Opportunities Await ‘One-Stop Shops’: Corporate Renewal in Infancy in Latin America

(TMA International Headquarters)

Despite the enormous presence in Latin America of U.S. and European multinational companies representing almost every existing industry in the world, the turnaround management industry remains in a stage of mom-and-pop shop development in the region.

About $54 billion (U.S.D.) of non-performing loans in Latin American countries are not appropriately served by specialized turnaround management firms or investment funds. Turnaround business opportunities await firms that can provide “one-stop shopping” for corporate renewal services in Latin America. Two major avenues for developing a presence in the corporate renewal industry in the region are:

1. Providing U.S. type turnaround services to U.S. and other foreign-based commercial banks, private equity funds, and financial institutions that have exposure in the region and to local commercial banks.
2. Sourcing and arranging new debt and equity for distressed companies.

U.S. banks have operated in Latin America for quite some time. Bank loans in the region represent the largest portion of U.S. credit exposure in emerging markets. At the end of fiscal year 2001, claims on foreign borrowers held by U.S. banks in Latin America were $77 billion, or 7.3 percent of the total. However, U.S. bank lending in the area fell by 18 percent in 2001 during the region’s most recent economic recession, according to the National Bureau of Economic Research and the World Bank.

The Latin American banking system has undergone substantial internationalization during the past decade, a sign that commercial banking practices in the region are closing the gap between their practices and those of large, developed economies. According to the Inter-American Development Bank (IADB), the foreign share of banking system assets in Latin American countries increased dramatically from 1995 to 2000 as follows:

1. Peru, from 20 to 55 percent
2. Mexico, from 5 to 45 percent
3. Argentina, from 20 to 45 percent
4. Venezuela, from 4 to 45 percent
5. Brazil and Colombia, from 6 to 22 percent

The growth in the number of nonperforming loans, and thus of the demand for turnaround management services, stems from a sharp reduction in the growth rate of Latin America’s $2 trillion gross domestic product (GDP), which fell to 0.9 percent in 2001, from 3.8 percent the previous year. Non-performing loans represent about 8 percent of the total loan portfolios of commercial banks operating in Latin America.

Along with the increased presence of international commercial banks in Latin America has come a large increase in the size of the private equity industry. Virtually nonexistent in 1992 ($107 million), the private equity industry had mushroomed to nearly $3.7 billion by 1998, before declining to $1.9 billion in 2000.

According to Asset Alternatives Inc., the first wave of private equity investment arrived in Latin America in 1992 and consisted of buyouts of companies in the traditional economy. A second wave of private equity investment, centered around Internet ventures, occurred in 1999 and 2000.

Turnaround opportunities in the region stem from a lack of successful exits from numerous investments made by Latin American private equity funds as far back as 1994. Time to exit is longer in Latin America, compared to more-developed economies. A wide gap exists between the number of turnaround management firms and special-asset funds in Latin America and the growing need for such services by commercial banks.

Few, if any, specialized turnaround management firms support Latin American commercial banks, and the same can be said for those that operate on the left side (or the lower right side) of the balance sheets of distressed companies, as occurs in the U.S. Furthermore, no specialized turnaround management firms combine Latin American and American professionals and practitioners, as often occurs elsewhere in the consulting business.

Today, the main method used by Latin American commercial banks and investment bankers faced with distressed companies is a rescheduling of debts; seldom are nonspecialized consulting firms hired to handle the managerial aspects of corporate renewal.

Major obstacles to Latin American business development cited by those surveyed by World Bank and IADB in 2001 included:

1. Financing (35 percent)
2. Taxes and regulations (15 percent)
3. Inflation (7 percent)
4. Crime and corruption (3 percent each)
5. Judicial system (2 percent)

Despite the internationalization of the banking system in the region, Latin America’s financial markets remain small. Private credit is 27 percent of GDP, a ratio that reaches 90 percent in some developed countries and East Asia. Stock market capitalization is only 3 percent of GDP, according to IADB.

One of the main reasons for the low credit penetration is that high interest rates prevail in Latin America. Real interest rates range from 10 to 40 percent because of macroeconomic mismanagement factors. The lending rate minus the LIBOR percentage average in Latin America is 22 points, while that figure reaches 1 point in developed economies. Also, a lack of competition allows Latin American commercial banks to charge interest rate spreads that are about five times as high as those of developed economies, according to the World Bank.

Basic macroeconomic trends indicate that pioneering the special-asset investment industry in Latin America could be very profitable. Key statistics suggest that the globalization of Latin America is continuing, which in turn will make exit mechanisms and higher rates of return on investments more available to investors in the future.

Economic Progress

Latin American countries have recorded substantial market-oriented progress over the previous decade, and World Bank forecasts call for stable macroeconomics from 2004 to 2010. The World Bank projects real GDP growth at 3.9 percent, the per capita GDP at 2.6 percent, and inflation at 5 percent over the same period.

Capital flight from Latin America is indicative of citizens and businesses trying to protect the real value of their savings in the face of government macroeconomic mismanagement; it does not represent a lack of return on investments or insufficient investment opportunities. World Bank data indicates that gross capital formation, as a percentage of GDP, is 21.4 percent, which is similar to 22 percent average posted by more-developed economies.

During the last decade, imports from outside the region grew by an average of 15.4 percent, while comparable figures for the rest of the world increased by 8.8 percent. Latin American exports to countries outside the region grew by 10 percent during the period, while comparable figures for the rest of the world rose an average of 8.4 percent. Exports among Latin American countries grew by 17.8 percent for the 10-year period, and imports among those countries grew by an average of 16.0 percent.

Average tariffs declined from more than 40 percent in 1985 to 17 percent in 1998, and tariff dispersion was reduced from 22 percent to 7 percent for the same period, according to IADB.

By 1998, the level of U.S.majority-owned foreign affiliate activity in Latin America was 20.5 percent. This means that the U.S. has 1.4 million citizens employed and $230 billion in sales in Latin American countries which, according to the National Bureau of Economic Research, represents the largest U.S. business presence in the world outside the 30 member countries of the Organization for Economic Cooperation and Development countries.

Direct foreign investment in Latin America, the most important source of financing for many countries in the region, grew from $8 billion in 1990 to more than $100 billion by 2001. In addition to more -traditional avenues of investment, Latin America has been a world leader in involving the private sector in infrastructure investment in projects involving port facilities, electricity, telecommunications, roads, and other ventures, according to IADB. The region remains the number-one recipient of direct foreign investment in the world, according to the World Bank.

Rates of return on their Latin American operations for most multinational companies are among the highest in the world. U.S. franchises, consulting companies, and commercial banks are more profitable in Latin America than they are most anywhere else. This suggests that applying best-practice management to companies in trouble in Latin America should generate higher rates of return than in many more-developed economies.

The franchising average growth rate in the last three years, estimated by the number of new stores opened, was 20 percent, with an estimated time of return of the investment of nine to 11 months. This suggests that introducing new compensation systems and best practices can produce attractive returns to investors in Latin America’s less efficient markets.

Legal Frameworks

Historically, Latin American countries have lacked effective judicial systems to protect either foreign residents or their own citizens. Corruption is also a serious ongoing problem in these countries. Income inequities have been blamed for what have sometimes been explosive political and social conflicts.

In many Latin American countries today, however, foreign and local investors and their creditors are increasingly protected by statutory and constitutional provisions and are able to pursue property claims through the legal systems. There have been no expropriations in the past several years, nor are any expected, particularly seizures of foreign-owned property. Despite progress in protecting legal rights, judicial procedures are lengthy, and judgments remain uneven.

The political climate in Latin American countries is moving toward more representative democracies. Members of the Organization of American States signed the Inter-American Democratic Charter in September 2001, for example, which states that representative democracy is indispensable for the stability, peace, and development of the region. This document is playing a significant role in providing limits to discretionary governmental policies.

The constitutions of many countries in the region allow for arbitration of domestic or international disputes as “provided by domestic law.” New laws are making arbitration agreements involving national or international firms automatically binding, eliminating the need for judicial mediation. The U.S. State Department has said these developments show promise as a dispute settlement mechanism under the new system.

Many countries in the region have ratified a series of international agreements on arbitration. Many are members of the New York Convention on the Recognition and Enforcement of Foreign Arbitrage Awards. In addition, many Latin American countries have in place bilateral investment treaties that provide for international arbitration of investment disputes under the auspices of the World Bank’s International Center for the Settlement of Investment Disputes (ICSID).

Many Latin American countries also participate in programs through the Overseas Private Investment Corporation (OPIC), a self-sustaining U.S. government agency that provides political risk insurance and loans to businesses investing in or competing in 140 emerging markets and developing nations around the world. Many have also joined the World Bank’s Multilateral Investment Guarantee Agency (MIGA), which provides investment guarantees against risks of currency transfer, expropriation, war and civil disturbance, and breach of contract by the governments.

Both turnaround management firms and lenders that specialize in investing in distressed companies must be introduced simultaneously to develop the corporate renewal industry in Latin America successfully. Today, neither industry segment enjoys a large enough presence in the region.

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Investment Strategies

There are a number of ways to invest in troubled Latin American businesses, including direct purchases of debt from principal creditors, refinancing, acquisitions, management buyouts, and turnarounds.

Other avenues exist through providing debtor-in-possession and exit financing, bridge/equity financing to relieve short-term liquidity constraints, bankruptcy-related financing, post-bankruptcy equity financing, and supplemental financing for complementary/add-on acquisitions. Still other opportunities are provided through bank loan substitution, industry consolidation, branding, franchising of industries, financing niche competitors of old monopolies, market expansion, and infrastructure projects.

In exploring business opportunities in Latin America, investors should investigate the following issues:

• Political Environment. The national government of the country should have an appropriate legal framework in place to protect investors’ and creditors’ rights and to offer minority-interest protection. The country should also be a member of the Organization of American States. Internationally recognized accounting firms should be operating in the country and should adhere to transparent accounting standards. The country’s tax structure should also be analyzed.
• Financial Status. Companies should have $10 million to $500 million in revenues, the ability to produce revenue in U.S. dollars, and sound underlying business fundamentals, despite their financial distress. They should be subject to investment scenarios in which the fund manager can either exercise control of the management company or expeditiously divest its ownership interest. They should have strong real or potential operating cash flows to service proposed debt and assets and cash flow that can be leveraged. Companies should have low capital expenditures, limited additional funding requirements for new capital equipment or research and development, and no significant contingent liability. In general, an investment fund should acquire securities directly from a portfolio company.
• Operations. Companies should be operating in South and Central America in industries that are profitable in the region and healthy in other parts of the world, and have benefited from technological improvement and innovation elsewhere. They should have diverse customer and supplier bases and the potential to export products and compete on a global scale or in geographically defined niche markets. They should also have well maintained facilities, productive equipment, and the potential to expand product lines.
• Management. Management should be competent, ethical, and amenable to forming alliances and added-value business strategies. They should be able to retain existing skilled professionals or recruit new employees who have strong innovative and entrepreneurial experience. Management should also be given an equity interest in the company as an incentive to ensure that the business becomes successful.
• Products. Products should meet relevant needs and have strong brand identification and low obsolescence. They should be subject to limited seasonality and business cycles. Production should be adaptable to changing technologies, and sales volume should show the potential to increase through implementation of value-added strategies and intangible asset management.
• Liquidity and Exit Mechanisms. Opportunities should exist for liquidity five to seven years after acquisition. This can be accomplished by investing in industries in which strong, easily identifiable strategic buyers can be identified or in which Latin American private equity funds are consolidating operations. Initial public offerings are also possible. The potential return should be commensurate with risk.