The financial storm that visited the Latin American capital markets in 1998 had an eerie similarity to Hurricane Mitch-both originated in the East, picked up steam as they headed west, and hit late in the year with devastating force. While Latin America’s financial turmoil receded somewhat in the year’s final months, institutional investors remained on the sidelines, waiting to see if the region’s commodity-driven economies would recover from the multiple blows inflicted by the Asian contagion, the Vodka Effect and the El Niño weather phenomenon. Some vowed to steer clear of Latin America and other emerging markets permanently, raising new questions about how the region would finance its long-term growth.
The year 1998 started with great promise for Latin America’s economies. Foreign capital, attracted by sound economic fundamentals and strong growth performance, poured into the region spurring private consumption and investment. Some analysts, eyeing the mid-summer privatization of Brazilian telephone company Telebras, even predicted that net private capital flows to Latin America in 1998 would surpass the record $87.5 billion received in 1997. Then Russia devalued the ruble in mid-August, sending portfolio investors running for the cover of US Treasury bonds and other low risk securities.
The massive capital drain that followed Russia’s debacle belied the notion that money managers had learned to discriminate between emerging markets that had undertaken painful measures to shore up their fiscal accounts, and others which hadn’t. As one investment banker noted at a financial conference in New York during the darkest days of the crisis, “You could write books on the differences between Mexico and Russia, or for that matter Mexico and Brazil; the bottom line is that it just doesn’t matter.”
Conditions touched rock bottom in early September when speculators started betting that Brazil, with its towering twin budget and current account deficits and overvalued currency, would be the next emerging market domino to fall. In the ensuing weeks, billions of dollars fled the nation’s financial system, depleting its foreign reserves and forcing the central bank to spike short-term interest rates to almost 50% in an effort to stanch hard currency outflows. The decision to defend the real at all costs, including a deep recession, raised borrowing costs for Brazilian corporations in local markets and sent ripple effects throughout the rest of the region. Shut off from external and internal sources of credit, many Latin companies scaled back or cancelled investment plans, undertook cost-cutting measures and sold off assets.
Brazilian President Fernando Henrique Cardoso’s re-election in early October, coupled with the arrangement of an IMF-led $41.5 billion rescue package and the third in a series of Federal Reserve interest rate cuts proved a tonic for the markets. In the year’s final months, a handful of Latin American borrowers returned to the international capital markets. Argentina led the way with a string of late-year sovereign issues, including a seven-year, $1 billion global bond in November. But for the most part, the public markets remained shuttered to all but the region’s strongest credits.
Not Bad, Considering
According to Captial DATA, Latin American borrowers issued about $34.3 billion in fresh debt in 1998-considerably less than in 1996 ($47.2 billion) and 1997 ($57.5 billion).
Nevertheless, the figure was still more than the $22 billion issued in 1993, to that point a record high. As in years past, sovereigns dominated international bond activity in 1998, accounting for the large majority of issuances ($17.26 billion), with corporates accounting for approximately $8.12 billion. Brazil, Mexico and Argentina placed the lion’s share of debt in all categories.
While corporate bond issuance was down almost 60% in year-over-year terms in 1998, a number of noteworthy and innovative deals did come to market. In late March, Mexico’s Grupo Minero placed $500 million of guaranteed senior notes in the Yankee market, securitized with receivables from future metals exports. In October, Banco Nacional de Mexico (Banamex) issued international bonds worth $300 million.
These were securitized with individual and corporate remittances to Mexico drawn on US banks and money transfer organizations. And in December, Mexican state-owned oil company Petroleos Mexicanos issued a $1.5 billion eurobond note with roughly two-thirds of the deal securitized with future receivables from the company’s oil exports.
A Dry Year Ahead?
If 1998 was a middling year for Latin corporate bond issuance, the outlook for 1999 is not much better. “There is not a lot of money waiting on the sidelines to invest in emerging markets,” said Anne Milne, head of emerging market corporate debt research at ING Barings. What little liquidity there is, she says, will be invested very selectively in high quality companies with stellar credit ratings.
Milne contends that the wide spreads on emerging market debt seen early in 1999 have created a “Catch 22” situation for Latin companies seeking to raise capital in international markets. “Those Latin companies that could issue now, probably will not, and those issuers which would be willing to issue, cannot.” Instead, she expects companies to cut back on capital expenditures, restructure, and solidify their banking relationships while waiting for the global environment to improve.
Milne anticipates very little issuance from Latin corporates in the first half of the year.
Jorge Arce, principal of international finance at BT Alex. Brown is more optimistic. He foresees a steady stream of Latin corporates returning to the international debt markets as early as the second quarter of 1999, provided the Brazilian situation settles. Blue chip companies from Mexico and Chile, and especially telecommunications firms, are expected to lead the way. “Investors would likely support telecom plays that have strong capitalization ratios, attractive business plans and proven sponsors,” he said.
Juan Csillagi, vice president of Latin industrial ratings at Duff&Phelps Credit Rating Agency, also anticipates financing opportunities for Mexican and Chilean corporates, as well as a smattering of highly rated companies based in Argentina and Colombia. Furthermore, he says he would not be surprised to see issuances in 1999 from companies based in countries that have only sparingly tapped the markets in the past, such as Peru.
Most analysts agree that the transactions that initially come to market will be guaranteed by multilateral agencies, insurance companies, or through receivables from future export sales. “Wrap transactions,” said Csillagi, provide added security that is essential to investors in this highly unstable environment.
Unfortunately, he points out that many Latin corporates lack the steady, dollar-based revenues needed to securitize issues.
For most Latin companies, the equity issuance window of opportunity closed early in 1998, and did not reopen for the rest of the year, leaving numerous brides standing at the IPO altar. Meanwhile, of the 35 new American depositary receipt programs initiated by Latin corporates during the year, a dozen were accounted for by the new holding companies created by the privatization of Brazil’s Telebras. But some analysts express cautious optimism that the outlook for equity offerings will gradually improve in 1999.
“Particularly in Brazil, there is a considerable reservoir of ADR issues waiting for equity markets to turn around,” said Peter J. Firestein, managing director, Latin America, at Thomson Investor Relations in New York. “If Brazil regains its financial footing, we will have very active capital markets.” Until they do, he says companies will have to rely on short- and medium-term debt instruments and syndicated loans to meet their financing needs.
Loan Lending
In 1998, as in 1997, syndicated bank loans made up the bulk of Latin America’s corporate financing in external markets. Volume was particularly heavy in the first half of the year. Between January and June, 118 syndicated loans worth almost $24 billion were issued to Latin companies. Activity tapered off in the second half of 1998, as bankers looked to curtail their exposure to all market risk. In the fourth quarter, loans to all Latin borrowers-sovereign, corporate and bank-amount to less than $1 billion. For the full year, according to Capital DATA, syndicated loans to the region totaled $50.56 billion-down from almost $58.98 billion in 1997.
The year’s noteworthy syndicated loan transactions included a $300 million credit arranged by Citicorp Securities, BT Alex.
Brown, Chase Manhattan and JP Morgan for Brazilian telecommunications firm Companhia Riograndense do Telecomunicacoes (CRT) in February, and a $400 million loan that ABN Amro, Deutsche Bank and Dresdner Bank co-arranged for Argentine conglomerate Perez Companc in May. The latter loan, which was priced at just 90 basis points over Libor with no covenants attached, was sold to a syndicate of 18 banks.
Most observers agree that the outlook for new bank lending to the region in 1999 is not encouraging, given the decreasing appetite for risk among commercial lenders. Indeed, BankAmerica Corp., America’s largest commercial bank, announced plans in late January to slash its emerging markets exposure by 50% in 1999, following sharp reductions during the fourth quarter of 1998. Many analysts expect other banks to follow suit. If they do, it will result in higher capital costs and more competition among a smaller universe of borrowers. “Banks are going back to basics, shorter terms, and strong structures,” said Arce of BT Alex. Brown.
Not everyone agrees, however, that the 1999 outlook for new bank lending to the region is dire. Michael Clayton, managing director in bank loan sales at Citicorp expects major banks to continue lending to top-tier corporations in “hot industries” such as telecoms, utilities, mining, and oil and gas.
Clayton also thinks that companies that generate dollars through exports or have an OECD-based parent or majority shareholder will continue to enjoy access to bank lending. “It is important to remember that banks are relationship lenders, not purely relative value buyers, and they will continue to support their global client relationships,” he said.
M&A Activity
In contrast to the sluggish pace of public market activity during the latter part of 1998, merger and acquisition (M&A) activity was brisk throughout the year. According to Securities Data, a record 879 deals were announced during the year (including privatizations) worth $86.12 billion-an increase of about $21 billion over 1997. Mega-privatizations in Brazil and Argentina and the sharp fall in private company valuations due to the global financial crisis were the primary reasons for the buoyant M&A activity.
M&A activity was particularly heavy in media and telecommunications, mining and transportation, energy and power, and financial services sectors. A number of significant transactions also took place in the food and beverage, consumer products and retail sectors. Brazil, Argentina and Mexico were targets of significant M&A activity by European multinationals seeking to consolidate their presence in the Nafta and Southern Cone Common Market (Mercosur) blocs.
The sale of Brazilian state-owned telephone company Telebras in July was the year’s landmark privatization. That long-awaited deal, which raised a staggering $19 billion, was the region’s biggest ever. Other noteworthy privatizations included the sale of Argentina’s airports for $5.1 billion and the privatization of São Paulo state electricity distribution company Elektro to Enron for $1.5 billion.
ABN Amro’s purchase of Banco Real for $2.1 billion was 1998’s largest non-privatization M&A transaction. Other significant deals included Valores Industriales’ acquisition of its remaining shares in Fomento Economico Mexicano, S.A. de C.V. (Femsa) for $1.9 billion, Light Gas’s purchase of Metropolitino Elektropaulo for $1.8 billion, and Credit Suisse First Boston’s acquisition of Brazilian investment bank Banco Garantia for $675 million.
If the first month of the year is a bellwether, 1999 will prove another active one for M&A activity in Latin America. In January, Spanish oil company Repsol expanded its regional presence by purchasing the Argentine government’s remaining 15% stake in oil company YPF SA for approximately $2 billion.
Perez Companc of Argentina, meanwhile, purchased a 60% share of local food producer Molinos Rio de la Plata SA from Brazilian agribusiness giant Bunge International Ltd. for an estimated $375 million, and Chase Manhattan Corp. acquired Brazilian investment bank Banco Patrimonio Participacoes SA from Salomon Brothers for an undisclosed amount.
“Given the cheap valuations in Latin America and the lack of liquidity that many companies face, we can expect another record year for M&A in Latin America,” said Walter Molano, head of research at BCP Securities, Inc. in Greenwich, Connecticut. Molano predicts that M&A transactions will increase by about 50% in dollar terms in 1999.
Not everyone, however, expects 1999 to be a bullish year for Latin American M&A. Bear Stearns managing director Mark Van Lith believes that while low valuations may attract bargain hunters to the region, they will also discourage sellers from liquidating assets, resulting in less volume than in 1998. Even if there were an increase in volume, he says that valuations have shifted so dramatically during the past year that aggregate dollar amounts will be less.
Brazil’s exchange rate volatility is another factor that may constrain M&A activity in 1999, says Palden Namgyal, JP Morgan’s vice president of M&A responsible for consumer industries in the Americas. “Nobody wants to go before their board right now to propose doing a deal in Brazil. You could close the deal at 1.50 reais to the dollar and the next week it (the exchange rate) could go to 1.60 reais, and your investment is worth a lot less.”
While bearish about the current environment for M&A in Brazil and elsewhere throughout Latin America, Namgyal is bullish about the long-term outlook. “People are evaluating and reevaluating timing and maybe price, but the strategic priority of being in the region still exists,” he said.
Going Private
The private equity market continued to grow in importance as a source of financing for Latin companies in 1998. Private equity funds, which target small and medium-size, privately held companies with strong growth potential, invested more than $2 billion in the region in 1998-the highest amount ever. Given the lack of alternative financing opportunities, many market analysts expect private equity to enjoy great demand in 1999.
“Brazil with its devaluation will offer great opportunities for private equity capital, since investors will now be able to buy greater assets with fewer dollars,” said Ricardo Silvagni, partner at PricewaterhouseCoopers-Argentina, who believes that Brazil’s devaluation will drag down asset prices in neighboring Argentina.
Thomas Keesee, managing director at Pactual Electra Capital Partners Ltd., also expects Brazil’s devaluation to be a boon to private equity, but only after the current financial market uncertainty subsides. “Everything right now is in a state of flux as a result of the real devaluation, but we could see a fair amount of activity towards year’s end.”
Walter Molano of BCP Securities is less sanguine about the outlook for private equity in 1999. The global financial turmoil, he says, has decreased the pool of eligible sellers, creating cut-throat competition and driving up prices. Moreover, a number of attractive private equity targets are not interested in surrendering control of their businesses to fund managers. Despite these concerns, most analysts, Molano included, see private equity as a bright spot in an otherwise bleak investment panorama.
Domestic&Multilateral Plays
With public markets effectively closed during the latter part of 1998, many Latin American companies, including a growing number of medium and large-size enterprises, began eyeing local capital markets as a source of financing. In Brazil alone, more than $10 billion in short- and medium-term commercial paper was issued during 1998 and market experts believe that number could more than double in 1999.
Although the creation of domestic capital markets throughout Latin America is a development that bodes well for the future, few analysts view domestic markets as a viable alternative to international markets given the high borrowing costs, unwieldy regulations and lack of liquidity.
“Local capital markets in Latin America, except in Chile, are simply not deep enough at present to finance significant corporate activity, and local borrowing costs are too high,” said Adrian Valenzuela, vice president of equity derivatives at Morgan Stanley Dean Witter. Furthermore, he said that the trend of sovereigns tapping the local markets for financing is creating a worrisome “crowding out effect” in countries like Brazil and Argentina.
With few other financing options available, many Latin American companies are pinning their hopes on multilateral agencies such as the Inter-American Development Bank, and the World Bank, and their private sector lending and investment arms, Inter-American Investment Corp. and the International Finance Corp., to help fill the capital void.
In early 1999, the IFC announced plans to ask its shareholders to increase its $5 billion capital base to help provide relief to cash-strapped corporations in Latin America and other emerging markets. John Soladay, principal economist in the IFC’s Latin America department, says the organization, which has lent an average of $1 billion annually to Latin America in recent years, and brought in a similar amount in syndications, is facing more than double this level of demand in the region this year.
Already this year the IFC has announced a number of new financing projects, including a $150 million credit, co-arranged with the IDB, for the privatized Argentine postal service, Correo Argentino SA. In addition, the two institutions are assembling a commercial bank loan of up to $108 million. For a number of Latin American companies, such credits will be their only source of external financing in 1999 unless the global financial environment improves.
If there is a silver lining to the current crisis in world financial markets, it is that Latin governments, for the most part, have not retrenched from the prudent macroeconomic policies of the early 1990s, but rather deepened reforms. Likewise, many of the region’s top-tier companies have responded to the global credit crunch by retooling and streamlining operations. If and when market sentiment changes, they will be well positioned to reap the benefits.
As Firestein of Thomson Investor Services said, “In 1999 we will continue to engage the struggle between good and evil in Latin America’s financial markets: On one hand, a vibrant, creative entrepreneurialism is on the ascendance, on the other, a heritage of over-regulation and less-than-rigorous controls is in slow, generational decline. There are hundreds of good companies using this difficult interval to strengthen themselves, knowing that the next opportunity will be stronger than the last.”
A Conservative Approach
Ricardo Silvagni, partner at PricewaterhouseCoopers in Argentina talks to LatinFinance about what his company is advising clients this year.
It looks like 1999 is going to be another difficult year for Latin American companies.
What strategy is PwC advising its Latin clients to take given recent events in Brazil?
There is no single recipe. Every company has a different profile and requires specific, tailor-made solutions. For example, do they have assets to sell? Do they have heavy debt service? Do they export or sell to the domestic market? If they export, is it to the US market, which continues to thrive, or is it to Asia, which is in recession? These are important questions that will determine the appropriate strategy.
What types of strategic advice are you giving your Argentine and Brazilian clients?
PwC is generally recommending conservative approaches for its clients in Argentina and Brazil. Our advice is to be cautious about the way you handle your finances, undertake cost-cutting measures, and hold off on new expenditures. With any luck, the international environment will improve in the second half of the year and domestic consumption will bounce back. At that point, they will be in a much better position to execute their growth strategies.
Should all companies be playing it safe?
Not necessarily. For companies that are cash-rich, now is a particularly good opportunity to buy out competitors. Companies experiencing financial difficulties will have problems accessing additional financing due to the increased credit risks and higher interest rates. In this environment, private equity funds and other financial buyers will play a key role in providing the capital that otherwise would not be available through bank loans and capital markets. Again, one size does not fit all.
Any final thoughts?
The current situation offers both opportunities and risks. There is no single solution. If you are a buyer, you are in good shape. If you are a seller, things are not as good.