Implications of the Current Business Environment for the Nascent PE Industry in Colombia

Andrés Cadena, McKinsey & Company

Colombian Private Equity & Venture Capital Seminar

2

MAIN MESSAGES

• Leading up to mid-2007, the growth of the PE market was fueled by a flood of capital and easy lending standards. However, liquidity dried up following the credit crisis, causing the buyout markets to collapse

• General Partners will concentrate in the short term in turning around troubled portfolios and in taking advantage of distressed assets. In the mid term the industry will return to fundamental-based deals (smaller, less leveraged, longer holding periods)

• The nascent PE industry in Colombia could take advantage of the current market conditions to leapfrog other economies. However, it is critical to take immediate actions on regulation, infrastructure and, moreover, education of both GPs and LPs.

3

IN THE PAST YEARS THE PE INDUSTRY EXPERIENCED UNPRECEDENTED GROWTH

* Funds raised in the previous five-year period, by vintage year** Rest of the worldSources: Private Equity Intelligence; PreQin, press search; team analysis

238 266

400

584

14

135

387

2004

26

173

465

2005

39

228

667

2006

58

275

Europe

918

U.S.

+33%

2007

ROW**

CAGR %

61

27

35

164

146

107

195

117

Q1 Q2 Q3 Q4 Q1

“Global PE fund-raising in Q1 2008 reached $163.5bn, the second highest in the history of PE”– PreQin 2008

2007 2008

Global buyout assets under management (AUM)*$ bn

Global funds raised$ bn

4

FUELED BY A FALLING COST OF CREDIT

*Spread denotes industrial B-rated bond index over swap ratesSources: Bloomberg; team analysis

High-yield spread over swap rates*Basis points

150

200

250

300

350

400

450

500

550

600

650

700

2007’06’05’04’03’02’012000’99’98’97’961995

184 basis points

639 basis points

5

PRIVATE EQUITY BECAME EXTREMELY LEVERAGED

Private equity leverage multiples* Estimated hedge fund leverage**

4.0x

2002

4.6x

20042003 2007

4.8x5.4x5.3x

6.2x

2005 2006

*Source: Morgan Stanley, September 2008**Source: McKinsey, October 2007

3,51,1

0,9

1,5

Assets

undermanage-ment

Leverage

throughderivativepositions

Leverage

throughdebt

Total

leveragedassets

Hedge funds and private equity firms control ~$2.5 trillion of equity but borrowed several times this amount to fund their investments

6

0

10

20

30

40

50

60

HOWEVER, JULY 2007 BROUGHT A REVERSAL OF THE CREDIT AND LIQUIDITY GROWTH

Sources: Dealogic; team analysis

Main drivers of liquidity growth• Growth in financial assets

(e.g., equity, private and government debt, bank deposits)

• Increasing importance of private capital

• Entry of new investors in the market through innovative financial products (e.g., CDOs)

Triggers of liquidity crisis• Complexity and opacity of

subprime/CDO risk• Mispricing of risk• Aggressive pursuit of yield

Global CDO issuance$bn

Areas of contagion• Mortgage-backed

securities• Wholesale funding

market• Hedge funds• Private equity

Crisis onsetJuly 2007

Credit and liquidity growthCredit and liquidity crisis and contagion

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

7

*Total deal value includes both equity and debt**Average taken of disclosed deal values. May exaggerate actual average since deals with undisclosed value tend to be small

Source: Capital IQ

Avg. deal size**$ Millions

73

186213

38 55Mega Deals

(over $2bn)46

372401401

663611444

2005

Q Avg.2006

Q Avg.2007Q Avg.

Q2 Q3Q1

2008

Total value* of announced global buyout deals$ Billions

Announced global buyout dealsNumber of deals

321304164

RESULTING IN AN 80% DECREASE IN GLOBAL BUYOUT DEALS

118

8

48

76101

219

245

4653

81

188

278

244

284

2003 2004 2005 2006 2007 2008***

AN IN A DRAMATIC CAPITAL OVERHANG ($400 BILLION) THAT NEEDS TO BE INVESTED

Private Equity capital raised and invested$bn

*Assuming a 2:1 debt:equity ratio**EVCA (most accurate) figures for Europe not yet available. Alternative source used but this may understate the global total***Cumulative uninvested capital since 2003, capital committed pre-2003 is unlikely to be invested at this point; assumes that 1/3 of capital on the road will close in Q4NOTE:Overhang = Uninvested Capital

Sources: Private Equity Analyst, EVCA, AVCJ, Venture Expert. McKinsey analysis, PE Intelligence

Buyout Investments*

Buyout Fundraising

Capital overhang (cumulative since 2003)**

$393 billion overhang

5 10

97

156

9

RAISING NEW CAPITAL WILL BE THOUGH AS PENSION PENSION FUNDS WILL NEED TO REBALANCE PORTFOLIOSTypical LP allocation to PEPercent of total portfolio

*Footnote

Source:Press search, McKinsey analysis

ILLUSTRATIVE

1,0

2,0

1,5

1,00,5

2,02,0

Cash back

Startof2009

11.5

Cash called

9.0

12.0

10.0

8.0

Cash back

Start of 2010

Cash called

Pre-stockcrash

9.0

Cashcalled

Cashback

Start of2008

Denom-inator effect

Start of2007

PE

targ

et a

lloc

atio

n ra

ng

e

PE allocations rise due to fewer

distributions

PE share of portfolio rises

following collapse in stock values

Limited exit opportunities

reduce distributions

New allocations fall 50% to keep PE

within target range

10

MAIN MESSAGES

• Leading up to mid-2007, the growth of the PE market was fueled by a flood of capital and easy lending standards. However, liquidity dried up following the credit crisis, causing the buyout markets to collapse

• General Partners will concentrate in the short term in turning around troubled portfolios and in taking advantage of distressed assets. In the mid term the industry will return to fundamental-based deals (smaller, less leveraged, longer holding periods)

• The nascent PE industry in Colombia could take advantage of the current market conditions to leapfrog other economies. However, it is critical to take immediate actions on regulation, infrastructure and, moreover, education of both GPs and LPs.

11

DEALS WILL BE SMALLER

Private equity deals are smaller

134155

97143

171

519

294

422

251

2008 Q32008 Q22008 Q12006 Q3 2006 Q4 2007 Q1 2007 Q2 2007Q3 2007 Q4

*Source: Dealogic

Average deal size*$ millions

Credit crisis

12

THE CAPITAL STRUCTURE WILL REVERSE TO EQUITY LIKES

Private equity deals involve more equity - average equity contribution % of purchase price

40%

38%

36%

34%

32%

30%

28%

26%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H08

2Q08

Credit crisis

13

AND COST OF CAPITAL WILL RETURN TO LONG TERM LEVELS

Private equity deals involve less favorable debt terms Average spread of leveraged buyout loans* Vs Libor

450

400

350

300

250

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1H08

2Q08

Credit crisis

Source:Standard & Poor’s

14

MAIN MESSAGES

• Leading up to mid-2007, the growth of the PE market was fueled by a flood of capital and easy lending standards. However, liquidity dried up following the credit crisis, causing the buyout markets to collapse

• General Partners will concentrate in the short term in turning around troubled portfolios and in taking advantage of distressed assets. In the mid term the industry will return to fundamental-based deals (smaller, less leveraged, longer holding periods)

• The nascent PE industry in Colombia could take advantage of the current market conditions to leapfrog other economies. However, it is critical to take immediate actions on regulation, infrastructure and, moreover, education of both GPs and LPs.

15

FOLLOWING THE CRISIS, BUYOUT ACQUISITIONS SHIFTED TOWARD EMERGING MARKETS

43

56 60 6456

30 30

371

Q2 ’07

10

35

97

Q3 ’07

49

57

75

Q4 ’07

18

51

39

Q12008

ROW

Europe

N.A.

100% =

8

282

2005

6

37

720

’06

1210

31

169

Q1 ’07

10

26

82

61

83

6957

48

12

3120

25

17

87 16

7

35

5 5

’06

173

2007

0

7

2008

Middle East

Africa

Other

Asia

100% =

4

’05

24

2

’04

4522

3

2003

171

Sources: Capital IQ; Asian Venture Capital Journal (AVCJ)

Buyout investments in emerging markets$ bn

Announced global buyout deals, by region%, $ bn

16* Central Eastern Europe** LPs set the risk hurdle for U.S. PE investments at 16.3%Source: Emerging Markets Private Equity Association (EMPEA)

8,98,0

9,0

6,45,86,76,76,5

5,05,9

Emerging Asia

CEE+Russia

MiddleEast

LatinAmerica

Africa

2006

2008

4

20

5

43

68

30

40

11

57

83

52

65

35

75

89

Asia

CEE+Russia

Middle East

LatinAmerica

Africa

2006

2008

2013

WILLINGNESS TO INVEST IN EMERGING MARKETS GREW DUE TO HIGHER RETURNS AND FALLING RISK PREMIUMS

… and PE risk premiums** over U.S. investments have fallen%

Most LPs expect to invest in emerging-market PE by 2013% of LPs who expect to invest in emerging regions

Returns have increased in all emerging markets …IRR

8 12

19

0

39

25

57

30

EmergingAsia

All emergingregions

10-year returns

3-year returns

Latin America CEE* +Russia

Avg. U.S. PE returns range

17

RECENTLY, CAPITAL FOR EMERGING MARKETS HAS FROZEN AS VOLATILITY IS HUGE AND CRISIS IMPACT IS UNKNOWN

CEE Current Account Deficits* Lat. Am. Fiscal Balances Pro-Formafor Commodity Prices at 10 Yr Avg.**

-5.3

-18.2

United States

-22.0

-4.9

HungaryRomaniaBaltic States

Bulgaria

-13.7-2.0

Chile

-5.0

Argentina

-8.1

8.7

Brazil

1.1 1.8 1.7

Peru

-2.6

*Economist Intelligence Unit, 13 October 2008**Morgan Stanley, 30 September 2008.

2007 actual

2007 Pro-Forma

• Eastern European account deficits and Latin American commodity dependency are key vulnerabilities – Certain CEE countries will experience credit contractions, reduced investment, and slower growth– Latin American governments may have to raise taxes or cut spending as commodity related

revenues fall

18

IF COLOMBIA MANAGES TO NAVIGATE THE CRISIS, IT COULD BE IN A STRONG POSITION TO RECEIVE PE FLOWS

7,7Δ GDP

4,4Δ Private

consumption

1,1Δ Government

consumption

5,1Δ Gross fixed

investment

0Δ Stock

building

1,9Δ Exports

4,8Δ Imports

1,7

0,6

1,9

0,6

1,5

3,0

3,4

2007 2008 (Forecast)%, Change

* ForecastSource:DIAN-DANE; The Economist’s Inteligence Unit©, Oct 22th, 2008.

• How exposed are our exports to a slowdown in the US? In Venezuela?

• Which investments will hold?

• energy?• mining?• Industrial?• Infrastruc-

ture?

• What role could PE play in holding current investment rates? What has to be done to facilitate these deals?

19

WHAT ACTIONS SHOULD BE TAKEN IMMEDIATELY?

Can we create a more competitive tax structure for GPs and LPs? • Carryforwards• Retefuente• Ganancia ocasional• Doble tributación

Can we strengthen the regulation (articulo 2175) to facilitate/stimulate investments from pension funds and insurance companies?• Flexibilidad en clases de activos• Desregulación vs. Lavado de activos• Condiciones de contratación pública

Should the government incentive the industry? • Cómo LP?• Cómo GP?• A través de políticas industriales?• Articulando inversionistas?• Generando economía de escala?• Predefiniendo proyectos infraestructura?

Is it feasible to accelerate the creation of top quality GPs?• Co-inversiones• Definición de conflictos de interés• Gobierno Corporativo• Procesos operativos claros• Certificados para GPs

NON EXHAUSTIVE