. . . as appeared in . . . Published by WorldTrade Executive, Inc. LATIN AMERICAN LawLaw && BusinessBusiness ReportReport

Volume 14, Number 09 September 30, 2006

Dealing (and Dealmaking) With Mexican Grupos: A Primer for the Private Equity Investor

By Alyssa A. Grikscheit and Javier Fierro (Goodwin Procter LLP)

Private equity investors are rediscovering . panded outside of Mexico. Founded and led by the Many foreign investors active in experi- Berrondo family, Mabe produces 35% of stoves and re- enced a rocky ride in the 1990s, which led to a sharp frigerators sold in the under the GE and downturn in fundraising and investment. When interest Hot Point brands. The Bailleres family is the largest sil- in the region began to revive, the Goldman Sachs BRIC ver producer in the world, the Larreas family is the third report focused many investors on Brazil. But in the first largest copper producer in the world and is the six months of 2006, Mexico attracted more investment largest cement manufacturer in the United States. The than either Brazil or Argentina. Some of these recent Salinas family has already expanded its network of over transactions evidence a maturing private equity market 1,000 Elektra stores into Guatemala, Honduras, Peru and in Mexico. For example, Advent International’s May an- Panama and recently announced that Uruguay and Ar- nouncement of the acquisition of Milano, a Mexican re- gentina will be next. tail business, has been described as the first middle mar- At first view, the Grupos with their complex and ket private equity deal in Mexico to use significant le- often seemingly inefficient organizational structures verage. Much has been written on the relative merits of may seem like dinosaurs of the past. However, these investing in Mexico vis-á-vis other Latin American mar- conglomerates have endured in part because they kets, as well as on the new Mexican securities law and help their owners overcome the market failures that other attempts at legal reform to attract private equity plague Mexico and other countries with weak in- investors. But very little has been written about a struc- stitutions. Some may argue that Grupos’ survival is tural issue private equity investors are bound to encoun- short-lived and that competitive global trade will ter when investing in Mexico: the Mexican grupos inevitably cause their extinction. Although possible, economicos or simply, “Grupos”. at present these Grupos are far too numerous and Grupos are the large family conglomerates that domi- powerful to ignore when investing in Mexico. nate the of Mexico and many other Latin American countries. In Mexico, Grupos have impeded Why do Grupos Exist? competition, keeping near-monopolies in certain indus- Grupos solve many structural issues that exist tries. For instance, there are only two beer companies, in Mexico and other developing economies. In par- two major food processors, two television networks and ticular, the bureaucracy of many emerging market six radio chains. Some Grupos have successfully ex- governments not only leads to higher transaction costs but also breeds corruption. From the perspec- tive of an entrepreneur, the threat of corruption combined with the red tape required to establish Alyssa A. Grikscheit ([email protected]) is a and run a business may seem insurmountable. Partner in the Business Law Department of Goodwin Procter Djankov (fig 1 on page 18) shows the positive rela- LLP. Her practice focuses on private equity, mergers and tionship between corruption and the number of bu- acquisitions and general corporate law. She specializes in reaucratic procedures required to establish and run international transactions involving Latin America and Eu- a business in a number of countries around the rope. Javier Fierro is expecting his J.D. from Northwestern world, with the positions of the United States and University School of Law and his M.B.A. from the Kellogg School of Management in 2007. MEXICO

Mexico being on the left and right side of the fig- when such contracts are clearly beneficial to both ure, respectively.1 parties. A Grupo solves this problem by horizontally In 2005, Transparency International ranked integrating both businesses to reduce contractual Mexico 65th out of 159 countries in perception of cor- uncertainty and eliminate the need for external en- ruption, while the United States ranked 17th.2 Ear- forcement. In addition to overcoming weak contract lier this year, the Mexican Congress passed legisla- enforcement rights, Grupos can also lower their cost tion allowing Grupo , a Mexican media and of capital. Some Grupos will own and operate banks entertainment giant, free access to digital band- and insurance companies which can then provide width while its competitors bid for the new digital scarce capital to other family businesses. Salinas spectrum. Political pundits call the new legislation, Pliego serves as CEO of Grupo Salinas and Grupo

Figure 1. Positive Relationship between corruption and bureaucratic procedures

Evidence: Grease or Sand? Corruption Index (1 = worst)

Source: Djankov et al (2001)

Ley Televisa (“Televisa law”). Elektra, two holding companies which own interests Besides corruption, firms in emerging markets in telecommunications, media and retail stores as well typically face weak enforcement mechanisms, weak as a bank, among those TV Azteca, Elektra and Banco capital markets, weak property rights and poor la- Azteca. Banco Azteca was established in 2001 primarily bor markets. Grupos can help address many of these to provide store credit to customers of , problems. For example, if contract enforcement is Mexico’s largest appliance retailer. weak, parties may be reluctant to contract, even

Table 1. Garza Sadas Family of Grupos

Grupo Top Executive , refrigerated Jose Calderon Rojas, Chairman Alfa products, aluminum auto parts, and CEO telecommunications Femsa Eugenio Garza Laguera, Soft drinks, beer and convenience Honorary Life Chairman stores Vitro Federico Sada ,CEO Glass Cydsa Tomas Gonzalez Sada Chemicals, plastics, yarn CEMEX Lorenzo Zambrano Cement

2 LATIN AMERICAN LAW & BUSINESS REPORT September 30, 2006 MEXICO

Understanding the Mexican Grupos Dealing (and Dealmaking) With Grupos There are three main common characteristics found As previously stated, dealing with Grupos can be a in a Mexican Grupo. First, the Grupo will typically run thorny issue, especially when trying to exit the invest- several businesses, and often these businesses will oper- ment. Some Grupos may not want to exit their invest- ate within various industries. Second, the Grupo will gen- ment because they want to pass down the business to erally be composed of more than one family, but their their offspring. Other less scrupulous Grupos may use connections run deep. And third, the organizational their political and economic muscle to shift to other structure is predominantly based on kinship. investments within the Grupo. On the other hand, a Grupo The Garza Sadas family from the industrial city of on an investor’s side can be a significant ally in an emerg- , Mexico provides a great example of the deep ing market. By integrating with a Grupo, an investor will roots the Grupos have in the Mexican and soci- gain political power, acquire local knowledge of the coun- ety. The Garza Sadas can be traced at least as far back as try, and avoid contractual problems with other local the late 1800’s when Isaac Garza, Francisco Sada, and firms, all while avoiding expensive research costs. The Jose Murgueza joined together to strengthen their fam- question therefore arises: how to find a suitable Grupo? ily business. Along the years, the Garza Sadas have joined As with any other investment opportunity, finding a Grupo with other powerful families either through joint busi- will inevitably require the investor to do its homework. ness ventures or even through marriages. In fact, some of the top Mexican Grupos (Alfa, Femsa, Vitro, Cydsa, Due Diligence Cemex) today can be traced back to this trio of entrepre- First and foremost, the investor needs to perform a background check on the family. The investor needs to identify red flags such as young and inexperienced fam- Earnouts can be a powerful tool in ily members in key management positions within the company. In addition, the investor needs to review their dealmaking with Grupos. resumes. Are they educated professionals or are they sim- ply in their positions because of their family name? A strong kinship bond within the Grupos sometimes dis- neurs (see Table 1). From the table below, one can also places sound business judgment and good corporate observe the magnitude of the Garza Sadas market power governance. and their diverse industry coverage. The investor should also identify the family patri- In addition to the large public firms that Monterrey arch within the Grupo. Sometimes knowing who holds families tend to operate, there are also smaller private the power within the family may not be readily appar- firms which are the preferred avenue for many Grupos ent because of the complexity of the Grupo network. from the Mexico City area. There are two main reasons Understanding the family organizational hierarchy will why Mexico City families tend to desire several, but prove invaluable when a conflict arises. The investor smaller businesses. First, the family can have majority should also verify whether the Grupo has the political ownership of the business. And second, and probably and economic muscle they claim to have; sometimes it most importantly, the family patriarch can eventually may just be pure bravado. give each of his offspring a business to operate after his In addition, the investor should check to see if the passing. Mexico City Grupos also tend to rely on kinship Grupo has commitments with other foreign firms. Such much more than the Monterrey families. In a Mexico City commitments may mean a Grupo has already been re- Grupo it will be more evident that all the top executives quired to keep family assets and company assets sepa- of the Grupo will be family members; in contrast, rate and to meet certain corporate governance standards. Monterrey Grupos will typically allow “non-family” It may also mean the Grupo’s reputation will be affected members into the management team. by a major fallout with a foreign investor. While check- Even though the Mexico City and Monterrey Grupos ing the Grupo’s commitments, the investor should also tend to operate slightly different business models, both check for potential conflicts of interest that may arise from Grupos strongly desire to maintain ownership and con- the transaction. Last year, the SEC filed a complaint trol of their family businesses; an especially thorny issue against Salinas Pliego after he allegedly defrauded in- for any investor. Many Grupos have been able to orga- vestors in a transaction that personally netted him $109 nize their corporate governance so that even though they million dollars.3 The complaint also alleges that Salinas may represent only 4-5% of the total equity investment, sold millions of dollars of his , while his self-deal- the families continue to maintain control of their invest- ing remained undisclosed. ments. Even when the best business decision for the fam- ily is to exit an investment, Grupos will on occasion ig- Negotiating With a Grupo nore sound business judgment for the sake of maintain- As mentioned above, it is critical to identify the key ing control of their businesses. players in the Grupo. This is particularly important in the negotiation process. Negotiating with a family mem-

September 30, 2006 LATIN AMERICAN LAW & BUSINESS REPORT 3 MEXICO ber with insufficient authority may mean that conces- the separation of family rights and obligations from those sions made by the Grupo are later reversed, effectively of the company. Enforcing these minority rights can be prob- giving the Grupo two bites at the apple. lematic, however, which is why it helps to have the Grupo’s It is also critical to build a relationship based on reputation or an earnout payment at stake. mutual trust. Although many Grupos have been success- ful in jurisdictions outside of Mexico where deals may Saying Goodbye to Your Grupo go to the highest bidder regardless of emotional or other At the outset of the deal, it is fundamental to con- connections, they still tend to rely on building relation- sider a range of exit strategies and plan for those out- ships before crafting and executing deals. comes. As every private equity investor knows, exits are Finally, it is crucial to note the long-term memory of notoriously difficult to script in advance. Nevertheless, most Grupos. Because of their family connections, man- it is crucial for a private equity investor to keep its op- agement is typically not very fluid. The investor’s man- tions open. Darby recently was able to partially exit from its investment in Promotora Ambiental SA de CV by sell- ing some of its shares in a Mexican IPO, together with Grupos have endured in part because the Garza Santos family. But IPOs are the exception rather than the norm, and private equity investors must care- they help their owners overcome the fully consider the exit timeline (if any) of their Grupo part- market failures that plague Mexico and ner to ensure that an exit is possible on favorable terms. Some Grupos may never permit a sale to a strategic in- other countries with weak institutions. vestor, or at least not to a competing Grupo. This may reduce exit options, and some investors may be forced to exit by selling to other private equity investors with agement team may change several times, while the longer mandates or different objectives. Grupo’s team remains more or less intact. Perceived in- justices by the investor will not be easily forgotten, and Final Thoughts may impact future dealings with the Grupo. Grupos can be both a source of competitive advan- tage as well as disadvantage for an investor deciding to Setting a Price invest in Mexico. A Grupo can provide the local knowl- Earnouts can be a powerful tool in dealmaking with edge needed to succeed in a country where the “rules of Grupos. They ensure that performance incentives are the game” are not clearly demarcated. But as with any aligned and serve as both “sticks” and “carrots”. The stick other relationship where reliance is of utmost importance, is essentially the investor’s bargaining power in the event there is always the possibility of something going awry. of future disputes, and the carrot, quite simply, is cash, Mexico is an attractive market for private equity inves- which may be in short supply in Grupos that do not in- tors, but it is even more attractive for informed inves- clude a captive bank. tors. By considering the peculiarities of Grupos before There are other possible leverage points. Sometimes dealing or dealmaking with them, investors are sure to a private equity investor will try to position itself as the structure better deals and achieve better exits. ❏ information gatekeeper. The investor may try to hold cer- tain valuable information or intellectual property sepa- rately from the portfolio company. Holding such infor- 1 Djankov, S., et al. (2001), “The Regulation of Entry,” unpub- mation or intellectual property directly may allow the lished manuscript, World Bank and Harvard University, rd investor to exert external pressure on the Grupo without 3 draft. 2 Transparency International (2005), “Transparency Interna- having to rely on weak institutions for enforcement. tional Corruption Perceptions Index 2005,” Berlin, Transpar- However, this approach may not be practical in Grupos ency International Secretariat. (www.transparency.org). where the management (and members of the Grupo) have 3 U.S. Securities and Exchange Commission (2005). http:// an inherent information advantage. www.sec.gov/news/press/2005-1.htm

Securing Minority Rights and Other Protections Another important factor in closing a deal with a Grupo is obtaining enough minority rights or other pro- tections to ensure an exit at a fair return. The core strat- egy as a minority shareholder should be to maintain suf- ficient control of key management decisions. Private eq- uity investors should require board seats, supermajority voting or veto rights for board decisions, special stock- Reprinted from Latin American Law & Business Report, with holder voting rights and preemptive rights. To further avoid permission of the publisher, WorldTrade Executive, Inc. exit difficulties and liabilities, the investor should insist on www.wtexecutive.com

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