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Venture Capital in Mexico: Lessons Learned from The North

American Environmental Fund (NAEF)

A white paper prepared by Endeavor1.

Disclaimer: Endeavor is responsible for writing this study. To the extent of the knowledge

given to Endeavor by the fund manager, investors, entrepreneurs and all stakeholders of

the fund during the development of this paper, we guarantee that all facts and comments

reflect the opinions of those sources interviewed. If any of the data contained in the study

is wrong or inaccurate, Endeavor shall not be held responsible.

1 By Tiffany Putimahtama (author) and Carlos de Rivas, Roberto Charvel and Fernando Fabre (co-authors).

For inquires about this paper contact fabre@endeavor.org.mx.

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I. Introduction

Private equity financing in Mexico2, following the model primarily used in the United

States, Europe and Japan, began being implemented in the late 1980s and early 1990s. The

North American Environmental Fund (NAEF) was one of the first multilateral funds3

established in Mexico and was founded in 1993 by Ventana, a U.S. private equity fund

manager, and NAFINSA, Mexico’s development bank. The USD $34 million fund

invested in companies in the environmental sector, focusing on the commercialization of

environmental technology and products for both industrial and urban applications. The

fund was projected to close after 10 years in 2003, but was given a 2-year extension due to

exit challenges. As of 2005, the fund was in the process of being closed.

The fund was ultimately unsuccessful due to a variety of external factors associated with

Mexico’s undeveloped investment environment, as well as due to internal factors

associated with the lack of understanding of private equity/venture capital philosophy and

the honoring of commitments, by portfolio companies and its original owners, lack of

entrepreneur culture in the country, the size of the companies to be able to attract potential

buyers, a as well as some others associated with fund management and investors. As the

fund was closing in 2005, NAEF anticipated recuperating approximately 30 percent of the

original capital invested in 12 companies.

The fund managers of NAEF believed that closing the fund in 2005 required not only the

typical closing and making appropriate distributions to shareholders, but also to document

the process as much as possible to further promote the private equity industry in Mexico.

To ensure transparency and objectiveness in the conclusions of the report, NAEF

2 Both terms private equity and venture capital will be used indistinctively to refer to investments in early or

late stage firms. 3 Multilateral funds refer to the Mexico’s government approved term for private equity funds.

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management asked Endeavor, a non profit organization that promotes entrepreneurship in

emerging economies, to undertake the task of documenting and writing this white paper.

This study aims to provide an objective detailing of the 12-year presence of the NAEF in

Mexico. Many lessons, positive and negative, can be learned from the NAEF experience.

A fund manager in Mexico (potential or existing) might learn from the NAEF experiences

in designing a fund concept, raising funds, filtering opportunities to invest in, structuring

deals, monitoring and adding value to investments, and exiting strategies. Moreover, it

intends to help future venture capital investors by identifying the risks and benefits of

investing in Mexico via example and events that occurred with the NAEF. Almost all

stake holders of the fund were interviewed to guarantee the most objective results.

II. Background

In 1992, American President Bush (Sr.), Mexican President Salinas, and Canadian Prime

Minister Mulroney signed the North American Free Trade Agreement (NAFTA) with the

proposed purpose of eliminating restrictions on the flow of goods, services and investment

within North America. However, NAFTA did not formally take effect until January 1,

1994. Included for the first time in U.S. and Mexican trade policy were regulations that

addressed environmental concerns. During previous decades, Mexico’s rapid population

growth and industrialization advanced with insufficient environmental investment,

resulting in polluted waters, poor air quality and large quantities of improperly stored

waste. Many policymakers believed that increased trade due to NAFTA without proper

environmental enforcement would worsen the situation, as U.S. and Canadian companies

would move their operations to Mexico to avoid their respective countries’ strict

environmental regulations. To address these concerns, NAFTA approved the North

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American Agreement on Environmental Cooperation (NAAEC) as a side agreement with

the aim of improving environmental regulations and enforcement in Mexico. The

NAAEC, in turn, created the Commission for Environmental Cooperation (CEC) to

address regional environmental concerns, help prevent potential trade and environmental

conflicts and to promote the effective enforcement of environmental law.

III. The Partnership

Around the same time NAFTA was being established (1992), the Mexican federal

government appointed NAFINSA, Mexico’s development bank an additional title as

Mexico’s “Environmental Bank”. Oscar Espinoza, CEO of NAFINSA at the time, and

Alfonso Caso, Director of Private Equity Investment, were in charge of supporting the

commercialization and transfer of environmental technology and products into Mexico.

Both decided that the best approach to promote Mexico’s environmental sector was to

establish a venture capital fund that would financially support and foster growth and profit

in environmental firms. However, added-value private equity models4, common in the

United States, were relatively new and unused in Mexico. During the mid-1980s,

NAFINSA started using private equity instruments via Capital Investment Societies

(Sincas) for long-term, minority share investments in small and medium-sized business.

Few of these open-ended funds have survived – presently, there are only a few remaining

Sincas, including Procorp, Argos, and Inbursa. Despite this experience, Mr. Espinoza and

Mr. Caso felt they lacked the know-how to structure and manage a venture capital fund.

They believed they could best attract international institutional investors if the fund were

held outside of Mexico by a foreign investment firm with a strong track record.

Consequently, they began to look for a reputable venture capital firm to manage the fund.

4 Added value private equity refers to equity investments in firms that also bring in talent and expertise in

different areas that the company might require. It is also called smart money.

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Ventana Global LTD (“Ventana”) was founded by Thomas Gephart, Chairman and

Managing Partner, in 1974 in Irvine, California. The company focused on contributing

added-value services and investing in companies in the environmental, biotechnology,

biotechnological engineering, medical products, health services, telecommunications

infrastructure, semiconductor and equipment, enterprise software and high tech

infrastructure industries. Since 1984, the company had sponsored four private equity

partnerships, all of which had international fundings. In 1986, Ventana helped organize

and manage a joint venture maquiladora project sponsored by Banamex, a large Mexican

bank, and in which NAFINSA also invested. Banamex managed the fund, which focused

on manufacturing companies along the Mexican-U.S. border. NAFINSA and Ventana

worked together as a team on this fund, providing oversight. Although the fund was

ultimately unsuccessful, NAFINSA felt that Ventana’s private equity experience in

Mexico, albeit limited, was invaluable as few foreign capital management groups were

present in Latin America.

At the end of 1991, Mr. Caso approached Mr. Gephart with the idea of jointly starting a

North American Environmental Fund (NAEF) that would seek “to focus their resources

and capabilities to support the environment in Mexico through investments in companies

which could contribute to its overall environmental development”. Ventana was

challenged by the idea. With the environmental requirements stipulated by NAFTA, both

Ventana and NAFINSA saw an opportunity for U.S. and Canadian environmental

technology firms to export solutions to Mexico, and equally, high growth potential for

Mexican firms involved in the environmental industry.

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The primary goal of the Partnership was to optimize the highest possible return on the

investment with a social view in being involved in the development of the environmental

sector in Mexico. The Partnership believed that by applying a value-added private equity

model to the sector they would contribute to its profitable expansion. A secondary goal

was the social and ecological benefit of proactively addressing Mexico’s environmental

problems. To a lesser degree, the Partnership also aimed to promote various investors and

portfolio companies, i.e. an environmental-friendly image for Petroleos Mexicanos

(PEMEX), the state-owned petroleum company.

Ventana was responsible for overseeing the management of the fund and NAFINSA was

appointed as lead investor. In May 1992, Mr. Gephart hired Carlos de Rivas, a Mexican

native, as Managing Director of Latin America to directly oversee the NAEF. While Mr.

de Rivas had no previous experience as a fund manager, as Senior Vice President for

Bancomer’s Venture Capital Division he managed two investment groups involved in

several growth sectors, e.g. high technology, environmental, real estate, etc. The

appointment of Mr. de Rivas as NAEF fund manager for Ventana was unprecedented; in

the early 1990s it was not common for private equity or venture capital funds to have a

local team on the ground. Most American, European and Japanese companies managed

their foreign funds from abroad and moreover, did not involve locals in the management

of their investments. Mr. de Rivas and Mr. Gephart also hired several business analysts for

the Mexico City office, dedicated time of a US-based Ventana Associate, and a percentage

of the US-based controller’s time to NAEF.

While Mr. Gephart and Mr. Caso began establishing the fund in 1991, they did not

formally sign a joint contract confirming their commitment to the NAEF until December

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1992. As such, it was generally agreed upon that the fund actively started in 1993. It took

about two years for all the legal proceedings to be settled and Ventana and NAFINSA

decided it would be best to legally domicile the NAEF in the U.S. Ventana set up a

Mexico City-based office, managed by Mr. de Rivas under the Ventana Latin American

Group, LLC, a California limited liability company and part of the Ventana Group of

Funds.

IV. Fundraising Process

Fundraising for the NAEF began the second quarter of 1992. The NAEF’s first investors,

apart from NAFINSA, were a Mexican petroleum company and a Japanese development

bank. To finance pre-operational tasks, including fundraising expenses, Ventana set up the

Ventana Environmental Organizational Partnership (VEOP). The investors mentioned

above, the Foundation for Environmental Education and various individual investors

contributed a total of $700,000 in start-up capital to VEOP in exchange for a NAEF

Limited Partner investor percentage. Ventana concentrated on attracting institutional and

multilateral investors that were conducting business in Mexico and interested in both

return on investments supporting the environmental industry.

To obtain potential NAEF Limited Partners, Ventana used their network of investors from

previous funds, conducted road-shows/presentations abroad and utilized investment

bankers that could receive a placement fee for recommending investors. Most investors

were foreign, based in the U.S., Europe, Japan and the Middle East, and involved in the

environmental sector, e.g. construction, waste management, etc. During the private

placement offering potential annualized returns were projected as returns similar to the US

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model, based on a purely speculative assumptions5. Ventana was to be paid an annual

management fee equal to 3 percent of the committed capital and a carried interest of 20%;

the remaining 80% was to be distributed among the Limited Partners.

By January 1993, NAEF had raised USD $20 million and initial investors contributed 50

percent of their capital. At the end of 1993, another 25 percent of the capital was

contributed and the final 25 percent at the end of 1994. Although investment in portfolio

companies began in 1993, Ventana continued to promote the fund from 1994 to 1998

because various investors remained on the fence about contributing to the NAEF. In

January 1994, NAEF raised another USD $4 million, for a total of USD $24 million. In

1998, a US development bank decided to invest USD $4 million in a custodial account

managed by NAEF to co-invest in all further NAEF investments, requiring matching

investors to contribute their matching shares. In addition, an Austrian bank decided to

invest USD $2 million in the NAEF. Exhibit I on the following page displays the type of

investors, their nationalities, and the amount each investor subscribed to the NAEF.

5 The 25% annual return is common among many fund prospects. One reason is that this rate is commonly

the “holding period expected return” rather that the “projected return”. Another reason is that the net return

for investors is actually the return after the deduction of management fees, fund manager fees, and carried

interest, which in the end is approximately an 18-19% net return. Yet this 18-19% net return is high

compared to historic world wide private equity returns, which have been usually around 300 basis points

above the S&P Index, or closer to a net ROI for investors of 14-15% per year.

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Exhibit I. NAEF Limited Partners and Capital Subscriptions

Type of Investor/Company Country Subscribed Amount

Percentage of NAEF

NAEF

Insurance Belgium $500,000 1.5%

Private Equity US/Mexico $500,000 1.5% Confidential Confidential Confidential Confidential Fluid Transfer, Machinery and Environmental Engineering

Japan $1,000,000 2.9%

Construction Spain $1,000,000 2.9% Environmental Cyprus $1,000,000 2.9% Construction UK/Middle East $1,000,000 2.9% Private Merchant and Investment Bank Austria $2,000,000 5.9% Waste Management US $3,000,000 8.8%

Oil Mexico $3,000,000 8.8% Confidential Confidential Confidential Confidential Confidential Confidential Confidential Confidential

Total $28,000,000

NAEF Sub-Fund

Confidential Confidential Confidential Confidential

Total $6,000,000

Total Capital $34,000,000 100.0%

Source: Ventana Mexico, December 31, 1999

As the largest investors were development banks, Ventana found they were held to the

many rules and exceptions stipulated by these institutions. For example, Japan’s

development bank required that its capital could only be directed towards companies in

emerging markets, and as such, only Mexican companies could receive their capital. While

the Mexican government entities did not specify their capital to only Mexican companies,

they expressed that their funds be invested in Mexican companies or in U.S. or Canadian

companies interested in conducting business in Mexico, thereby benefiting the country

through technology transfer. However, NAFINSA did stipulate that the NAEF could only

acquire minority shares of companies, as they wanted to follow a venture capital model.

Ventana would provide oversight, sit on the Board of Directors and be present to offer

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advice, but management direction was ultimately to be left in the hands of the

entrepreneurs6.

V. Investor Expectations

While all Limited Partners invested money in the NAEF for profit, some investors had

both social and image as secondary motives. NAFINSA specifically chose the

environmental sector for a venture capital fund because of their “Environmental Bank”

charge from the Mexican federal government. They did not want to create a sunk-fund or

create an environmental foundation; they aimed to develop the sector and believed the

fund would be profitable, albeit with lower returns (between 12 and 14 percent, after

management fees) than what they thought a normal venture capital fund would obtain

(anywhere between 20 to 25 percent, depending on risk)7. For PEMEX, they invested in

the NAEF to propagate a positive, environmental-friendly image for their company in

addition to expecting a return.

VI. Selection and Screening Process

Once fundraising got underway in early 1993, Ventana began concentrating their efforts

on screening companies. The General and Limited Partners focused on selecting

environmental service, product, manufacturing, and technology companies in North

American involved in:

Water;

Wastewater;

Air Pollution;

6 This requirement is no longer effective in other funds that receive funding from NAFINSA.

7 This is further evidence of the common mistake made by fund managers and investors about the

expectations of holding period returns, versus historic returns normally seen in other funds. Also, the

expectation concept of a “normal” fund vs. an “abnormal” one is not clear, unless the social part of the latter

is considered in the expectation.

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Remediation;

Solid and Hazardous Waste;

Engineering and Consulting;

Instrumentation;

Alternate Energy;

Resource Recovery; and

Recycling and Related Fields.

The NAEF aimed to invest in companies with revenues between USD $1 - $30 million

and a minimum age/development cycle of two years. The NAEF also required products

and/or services to be at a commercialization stage. Mr. de Rivas was at the forefront of

selecting potential portfolio companies. This process included everything from soliciting

and cold-calling companies to recommendations from NAFINSA and NAEF investor

partners. Ventana’s methodology for choosing companies focused on the following:

Early stage for high-upside: Ventana typically concentrated on investing in early

and first-stage companies, where they were able to acquire a substantial equity

position. However, in the NAEF, Ventana aimed to choose more mid-tier

companies because small companies, early stage opportunities and emerging

technologies were too risky in Mexico8;

Strength of management: Ventana placed considerable emphasis on the evaluation

of the management team of prospective portfolio companies. Ventana sought

investments where top management was combined with industry experience. In

particular, much of the due diligence process focused on this area, as Ventana

8 This risk return profile can be thought of as follows: A typical venture capital fund in a solid

macroeconomic environment expects to invest in early stage companies with significant market penetration

risk, such as biotechnology or IT. In Mexico, high macroeconomic risk plus early stage risk turns out to be

too high such that it does not offer enough high returns. This is why funds in Mexico typically invest in mid

or late stage firms.

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believed a strong working relationship between the CEO of the portfolio company

and themselves was imperative to investment success;

Strategic position in growing or new market: A portfolio company had to address a

genuine market need or identify a new market altogether. Existing markets had to

be specific, large and growing, or changing rapidly. It had to have no entry barriers

and be highly profitable; and

Proprietary technology: While not a strict requirement, Ventana searched for

companies that were novel and defendable, e.g. had a patentable technology or

process.

The Ventana Mexico team thoroughly analyzed each company before investing. This

analysis included a review of the company’s management team, technology, strategy,

business plan, markets, competitors, cost structure, regulatory profile, patents, financing

requirements and deal structure. Ventana also leveraged its extensive network of business

leaders for further analysis forming specific committees and more than one board of

advisors, including its Business and Scientific Advisory Boards. Ventana formed an

Investment Advisory Committee (IAC), consisting of the Ventana team and investors. All

investments were presented to the Investment Advisory Committee, made up of investors

in NAEF, prior to the final investment commitment. Exhibit II on the following page

displays the five phase analysis that all Investment Opportunities underwent before

General and Limited Partners made any Investment Decision.

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Exhibit II. Due Diligence Method

Phase I Phase II Phase III Phase IVInvestment

DecisionPhase V

Review of

business plan

Sector

validation

Meeting

investment

parameters

Initial market

analysis

Initial financial

projections &

strategy

Review of

business plan

Sector

validation

Meeting

investment

parameters

Initial market

analysis

Initial financial

projections &

strategy

Review of

business plan

Sector

validation

Meeting

investment

parameters

Initial market

analysis

Initial financial

projections &

strategy

Final decision

process

Requires

Investment

Advisory

Committee (IAC)

recommendation

Presentation &

discussion of

analysis results

with IAC members

Detailed interviews

with management

Visit to facilities

Verification of claims

made in the business

plan

In-depth analysis of

market trends and

conditions

In-depth review of

financial projections

Initial analysis of

valuation & deal

structure

Issue final

decision

Investment

deployment

Board

meetings

Continuous

advise and

support

Source: Ventana Mexico, January 2005.

The IAC convened approximately every quarter and meetings revolved around the

following:

Administrative issues: addressed the NAEF’s financial position, fundraising

activities, publicity of the fund in the U.S. and Mexico and policy/investment

strategies;

Companies in Phase I Due Diligence: provided a brief company overview and the

potential of the company’s sector. Presented new and declined companies in this

phase;

Companies in Phase II Due Diligence: provided an in-depth company overview

and the investment opportunity. Also presented new and declined companies in

this phase;

Companies in Phase III Due Diligence: generally presented a detailed company

description, including a management outline, market overview, market size and

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trends, services provided, competition, marketing and sales strategy, operations

and development plans. Also presented new and declined companies in this phase;

Recommendations for Investment: discussed companies who had passed through

Phase III of the due diligence process, primarily focusing on the proposed joint

venture structure, and in which the IAC made a decision to invest in the company

or decline it; and

Portfolio Investment Updates: provided information on the current status and

progress of NAEF portfolio companies.

In general, the due diligence process focused on the skills, judgment, integrity, financial

understanding, and leadership qualities of the executive management team. Mr. de Rivas

estimated they screened around 400 companies in total.

Most companies were declined for the following reasons: they were not in an appropriate

stage of growth; their business did not make a significant contribution to the Mexican

environmental industry; or, the company’s owners were not willing to sell to a third party

or search for an IPO or other related exit strategies in the future. For example, the NAEF

identified a research lab that they believed had significant potential, but it was in a very

early stage of development. The NAEF and the research lab determined that it would be

more beneficial for the company to first seek private individual investor funding, in order

to gain ground on its developmental tasks prior to approaching the venture community. In

another instance, NAEF tried to facilitate an alliance between a Mexican environmental

laboratory and engineering services company and a U.S. based testing laboratory. The

NAEF believed that the Mexican company not only needed a capital infusion, but also an

infusion of a more sophisticated operating management that could assist in the

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improvement of their quality control efforts. In the end, the alliance between the two

companies fell apart due to a higher valuation expectation by the CEO of the Mexican

firm, who claimed that the company’s valuation should have been higher due to several

income items not reported in their accounting statements. However, the U.S. firm

remained unwilling to accept the proposed valuation from the Mexican laboratory.

VII. Investment process

Between 1993 and 2002, the NAEF invested in a total of 12 companies . The NAEF did

not invest in any Canadian companies because they did not encounter any that had

business ties to Mexico or were interested in entering the Mexican market. Exhibit III

presents the NAEF portfolio and the amount of capital invested in each company.

Exhibit III. Ventana Portfolio Companies

Company Name Industry Original Amount Invested

NAEF & Limited Partner Percent Ownership

Celsol/Óptima Energía, S.A. de C.V. Energy services $1,082,400 41% Fypasa Construcciones, S.A. de C.V. Waster water treatment $3,000,000 17% Reciclados de Mexico, S.A. de C.V. (Recimex) Recycling $2,129,200 51% Geologic de Mexico, S.A. de C.V. Waste management $1,900,000 65% Reciclados Industriales de Mexico, S.A. de C.V. (Rimex) Recycling $1,500,000 49% Safety Storage Hazardous waste storage $2,500,000 N/A Liberty Environmental Partners Private equity fund $299,990 10% Holding Color, S.A. de C.V. Paint $1,500,000 35% Consorcio Deter, S.A. de C.V. High-pressure water

cleaning $1,050,000 50%

Consorcio Beta, S.A. de C.V. (Airtemp) Air conditioning $2,610,000 32% Thermatrix Air pollution $2,747,989 100% Water Capital Leasing S. de R.L. de C.V. Equipment leasing $3,000,000 66%

Source: Ventana Mexico, 2005.

Towards the end of the due diligence process, term sheets were drawn up during Phase III

to detail proposed investment terms and conditions. For example, the primary point of

negotiation over the term sheet for the company Celsol was its valuation. The NAEF

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believed that the company’s valuation at the time was USD $1 million; the founders of

Celsol contested that their company’s worth was USD $1.5 million. The NAEF agreed to

value the company at USD $1.5 million under the terms that the company would

incorporate a ratchet agreement. This agreement allowed the NAEF to adjust the

conversion price of the company’s Initial Public Offering (IPO) so that the conversion

ratio would provide the NAEF with at least an equivalent of 40 percent, and up to 70

percent, of the company.

III. Monitoring

Ventana’s methodology involved regularly measuring each portfolio company’s

performance against predetermined milestones to ensure that each made significant, and

anticipated, progress. At Ventana’s annual meetings, progress reports were supported by

financial and operating reports on each investment. The Limited Partners were also

informed of any material transactions and valuations.

Celsol/Óptima Energía. A prime example of Ventana’s added-value contribution is

reflected in Celsol, now renamed Óptima Energía. Celsol was founded in 1988 by Enrique

Gomez and originally manufactured thermal solar cells. The company aimed to provide

“Performance Contracting” (PeCo) to their clients (primarily hotels and resorts), a system

whereby Celsol implemented energy projects that were paid for from the very savings

generated by the project. As this system required a considerable amount of up-front capital

to start projects, Celsol began looking for approximately USD $1 million to purchase and

install the energy saving equipment. In 1994, they approached NAFINSA for capital,

which in turn referred them to the NAEF. The due diligence process took about a year

before the NAEF invested slightly less than USD $1.1 million in the company (41 percent

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of the company’s stock) at the end of 1995. In the investment contract, Celsol was subject

to performance evaluations by Ventana. Mr. de Rivas worked with Mr. Gomez to

institutionalize the company and create a more formal Board of Directors that met every

quarter.

However, from 1996 to 1998 the company’s financial situation continued to worsen due to

the long payback periods of their projects. With the company near failure, the NAEF team

requested that Celsol hire a strategic consultant/Chief Financial Officer (hand-picked by

the NAEF) to assess the company, including analyzing their financials, clientele and target

market. The consultant/CFO found that the primary focus of Celsol’s business was heating

water, a low-demand service for their clients. From 1998 to 2001, the NAEF team and Mr.

Gomez decided to change the focus of the company from a thermal solar cell manufacturer

to an Energy Savings Company (ESCO). As part of the marketing strategy, the company

was renamed Óptima Energía and promoted itself as providing air conditioning energy

savings services. Mr. Gomez examined new technologies and invented a patented, energy-

efficient air conditioning equipment system. This equipment uses the recuperated heat

from air conditioning to produce electrical energy, which in turn is used to heat water and

operate waste water treatment systems.

Once the company redirected its focus, sales increased and the company’s financial

position improved. In December 2002, Óptima Energía began its first energy savings

project; at the end of 2004, they had 8 projects contracted and performance contracting

sales of $10 million. While the company’s cash flow was still low and contingent on

future contracts, they were well-positioned for growth and in 2002 obtained additional

capital from the Fund for Latin American Clean Energy Services (FLACES). The strong

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working relationship between the NAEF and Mr. Gomez resulted in the successful

repositioning of Celsol/Óptima Energía and created a more efficient and growth-based

company.

Fypasa Construcciones. The monitoring relationship between the NAEF team and

Fypasa Construcciones, a waste water plant construction company, was more mixed than

that of Celsol. The NAEF approached Fypasa in 1993 with their investment opportunity.

During this time, the Mexican government was issuing bid proposals to private companies

to construct and operate waste treatment plants. Compensation to the winner was paid

upon completion of the project. IN 1993, Fypasa won the waste water treatment plant

project for Toluca, Mexico, a growing town outside of Mexico City. Although Fypasa was

not interested in a new partner, they needed the capital to fund the construction and initial

operation of the plant. As Fypasa was unable to obtain a bank loan, they decided to accept

the NAEF as a partner in September 1993 and sold 17 percent of the company’s preferred

stock to the NAEF in exchange for USD $3 million. Fypasa was the NAEF’s first portfolio

company.

In March 1994, the NAEF lent Fypasa approximately USD $2 million in a bridge loan,

with the right to capitalize the loan, to continue construction on the Toluca plant. Fypasa

eventually paid back this loan (see next paragraph). Construction of the plant finished in

November 1994 and Fypasa was to have started receiving compensation thereafter, but the

peso crisis hit and the government suspended all payments. From March 1995 to February

1996, Fypasa continued operating the plant and entered in negotiations with the

government for payment. During this time, Fypasa was approached by various buyers,

such as Wheelabrator and Azurix. The NAEF team attended several of the buyer-meetings

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and tried to facilitate the sale, but all were abandoned during the due diligence process.

After these failed-attempts, the relationship between Fypasa and the NAEF began to falter.

The NAEF felt that Fypasa management had deliberately deterred buyers by not

proactively collaborating during the due diligence process; in contrast, Fypasa felt that

they had been overly-pressured by the NAEF to sell so that the NAEF could get their

equity as soon as possible.

The relationship turned worse when the NAEF sued Fypasa to receive repayment on their

loan. In 2005, Fypasa and NAEF negotiated an exit strategy of USD $1 million in equity

and USD $3.6 million in loan repayments. Because the company’s financial position was

volatile during the peso crisis, and due to unclear financial reporting. Although the initial

relationship between the NAEF and Fypasa was strong and benefited both parties, the

dissolution of trust and lack common goals led to a hostile partnership in the end. Fypasa

has continued to conduct business, but at a much lower volume than before and at a break-

even cash flow rate.

Reciclados de Mexico (Recimex). The investment relationship between the NAEF and

Recimex demonstrates venture capital directed towards a Mexican start-up company. In

1991, Recimex’s two entrepreneurs began investigating plastic recycling methods.

NAFINSA recommended Recimex to the NAEF in 1992 and the two parties began

working together to define the company’s business plan. Over the course of a year, they

collaborated to identify and plan all the components needed to launch the company. In

1994, the NAEF invested approximately USD $2 million in Recimex, acquiring a 51

percent share in the company, with the stipulation that the company had to find another

partner and obtain credit to purchase their equipment before receiving the capital. Recimex

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complied with these requirements and began production in 1995. From 1995 to 1998, the

company and NAEF worked closely together, with the latter providing supervision,

consulting and general assistance to Recimex management. However, company sales did

not increase as anticipated due to the Mexican economic downturn and the drop in raw

material prices. Additionally, recycling was just gaining recognition as an industry during

this period and lacked the support of the government and related industries.

In 1999, NAEF and remaining partners of Recimex claimed they asked (and later forced)

the entrepreneurs to resign because their management decisions continued to negatively

affect the company. However, the entrepreneurs state that they left the company because

their shares had been over-diluted. The company continued operating in decline with

heavy bank debt until 2004, at which point the partners and the NAEF decided to file

bankruptcy to protect everyone involved including the Limited Partners. NAEF had

previously, at the same time with the other investors, guaranteed a portion of Recimex’s

debt that will not be negated in the actual bankruptcy, but will be negotiated after the

bankruptcy is final.

Reciclados Industriales de Mexico (Rimex). Rimex was founded in 1994 and was

involved in the collection, recycling and commercialization of post-consumer, non-

refillable polyethylene terephthalate (PET) bottles in the form of dirty green and clear

ground flakes, which are used in the textile and packaging industries. In 1999, NAEF

invested $1.5 million in Rimex in exchange for 49 percent of the company.

Rimex established a number of promising alliances, e.g. a commercial alliance with

Wellman, Inc, the world’s largest plastic PET recycler, that included an engineering

21

service, licensing agreement, and supplier contract and assured the company sales of 22.7

million tons. The company also contracted with an American firm, Exim Trading Group,

to consolidate a distribution network in the U.S. for post-consumer recycled PET. In spite

of these alliances, Rimex encountered many of the same market, economic and lack of

demand problems as Recimex. Since 1995, the company had experienced financial

problems and while it has continued operating, it is at break-even. As of 2005, NAEF had

not reached an exit strategy with Rimex and still held the company’s shares.

Geologic de Mexico. In 1997, NAEF invested USD $1.9 million in Geologic de Mexico

(65 percent of the company with the understanding that it was going to be under 50

percent after acquisitions and mergers took place). Geologic was incorporated in 1997, as

a holding company, to consolidate NAEF’s investment strategy to build a full collection

(transportation, disposal, etc.) of national bio-infectious waste management in Mexico.

Geologic’s primary business was acquiring smaller environmental companies. One of the

companies that Geologic acquired was involved in constructing waste water treatment

plants in Mexico, whose owners were a group of U.S. attorneys. Prior to NAEF’s

investment in Geologic, the construction company had experienced problems obtaining

payments from the Mexican government. The U.S. owners sued the government for back-

payments and were awarded USD $7 million. However, the company continued to

experience problems obtaining operating permits and decided to sell to Geologic.

NAEF was involved in Geologic’s purchase of a toxic waste hauler and treatment

company. Geologic and the previous owners negotiated an agreement whereby Geologic

would make payments to the owners in milestone installments. Post-sale, a number of

problems arose, the largest of which was a discovery that the company had a large sum of

22

outstanding back-taxes payments. Geologic and NAEF received an offer from the plant’s

operating manager to purchase the plant, and they decided it would be wise to sell the

company and exit the investment. However, the previous owners (U.S. attorneys)

contested that Geologic and NAEF had not made any of the anticipated investments or

improvements to the company, thus lowering the value of their milestone payments. The

U.S. attorneys sued NAEF and Geologic in the U.S. on a contract violation basis, but the

U.S. courts ruled that the case first had to be settled by the Mexican courts. No active

litigation has taken place as of July 2005.

IX. Exits

Exiting from the portfolio companies was the largest challenge the NAEF faced. While

various exit strategies have been agreed upon, as of June 2005 the NAEF had only exited

from 3 of the 12 portfolio companies.

Safety Storage. In 1994, the NAEF invested USD $2.5 million in Safety Storage, a

company involved in the design, manufacturing and distribution of prefabricated chemical

storage buildings. However, information from the due diligence process surfaced post-

investment that revealed discrepancies in the company’s financial statements. The NAEF

decided to withdraw from the investment, as Safety Storage’s audits were not consistent

with what was reported during the due diligence process. Safety Storage refused to reverse

the investment and as such, the NAEF sued the company. The NAEF eventually recovered

approximately USD $1.8 million and a note that required Safety Storage to repay the

balance of the capital if the company was ever sold.

23

Liberty Environmental Partners. The NAEF invested in May 1994, or as a fund of

funds investment, with full approval of the partners. Although the LEP did not direct

capital towards any Mexican environmental companies but tried to transfer environmental

technology to Mexico, the NAEF decided to invest in the fund because of its similar goals

and venture capital structure. The LEP made direct investments in the environmental

services, industrial technology and energy efficiency markets. NAEF invested in 10

percent of the LEP, contributed in a lump sum amount. The fund consisted of 12 different

portfolio companies.

LEP, a fund with the same focus as NAEF but investing in U.S. environmental companies,

also did not ultimately return capital.

Holding Color. In 1998 the NAEF was approached by Holding Color, a holding company

of Pinturas El Aguila and Colorantes y Oxidos. Pinturas El Aguila is a family business

with more than 60 years in the domestic paint industry. In 1992, El Aguila founded

Colorantes y Oxidos, an ecologically-friendly synthetic iron oxide producer specializing in

yellow and red pigments obtained from industrial and consumer tin waste. The NAEF

invested USD $1.5 million in Holding Color (purchased 35 percent of the company) and

directed the capital towards increasing the production capacity of Colorantes y Oxidos.

The NAEF established a custodial account for the capital and assigned Mr. de Rivas as a

secondary signer. In 2000 the company’s sales declined as a result of the influx of Chinese

products in the market. As they could not compete in the global market, Holding Color

ceased exporting and focused on the Mexican market. From 2000 to 2005, Holding

Color’s revenues continued to decline with negative growth foresight due to low domestic

demand and the inability to compete with China’s lower-cost producers.

24

In 2005, the NAEF and Holding Color negotiated a USD $1.2 million buy-back exit,

representing a loss of USD $300,000 on the original capital invested. Holding Color’s

owner used proceeds from a sale on family real estate to buy-back the NAEF’s shares, and

the NAEF accepted the loss on their investment because no better exit strategy existed.

Holding Color management felt the NAEF investment was beneficial because it helped the

company attain growth in the beginning and later, helped them stay in business. However,

in hindsight of China’s presence in the market, Holding Color management stated that

they would not redo the investment if given the opportunity. The production margin is

high for their energy-intensive products, and the Mexican market for their ecologically-

friendly paints has continued to diminish. While the NAEF concurred that the economic

downturn and entrance of Chinese products hurt Holding Color’s business, they felt that

the company could have formed strategic alliances or merged with Chinese producers to

offset their market loss. The NAEF also felt that a new influx of management could have

beneficially impacted Holding Color’s outlook. However, the small, family-owned

company implied that they were opposed to any management change and were not

inclined to sell the company, primarily because the company had not increased in value.

Consorcio Deter. In 1999, the NAEF invested approximately USD $1 million in a 20

year-old company called Consorcio Deter that specialized in high pressure water cleaning

services. The NAEF saw high growth potential in Deter’s services and purchased

approximately 50 percent of the company. Inclusive in the terms of the investment was a

ratchet agreement (used to motivate the CEO to obtain high performance results), whereby

NAEF’s ownership could be taken down to 33 percent, based on the company’s

performance. However, during this time, the company had problems with partial payments

25

from clients and with the Mexican Ministry of Finance and Public Credit, (Hacienda). To

remove themselves from these problems, the NAEF stipulated during contract negotiations

that Deter could not use the venture capital funds towards resolving their Hacienda

problems or towards working capital. To further enforce this, the NAEF placed the

majority of the capital in a custodial account, in which Mr. de Rivas was a secondary

check signer.

Post-investment, the company maintained a strong presence in the market. However, by

2002 sales strongly declined as customers canceled and/or cut back their contracts. In

particular, PEMEX’s decrease in contract volume greatly impacted the company. To

improve their situation, Deter changed middle-management and downsized the company

in December 2003; as a result, sales and cash flow improved through 2004. Although the

company maintained break-even, its value had not grown to make it an attractive

candidate to a 3rd

party buyer. Neither did the company have enough liquid capital to buy-

back the NAEF’s shares. The NAEF and Deter negotiated an exit strategy whereby the

NAEF would take ownership of the company’s equipment and the company would buy-

back their assets in installments – in essence, a leasing agreement. The NAEF had the

option to sell the equipment to a 3rd

party buyer, although Deter retained the first right of

refusal.

According to Deter management, the company was unable to maintain or increase their

rate of growth due to the Mexican economic downturn. Management also felt that

although the NAEF capital helped keep the company afloat, more active participation by

the fund would have perhaps contributed to the success of the firm, e.g. assistance with the

commercial positioning of the firm, administration and auditing. The NAEF management

26

concurred that they could have participated more in the direction of the company. If the

investment could be redone, the NAEF would have installed a new management team,

particularly one that would have focused on changing the company’s contract bidding

process. The NAEF felt that the company’s lack of growth stemmed from four key points:

The Mexican economic downturn and the subsequent lack of demand in the

company’s industry;

Not enough money was invested to promote substantial growth in the company;

Deter did not make good use of the capital – even with the NAEF’s stipulations

and mechanisms to oversee money management, the company still directed a large

portion of the capital towards resolving their Hacienda problems; and

An old-fashioned management structure that lacked a viable growth strategy and

too much reliance on government contract bids.

Consorcio Beta. NAEF invested approximately USD $2.6 million in 1996 in Consorcio

Beta (32 percent of the company), the holding company of Airtemp and Airsystems.

Airtemp was founded in 1984 to supply air conditioning systems to the Mexican

automobile industry; Airsystems was incorporated in 1994 to supply recyclable aluminum

condensers to the same market. The family-owned company experienced a high-rate of

growth post-investment and possessed large clients such as General Motors, Dina

Camiones and Ford Motor Company. As an ISO 14000 certified company, an

internationally accepted specification for an Environmental Management System (EMS),

Beta was an attractive candidate to a 3rd

party buyer. A number of US car companies

approached the company with acquisition offers, but negotiations always failed during the

due diligence process. To promote the acquisition process, the NAEF hired an attorney to

27

collaborate with Beta management in attaining a 3rd

party buyer. However, after a number

of unsuccessful negotiations, the NAEF and the attorney discovered that Beta

management, particularly the CEO, had no intention of selling the company. Moreover,

the company often interfered with negotiations or acted uncooperatively to negatively

affect a buyout. By 2000 the company’s revenues had significantly decreased due to cash

flow problems, the downturn in the Mexican auto industry and management troubles, thus

deterring any further acquisition offers. In 2005, the company was at break-even and

producing at about 35 percent of its previous capacity.

As a minority shareholder with a put-option, the only exit options the NAEF had were

finding a 3rd

party buyer or a buyback of their shares by Beta. However, by Mexican law

you cannot obligate someone to buy your shares, and thus cannot enforce these types of

put-options. In 2005 after extended negotiations, Beta’s CEO agreed to a buyback of USD

$3 million over 40 months.

Thermatrix. NAEF invested approximately USD $3 million in 2001 in Thermatrix (7

percent of the company), established in 1992 to provide high performance, cost effective

solutions for the prevention, minimization or destruction of a broad variety of volatile

organic compounds and hazardous air pollutants, wastewater treatment emissions, and the

treatment and remediation of a variety of hazardous and non-hazardous wastes. These

solutions, founded on a patented flameless thermal oxidation technology, included a full

range of products and services from engineering services to turnkey pollution control

systems; and from compact, stand-alone emissions control devices to large scale process

treatment systems.

28

Thermatrix was poised for significant growth and apart from NAEF, had raised USD

$12.1 million in venture capital by 1994 from other equity investors, such as CIBC Wood

Gundy and Vencap Equities Alberta, Ltd. The company successfully completed projects

for companies such as Dow Chemical, the U.S. Department of Energy and Georgia Pacific

Corp. In 1998 NAEF decided to set up a holding company in Mexico, Thermatrix de

Mexico, with the rights to transfer and exploit the technology in Mexico. NAEF

transferred their shares from Thermatrix to Thermatrix de Mexico. After selling various

shares, NAEF’s final investment in Thermatrix de Mexico was USD $2.7 million with 100

percent of the company shares. Towards the end of the 1990s Thermatrix began

experiencing financial problems and in 2002, Linde AG acquired the stock of Thermatrix.

NAEF implemented debenchers during the negotiation process to retain their shares for

the Mexican holding company. After trying to implement Thermatrix’s technology in

Mexico, the company was unsuccessful and filed Chapter 11 bankruptcy. Ultimately,

NAEF was forced to accept a full loss on their investment.

Water Capital Leasing. NAEF’s investment in the Water Capital Leasing occurred late in

the course of the fund (2002). The investment in the water treatment plant company

consisted of USD $3 million for 66 percent of the company. The NAEF was intimately

involved in the founding and structuring of the company. Post-investment, the NAEF set

up a joint-venture company, Water Capital Operations Administrator, through which the

NAEF paid performance-based fees to Water Capital Leasing Services, the company of

the original founders. The NAEF also hired an outside consultant, Luis Arrieta, an expert

with 25 years experience in leasing contracts, to help the founders with their business. In

2003, the founders of Water Capital Leasing signed a one-year contract with Mr. Arrieta

to hire him on as a full-time employee. In 2004, Mr. Arrieta left Water Capital Leasing

29

due to differences of opinion; however, he was hired on by the NAEF as advisor and

President of the Board of Directors of Water Capital Operations Administrator due to his

intimate knowledge of the company.

Water Capital Leasing Services experienced a high rate of success and growth. However,

the growth of the company was not without complications and NAEF decided to protect

its position in September 2004. NAEF proposed the implementation of a new

administration, allowing Mr. Arrieta to form his own servicing Company and finance

deals brought into Water Capital Leasing by other leasing promoters. After changing the

company’s management, NAEF negotiated a USD $5 to $7.5 million exit agreement for

the end of 2005/February 2006.

In monetary and bottom-line growth terms, Water Capital Leasing Services was the most

successful investment of the NAEF portfolio. NAEF’s venture capital, introduction of

outside management and assistance in strategic planning helped the company grow from a

start-up to a multi-million dollar firm.

X. Lessons Learned

NAEF management and investors alike were asked what they would change about the

investment if it could be redone. Recurring themes are summarized below:

Environmental sector: While nearly all parties involved agreed that the

environmental was a worthy industry to invest in for the social impact, they

concurred that it was not a high money-making sector. The political, economic and

financial problems and the lack of enforcement in Mexico overshadowed the

importance of the environmental sector over the 12-year run of the fund.

30

Moreover, the NAEF believed that the environmental sector, overall, was not a

lucrative field, as the LEP fund also did not perform well. Various individuals

suggested that if another fund were started, they would not restrict it to one sector

or one with such specific parameters.

Lack of private equity/venture capital understanding in Mexico. From the

point of view of NAEF, Mexican entrepreneurs’ lack of exposure to private equity

and venture capital was one of the primary causes of the downfall of the fund.

Mexican small business owners, most of them family-owned, viewed venture

capital as an alternative (and particularly, an inexpensive substitute9) to bank loans.

Moreover, because of the 1995 crisis and the large amount of loan defaults, many

business owners were accustomed to defaulting or not complying with their

financial obligations.

Fewer investments/investments in larger companies. NAEF management

believed that investment in less companies (and hence more money directed

towards each firm) and larger companies would have facilitated easier exits.

Investing more money in each company would have perhaps given them more

leverage in growth and expansion. Larger portfolio companies with higher

revenues and profits would have attracted more 3rd

party buyers or introduced the

possibility of taking the company public. Additionally, a larger company could

have attracted other private equity investors.

Management. Although NAEF management actively participated in various

companies, e.g. Water Capital Leasing and Recimex, they primarily sat on the

Board of Directors and provided oversight to most other portfolio companies.

NAEF management stated that in future investments, they would take over the

9 In a period during which interest rates could top 50% to 100%.

31

company’s management from the beginning to avoid the problems associated with

family-owned businesses or management averse to change.

Expectations. In negotiations, the definition and purpose of private equity should

be made clear from the beginning. Private equity firms, particularly foreign firms,

should be aware of the obstacles to private equity investments in Mexico and

should make provisions to address them, e.g. lack of exit strategies, lack of

minority shareholder rights, family-owned businesses, etc.

32

XI. Results

When the NAEF was founded, Ventana and investors projected it to close within 10 years.

In 2004, both parties realized that it would be impossible to exit all their commitments

within the stated timeline and the fund was extended for another two years. Moreover, at

this time the Limited Partners realized that the portfolio companies were going to prevent

the Fund from returning capital due to non-existent and/or thwarting exits. As such,

NAFINSA, the Mexican petroleum company and a Mexican construction firm became

more involved with Ventana management and offered their expertise and clout to

negotiate better exit strategies. However, the investor’s ultimate prevailing conclusion was

that expensive legal action against the portfolio companies was the only solution.

As of March 2005, approximately US$5 million of the total invested capital was exited

and marked for distribution to the investors. NAEF anticipated that they will ultimately

return about 30 percent (US$10 million) of the original capital to the Limited Partners.

Various investors, such as one of the U.S. development banks, would have liked to extend

the timeline of the fund in hopes of recovering more capital; other investors would had

liked the fund to close earlier to mitigate any further legal issues associated with the fund.

Internal Factors. While investors and Ventana noted external factors as having the largest

impact on the outcome of the NAEF, they cited a number of internal factors that

contributed to the fund’s results.

Not surprisingly, investors primarily expressed concern and criticism about Ventana’s

management of the exit strategies. Various investors felt that Ventana was not firm enough

with portfolio companies and should have sued more companies and/or sued companies

33

earlier than they did. Investors felt that Ventana maintained too amicable a role with CEOs

and were not forceful enough in their negotiations or renewing contracts. Ventana’s

response was that they were often hesitant to sue their portfolio companies because they

held an ownership stake in the companies; in essence, they would be suing themselves.

Additionally, NAEF did seek legal advice but was cautious in suing companies because

they found the process to be expensive and the chance of recovering any monetary

rewards low. In the instances that they did sue, such as with Geologic, the process was

difficult, lengthy, and complicated.

NAEF felt constrained by Mexico’s and Japan’s development banks’ restriction on only

acquiring less than 50 percent of any portfolio company. They felt this put them at a large

disadvantage when exiting the companies, as they did not have control over the exit

process as minority shareholders, e.g. could not force a company to be sold to a 3rd

party

buyer. However, the development banks believed that investing less than 50 percent in any

one company complied more faithfully with a venture capital model10

.

Surprisingly, issues were also raised about Ventana’s management fees, which some

investors felt were high. As the NAEF was one of the first Mexican venture capital funds,

some investors claimed they agreed to the management fees Ventana proposed because

they lacked a point of reference as to what they should have been. In discussions for the

two-year extension of the fund, investors negotiated a decrease in Ventana’s management

fees. Ventana felt their management fees were comparable to other private equity firms

and yet believed that substantially lowering their fees in the two-year extension

demonstrated their commitment to the fund. We found this opinion from some investors

10

Owning less that 50% and suing companies are related topics in México. Minority shareholders are not

protected by Mexican law and courts tend to favor majority shareholders. Suing companies in NAEF’s

position would at first seem impossible, and even a wasteful task.

34

surprising since a NAEF´s management fee is consistent in small funds around the world.

For larger funds, with committed capital above US$100 million, fees average 2%.

NAEF´S fee on a $30 million fund produces an annual budget of approximately

$900,000. This budget has to cover all the fund manager expenses including office,

promotion, monitoring, analysts, etc. The lack of understanding of the management fee

structure by some partners is further indication of the lack of culture of venture capital

among institutional investors.

Many investors felt that Ventana management team’s lack of experience in the Mexican

investing environment contributed to the negative outcome of the fund. Although Mr.

Gephart had ample experience with venture capital in the U.S., investors believed it did

not transfer well to Mexico’s business environment. In regards to Mr. de Rivas, investors

also felt he lacked in-depth expertise and track-record in venture capital. NAEF

management agreed with this concern, although they felt that they were at a disadvantage

given the numerous external factors they encountered, particularly the lack of private

equity as an investment vehicle in Mexico and the associated inexperience and

expectations of entrepreneurs with this type of investment. Further variables that affected

the overall results have to do with a lack of support from some of the local founding

partners to the general manager of the fund. For example, NAFINSA´s commitment stated

that their role was to support Ventana to understand the Mexican business culture and to

transfer its own experience on the Mexican venture capital and private equity sector, a

commitment which according to Ventana was not executed.

As a general observation, encountering fund managers with local experience plus a track

record in Mexico is close to impossible. To build a track record a fund manager must

actually manage a fund, which is typically a 6 to 10 year endeavor, and the earliest funds

35

operating in Mexico only date to the late 80s. In addition, the trend before NAEF was for

foreign venture capital companies to hire a foreign manager to manage the fund from

abroad.

Investors also addressed reservations about NAEF’s portfolio company selection process.

Various investors felt that NAEF chose companies in which they could take a paternalistic

role, rather than focusing on companies where the NAEF could add value11

. Other

investors expressed the lack of organization in the selection process, i.e. presentations at

annual meetings were not profound and lacked in-depth information. NAEF believed that

IAC members had an accessible platform to express their opinions about the companies

selected and that the fund management was open to investors for further data and

information about the investment process. Additionally, according to the fund

management, not one investor requested additional information during the course of the

fund.

External factors. Both investors and NAEF management concurred that the following

external factors unique to Mexico (and similar emerging markets) impacted the NAEF

outcome:

Economic downturn: After repeated economic crises during the 1980s that

included devaluations of the peso and foreign financial rescue packages, the

Mexican economy appeared to be in recovery during the early 1990s. The entrance

of NAFTA also lent credibility to the Mexican economy. However, in December

1994 the Mexican government devalued the peso once again due to high inflation,

11

While this comment comes from interviews with investors, it is hard to get a true understanding of the

statement. Paternalism might be a form of adding value in venture capital.

36

capital flight and its inability to service its debts. Ventana cited the economic

downturn as the most influential and unforeseen factor affecting the unsuccessful

outcome of the NAEF. While investors concurred that the economic downturn

negatively impacted the investment, they did not believe it to be the central issue

for the unsuccessful results of the NAEF12

.

Environmental sector: As discussed earlier, NAEF was founded upon the

expectation that the environmental sector would be a dynamically growing

industry in Mexico after the establishment of NAFTA. While investors and

Ventana recognized that the fund would also be socially aligned, in the end

industry growth did not meet expectations. Both NAEF management and investors

believed the 1995 peso crisis overshadowed the government’s role in enforcing

environmental regulations and the importance of the industry, which in turn

weakened the demand for environmental services.

Financial structure: The private equity model used in the U.S., Europe and other

countries with efficient financial industries has encountered many obstacles in

Mexico. One reason the model has not integrated smoothly is that Mexico does not

have the institutional framework that promotes the scalability and growth of small

companies. This includes a complicated and weak banking system that does not

allow for easy loan access for expansion rounds and leveraging of small

businesses. Neither does the Mexican government provide ample resources to

small businesses, such as the Small Business Administration in the U.S. that

provides administrative support and grants to start-ups. Additionally, the Mexican

Stock Market is comparatively small and is controlled by a handful of large firms.

As such, exit strategies via IPOs or mezzanine financing are virtually non-existent.

12

Investors agree that the risks of investing in emerging economies have to be taken into account prior to

making the investment. Risk management strategies should have been implemented in each deal.

37

Contributing to these difficulties is that Mexican businesses (particularly start-ups

and small businesses) lack the institutionalization to be prime private equity

candidates, e.g. fiscal transparency, universal accounting standards, organizational

structure, etc.

Legal framework: Mexico’s need for stronger foreign investment and tax laws

has also hindered private equity. Like the NAEF, many private equity firms prefer

to legally domicile their funds abroad (such as the U.S., Canada, Europe or fiscal

paradises, e.g. Bermuda, Cayman Islands) to avoid the economic risks associated

with emerging market countries. While it is possible to incorporate a business in

Mexico, the country lacks comparable vehicles or structures as in developed

countries to protect investors from fiscal responsibility.

Regulatory system: In conjunction with the legal system, the Mexican regulatory

framework does not provide private equity funds with the infrastructure necessary

for successful investments. Minority investors in Mexico cannot enforce put-

options, and implementing other terms such as tag-along or drag-along rights are

possible but often difficult to impose. In 2005, the Mexican Congress proposed a

new law that aimed to improve corporate best practices, particularly focusing on

the way capital gains are taxed and the enforcement of minority shareholder rights.

When all other means of exit failed, the portfolio companies did not honor their

obligations, leaving expensive legal action as NAEF’s only exit alternative and

completely dependent on the decisions of Mexican courts.

Private equity expectation. After the 1995 crisis, all types of financing were

difficult to obtain and Mexican companies began turning to private equity as a

substitute for loans. This mentality negatively impacted private equity firms as

portfolio companies often viewed management participation as intrusive. Mexican

38

companies have also typically been inclined to buyback their shares and retain

ownership of their company than sell to a 3rd

party buyer. Moreover, the 1995

crises set a precedence of companies defaulting on their payments and re-

negotiating their contracts, which put the NAEF at a disadvantage. The

entrepreneur’s attitude towards private equity was an inexpensive and attractive

alternative to loans – in some cases, entrepreneurs viewed the capital as “free

money”, rather than a vehicle for growth, which was later reflected in their

unwillingness to repay. The main reason for the NAEF two-year extension was to

re-negotiate the contracts with which numerous of their portfolio companies did

not comply.

Family-owned businesses. Traditionally, original shareholders in Mexican

companies are family members who are typically unwilling to sell any equity in

their company or relinquish control to outsiders. The control and direction of many

small- and medium-sized firms are passed down from generation to generation,

with the mentality that the company be sustainable to provide for the livelihood of

the family. The legacy of the company often takes precedence over expansion and

growth. For example, the NAEF could not convince the CEO of Consorcio Beta to

sell his company to a 3rd

party buyer because he had no interest in relinquishing

control of his family-owned firm.

Lack of entrepreneurial culture. While Mexico has a relatively strong

entrepreneurial culture (particularly in the informal sector) compared with many

other emerging economies in Latin America, it still suffers from a dearth of

entrepreneurs with value-added, scalable companies. Much of this is due to the

population’s lack of financial resources that allow them to incur the risk of starting

a business (and finding alternative employment should their venture fail). Other

39

factors to take into account are the lower level of education (compared to the U.S.),

the lack of data available on markets, demographics, competitors, prices, costs,

etc., regulatory hurdles and labor market rigidities, lack of R&D efforts and

general lack of financing options, including risk capital scarcity.13

These factors

undoubtedly made it more difficult for NAEF to encounter Mexican firms that

complied with their value-added and scalable criteria. Similarly, the portfolio

companies that NAEF did choose were likely unfamiliar and averse to the high-

risk decisions NAEF recommended to them.

Fund Management Experience. The lack of any local fund manager with a strong

track record in venture capital when NAEF was founded likely negatively

impacted the fund. A report on “Managing SME Investment Funds in Latin

America and the Caribbean: Lessons Learned and Recommended Best Practices”

published by Babson College and the MIF cited investment experience as one of

the imperative factors in a successful investment. The study noted “proven

experience in business and financial transaction work, especially hands-on

experience in deal analysis and structuring” as key components. The study also

states that “the fund management team have at least a working knowledge of LAC-

based financial customs and norms.” While NAEF appeared to comply with these

best practices, the outcome of the fund demonstrates to what high degree of

experience and knowledge is needed to achieve successful results in Mexico.

XII. Conclusion

This paper was prepared to disseminate awareness of the realities of the venture capital

industry in Mexico from the point of view of a real-life fund. While every fund and

13

Fabre, Fernando and Smith, Richard, “Building an Entrepreneurial Culture in Mexico,” Prepared for

Nacional Financiera, SNC under a grant from U.S. Trade and Development Agency, May 2003.

40

investment is unique, the aim of this paper was to impart to readers, particularly future

fund managers, the general lessons learned from NAEF.

As discussed above, the overriding oversight conveyed by NAEF management, investors

and portfolio companies was the differences and lack of expression in expectations

between all parties. NAEF management established the investment with a specific venture

capital model that functioned in the U.S. and that they believed could be transferred to

Mexico; however, Mexican portfolio companies ultimately did not understand the model,

nor did they comply with the investment rules. Investors imposed regulations, e.g. NAEF

49 percent or less ownership in companies, that they believed would promote the venture

capital model in Mexico, while in fact several of these regulations hindered more than

helped the investment.

With these hindsight ideas in mind, readers and future venture capital funds should realize

the importance of transparency, clear conveyance of expectations, and due diligence in

Mexican investments. While the venture capital landscape in Mexico is improving

(particularly in the promotion legal instruments which will aid foreign investors in exit

strategies), investors still need to take additional precautions and incorporate stricter terms

when seeking investors and choosing portfolio companies. By delving into the detailed

aspects of NAEF, it is hoped that future venture capital funds will be able to overcome the

hurdles encountered by NAEF and further understand the context of investing in Mexico.