Venture Equity in Latin America: Impact of US Credit Crisis

Venture Equity Latin America (VELA) recently discussed and listened to presentations on the impact of the US market and credit crisis with a number of key executives involved in Latin America PE/VE at a conference, and most agreed that U.S. economic weakness won’t have a major impact on venture equity in Latin America.
“I’m optimistic” about Latin American venture equity, said Juan Carlos Torres, senior partner at Advent International, a major private equity firm in the region. “I’ve been through so many Latin American crises that this is nothing.”
Steven Puig, vice president of private sector operations for the Inter-American Development Bank said he is “optimistic” about the Latin American economy for the same reason. “We’ve likely seen worse homegrown crises in the past and absorbed those. Dealing with an external crisis is something that could be more manageable.”
Most financial institutions are still liquid and with the level of venture equity funds raised for Latin America so low, there’s plenty of room on the upside, Torres said. While private equity funds raised $60 billion to invest in Asia over the last three years, they took in only $7.6 billion for Latin America.
“Many financial institutions are looking for other markets than Asia, so there is a lot more focus on Latin America,” Torres said. “We had more visits from financial institutions in the last year than in the previous 11,” he said.
There are several good reasons for venture equity investors to choose Latin America over Asia, said Bernard McGuire, director of private equity for the Overseas Private Investment Corp. (OPIC).
One he specified is that it’s easier to put a hedge on a Latin American investment than one in Asia. For example, in Latin America, investors can buy convertible notes, while in India and China they can’t, McGuire said.
Advent certainly isn’t having trouble telling investors the Latin America story. The firm was able to draw $1.3 billion in three months last year for its latest fund, which was heavily oversubscribed, Torres said. That fund drew about 60 percent of its investors from U.S. financial institutions and the rest from Europe and the Mideast.
Advent has seen strong demand from sovereign wealth funds in Asia and the Mideast, Torres told VELA. “About 20 percent of our investors came from there over the last year or two, and I think that will keep growing.”
He said Advent likes to choose its deals by sector. “The advantage of that is you get scale, accumulate knowledge and, most importantly, learn from your mistakes,” he said.
For example, Advent has closed 11 deals in the airport sector during its 12 years in Latin America, Torres said. Those deals covered retail shops in airports, food and beverage operations and airport concessions.
In exiting those investments Advent earned a return ranging from 82 percent for the food and beverage deals to 968 percent for the retail deals.
Other sectors in which Advent is active include financial services and retail, Torres told VELA. And the firm is looking at the energy industry. Why? “It’s a key sector in Latin America that is still fragmented,” he said. “It’s not controlled by large multinationals, so there are opportunities for consolidation.”

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Taxation of Management Fees in Latin America

Latin American subsidiaries of US companies are caught in a bind. Parent companies in the US are being required by transfer pricing rules to charge foreign subs for services, but Latin American tax authorities often don't accept the service fees as deductible business expenses.

A recent article in Practical Latin American Tax Strategies, published by WorldTrade Executive reviews the tax deduction for management services in the major countries and provides some suggestions for ways to meet the deductibility tests. The article was prepared by some of the members of the Latin Tax practice at PricewaterhouseCoopers.

For example, for Brazil the authors note the following:

Expenses recognized by a Brazilian entity are deductible for tax computation purposes if:
1. actually incurred;
2. ordinary and necessary to conduct the business activities of the company; and
3. properly and adequately documented.

In the context of service fees, expenses will only be considered as actually incurred when the services (and related benefits) have been in fact received by the Brazilian Affiliate. In prior decisions, the Brazilian tax authorities and local courts have repeatedly ruled against the deductibility of expenses deriving from intercompany service agreements (particularly those related to cost sharing agreements) due to the lack of proof that the services and related benefits had actually been received by the Brazilian entity. It is indisputable from these cases that the mere documentation that the services were contracted, assumed and paid was not considered as sufficient proof.

Moreover, it should be noted that sufficient documentation is essential to substantiate any claims that the expenses are ordinary and necessary for the maintenance of the company’s activities and source of income, especially in the case of international intercompany service agreements.

For deductibility purposes, the Brazilian Affiliate will have to prove that it actually received an identifiable benefit from each of the charged services listed in the corresponding agreements. In this regard, Brazilian tax authorities may question expenses related to services provided to all beneficiaries of the group (such as the “Allocated Services”), if such expenses only result in benefits for certain Affiliates and do not clearly include the Brazilian Affiliate. That service fees paid to related companies abroad are often subject to special scrutiny by the tax authorities.

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