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Letter from Latin America, Dirk Donath, Pegasus Venture Capital

The news coming out of Latin America hasn't exactly been too good for some time. Argentina has been in a recession for three and a half years. Brazil hasn't looked positive for the last six months. And now Mexico, which had been in forging ahead because of its ties with the US, is sharing its neighbour's downturn. Many people must be wondering what happened to the promise that Latin America held for investors in the early 1990s.

That promise hasn't disappeared. There's no doubt that the Latin American market is risky. It's even more risky if you're an early-stage investor, as we at Pegasus are. It can be a rough place to be. But despite all the challenges here, there have been a series of underlying changes that make the Latin region an extremely good medium to long-term proposition.

The later stages of private equity have been an exciting proposition here for several years now. The interest started with the mass privatisation programme that occurred in the late 1980s and early 1990s. Before that, private institutional investors didn't really exist, but more recently, you have had some of the big private equity names jostling for position. There are now large financial institutions (eg, Deutsche Bank and JP Morgan), international funds (eg, Hicks Muse Tate & Furst) and several local funds, (eg, Exxel Group, GP Partners). They have been taking advantage of the many family business owners deciding to cash out of their companies. What we haven't seen to a large extent this far is the ‘filtering down' into earlier stage venture capital investing.

And that's what we target and arguably what Latin America in general really needs. We'd love to see more pure venture capital players enter the market. By that I don't only mean large firms dabbling in VC. The last couple of years saw several big funds and big names dipping their toes into the venture capital waters here. Of course, we saw the dot.com euphoria here as well. Similar to firms in the US and Europe, they were tempted by the promise of huge gains to be made in technology and internet companies. But they have now pretty much retreated, having been badly burned by the subsequent fall-out. These larger firms just aren't set up to invest smaller amounts of capital and spend lots of time and effort helping companies to grow. They are structured to do larger, later stage deals, so it's hardly surprising that they had limited success in this type of earlier stage investing.

The Latin region needs dedicated investors and managers who can devote time and management experience to their portfolio companies as well as capital. There is some early-stage money available here, but it tends to come from angels, families or corporates. They provide some much needed capital in the absence of ‘classic venture capital'.

I am convinced that the emerging small and medium-sized companies will be the engines of growth in Latin America and venture capital funding will be instrumental in this. It's a similar situation to that of the US post World War II and again in the early 1990s. The Fortune 100 companies didn't really drive the economic growth in those periods. It was the new companies that forged ahead. Here, in Latin America, there are new entrepreneurs with some fantastic ideas, many of whom have MBAs from top schools in the US. They have world-class skills and they're returning to Latin America to take advantage of the post-privatisation economy. They want to do things in new ways. They want to break the rules and shatter the old state-led and hyper-inflation mentality. Until recently, the best managers typically went to the US, worked in some of the multinationals and global banks or consultancies and then returned to run family businesses. The opportunities that exist today just weren't there. Success depended on who you knew and contracts were awarded on the basis of contacts. Now, good managers can return, use their entrepreneurial flair in a much more fair market and take advantage of deregulation, globalisation and new consumers. Latin America is a huge market that has been under-served and in the medium to long-term will offer huge growth and potential.

Yet there is still one large hurdle for these entrepreneurs: funding. In the US or Europe, companies that have been in existence for a while can usually gain bank financing. Here, the scale of the government debt implies that even large companies find it virtually impossible to obtain bank credit loans. Besides, the interest rates are prohibitively expensive - they're in the range of 25 to 30 per cent or more. Governments, beleaguered with budget deficits, are limited in what they can offer to sponsor small business activity here. So even if you're a company that has existed for a few years, has cash flow and sales, your opportunities for capital are very limited. I have seen a lot of very promising young companies with some great prospects go to the wall because they can't get funding to take them to the next stage. We are seeking to fill that vacuum.

There's no doubt that the opportunities for venture capitalists are here, but it's not an easy market. The macro-economic environment makes things difficult. And exits are not always immediately evident. There is no robust public equity market - Argentina's public market is even shrinking as many companies have recently been de-listed. There are plans to develop a Nasdaq-style market in Brazil and this will help exits, but that is several years off. Strategic buyers, such as multinationals in the region, are really the most viable exit option. Persuading institutional investors to enter this risky market is a challenge, as well. You have to target people who fully understand the business and economic risks involved and who have an appetite for those risks. But I am convinced that, for the right venture capitalists, there are some exciting opportunities in Latin America in a range of sectors. I would encourage them to at least take a look so that together, we can help the region's economy grow and build a professional Latin American venture capital industry.

Dirk Donath is managing director and founding partner of Pegasus Venture Capital. He was a partner in the Mercosur office of McKinsey & Co in Buenos Aires and has co-founded various enterprises, including FarmaCity, a chain of retail pharmacies in Argentina. Pegasus Venture Capital focuses on high growth companies with new ideas in Latin America.