by Lulu Rumsey

Leverage levels for private equity purchases in Latin America remain low, with the high incidence of liquidations, low liquidity and high interest rates leaving investors cautious, heard delegates at Latin Lawyer´s 7th annual private equity conference, held in New York in September.

Debt financing in Latin America is still not as forthcoming as in other areas of the world. ′′Latin America is still at a point where, instead of leveraged levels of six or seven times [a company´s EBITDA], the banks and the other providers of financing provide leveraged financing at three or four times,′′ said Florack. 

As economic growth in Latin America slows, more and more companies are testing the region´s insolvency laws. But while bankruptcy laws in Brazil, Mexico and Peru offer investors some clarity that their investments will be protected if a company becomes insolvent, the high rate of liquidations resulting from insolvency procedures is putting investors off high leverage ratios. In Brazil, around 90% of companies going through bankruptcy are believed to end up in liquidation.

′′Many acquirers in Latin America have at the back of their mind that the end game is a lot closer to liquidation than what you have in other regions, where you´re actually able to effectively restructure,′′ said Alberto Manotas, a financial advisor at JP Morgan. ′′Even when they´re going for an acquisition, [buyers] are still trying to be very cautious,′′ he continued. ′′That´s why most of the large acquisitions in Latin America have always had an equity component, because taking those one or two turns of additional leverage will take you closer to that end-game which everyone knows is hard to stop once you’re there.′′

Mired in economic recession, Brazil faces unique challenges standing in the way of leveraged deals. Political instability has contributed to high interest rates that have upped the cost of borrowing. Few buyers can afford to borrow huge sums at a 14% rate. ′′We have a legal system that supports leveraged transactions but we don´t have the market for them, and the reason is fairly simple: money in Brazil is far too expensive,′′ said Mauro Cesar Leschziner of Machado, Meyer, Sendacz e Opice Advogados. ′′Banks are not lending, so we have a liquidity issue. And even with the interest rate being as high as it is, banks are concerned about defaults, so we don´t have an active free market.′′

Investors have predicted that Brazil´s new government will lower interest rates for the first time since 2012 this month, but until that happens private equity investors are likely to continue steering clear of debt-heavy transactions. The lack of available leverage means private equity companies focus more closely on targets´ performance. ′′They try to get higher returns by investing in the performance of companies with better strategies from the get go,′′ explained Leschziner.

Leschziner called for a reform of Brazil’s tax system to make lenders feel safer investing in leverage. ′′What we need today is a tax reform that will make the tax system less complicated.  For several of my foreign clients, their major nightmare is trying to understand how the tax system works in Brazil.′′

Lower value deals are now more common in Brazil. ′′ Instead of larger deals that require more finance, you see local players focussing on smaller deals that require less financing but which they can devote attention to and get the performance and the return that they need,′′ said Leschziner.

But structuring small investments can take as much hard work as large ones, which puts some investors off.  ′′There is a basic issue about people being willing to invest in small liquid deals,′′ said panel moderator James Florack of Davis Polk & Wardwell LLP, who said Term Loan B-type loans have to amount to between US$100 million and US$150 million to be worthwhile.

These kinds of loans come from non-traditional lenders, such as hedge funds, institutional investors or collateralised loan obligations. ′′Sometimes it´s because of the investor parameters - because they´re not allowed to invest in things that don’t have a certain liquidity - but other times it´s just a practical matter, where they just don’t want to be in a position where not enough people know this investment so that we need to get out of it,′′ said Florack.

Restricted access to Term Loan B loans also explains Latin America´s low leverage levels. In Mexico, where liquidity is high and cross-border financing is available, high withholding taxes levied on loans from funds means companies prefer to borrow from banks. ′′I think the challenge today is getting more funds as market participants, because there are a fair amount of assets especially in the energy sector waiting to be financed,′′ said Luis Nicolau of Mexico´s Ritch, Mueller, Heather y Nicolau, SC.

In Peru, companies cannot provide collateral in connection with the acquisition of their own shares - a common component of leveraged buyouts. The restriction is one of several contained in local corporate law that make leveraged buyouts rare in Peru. However, several US banks have been able to successfully provide leverage to holding companies, which concurrently upon closing pledge the shares they have acquired as collateral for the loan. ′′It´s not perfect or ideal but we′ve been able to keep the L in the LBO,′′ said Sergio Amiel of Garrigues (Peru).

The private equity conference considered what investors can learn from corruption scandals in Brazil; the risks associated with distressed M&A; why investors are less likely to be successful in state disputes; and reasons to be optimistic about private equity activity in Latin America.

 (Latin Lawyer - 18.10.2016)

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