What Not to Do In Equity: The Hexagon of Equity Pitfalls

WHAT NOT TO DO IN EQUITY:
THE HEXAGON
OF EQUITY
PITFALLS
PABLO E. VERRA
January2020
Underestimating
the macro
environment
Driving
equity
based on
volume
targets
Rushing
structuring &
giving up
rights
Lack of
accountability &
proper
incentives
for staff
Using a
blanket
approach for
industries &
countries
Picking the
wrong sponsor
for equity
© Pablo E. Verra – 2020

The Infamous Hexagon of Equity Pitfalls
1
Underestimating
the macro
environment
Driving
equity
based on
volume
targets
Rushing
structuring &
giving up
rights
Lack of
accountability &
proper incentives
for staff
Using a
blanket
approach for
industries &
countries
Picking the wrong
sponsor for
equity
If you are an impact investor, you should beware of the infamous hexagon of equity pitfalls. Clearly,
avoiding these 6 rather common traps will not guarantee you record-breaking IRRs but, at least, you would
not be making what I consider, in my humble opinion, 6 avoidable mistakes in equity investing.

1. Underestimating the Macro Environment
2
Equity investments, unless hedged (and hedging equity is rarely feasible and usually expensive!), are
denominated in local currency and, as such, carry FX risk. Understanding and predicting, as good as you
can, the macro conditions is critical to better project US$ returns – great IRRs in local currency do not
mean great IRRs in US$, Euros or Swiss Francs. What really matters is what is the currency you are
raising, and, thus, deploying!
Oops! I spent 3
months arguing
whether the
EBITDA margin
needed to be 20 or
25% and whether
to pay 1.4x or 1.5x
value... and the
local currency
devalued 50% 6
months after I
invested! There is
no way I can turn
this around for my
US$ investors!
Source: Bloomberg.

1. Underestimating the Macro Environment (cont’d)
3
Local presence has proven to be critical to better foresee macro and industry dynamics that may affect
equity investments. It is proven that funds with a local presence perform better than fly-ins!
Comparing LAC PE/VC Returns
in Local Currency & US$
(since inception)
Multiple of Invested Capital
for Realized Latin American Investments (in US$)
Source: Cambridge Associates. The Private Path to Latin America’s Most Dynamic Sectors.

2. Driving Equity Based on Volume Targets
4
PE & VC funds correct based on macro trends – they raise less money and invest on fewer deals if the
environment is less conducive for equity. Some impact investors, including some multilaterals, define their
equity targets based on “annual invested volume” – this is a recipe for disastrous over-investing, bias in
favor of big tickets and reduced leverage when structuring. Absolute volume targets go against this
recommended behavior and should be avoided.
Annual EM-focused PE Fundraising Annual LAC-focused PE Fundraising
# & Aggregate Value of PE Deals in LAC # & Aggregate Value of VC Deals in LAC
Source: Preqin
Private Equity
Online &
LAVCA.

3. Rushing Structuring & Giving Up Rights
5
As an impact equity investor, there is a universe of structural clauses that should be avoided in order not to
restrict the investor’s capacity to maneuver an equity investment. Furthermore, rushing the processing of a
transaction could derive into operational mistakes that can end up costing a lot of US$.
• Clauses that limit the investor’s exit options, hence minimizing liquidity for the
investor’s shares
• Rights of First Refusal (ROFR); Rights of First Offer (ROFO).
• Clauses that are value distractive for the investor
• Call Options, Drag-Along Rights, ROFO, ROFR.
• Believing that a put “guarantees” the investor an exit
• Puts may not be enforceable in times of distress;
• Put agreements may have to be litigated before NY courts and enforced
before local courts law; and
• The bylaws of the company may not even reflect the put agreement.
• Overly complicating formulas or clauses
• If not properly reflected in the agreements, the sponsor may not respect the
original commercial understanding at the time of signing.
• Allowing the sponsor to sell a key subsidiary without a veto right
• Price incentives between the sponsor and the investor may not necessarily be
aligned (e.g., sponsor may have a much lower entry multiple).
You guessed right! I
have personally
been burnt by
many of these
clauses. And I will
dedicate another
chapter of this
primer series to
proper structuring
and the rationale
for accepting / not
accepting certain
rights. Please,
include anything
you want me to
cover in your
comments!

4. Lack of Accountability & Proper Incentives for Staff
6
Often, impact investors manage both equity and debt funds. This may seem obvious, but I have seen several
situations where there is an unintentional bias to prefer debt deals because, in most cases, they are
easier to negotiate and funds can be deployed more rapidly. If you are in this dual investment scenario,
remember that you owe fiduciary duties to all your limited partners. I have also seen structures in which deals
are negotiated and signed by senior executives and then ‘transferred’ to be monitored by junior team
members – this reduces accountability and the capacity to detect operational mistakes.
Time of Investment
▪ Much more time
consuming than debt;
▪ Requires developing
trust with a client.
▪ Better to align deal
breakers (e.g.,
valuation
expectations) as early
as possible;
▪ Extensive negotiations
are usual;
▪ No ‘cookie cutter’
approach – each deal
is different.
▪ Usually performed by more junior team members;
▪ Closely monitor performance – mark to market needed if
company is listed in an active market;
▪ Choose the ‘right’ Board member and organize frequent
calls with him/her;
▪ Resolution of operational problems – utilization of
supermajority / veto rights (e.g., in the event of a merger
or an acquisition).
▪ Usually negotiated
by senior officers;
▪ Rapid and intense
process (weeks can
make all the
difference).
Senior Officer Investment Team Junior Officer Senior Officer
PREFERRED: Investment Leader
Sourcing
Execution
& Signing Portfolio Monitoring Exit
Most of the work
happens HERE!I recommend that
the “deal maker”
stays as the
ultimate
responsible
officer from the
origination of the
deal until its exit. In
equity, we say that
the “real work
begins when you
sign the
subscription
agreement”.

5. Use a Blanket Approach for All Industries & Countries
7
I have been lucky enough to have worked in 22 different Emerging Markets. Each deal, each context, each
sponsor and each negotiation has been different. Due to this, I naturally have a bias to favor industry and
region-specific funds than global ones. When an investor approaches me with a global fund, the first question
I usually ask is “how are you going to know what happens in Indonesia from your office in Midtown?”.
Granted, there are successful global funds (it may be easier in public equity than in private equity), but, in
most cases, even these global funds have separate, dedicated, teams to look at each industry and region.
Source: Private Equity
International.

6. Picking the Wrong Sponsor for Equity
8
When doing debt, your counterparty – in most cases – is the company; when doing equity, your
counterparty is the sponsor.
• Sponsors usually negotiate harder on equity than on debt (e.g., they are giving you a part of “their”
company);
• It is very difficult to determine the financial “capacity” of a sponsor to honor e.g., a put (and this
financial capacity may easily change over time);
• Sponsors may not reflect the full extent of the equity agreements in the company’s by-laws and
may drive a potential litigation into local courts (where by-laws usually take precedence);
• Sponsors will probably not be aligned with the investor on valuation when exploring a potential
exit (e.g., their entry valuation multiple may be much lower than the investor’s);
• Sponsors may delegate on management the negotiation of the agreements, but may be behind the
negotiation of “key” clauses;
• Sponsors may lie, threaten the investor and use the press to bad-mouth the investor;
• Sponsors may tell one story to you and a completely different one to the other shareholders; and
• You will never know more about the company that you are investing in than what the sponsor
knows (that is why it is essential to carefully structure an equity investment).

Being Selective is Good, and It Is Expected!
9
“Most buyout firms that I know do 1 deal per general partner per year. You could
think of that as a maximum. One firm I know very well has 8 practice leaders and aims
to do 4 deals a year.”
Josh Lerner – Faculty Chair of Private Equity – Harvard Business School
30 investments discussed
at final investments committee stage
250 unique investments discussed at
investment committee
1,000+ investments
evaluated in a typical
year
Prioritization by industry
investment team
Investments brought by senior advisors,
PE firm relationships, other business lines and industry expertise
Source: streetofwalls.com.
10 completed investments!

Being Selective is Good, and It Is Expected! (cont’d)
10
Do’s
• Well managed companies with good sponsors;
• Historical perspective and conservatism on valuations;
• Attractive ex-ante risk return balance;
• Find the value of the investee company on a pre-money
basis (e.g., how much the company is worth as is and
without the injection of new capital);
• Specific situations in large under-penetrated markets with
good growth prospects (e.g., insurance in LAC,
infrastructure finance in Mexico or Colombia, health
insurance in middle-income countries with poor public
health services);
• Large under penetrated countries/regions where you are
underweight;
• Opportunistic situations (e.g., forced sales or retrenchment
from European players; new private sector banks - but not
all new private sector banks; remaining bank privatizations
- but not all bank privatizations);
• Encourage South-South M&A across your portfolio;
• Help bring strategic investors into new markets (e.g.,
Chinese, Japanese, and Western banks and insurance
companies into Latin America).
Don’ts
• Compromise on management or sponsor quality;
• Compromise on valuation;
• Invest in very hot markets;
• Overly rely on financial projections and/or comparables
instead of historical perspective on valuation;
• Pay for the value that you are expected to add as investor;
• Make large investments in small and/or over-penetrated
markets;
• Pay a premium to market;
• Assume that you will exit at a higher multiple than entry;
• Invest in publicly listed shares in particular during book
building processes;
• Accept weak terms, particularly sales restrictions and call
options.
Source: IFC. Reproduced with Flavio Guimaraes’ permission.

LET’S KEEP TALKING!
Pablo E.Verra
pablo_verra@hotmail.com

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