to confront the challenge of addressing the world’s increasing economic imbalance. Past efforts, he contended, while well intentioned, have encouraged dependency and been too bureaucratic. What were needed instead were programs to promote independence and facilitate local economic benefit. The following excerpt from his letter explains that what he believes the U.S. needs to do for the developing world is what U.S. citizens have done for themselves – create wealth by investing in entrepreneurial enterprise:

There should be much greater involvement from the United States in enterprise-based development strategies for poor countries. The U.S. is the homelandof modern entrepreneurship, and we owe much of our national prosperity toour skill in using risk capital for productive purposes. Why, then, should wesettle for traditional international development programs that are grant-basedand more bureaucratic than entrepreneurial?1

The question posed by Rev. Knowles is an important one for our time, where new ideas and new approaches will be needed to address the shortcomings of globalization and uneven economic progress. The purpose of the “Knowles Conference” will be to address the feasibility of creating a new kind of venture capital-based organization that will concentrate on equity investments in developing countries. Unlike Oikocredit, the organization he represented in the United States for the past five years, micro-credit initiatives, and other organized efforts which Rev. Knowles believe do an excellent job of mixing charity with general community improvement, the new enterprise he has in mind will focus on the economic benefits of individual achievement. Its mission will be to foster rapid, sustainable, high-quality job creation based on the U.S. venture capital investment model. Its overall objectives will be to stimulate rapid, widespread economic growth in developing countries by investing funds in individual entrepreneurs and small or medium-size partnerships, by making capacity-building grants linked to enterprise

1Letter from Rev. Louis Knowles to Andrew R. Horowitz, October 23, 2001, pg. 1.

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development, by supporting and encouraging local venture capital formation, and by providing skilled technical and managerial assistance.

Until a better acronym is chosen for this new entity, we will temporarily use FREEDEM - the Fund for Rapid Entrepreneurial and Economic Development in Emerging Markets. Can it succeed? What evidence is there to suggest that an organization established to promote entrepreneurial activity in developing countries can be effective? What precautions should such an entity take to reduce its risk and ensure success? What should be its investment strategy? Are there specific countries it should focus on in the short term? If so, which countries should be selected and what criteria should be used to choose them? What kinds of projects should this new entity invest in? Who will make specific investment decisions? How and by whom will investments be managed and monitored? Who will own FREEDEM? Should it be established as a for-profit or not-for-profit entity? How should it be governed? Who will invest in it? How much money will it need to raise? Are there any models of venture capital and private equity investment operating successfully in emerging markets today that can be looked to help answer these questions? If none exist, or exist only in some partial or incomplete form, can a new a model be devised?

While many questions need answers, it’s not difficult to agree on reasons why an American initiative to promote entrepreneurial enterprise in developing countries constitutes an important undertaking. The need to reach out to the developing world in positive and productive ways has never been greater. Certainly the events of 9/11 evidenced the devastating consequences of continuing to ignore the underlying economic causes of violent conflict. The fruits of what is popularly called Globalization have not spread equally or equitably throughout the world. The combination of high expectations and unmet desires has become a recipe for disaster in the developing world, boiling over into seemingly senseless acts of violent outrage. It is in the belief that true globalization can only be achieved by reducing societal gaps between people and encouraging rapid and sustained economic improvement that the idea of a new initiative to promote investment in entrepreneurial ventures in the developing world is hereby offered for serious discussion and debate.

This paper seeks to provide a framework within which a thoughtful examination of Rev. Knowles’ hypothesis can take place. Its purpose is to set the stage for a productive dialogue among an audience of skilled venture capitalists, philanthropists, academics, representatives of major public and private institutions, and others interested in exploring new ways of promoting economic development in developing countries, or, what for the purposes of this discussion will henceforth be referred to as “emerging economies.”

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SUCCESSFUL INVESTING IN EMERGING ECONOMIES

The first question that must be asked in approaching Rev. Knowles’ hypothesis and the possibility of creating a venture capital equity fund to invest in early stage businesses in emerging economies is what are the realistic prospects for success? Any imagined benefits that could be achieved through venture capital investing in emerging economies will mean nothing if it turns out that this method of investing is unprofitable. Unfortunately, this question cannot be easily answered. While much is known about venture capital (or equity) financing in the United States, there is little understanding about what are the best ways to succeed in funding high growth, entrepreneurial ventures in other parts of the world, especially in poor countries and emerging economies. One reason for this is the simple fact that venture capital financing in emerging economies is rare.

The factors that underpin successful venture capital funding are a function of the environment within which it operates, or what economists call the “institutional context.” To succeed, venture capital investment needs access to a deep supply of creative entrepreneurial talent, large growth markets, and savvy, risk-qualified investors. It thrives best in a stable political system, and an economic environment that consists of predictable business and monetary cycles, reliable information sources, access to responsive capital markets, and clear contractual relationships enforceable by an established legal system. Most importantly, to succeed, venture capital firms in developed economies rely on robust financial and capital markets to achieve their ultimate goal of executing an early exit or harvesting event, either an Initial Public Offering (IPO) or a merger or acquisition.

These conditions, while present in most developed economies, are rarely found in emerging markets, a circumstance that has created a psychological barrier and a deterrent to attracting equity capital in emerging economies. Yet, in spite of these negative factors, there has emerged over the years a breed of U.S. venture capital investor that has demonstrated success in taking advantage of what it perceives to be enormous opportunities available to investors who are willing to make private equity investments in emerging economies. One representative of this group of outward looking venture capital investment funds is Advent International Corporation, a Boston-based firm that has focused considerable attention on the emerging economies of Asia and Latin America over the past two decades.

THE CASE OF ADVENT INTERNATIONAL

Advent claims to be one of the world’s largest venture capital private equity firms, with fifteen offices in fourteen countries and $6 billion dollars under management, up from $1.7 billion in 1997. It currently employs over one hundred investment professionals operating in the U.S., Europe, Latin America, and Asia. The firm maintains a diverse portfolio of companies involved in a wide range of market sectors, including financial and business services, specialty retail, chemicals, media, pharmaceuticals, software and related information technology, telecommunications, health care, life

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sciences, and energy. It invests in companies at all stages of development, from early stage (even seed) startup growth enterprises to large, profitable businesses. Since its inception in 1984, Advent purports to have invested in over five hundred companies, one hundred and twenty-five of which have completed IPOs on twenty-one stock exchanges worldwide. Over this period, the firm says that it has raised over $9 billion for its portfolio companies through public equity and debt offerings.2 Approximately thirty-percent of Advent’s investment activity is devoted to emerging markets, making it one of the leading venture capitalists in the developing world.

Why has Advent been so successful? A 1997 Harvard Business School case study attempted to provide some answers. The study focused specifically on Advent’s venture capital activities in Latin America. It identified the following four key factors that contributed to Advent’s achievements in the emerging market sector:

1) a strong management team experienced in international venture capital, 2) a mode of entry based on developing strong relationships with locals who

know their respective markets, 3) an investment strategy based on diversifying risk, and 4) the ability to attract a base of highly diversified institutional investors capable

of tolerating the high level of risk associated with volatile emerging market investments.

These factors are worth exploring in some detail, since they provide important clues regarding how to proceed with the planning for and creation of a U.S.-supported venture capital organization designed to promote entrepreneurial development in emerging economies.

Strong Management Team

According to the study, Advent International’s greatest strength, and a main reason for its success, was its experienced management team, led by its chairman and founder, Peter A. Brooke. A forty-year veteran of venture capital investing, Mr. Brooke was already a successful domestic venture capitalist when he decided to pursue investments on a global scale. He had already built TA Associates, which he established in 1968, into the largest venture capital firm in the United States when he decided to spin off its international group to form Advent International in 1984. Advent would become the world’s first global venture fund manager. Its success was based on Brooke’s assessment of the large number of investment opportunities available outside of the United States.

Brooke’s commitment to foreign investment was based on his belief in the theory of imperfect economic markets. He viewed the United States as approaching a “perfect market” - an investment arena that featured an almost ideal combination of market 2 Discussion of Advent International is based on the 1997 Harvard Business School case study, “Advent International: The Leader In Global Private Equity,” prepared by Research Assistant Elizabeth Stein under the supervision of Professor Debora Spar, and the on the Advent International website, www.adventinternational.com/adventlayer1.html.

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efficiency and abundant capital resources. As far as he was concerned, the success of the U.S. economy was adversely impacting high-risk venture capital and private financial returns. Vigorous domestic competition resulting in narrow business margins and lower than optimal economic returns, while favorable to U.S. consumers, threatened the historically high returns desired by venture capital investment firms and their exclusive clientele of highly diversified institutional investors. The rest of the world, on the other hand, was much less “perfect.” This was especially true of emerging markets, which were hampered by limited access to information, immature financial infrastructures, and meager sources of investment capital. For Brooke, these deficiencies offered opportunities that knowledgeable capital providers could advantageously use to negotiate favorable pricing transactions and generate higher returns to investors. “We have the chance to buy stakes in companies at the right price,” the Harvard case study quotes Brooke, “and that means a very low price.”3 Brooke perceived diversification into emerging markets not only as an obvious direction to be taken by early stage venture capital managers. As far as he was concerned, it was a crucial step that needed to be taken to ensure future success.

The Advent Network: Reliance on Local Partners

While Advent’s decision to embrace international investment was shared by many of its competitors in the private equity community, it was one of few firms to develop a truly global investment capability in a single fund. In the late 1980’s and early 1990’s, the portfolios of most private equity fund managers who had followed Advent’s lead in diversifying into foreign markets were primarily local in character. While most fund managers obtained and invested their capital from and within local market sources, Advent made a conscious effort to establish a balance between local knowledge and global flexibility. This approach was based not only on Brooke’s strong commitment to foreign investment, but in his belief that local managers could make better investment decisions about local market conditions and opportunities than could less well informed outside managers. As a result, Advent established and empowered regional teams of managers in its target markets who were natives of the countries selected for investment. They possessed operating experience with companies in the local economy, and were well connected politically in their respective countries and regions. The case study explains how this process worked:

Typically, Advent created an affiliate by first building relationships with a handful of key financial players in the target country. Most often, these players were banks or investment institutions with strong connections to the local business community and government. Once Advent and its selected local partners agreed to join forces, they formed a new joint-venture investment firm. This entity became an ‘Advent Network’ affiliate.4

3 “The Advent of Venture Capital in Latin America,” Harvard Business School Publishing, Boston, MA 02163, 1997, pg. 2.4 Ibid., pg. 3.

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The construction of the ‘Advent Network’ was a brilliant business move. Acting through its local partners, Advent became closely linked to the major political and financial decision-makers in each of its respective markets. Over time, this network would evolve into a permanent Advent presence in each of its operating regions of the world: Europe, Asia, and the Americas. In 1990, the firm combined its regional offices in London, Frankfurt and Milan into a single European office. Two years later it did the same thing in Asia when it consolidated several regional offices into a single location in Hong Kong. The purpose of creating these permanent offices was not to usurp local management and investment decisions, which continued to be the responsibility of the regional offices, but to augment the performance of these regional centers by providing improved due diligence capability and increased access to additional capital.

Attracting and Retaining Capital Investors

Measuring success in the world of venture capital and private equity investing is not easy to do. Typically, the companies that are either started or invested in by venture capital funds take many years of growth and development to mature into liquidity, or harvesting, events, either as an Initial Public Offerings (IPO) or acquisition sales. It takes up to ten years, and sometimes even longer, to determine the ultimate internal rate of return (IRR) of a particular fund. In the United States, venture capital firms have generated an IRR averaging slightly more than twenty percent over the past three decades, about a 25% higher return than the S & P large industrial stock average for the same period.5 Because of its higher risk, higher returns are required to attract institutional investors willing to invest in these funds, especially those that invest in emerging markets. While investment analysts differ on the specific number, it is generally believed that at least an additional twenty-percent return is required for foreign investing.6 It seems reasonable to assume that successful firms in this market space are generating average returns in the neighborhood of twenty-five percent and higher.

Based on its lofty numbers, Advent gives the appearance that its IRR falls in line with these averages. For example, on January 10, 2002, the firm announced that it had finished raising $1.9 billion for its Global Private Equity IV fund (GPE-IV), the most it has ever raised in its eighteen-year history. This amount represented almost half of what the firm had raised in its previous three funds, dating back to the $231 million accumulated in its first fund in1989. The firm’s ability to raise the kind of money it has, especially in the current global investment climate, bears testimony to the credibility it has achieved among its list of highly diversified corporate, government, labor, and private foundation clients. Douglas Pearce, Chief Investment Officer of the British Columbia Investment Management Corporation, recently explained why he remains one of Advent’s most satisfied and loyal investors. “We are delighted to participate in Advent’s newest global fund,” noted Mr. Pearce. “We have been investing with Advent

5 Presentation of Dr. Richard Smith, Professor of Finance, Peter F. Drucker School of Management, to a group of Orange County, California, Tech Coast Angels, Nov. 28, 2001.6 Harvard Business School, ibid., pg.

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for over 10 years and have been pleased with their ability to consistently deliver premium returns.”7

Diversified Investment Strategy

One reason for Advent’s loyal institutional investment base stems from its ability to devise, implement, manage, and offer its fund investors a highly diversified investment strategy. Unlike some of its competitors, Advent, through its creation of new venture capital funds, has pursued a steady course of multi-region and multi-nation investing, thus avoiding the high risks of over-investing in any single region, country, or enterprise. While it is one of the leading venture capital and private equity investors in emerging markets, the majority of its investments are made in the developed economies of Europe and North America. Advent’s most recent fund, for instance, is primarily focused on investments in the developed rather than developing world. This approach has allowed the Advent organization and investors in its funds to hedge their foreign investments by regularly taking advantage of changing economic conditions that occur throughout the world. This means that Advent management must be knowledgeable about the specific private equity circumstances in each of its geographic spheres of interest, including such critical factors as fluctuations in national exchange rates and changes in local tax policies. The firm also has had to be cognizant of the needs and concerns of its investor client base, whose interests Advent believes are best served when its managers pay close attention to prevailing market conditions and country risks.

What originally peaked Advent’s interest in emerging markets, and what continues to keep it high, is the fundamental dynamic that drives successful venture capital investing: imbalances in the availability of private capital for investment. Advent constantly targets emerging markets that exhibit a combination of strong economic growth and inadequate availability of local capital. While such capital imbalances can occur anywhere in the world, they tend to be a common feature of emerging economies, where financial infrastructures are weak and access to local capital is scarce. Advent managers are especially on the alert for private companies in emerging markets that must vigorously compete for a limited pool of investment capital. But these investment opportunities can be extremely risky. What makes them so risky is the flip side of the capital imbalance equation, namely, when there is a need to exit an investment after only a few years. The success of an investment is measured by its ability to generate an attractive internal rate of return to its investors. Thus, in addition to targeting private high growth companies, it is equally important that the companies Advent invests in reside in economies that can absorb an early cash event, either an initial public offering or acquisition sale. Venture capital companies like Advent thrive in environments where these sorts of trade-offs exist.

7 “Advent Raises 2 Billion Pound Global Private Equity Fund,” Advent News press release, January 10, 2002.

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Opportunities in Latin America: Special Focus on Mexico

One of the emerging market regions of the world where the combination of factors sought by Advent is considered to be in desirable alignment is Latin America. According to the HBS case study, the region met Advent’s investment criteria. It was large, it was growing, and it was nearby. More importantly, it suffered severely from the kind of capital imbalances that Advent management finds so attractive for external private equity investing.8 Four countries were singled out for scrutiny in the 1990’s: Argentina, Brazil, Chile, and Mexico. While each country had historically been plagued by political and economic instability, and while each was known for its widespread corruption, inefficient business practices, and unequal tax treatment for foreign investors, these particular countries were given credit for beginning to take steps in recent years to modernize their economies, enter into broader and freer trade agreements, and encourage foreign investment. Advent sensed opportunity in this changing environment. Of the four, Mexico, despite the inherent risks associated with periodic and perilous devaluations of the peso, became the recipient of the firm's particular attention. It focused its spotlight on the country in February 2000 when it promoted Juan Carlos Torres to Managing Director for Mexican operations. Torres had been sent by Advent from Spain to Mexico in 1996 to open its Mexico City office. His primary investment mission was to identify and pursue expansion, acquisition, buy out financing, as well as early stage opportunities. Over the next four years, Torres established an impressive portfolio of local investments, including Aeroboutiques, a duty-free store chain listed on the Mexican stock exchange, GESA, a Pepsi bottler in southern Mexico, and Fumisa and Aeroplazas, both operators of commercial space in Mexican airports.

Key Lessons of the Advent Case

Just because Advent International has been successful in investing in entrepreneurial ventures in emerging markets, there are several important reasons why its experience may not actually shed much light on the likelihood of success for an organization like FREEDEM, especially if it is dedicated exclusively to making investments in emerging economies. As pointed out earlier, Advent’s investments in emerging markets should not be viewed as isolated events, but in the context of a highly diversified, well-hedged investment strategy. Nor do the specific investment opportunities targeted by Advent necessarily coincide with those that might be most appealing to an organization devoted exclusively to investing in emerging economies. For example, Advent’s investment focus in emerging markets has been on later stage companies that are already producing revenue but need an infusion of outside capital to rapidly grow their businesses. Its emphasis has not been on funding earlier stage businesses, including start-ups, which often require many more years of support than do older, more established firms in order to achieve desirable levels of growth and profitability. Advent’s investment objectives are to achieve rapid short-term growth and an early liquidity event, not necessarily to promote consistent, long-term, sustainable economic growth.

8 Ibid., pg. 8.

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Albeit these caveats, there is nonetheless much to be learned from Advent’s experience. The first lesson is the essential need for a strong management team. The HBS case study highlighted Advent’s reliance on experienced, visionary managers as critically important factors to its success. An important component of this strategy was Advent’s ability to identify, develop, and nurture talented local managers who were well informed and who brought with them close and established links to local centers of political and business influence. Yet, it seems safe to say that far more will be required on the part of a new investment vehicle focused exclusively on investing in entrepreneurial activities in emerging economies. Because of its narrower, less-diversified investment focus, such an effort will have to devise and implement an even more effective investment strategy than Advent’s. In economic terms, the decision to invest on a less well-diversified basis, while holding out the promise of realizing higher economic returns, introduces higher levels of uncertainty and, thus, a higher probability for failure.

Before moving on to a discussion of whether or not it is possible to succeed at investing exclusively in emerging economies, and, more importantly, how this might be accomplished, it is necessary to single out perhaps the most salient point to be learned by the Advent case: the fact that it represents an investment model that may speak directly to the needs of the developing world, or what, economically speaking, are capital deficient, volatile, unpredictable, extremely risky economic environments. The fundamental nature of the U.S. venture capital investment model is to promote rapid economic growth by harnessing and managing scarce capital resources for high-risk enterprises that reside precisely in these sorts of conditions. As Advent’s Peter Brooke discovered long ago, opportunity is bred in “imperfect” economic markets where access to local capital is scarce and information about how to secure it is difficult to obtain. If Mr. Brooke is right, does it then follow that Rev. Knowles’ hypothesis is true – namely, that the U.S. venture capitalist model is exactly what is needed to spur rapid, widespread economic development in emerging economies? Maybe so, if a risk-tolerant investment strategy can be created to improve the likelihood of success.

THE DEVELOPMENT OF AN INVESTMENT STRATEGY FOR EMERGING ECONOMIES – The Case of Mexico

The idea of developing a risk-tolerant investment strategy for venture capital financing of new ventures in emerging economies appealed to Dr. Richard Smith, professor of corporate finance at the Peter Drucker School of Management in Claremont, California, where he teaches several courses on new venture finance. With his wife, another noted economist who teaches undergraduate economics at the adjacent Claremont McKenna College, Dr. Smith had recently co-authored Entrepreneurial Finance, a textbook on the subject of financing new ventures that has become required reading at leading business schools throughout the country. In addition, Smith had created the Venture Finance Institute (VFI), a research institute of the Claremont Graduate University (CGU) to study the role of new venture financing in generating rapid, sustainable economic growth. Upon learning of Rev. Knowles’ proposal to convene a

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meeting of leading philanthropic and Protestant Church investment leaders to explore the feasibility of creating a new U.S. entity to achieve the same purpose, Smith offered to host this meeting through the auspices of his institute. Subsequently, he would obtain the support of the Peter Drucker School of Management and the Claremont Graduate University, both of whom shared Smith’s enthusiasm for the project.

Because of their close ties to the area, and especially to elements within the newly elected government of Vicente Fox, Dr. Smith and his CGU colleagues believed that Mexico would make an excellent test case. To Smith, Mexico also appeared an ideal starting point for the same reasons that had originally attracted Advent’s Peter Brooke to the region almost twenty years earlier. First, it represented a large and growing market. Second, through the signing of the North American Free Trade Agreement (NAFTA) and earlier efforts to breakdown barriers to freer and broader trade relations with its North American neighbors, Mexico had demonstrated a commitment to liberalize its historically closed, highly protected, and corrupt business environment. Third, it was close to the United States, a factor that made interaction between the two countries relatively easy and convenient. It also so happened that Smith had already planned to teach an MBA course in Mexico from March 17-22, 2002, in cooperation with Anahuac del Sur University, a business school in Mexico City that had participated in other collaborative activities with CGU. The course was titled “Strategic Risk Management in an Emerging Economy” (MGT 410). Forty CGU students attended the course, both MBA students from Claremont’s Peter F. Drucker School of Management and PHD students from the school of economics. It was co-taught by Mr. Fernando Fabre, a finance professor at Anahuac del Sur who was also a PHD student of Smith’s. Ten former Anahuac del Sur business school students who are now employed by either Mexican government or foreign owned businesses also participated in the class. Classes were held at the Anahuac del Sur University campus in south Mexico City. One of the main purposes of the course was to assess and evaluate strategies for successfully investing in emerging market economies, with special focus on Mexico.

Teaching of the course was shared between Dr. Smith and Mr. Fabre. For his part, Fabre was primarily responsible for supplying facts about Mexico. Dr. Smith, on the other hand, provided the theory, led most of the class discussions, and assigned an assortment of Harvard Business School case studies and other readings that dealt with the issue of investment risk management. Several of these dealt specifically with Mexico – its turbulent economic and political history; its violent drug cartels; its border issues with the U.S.; its vast array of human and natural resources; its vertically integrated, concentrically focused corporate business structures; and its untapped economic potential.

“Strategic Risk Management in an Emerging Economy” could hardly be considered a how-to guide for successfully investing in Mexico or in any other emerging economy. Its design reflected a broader purpose - namely, to construct a road map, or methodology, for effectively assessing and managing investment risk in an emerging economy and, in so doing, increase the probability of successfully investing in these risky

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environments. Regardless of the country involved, the method and process of analysis would be the same, consisting of following four basic steps:

Step one – Learn as much as possible about the recent economic history of the country in question in order to understand the inherent risks of doing business there.

Step two, consisting of the following three parts –

1) become familiar with the country’s primary economic markets;2) develop an understanding of its competitive advantages and

disadvantages; and3) identify areas of strategic opportunity for widespread economic

growth.

Step three – Explore proven risk management strategies and techniques that can be employed to improve the likelihood of making profitable venture capital private equity investments in emerging economies.

Step four – Locate where sources of available financial capital reside and determine how they can be accessed, either through strategic partnerships or other means, in order to achieve successful harvesting events, such IPOs or acquisition sales.

STEP ONE: Learn about the Economic History of the Country

Financially speaking, Mexico has been in a descendent mode ever since it broke away from Spain in a bitter war of independence that lasted from 1810-20. Mr. Fabre explained how the country’s independence set the stage for more than a hundred more years of foreign wars and constant political turmoil. First there was the war against the rapidly expanding United States of America that ended in 1848 with Mexico losing control of a land mass in North America that encompassed an area stretching as far south as Texas, as far west as California, and as far north as Oregon. This was followed by another European invasion, this time from the French who, with the arrival of Maximillian in 1855, were determined to carry their war with Spain on the European continent to far away battlefields in the New World. A second revolutionary war against the French ended in 1876, followed by a thirty-four year old dictatorship, and eventually ending in the Mexican Revolution that lasted from 1910-17 and which restored land rights and other freedoms that had never been implemented in Mexico’s constitution of 1821. While the birth of the Partido Revolucionario Institucional (PRI) in 1918, and its subsequent rise as the dominant political power in Mexico for sixty years, from 1940-2000, restored some much-needed order to Mexican political affairs, the economic track record of this notorious single party regime has been abysmal. The value of the peso relative to the U.S. dollar when the PRI assumed political control of the country in 1940 was eighty pesos to one dollar. When the PRI was finally forced to give up power in 2000 with the election of Vicente Fox Quesada, a candidate of the Partido de Accion

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Nacional (PAN), the peso was worth only ten cents U.S.9 It was during this period that Mexico became poor.

Poverty, like the exchange rate between the dollar and the peso, is a relative term. It has no real meaning by itself, but only in relation to what you compare it to. Mr. Fabre made this point when he noted out that, while Mexico looked good in relation to its Latin American neighbors, at the macro-economic level, the country was poor relative to the United States. The real issue of poverty has to do with economic growth. Neither Mexico, nor its Latin American neighbors, nor any developing nation anywhere in the world has been able to keep pace with the magnitude of growth taking place in the U.S., Europe, and parts of Asia over the past two decades. When objectively viewed at its most fundamental level, the whole developing world has been losing pace vis-à-vis the developed world during this period. This circumstance actually has been common knowledge for some time. More than a decade ago, Pedro Belli, a former senior economist at the World Bank, recognized the problem of the widening gaps between developed and developing countries when he noted that the 1980’s witnessed Latin America’s percentage of world trade drop 20% and that of Africa plunge a staggering 50%.10 The gaps were large then, and they have continued to widen.

Large economic gaps also plague Mexico. Except for a brief period of high economic growth and stability that occurred from 1956-1970, spurred on by the explosive rise of Mexico’s nascent oil industry, the country has been mired in economic stagnation, even negative growth. Over the past three decades, Mexico has experienced a series of almost predictable economic crises associated with the transfer of political power from one PRI administration to the next. Mr. Fabre said that the Mexicans have a term for it – sexenio (every six years). Each new PRI Presidential administration since 1970 has been born in the midst of some new economic crisis, usually a large devaluation of the peso like those that were witnessed in a series of six- year periods: 1976, 1982, 1988, and 1994. Mr. Fabre explained that the process seems to work in three distinct and fairly predictable phases: phase one, or the first year, is when the new in-coming PRI administration repairs the problems left behind by the previous administration; phase two, or the middle years, is a period of somewhat sustained economic growth stimulated by strong government spending and/or outside foreign investment; and finally, phase three, or year six, is when some new catastrophic problem suddenly strikes to send the economy and the nation back into another tailspin. To an outsider, this boom-and-bust cycle appears ludicrous since it all takes place within the context of a one-party political system. But according to Mr. Fabre, this is the way things have been done during Mexico’s recent political and economic history.11

The way things have been done in Mexico, which is typical of the way many authoritarian regimes manage their emerging economies, has devastated Mexico. The last major crisis that occurred in the 1994/1995 time frame was particularly destabilizing, 9 Fabre, Fernando, “The Economy of Mexico – Recent History and Current Situation,” lecture, March 17, 2002, Hotel Royal Pedegral. 10 Belli, Pedro, “Globalizing the Rest of the World,” Harvard Business Review case study, July-August, 1991, pg. 1.11 Fabre, Fernando, Ibid.

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not only because it ultimately resulted in a gigantic sixty percent devaluation of the peso and an extremely costly international bailout package orchestrated by the Clinton Administration, but because it revealed the true corrupt nature of the nation’s one-party political system. The PRI administration of Carlos Salinas de Gortari, which had lobbied hard for passage of NAFTA in hopes of bringing modernity to the country by opening up new Mexican markets to foreign competition, was determined to break Mexico’s venerable, albeit cataclysmic, economic cycle. The administration’s refusal to devalue the peso in the middle of 1994, toward the end of Carlos Salinas’ six-year Presidential term, even in the midst of compelling arguments to do so, was intended to spare the nation yet another damaging body blow. The Salinas administration had already been rocked by a period of political insanity and economic scandal that may have rivaled any other in the country’s turbulent political and economic history.

The first blow came in January 1994, when there was an indigenous revolt in the southern state of Chiapas. This was followed by a series of drug related political assassinations, including the alleged cold-blooded assassination in March of Luis Donaldo Colosio, then the leading PRI candidate to replace outgoing President Salinas. Shortly after the peso was devalued on December 14, 1994, only two weeks after the next PRI government of Ernesto Zedillo had assumed power, Mexico suffered yet another series of crippling political and economic blows. Chief among these was the arrest of outgoing President Salinas’ brother, Raul, for his alleged involvement in the assassination of the ex-Secretary General of the governing PRI, Jose Francisco Ruiz Massieu, in late September 1994. In the face of almost daily bad news flowing from the country, foreign investors panicked. Just as fast as their money had flooded the country in the aftermath of the passage of NAFTA at the end of 1993, money was now leaving it at an even more astonishing rate. By middle of 1995, Mexico was in chaos. It was also broke.

Jorge Castaneda, Mexico’s current Foreign Secretary, has referred to the events leading up to, during, and just after the Salinas government as “The Mexican Shock” that shook both the nation and the world.12 From an economic point of view, there were two defining events featured by the Salinas government that propelled the country along the way to its mid-nineties crisis. Looking to the future, and especially attempts that may be taken to construct a viable, risk tolerant investment strategy for sustained economic development for Mexico, it will be important to understand the significance of these events and the enormous impact they have had on the Mexican economy. The first event was the 1987 decision to sign the General Agreement on Tariffs and Taxes (GATT). This event actually preceded the inauguration of the new Salinas administration that took power at the end of 1988, although it was an important component of Salinas’ presidential campaign. This signaled the country’s intention to open its borders to international competition. Up to that time, Mexico had relied on the use of import quotas, high tariffs, and government subsidies both to support its domestic economy and to protect its key industries from foreign competition. But the country was losing the balance of payments war. Due in large part to the collapse of world oil prices, the sentiment in both Mexico City and Washington was that Mexico needed to diversify. Encouraged by the U.S., whose economy coincidentally was experiencing slow growth

12 Castaneda, Jorge G., The Mexican Shock, The New Press, New York, NY, 1995.

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and which looked upon Mexico and its Latin American neighbors as valuable new growth markets, and especially the World Bank, which made Mexico a “GATT adjustment loan” of $500 million U.S. in 1986, the decision to join GATT announced Mexico’s entrance into the world of free trade and its ticket into the global marketplace. The second defining event, of course, was NAFTA, which sought to cement Mexico’s economic destiny to that of the U.S. and Canada. NAFTA was wholly conceived, lobbied, and implemented by the Salinas administration. One class reading, a Harvard Business School case study prepared by Walter Nimocks, a 1994 Harvard MBA student, argued that NAFTA defined President Salinas’ three-part economic strategy: “increase exports, attract foreign capital, and stabilize the currency.”13

The problem with the Salinas economic development strategy is that it didn’t work. True to its predictable six-year boom-and-bust cycle, an appreciating peso between 1989 and 1993 eroded the country’s export capacity and led to a large increase in imports. The need to raise interest rates in order to pay down the cost of an expanding national debt put additional pressures on a stagnating economy. Moreover, Mexican companies, especially its mainstay, industry-concentric, family-controlled conglomerate business enterprises, had a difficult time competing with their highly efficient, technology advanced, capital rich U.S. competitors. It was also during this period that the government began to privatize the economy and liquidate assets as the way to raise capital to cover its most pressing debts. The prize jewels, including the laboring oil industry, were not sold off. But virtually everything else was to the highest bidders, including the nation’s telecommunications industry and its decimated banking industry. When foreign capital began to flee the country in early 1994, the country was verging on economic collapse. Another sexenio were in the books.

The vicious cycle would eventually be broken on December 1, 2000, when Vicente Fox, the Partitido Accion Nacional (PAN) candidate, upended the PRI’s sixty-year domination of Mexico’s political system. The 1995 crisis signaled the beginning of the end. It was clear even to the most diehard PRI supporters that it was time for Mexico to embark upon a new course of action. If Mexico were to progress economically and become an effective competitor in the global marketplace, new leaders would be needed to show the way. New ways of seeing and analyzing the world would be needed. A new strategy of economic development would have to be developed. Mr. Fabre admitted that the first year of the new Fox administration had not been kind, at least from an economic standpoint. The events of 9/11, coupled with a prolonged North American recession, were hurting the country, especially its travel and tourist industries that were major employers of Mexican labor. Yet, even though no economic progress had been achieved in the first year of the Fox administration, a sort of ironic solace could be taken in the fact that Mr. Fox had at least, and at last, broken the sexenio pattern. The new administration’s slow start did not seem to disturb Mr. Fabre, nor did it appear to concern the former Anahuac del Sur University Mexican students in the class. They conveyed a strong sense of optimism about Mexico’s future. They were eager both to understand and come to grips with the mistakes that had been made in the past and to learn about new

13 Nimocks, Walter, “Grupo Industrial Bimbo S.A. de C.V.,” Harvard Business Review case study, 1994, pg. 4.

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approaches that could be taken to promote rapid, sustained economic development in their country.

STEP TWO: Define and Assess Economic Markets, Competitive Strengths, and Strategic Opportunities

At this point, Dr. Smith assumed control of the class and began to give it structure and direction. On top of the information about the risks of doing business in Mexico, about the past failures of the Mexican economy, and about the enormous challenges it currently faces, Smith began to overlay a methodology for constructing a risk-tolerant investment strategy for the country, a methodology he noted could be applied to any emerging economy nation. The process needed to begin by identifying economic markets that have the potential to foster sustained economic growth, assessing competitive strengths that can be marshaled to exploit these markets, and exploring strategic opportunities available for encouraging investment and maximizing economic growth. Given the new realities of competing in a global marketplace, and especially of doing business in an environment of reduced import restrictions and increased foreign competition, it would be more important than ever for leaders of emerging economies to carefully identify economic markets and construct strategies that could sustain steady, long-term growth and reverse the historical patterns of perennial trade imbalances and depleted capital reserves.

Achieving this task, Dr. Smith noted, would constitute a difficult and challenging undertaking for a country like Mexico. As is the case for all developing countries, the micro-economic performance of specific industries and certain individual firms is heavily influenced by macro-economic factors. Currency ratios, interest rates, and the direction of balance of trade payments are the economic factors that drive emerging economies. This is because emerging economies, unlike their counterparts in the economically advanced world, lack viable domestic markets. They need to be oriented outward in order to grow. This makes them vulnerable to circumstances and conditions outside of their control. Mexico is no exception. The first piece of evidence cited was the large maquila industry that has grown up along the U.S.-Mexico border. Maquilas are modern, foreign-owned factories that employ highly skilled Mexican workers. They are creatures of NAFTA and earlier free trade initiatives. These entities have largely become tax-free havens for name brand international manufacturers to produce automobiles, textiles, computer systems, and a wide assortment of consumer electronics products exclusively for foreign export. This “outward looking” approach also explains the emergence of a large Mexican tourist industry that caters almost exclusively to the U.S. market.

These industries and others like them have evolved by exploiting two long known competitive strengths of Mexico: its cheap labor and close proximity to the U.S. market. Except for the employment they provide, they operate virtually outside and independent of the internal Mexican market. Often times, because they are so far removed, their individual corporate interests can interfere with the best interests of the majority of the country. Take, for instance, the case of the peso. When it devalues, these industries benefit. In the case of the maquilas, they gain because their exports are more

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competitive, while, in the case of the tourist industry, a devalued peso means greater purchasing power for Americans and therefore more tourism. The problem, of course, is that lower prices for foreigners mean higher prices for domestic consumers. This is how the downward spiral begins, with higher domestic prices leading to fewer domestic purchases, followed by no economic growth (or worse, recession), then higher domestic interest rates to pay for the interest costs of ever-increasing public and private sector debt burdens, inflation, and, ultimately, economic collapse. Mr. Fabre and and his Anahuac del Sur University colleagues confessed that this way of doing business represented a broken economic system. Dr. Smith’s admonition about what needed to be done to break this pattern seemed worth heeding: identify economic markets whose economic success is based on competitive strengths other than cheap labor and closeness to the U.S. as criteria for success. The challenge, everyone agreed, was two-fold: first, to identify new areas of competitive strengths, and then to determine new ways to succeed in financing the creation of new business enterprises based on them.

Identify New Avenues of Competitive Strength

An explanation for this point of view was contained in Michael E. Porter’s 1990 Harvard Business School case study titled “The Competitive Advantage of Nations,” one of the assigned readings. It dealt specifically with the issue of the competitive advantages of nations. Dr. Porter’s study challenged the prevailing thinking at the time regarding the determinants of competitiveness. Instead of dwelling on labor costs, interest and exchange rates, account balances, and even economies of scale, Porter focused on innovation as the determining factor of a nation’s ability to compete. Based on his four-year study of the patterns of competitive success in ten leading industrialized trading countries, he concluded that the most important factor affecting a nation’s ability to compete is its ability to bring its unique blend of talent, forward-looking managers, and dynamic leadership to bear on a specific area of interest.14 While the relevance of his study to emerging economies has been criticized because the research was restricted to industrialized nations, Porter’s contention is that any country – indeed, every country – can effectively compete in today’s global economy. The key is being able to identify its primary strengths, develop tools designed to exploit these strengths, and create a business environment that can nurture innovation and encourage economic growth.

One of the principal points of Porter’s argument is that competitive advantage, even in an age where the Internet and advanced telecommunications technology have virtually eliminated distance as a barrier to conducting business, is geographically based. Porter would later coin the term “clusters” that has become popular today. Clusters are defined geographic centers of creativity and excellence.15 Examples cited by Porter included the entertainment industry in Hollywood, finance on Wall Street, and consumer electronics in Japan. Examples of successful clusters operating in emerging economies include software programmers in India and eco-tourism operators in Costa Rica. According to Porter, what makes “clusters” work is the way they can closely link 14 Porter, Michael E., “The Competitive Advantage of Nations, Harvard Business Review case study, Harvard College, 1990, pg. 75.15 Porter, Michael E., “Clusters and the New Economics of Competition,” Harvard Business Review case study, Harvard College, 1998, pg. 78.

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companies and institutions in a particular field and spur innovation through local competition, easy access to information, and the concentration of specialized talent. In the case of Mexico, Smith asked the class to consider where clusters of competitiveness strength could be identified. Examples included the many indigenous native artisan communities in Mexico, especially those located in the poor southern states of Oaxaca and Chiapas, which contained and nurtured some of the world’s finest craftsmen. Another example was the teaching of Spanish. The city of Cuernavaca, for example, located just one-hour south of Mexico City, already exists as a “cluster” of Spanish language schools, yet this unique resource is barely known outside of the local region. In the global marketplace, everybody wants and needs something. The challenge for investors as well as governments, according to Porter, is to identify where talent and competitive strength reside, determine what the market is for this talent, and figure out how to put the two together.

Focus on Strategic Opportunities

No less important than assessing profitable economic markets and competitive national advantages is the need to identify where strategic economic growth opportunities exist and determine how they can be incorporated into viable emerging economy investment strategies. To accomplish this, rather than focusing on strengths, Dr. Smith noted that it would be necessary to focus on weaknesses. Like most emerging economies, Mexico’s principal economic weakness is lack of investment capital, not just conventional debt financing, but even more importantly, equity capital. Mr. Fabre stressed this weakness when he had earlier pointed out that the 1994/1995 economic crisis virtually decimated Mexico’s banking industry. When the peso was devalued, loan defaults skyrocketed. Even today, according to Fabre, only the largest Mexican companies can qualify for a bank loan, which even for these few can take up to eight months or more to secure. For small and medium size firms, debt financing is virtually unavailable. And so far as equity capital is concerned, outside of a few instances, it is nonexistent.

In economics, weakness is the breeding ground of opportunity. This essential tenet was affirmed by Mr. Fabre’s contention that the inability to secure financial capital in Mexico today has little to do with the demand on the part of Mexican businesses for it, or their ability to pay. The problem is availability and access. Fabre believes that foreign investors, including large U.S. pension and other diversified mutual funds that were burned in Mexico’s last crisis, are still afraid to re-invest in Mexico. Their unpleasant memory of Mexico’s recent economic collapse, coupled with a prolonged downturn in the U.S. stock market, are viewed as the principal deterrents in preventing foreign capital, especially private equity capital, from returning to the country, not a lack of investment opportunity. This circumstance has created the same kind of capital imbalances that prompted Peter Brooke of Advent International to enter the private equity markets in Mexican in the mid-1980s. More will be said in the next section about the kinds of investment opportunities this circumstance opens up for new venture capital activity, as well as some observations about how these opportunities might be pursued. The main point to be made here is that, from a venture finance standpoint, this is an excellent time

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to be investing in Mexico, especially in economic markets and industries where the primary constraint on growth is inadequate access to capital.

STEP THREE: Develop Strategies for Managing Risky Assets

At this point, the class turned in the direction of Dr. Smith’s academic and professional expertise: strategies and methodologies for managing risky investments. Smith began by defining risk as uncertainty. The successful investor, he observed, is one who is not only able to make investment decisions that can reduce the level of uncertainty with respect to the inherent or relative value of a specific asset, but whose decision making process can actually result in maximizing returns on a risky asset. It should be noted that Smith is part of the academic movement in economics that has transformed equity investing from an art into a complex science. The principal achievement of this modern genre of economic thought has been the pioneering development of modern portfolio theory, an investment approach that evolved during the second half of the 20 th

century and which contends that the characteristics of an asset can be precisely measured and its true economic value enhanced by a well-managed, diversified portfolio of risky assets. Financial risk can be reduced, and long-term economic growth sustained, by an investment strategy based on investing small amounts of equity in many assets rather than investing a large amount of money in a few assets. Nobel prizes have been awarded to economists over the past three decades who have mathematically proven that this sort of diversification is the key ingredient for mitigating market risk, and the driving force behind consistent, long-term economic growth. Smith, for one, contends that modern portfolio theory, which has been deployed so successfully in developed economies, can also be successfully applied to emerging economies.

The techniques of risk management derived from modern portfolio and asset diversification theory are commonly referred to as “derivatives,” or “hedges.” Hedging strategies dominate today’s modern commodity and stock market exchanges. They can be thought of as insurance policies designed to limit the down side losses of a particular investment, while leaving open-ended its upside potential. The lexicon of hedging schemes or derivatives includes terms like forwards, futures, options, swaps and even more elegant contractual or market driven initiatives designed to limit and manage risk. Forwards are privately negotiated agreements to buy or sell a given asset that will be delivered at a later date at today’s price. A forwards contract entered into by a farmer, for example, might be used to hedge the risk that the price of a crop of corn will be worth less tomorrow than it is today. Futures contracts are standardized forwards contracts that can be bought or sold on a public exchange and secured by margin balances. Options are rights to buy (calls) or sell (puts) a forward or futures contract. Another type of hedge is a swap, or an agreement between two parties to exchange future cash flows associated with a specific asset. An example of a swap would be agreeing to exchange the cash flows on a variable rate loan with those of a fixed-rate loan. In each case, these are techniques designed to delay, postpone, and, in certain instances, even abandon risky investment decisions. Their purpose is to buy time for investors to obtain additional information before a final decision needs to be made regarding whether or not, and how

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much, to invest in a risky asset. They are designed to transform one’s thinking about investments as risky events to thinking about them as opportunistic activities.

Although portfolio risk management theories have been most widely used to manage risks associated with financial assets for which an abundance of high quality information is generally available, attempts have also been made to apply these theories to certain operational aspects of a specific investment choice for which less perfect information can often be obtained. According to Dr. Smith, one of the more promising of these attempts is an approach that economists call “real-options,” which involves the application of financial hedging tools to such areas as new venture investing, where little (and usually no) meaningful historical information is available to derive an estimate of the value of an economic asset. Two of the assigned Harvard Business Review readings dealt with this approach. One, written by two Harvard researchers, Martha Amram and Nalin Kulatilaka titled “Disciplined Decisions: Aligning Strategy with Financial Markets,” asserted that real-options has become one of the most powerful decision-making tools available to corporate managers who need to make investment decisions about the value of risky assists.16 In brief, here’s how the approach works. Instead of approaching a new investment decision as an all or nothing proposition, as do conventional net-present-value approaches to valuing risky assets, a real-options approach seeks to divide the decision-making process into a series of discrete, well-defined stages. At each stage, a decision can be made by investors either to continue to invest in a given project, or to modify, or even abandon, their investment. The value of this approach, paradoxically, is that it transforms risk from a negative into a positive characteristic, and, in so doing, accomplishes what a well-hedged investment strategy is supposed to do: allow investors to protect the full upside potential gain in the value of their investment while limiting their potential downside losses.

So be it for the theory of risk management strategies. The question is can they actually work in emerging economies, and, if so, where and how can they be best deployed? While hedges and derivatives have been shown to be tools that can effectively manage risks in developed economies, their application is still unproven in an emerging economy environment where the magnitude and the unpredictability of risky events loom large. In the case of Mexico, for example, while investors can hedge against the devaluation of the peso by investing equally in firms that both benefit and suffer from currency shifts, one wonders whether there is really any positive economic value created by pursuing these sorts of trade-offs. Moreover, there is no amount of financial hedging that can protect risky assets from the kinds of devaluations that frequently afflict emerging economies like Mexico’s without any apparent warning and at a moment’s notice.

There probably are warning signs, and certainly a better job will have to be done to detect and react to them. But the real challenge of creating a risk-tolerant investment strategy for successfully investing in emerging economies is not to predict the next economic collapse; it is to figure out how to avoid it. While there may be no effective

16 Amram, Martha, and Kulatikaka, Nalin, “Disciplined Decisions: Aligning Strategy with the Financial Markets,” Harvard Business Review case study, 1999, pg. 104.

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financial hedging tools for overcoming a fifty or sixty percent peso devaluation if you are an investor in a Mexican company that relies heavily on foreign imports, there are hedging approaches, including abandonment options, that can be deployed to protect investors from the worst things that can go wrong. The business challenge, in addition to investing in good people with great ideas, is to focus investment activity on economic markets that operate outside of the country’s main economic weak points while at the same time possessing prospects for significant long-term growth. In the case of Mexico, this not only means concentrating on the financial services arena where, as noted earlier, great capital imbalances and opportunities reside. It also means investing in these opportunity-rich market sectors in ways that can both mitigate investment risk and strategically stimulate economic growth.

A Risk-Tolerant Investment Approach for the Financial Services Sector

There are basically two ways to go about making equity investments in the financial services market sector. One way is to directly invest in a bank, or any direct supplier of financial capital. This is the usual way of investing. This is what U.S. Citigroup did, for instance, on a very large scale when it bought Mexico’s Grupo Financiero Banamex-Accival a few months ago. The way to make money as a bank, as we know, is to charge fees and collect interest rates on loans made to individuals and businesses. This can be a good business in a country like Mexico where interest rates have been averaging fifteen percent and higher. The financial arbitrage opportunities available to financial service organizations that can secure an loan funds in low-interest rate U.S. dollars and collect interest payments in pesos at prevailing domestic Mexican interest rates can be huge. Supposing that one is available, the hedging instrument to accomplish this arbitrage might be a forwards or futures contract, of even a swap. The problem with this apparent high margin business opportunity is what can happen to it in the event of a major devaluation of peso. The scenario that follows is a typical one. First, domestic borrowers begin to default on their loans once they discover that their loan payments, denominated in pesos, have increased beyond their ability to pay. This means that the local Mexican bank from which the loan was obtained no longer can keep up with its debt payments to its U.S. banking partner and is forced to default. Since it is the deep pocket, the U.S. banking entity gets stuck with a portfolio of non-performing loans. While the foreign bank can afford the loss and will end up taking a tax write-off and recouping its losses by charging its other customers more, it will think twice before ever making a new investment in Mexico. If it had been a venture capital fund that had invested in this arrangement, it probably would have lost its entire investment. The direct investment approach can be extremely risky in an emerging economy like Mexico.

The way around this problem, in economic terms, is to hedge the original underlying investment. Instead of investing directly in the source of financial capital, the bank, why not invest in an entity that, while it may be related to the underlying asset and to the owner of that asset, would be immune from the adverse consequences that can occur from a breakdown in the economic system, including a major currency devaluation? So far as opportunities in the financial services sector are concerned, this might mean investing in a commercial loan brokerage business that would serve as an

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agent between banking enterprises either in Mexico or the United States and local Mexican businesses. This new brokerage business needs working capital in order to hire sales agents who will solicit loan business from the underserved local business market. It has already secured agreements with foreign banks and other lending institutions to become their exclusive agents in the Mexican marketplace. It has reached agreements with its capital finance partners to receive a fee from them for soliciting and servicing local business customers on their behalf. The investment decision, in this case, is as simple and straightforward as the business itself. Because it is an agent, the new business avoids incurring any significant risks associated either with the underlying economic asset, the loan, or with the provider of that asset, the foreign financial services entity. This is not to say that new business would be immune from macro-economic conditions, including a major currency devaluation sexenio. It just means that even if its income drops to zero during a given crisis period, there will be no underlying liability that might threaten the long-term viability of the business. The prudent investor might simply build an income of zero into the business model every sixth year. Instead of going out of business sexenio, perhaps the entrepreneur could, like a college professor, take a sabbatical year to learn something new that might help his business grow more in the future. In an economic environment as capitally imbalanced as Mexico’s is, this type of business model makes sense from a real-options point of view, since it is built by taking small, strategic steps, each designed to create the conditions and framework for rapid, widespread, sustained economic growth.

It is not difficult to imagine the many ways this derivatives-based, real-options approach to venture capital investing can be applied to emerging economies. Nor is it hard to imagine how it could be implemented quickly and on a broad scale. Staying within the financial service sector, equipment leasing is another obvious example of where this risk-tolerant business model could be applied. Mexican businesses at all levels need to modernize now in order to compete in the future, not only internationally but, perhaps more importantly, domestically. They will need new technology and state-of-the-art equipment to succeed. Since this equipment will probably have to be leased, a new opportunity has now opened itself up to the young Mexican entrepreneur that was funded earlier to broker working-capital loans. Now this ambitious entrepreneur can explore the possibility not only of becoming an agent for equipment leases on behalf of its existing clients, but also of expanding his business to include foreign equipment leasing companies who may see opportunities for doing business in Mexico. The same marketing network the entrepreneur has already created to sell general business loans can now be leveraged to distribute an assortment of financial products and services, including equipment leasing. This is one way that capital resources can be quickly spread throughout an emerging economy at minimal investment cost and risk.

It can be argued that these ideas for venture financing do not conform to the customary uses of venture capital that have evolved in developing economies, where VC firms are renowned for investing in high-tech ventures. But there are numerous examples where successful venture capital investing has occurred in non-high-tech industries. The main interest on the part of venture capital investors is not in technology per se, but in rapid growth opportunities in large market segments. In the case of Mexico, however,

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some the greatest investment opportunities may reside in a business category that sits somewhere between the high-tech and business service sectors, namely, outsourcing, a variant of the financial brokerage model. Business outsourcing consists of providing a complete turnkey solution for a particular business activity, typically involving a company’s telecom and computer data requirements, its administrative and payroll needs, or some other non-core business function. The basic proposition for outsourcing has been that firms need to be as technologically up-to-date and operate as efficiently as possible in today’s rapidly changing business environment, and that the best way to achieve this operational competitiveness is to contract out non-core aspects of their businesses to firms that have specialized knowledge and expertise in these particular areas. Business outsourcing has been widely practiced in the U.S. and elsewhere over the past two decades, although it’s popularity has begun to wane in recent years, especially in the aftermath of the dot-com meltdown. While its primary selling points are based on performance, the key benefits it offers emerging economies like Mexico are financial. Without having to invest in any equipment or technology, outsourcing allows customers to access state-of-the-art products and services on a transaction-based, pay-per-use basis. In the case of general public, this might mean the ability to pay for the use of the Internet at a local Internet Café. In a business environment, it could mean obtaining a wide assortment of computing and telecom equipment-based services that might be otherwise unaffordable, and even unleasable. Outsourcing also makes good investment sense. Not only can investors use the equipment and technology upon which outsourced services are derived as collateral for their invested capital, they can also look to the cash-flow generated from an outsourcing business as additional security for their investment.

STEP FOUR: Locate Capital Resources and Develop Harvesting Strategies

Based on the foregoing, it appears that the prospects both for sustainable growth and high financial returns in Mexican economic markets may be pretty good. This is certainly true from the demand side of the economic equation. The problem, however, is on the supply side, which governs the ability of private equity and venture capital investors to take advantage of harvesting opportunities. Capital imbalances, as noted earlier, are two-edged swords in emerging economies. While, on the one hand, they create an environment that is extremely growth friendly, they pose a serious challenge for harvesting investments. It can be argued that a venture capital fund does not necessarily have to rely on harvest events to be successful. If the companies it invests in are solid, profitable businesses, it is quite possible to achieve high rates of return for investors from the positive net income generated by its portfolio businesses. This is an approach often pursued by later stage private equity funds. But it is not how a venture capital fund is designed to work. Nor is it the best way to take advantage of the real value of true new venture capital investing. A venture capital approach is based on investing in individuals who have the ideas - and the talent - to create businesses that have the potential to accelerate economic activity in large and dramatic ways. Venture capital managers seek to make investments that can produce large multiplier effects. They know that most of their investments will fail. They also recognize that, if they are doing their jobs properly, the new businesses they create will probably be cash flow poor for years. Venture capital

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funds don’t need to be cash flow positive; they need to be cashed out. This can be a difficult goal to achieve in an emerging economy.

The initial question that must be answered regarding the matter of exiting venture capital investments in emerging economies is where will the money come from. Given their undeveloped capital markets, the feasibility of relying on a domestic IPO is poor. Usually the only available route is an acquisition by or merger with an established domestic or foreign company. This path, too, has its limitations. Remember that venture capital funds are accustomed to selling the companies in their portfolios for extremely high multiples, and that these premium prices usually demand the presence of a large number of qualified buyers competing to keep the price of new ventures high. This process involves locating the most qualified buyers in a given market, identifying what their business needs are, and determining what they would be willing to pay for a particular purchase. This is a relatively easy process in the U.S. and other developed economies where there are usually large pools of qualified and competitive buyers in the market, along with large numbers of investment bankers and other financial entities available to assist in the process. It’s a much more challenging task in an emerging economy, where the gross national product is small and barely growing, and where what wealth does exist is highly concentrated in a few institutions. In a situation like this, not only are investors dealing with an asset base that is small, but they are also operating in an environment where the pool of qualified buyers is also small. In this regard, Mexico appears to be no different than most emerging economies. Its domestic wealth, too, resides in a highly concentrated business sector. Mexicans refer to members of this elite business community as grupos, uniquely Mexican-style conglomerate business forms that are comprised of focused family-owned and operated businesses. While the prospect of doing business with the grupos may involve some harsh negotiations and a significant challenge, because it represents a possible exit scenario, it must be addressed. The Mexican Grupos

In order to gain a proper perspective on the economic role that the Mexico grupos may be able to play as potential business partners, it would first be helpful to understand the latest economic thinking regarding the role that conglomerate businesses perform in emerging economies. Understanding this perspective is important, especially since conglomerate forms of business, once popular in the 1960s and 1970s, are now out of favor in the U.S. and in most other developed economies. Ideas like decentralization of the firm, a focus on core competencies, and other methods of enhancing productivity have become the driving forces behind corporate growth strategies in Western economies. Yet, many economic experts contend that the conglomerate business form has an important role to play in the economic growth of emerging economies. Two Harvard Business Review readings assigned by Dr. Smith made and attempted to support this assertion. They were based on research conducted by two Harvard Business School professors, Tarun Khana and Krishna Palepu. In both studies, these researchers found that conglomerate forms of business can help promote sustained economic growth by providing a strong “institutional context” that is frequently missing, or at least severely lacking, in emerging economies. Like the chaebols of Korea and the business houses of

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India, the grupos of Mexico, they contend, “add value by imitating the functions of several institutions that are present only in advanced economies.”17 In the absence of well developed product markets, a lack of trained managers, and weak capital markets, a highly diversified business group can help bridge the gaps and fill the institutional voids that plague emerging economies and make doing business in them so volatile.

Several Mexican grupos were examined, both in class lectures and in the assigned readings. These included Grupo Vitro, a large consumer products conglomerate; Grupo Porcicola Mexicano, a vertically integrated commodity business; and Grupo Sidek, a holding company that operated two concentric, vertically integrated, albeit unrelated, business conglomerates – a steel manufacturing business and a real estate/tourist industry business. These businesses and many others like them had emerged during Mexico’s period of one-party PRI rule. Most had been created since WWII, when the PRI began investing in the infrastructure needed to support the development of the country’s emerging oil export business. Up until the mid-1980s, when free trade restrictions began to lift and privatization initiatives rise, these family-run enterprises had flourished. However, in the 1990s, with the passage of NAFTA and the takeover of the PRI by its technocratic wing, pressures started to mount for these Mexican-style concentric oligopolies. No longer protected by high tariffs, stiff foreign quotas, and other import substitution policies, the grupos were forced to compete on their own against U.S. and other large international businesses. While a few have succeeded and remain autonomous (CEMEX, the 4th largest cement manufacturer in world, for instance, has become a full-fledged transnational corporation with exports all over the Americas and Europe), most of these enterprises have struggled. Some, like the country itself, almost went bankrupt and were forced to sell off valuable assets. Others, like FEMSA, the world’s single largest Coca-Cola distributor and former employer of President Fox, have entered into an assortment of partnerships with foreign firms in order to survive. The problem for the grupos is the same faced by the entire country: lack of access to capital. This common cause may make the grupos important partners in devising and implementing a venture capital finance approach for promoting widespread, sustained economic growth. One of the assigned case studies offered insights about what might constitute the basis for such a partnership, how it might evolve, and what benefits might result. It dealt with Grupo Industrial Bimbo, Mexico’s leading bread manufacturing and distribution business.

The Case of Grupo Bimbo

Grupo Bimbo is the Wonder Bread company of Mexico. It fits the mold of the typical Mexican grupo. It is vertically integrated in one business sector, in this case bread. It operates more than seventy-five plants, mostly in Mexico, but also others in the U.S., Argentina, Brazil, Columbia, and several other Central and South American countries, that manufacture over 750 unique bread products for the Mexican, U.S., and the Latin American markets. In Mexico, it also owns more than 25,000 vehicles that distribute its products to more than 400,000 clients on more than 12,000 routes traveled weekly, giving the company one of the most extensive product distribution systems in the

17 Khanna, Tarun, and Palepu, Krishna, “Why Focused Strategies May Be Wrong for Emerging Markets,” Harvard Business Review, July-August 1997, pg. 3.

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country. In 2000, the company achieved revenues of more than U.S. $3 billion, up considerably from the $1.8 billion it had achieved in1994 when the Harvard Business Review case study on it was published.18 This growth can be attributed to both internal expansion and the company’s aggressive strategy of acquisitions and business alliances. Yet, while Bimbo has obviously come a long way since it was created in 1945 by Lorenzo Servitje, its current president, Roberto Servitje, Lorenzo’s son, has expressed concerns about the company’s future ability to compete in the new competitive economic environment created by NAFTA and earlier free trade initiatives. These concerns, which were chronicled in the 1994 Harvard Business Review case study on the company, are worth reviewing here because they point to opportunities that were then, and presumably still are, available for venture capital investors and existing Mexican businesses to work together for their mutual financial benefit.

In looking to the future, Mr. Servitje was not concerned about his own company. He had invested heavily to modernize Bimbo’s plants and manufacturing processes. He believed Bimbo itself was internally strong enough to compete with the highly efficient, well-capitalized U.S. and other international competitors, such as PepsiCo, Ralston-Purina, Nabisco, and Campbell Taggart. His concern was the country, especially its inefficient agricultural sector. The primary raw material required to manufacture Bimbo’s bread products was wheat. For years, the company had purchased wheat from Mexican farmers through a government-trading agency that was responsible for handling all necessary transactions for the wheat the company purchased from Mexican farmers. While the quality of the wheat was not always consistent, the prices were. But in 1992 this government-purchasing agency was dissolved in a government cost-cutting campaign. This meant that Bimbo had to develop its own relationships with suppliers and create its own infrastructure to manage its input sourcing needs. In the short run, the company would have to increase its imports from Canada and the U.S. While this foreign wheat was superior in quality to that produced in Mexico, it was expensive, especially its transportation costs. The company believed that the long-term solution lie in upgrading the country’s agricultural capability. Not only would this cut its transportation costs, but, as Roberto Servitje was quoted at the time, “it would also contribute to the social and economic development of Mexican farmers.”19 In order to improve the quality and reliability of its raw materials, the company began to backward integrate into several areas of agricultural production, making a series of investments in wheat, strawberry and broccoli production facilities. The message Bimbo was sending to Mexican farmers was clear: Mexican agriculture had to improve if Bimbo was going to be able to effectively compete. The message it was sending to private equity investors was equally as clear: bring us a good idea that will improve the quality, supply, and distribution of our raw materials, and we will buy it – the product and even the company.

It is with a certain amount of trepidation that the suggestion of doing business with Grupo Bimbo or any Mexican family-owned conglomerate is offered in the context of - or to anyone interested in - socially responsible new venture financing. The Mexican

18 Nimrocks, Walter, MBA ’94, “Grupo Industrial Bimbo S.S. de C.V.,” Harvard Business School case study, November 14, 1994, pg. 5.19 Ibid., pg. 8.

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grupos, after all, represent the country’s closed elite business power structure. To many, these enterprises are viewed as barriers to any real economic progress in Mexico, not as solutions to the country’s problems. But this is a new day in Mexico. Its business elite must now compete head-on with formidable U.S. and international firms. The political juggernaut has been, if not unhinged, at least shaken. Gone, too, are many of the government support mechanisms that used to help Mexican big business get by in tough times. Because of the times, today these enterprises find themselves in the same boat as everyone else in the country – standing alone, looking for new ways to compete, for new markets to enter, for better ways to attract and serve customers, in short, for new ways to survive and grow. Their own survival will depend both on the creation of an economically strong Mexico and on their ability to help develop and make use of the country’s vital tangible natural and intangible human assets. For this reason, they, too, need to be included in discussions regarding how venture capital financing might be used in Mexico to promote sustained economic growth.

SUMMING UP AND LOOKING AHEAD

This discussion started with a question about whether or not the U.S. venture capital model for creating economic wealth can achieve the same results in developing countries, or what have been called “emerging economies.” This question arose out of concerns about the effectiveness of conventional U.S. financing methods used over the past twenty years to combat poverty – private gifting, government aid programs, and, more recently, small interest-bearing loans to individuals and small community groups. While the old methods have and continue to work, as evidenced by the benefits they provide their recipients, the problem that these approaches were targeted to solve has escalated far beyond their original purpose and scope. The economic gaps both between and within nations of the world continue to widen at an ever-increasing rate. Concerned Americans like Rev. Knowles and others who have devoted their professional lives to fighting world poverty recognize that new approaches will be needed to deal with this reality. What they want to know is what all people concerned about this problem want to know: how can this trend be reversed, and can the U.S. economic model of promoting and financing entrepreneurial business activity play a role in reversing it? This is the question that will be addressed at the upcoming conference that is being hosted by the Venture Finance Institute of the Claremont Graduate University on September 26-27. It is also the question that this discussion paper considered, at least partially.

Economically speaking, the answer to this question is a resounding “maybe.” True, the case of Advent International proved that the U.S. venture capital finance model works. Plus, it identified several important components of the model that are essential for making it work properly, including a strong management team, a strong network of influential local partners, and an investment strategy that appeals to and rewards highly diversified investors. But the problem with Advent is that it was already a highly diversified investor. Emerging economy investments represented only a small percentage of its portfolio of investments. Its performance, therefore, would not be a good predictor of success for a less diversified entity whose investment activity would be focused

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exclusively in emerging economies. Recognizing this weakness, the discussion turned to the subject of risk management and a look at some of the latest research findings available regarding the best way to invest in and manage risky assets in emerging economies. A methodology for developing a risk-tolerant investment strategy expressly for emerging economies was outlined, based on a Peter Drucker School of Management MBA course that was held in Mexico City in March 2002 in cooperation with Anahuac del Sur University. The analytic framework of this methodology called for defining economic markets, competitive strengths, and strategic opportunities. It also included a review of the arsenal of risk management tools that already exist, and an examination of the ways these tools could be applied for making investment decisions that could lead to rapid, widespread, sustainable economic growth in an emerging economy. In the end, special attention was focused on the complications that exist in harvesting private investments in emerging economies. Some specific harvesting approaches were discussed, plus ways to locate others were suggested. Some may consider the proposals outlined as too radical, while others may see them as too limited. They are probably both. Plus, whether any of them have any realistic chance of ever being implemented or working is an open question. These approaches, like many other points touched upon, require much further discussion and debate.

The selection of Mexico as the test country to use for applying the concepts of economic growth and other fundamental questions raised turned out to be an excellent decision. Mexico contained all of the conditions that needed to be dealt with in order to develop a risk-tolerant investment strategy for promoting rapid, widespread, sustained economic growth in emerging economies. It is an economically poor country. Business in the country is controlled by large, bureaucratic, family-owned conglomerates that have struggled to keep pace with the myriad of changes that had transpired over the past two decades in the global marketplace. Because it is a nation of great wealth at the one end and great poverty at the other, it lacks an adequate domestic market, i.e., a middle class. This has forced the country to look outward for sources of new and sustained income, a circumstance that has left it vulnerable to periodic, catastrophic economic collapse. For sixty years, the country had been governed by a corrupt, one-party political system that had not only institutionalized the country’s cycle of poverty, but also had mortgaged its future through the sale of valuable national assets in order to pay down a mushrooming national debt. These were the conditions of a broken economic system. They resemble conditions resident in virtually every poor country of the world. If the U.S. venture capital approach to sustained economic growth could help reverse these conditions in Mexico, did this mean that it could do the same thing elsewhere?

While it may be too early to know if Mexico can be a good beta test for the hypothesis that the U.S. venture capital method of financial investment can spearhead economic growth in emerging economies, there can be little doubt that what makes Mexico an excellent place in which to conduct a trial is the country itself. The election of Vicente Fox in 2000, which ended the country’s one-party rule, signaled that Mexico recognized the need to make drastic changes. While exactly how fundamental and long lasting these changes will be is yet to be seen, there can be cause for optimism by simply knowing that positive change can occur. Not only can it occur in the political arena, but,

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as this discussion paper has tried to point out, it can take place on a wide assortment of economic fronts as well. Mexico, as has been shown, is a country rich in opportunities. The challenge for investors interested in taking advantage of these opportunities will be developing new perspectives and approaches for identifying precisely where they exist, learning how to invest in talented entrepreneurs who have great ideas about how they can be turned into strong businesses that can employ large numbers of people, and establishing partnerships with local businesses that can lead to profitable harvesting events.

In the end, Mexico may have just as much to teach the U.S. about what is necessary to truly achieve sustained economic progress than it has to learn from its northern neighbor. America was rocked by the events of 9/11 when the unthinkable happened. While the military response in the wake of these events has been predictable, what was so unpredictable, at least at the time, was the event itself. Even now few Americans really understand the message that was being sent from a remote and alien region of the world. It was the same message Mexico received on New Year’s Day, 1994, when a group of indigenous Indians in the southern state of Chiapas led a well organized guerilla movement that toppled the local government and served warning on an unsuspecting Mexican nation that all was not well in the hinterland. What the people of Chiapas, like millions of other Mexicans, were saying is that they wanted into the system. They wanted access to real financial resources and they demanded to participate in decisions about how these resources would be spent and administered. The government’s initial response then, too, was repressive, which only strengthened support for the guerilla movement and perpetuated the violence. Only time can tell if a new and different approach will succeed in addressing the political and economic needs of the people of Chiapas. Chiapas is, after all, a “cluster” of Mexico’s extraordinarily creative and talented artists and artisans. This makes it a potentially valuable economic asset. If Mexico can find a way of closing the economic gaps that exist between the rich and poor within its own borders by making productive use of the talents of its own native populations, it will have something important to report to the world. If the U.S. venture capital model of entrepreneurial initiative and private investment can help close these gaps, then it may have an even more powerful message to deliver. Hopefully the discussion begun here can stimulate serious thought and planning about what can be doneto make this happen.

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ABOUT THE AUTHOR

Andrew Horowitz is a former entrepreneur and presently an angel investor living in Southern California. He also mentors young entrepreneurs

interested in starting new telecommunications service businesses.