The boom in Latin American mergers and acquisitions is drawing more and more first-time foreign investors into the region. As Eastern Europe and Asia become less attractive, more investors from North America and the European Union are taking their first steps into acquisitions and joint ventures with Latin companies. But there are plenty of potential pitfalls as they do so.
They may find that they have bought a company stripped of its assets, or that never had any meaningful assets. They could discover that the company has accumulated large, unprovisioned tax or environmental liabilities, or that their potential joint venture partner is using the business as a cover for laundering the proceeds of drug deals.
Investment advisers are, nevertheless, relatively sanguine. The first rule in dealing with this situation is to apply some common sense. “If you don’t know who you’re dealing with, you really ought to,” says Ian Reid, head of Latin American M&A at Morgan Stanley Dear Witter in New York. Any business executive or banker who has failed to notice the high-profile instances of money laundering and corruption-and the authorities’ steps to curb them-has missed more than a few tricks.
The US Customs Service’s 30-month investigation into money laundering in Mexico in its Operation Casablanca, which culminated in 1998, showed just how seriously the US authorities take the issue. The operation targeted 14 Mexican, Venezuelan and Spanish banks and led to indictments against Bancomer, Banca Serfin and Confía, then in the process of being acquired by Citibank, with forfeiture actions against 11 others.
Corruption went to the top of the tree in Mexico-in the form of Raúl Salinas, brother of the disgraced former president-to the further embarrassment of Citibank, which had accepted large sums of his money on deposit. “That was a powerful wake-up call to US banks, which have become much more careful about accepting money from sources which they don’t quite believe,” says Simon Strong, a director in the Latin American business intelligence and investigations division of Kroll Associates in Miami.
That kind of precaution is advisable, given that corruption persists in the region. According to Miguel Schloss, executive director of Transparency International in Berlin, only Costa Rica and Chile stand out as being relatively free of corruption. The continuing existence of corruption and money laundering and tougher penalties in their home jurisdictions means that international banks are getting more careful. So are companies that invest in the region.
In addition to having lawyers and accountants pour over the details of deals and carrying out the kinds of due diligence that would be normal in any M&A activity, they are hiring more special investigators who make it their business to uncover questionable activities on the part of senior executives and stakeholders in local operations. “We look for the between-the-lines information that is not within the sphere of the lawyers or accountants,” says Strong.
Jeff Katz, a former Kroll man who is now chief executive of London-based corporate investigations and risk mitigation outfit Bishop International, sees a steady stream of enquiries from investors who are unsure of how to handle their first moves into the region. Kroll, likewise, has responded to growing demand by opening offices in Santiago and Rio this year. Strong adds, “Our business in Mexico has grown enormously over the last year and a half.”
Katz identifies four obvious areas that companies need to guard against: involvement with drugs, which is closely associated with money-laundering, kickbacks and extortion from terrorist groups.
The last of these-sometimes referred to as a “revolutionary tax”-affects mostly mining and other natural resource companies. BP Amoco and Occidental Petroleum both have operations in Colombia and both have come under guerilla attack. This is typical of the difficulties in which companies can find themselves when their operations are being conducted in areas of conflict.
Avoiding situations of this kind is, however, a fairly basic matter of determining the extent of political conflict in a particular region. A number of firms offer surveys that will set out the security picture and the respective strengths of guerrillas and security forces in remote areas.
The analysis requires greater subtlety when it comes to identifying business partners in a region of conflict. As Mark Carlson, general manager of the Control Risks office in Mexico City and a 10-year veteran of Colombia says, “One typical question that needs to be asked is ‘why is this company having such success when there is a high guerrilla presence to the east and a sizeable paramilitary presence to the west?’”
The obvious answer is that the company is paying off either one or both sides, or is even more closely involved. In Colombia, where drug money is also highly pervasive (and often overlaps with terrorist activity), investors are probably well-advised to ask similar questions about any enterprise that is enjoying obvious success.
As Strong says, “Colombia is an extremely difficult country in which to do business, and one shouldn’t underestimate the impact of drug money. Competitors may be accepting it and gaining an advantage and army officers can be faced with appalling temptations. It’s crucial for foreign investors to ensure that they do business with people who are really determined to keep their ship straight.”
The amount of money companies are willing to spend on checking out credentials varies according to the size of the deal and the motives of the investor. The checks may be in response to rumors, or to gain leverage in negotiations, or to get to know future partners better.
In any event, such due diligence seems like good value. For $20,000-$50,000 Kroll will run background checks on potential partners, with the depth of investigation determined by the size of the transaction. Katz relies on long-established relationships with local agents in smaller deals, but when “it runs into eight- or nine-figure sums, we send someone over from London to coordinate.”
Arguably, says Strong, background checks matter less when a company is making an acquisition as opposed to a joint venture. Assuming the accounts check out, the background of the principals is less important. Equally, says Ian Reid, tax and labor law issues can be exaggerated when it comes to acquisitions. “They may appear to be huge issues, but they often don’t turn out that way. Local legal systems can be slow and inefficient, but they are not unfair to foreign investors.”
In the case of a joint venture, however, the identity and interests of local partners does matter for a number of reasons. As Roger Ullman, managing director and head of Latin American M&A at Merrill Lynch in New York, says, “There is more scope for disagreement over strategy and objectives, especially where acquisitions are made by consortia.”
Ullman attributes much of the current “second wave” of M&A activity in the region to the “rationalization” of corporate structures that were put together by consortia of local and multinational businesses in Latin America’s initial privatization process. Framing an agreement correctly matters as much as choosing a partner: a lesson that buying companies have, Ullman says, learnt over the last five to ten years. Consortia have had their day as acquisition vehicles.
Checking out reputations is not easy. Local lawyers are often keen to push deals through and to collect fees. Kickbacks to the promoters are always a risk when outside investors are being urged to take on some new piece of business.
There is often plenty of information available in the public domain. That means scouring all the available databases, although there are obviously fewer computerized and centralized records in Latin America than in the US or Western Europe. To find criminal records, “you need to know where to look” says Carlson. Moreover, says Strong, rich and powerful individuals may be in a position to tamper with records.
Carlson builds up a picture of an individual under investigation partly through press reports, which will turn up allegations, known associations and details of government investigations. Beyond this, his team will talk to former employees. As he says, “Colombia is not a big world.”
Then the investigators turn to informal channels. Kroll’s teams-composed of lawyers, accountants, bankers and journalists as well as ex-CIA, FBI or IRS operatives-use their network of contacts to probe the business interests of an individual and his or her family.
If anything, the closed nature of Latin America’s elites serves to draw attention and suspicion to the newly monied. Investigators often talk of “gray areas” and emphasize that they do not make recommendations to clients. Says Strong, “it’s not always possible to substantiate things. We provide the client with context and try to evaluate that context.”
Experienced investors are clearly comfortable about expanding their operations in the region. Andrea Tamagnini, head of investor relations at Banca Commerciale Italiana, explains that the bank, with many years of experience in Latin America, has made a series of acquisitions in Peru, Brazil and Argentina over the past two years because “we know the market, the players, the banks and the customers.”
Kroll has found itself on the other side of the fence in defending Mexico’s Banorte against money-laundering charges in Operation Casablanca. The US was forced to return $1.39 million seized from the bank and abandon further claims of money laundering.
Kroll’s investigation revealed that Banorte had closed suspect accounts, had rejected one wire transfer from an undercover account and questioned Bank of America over another suspect wire transfer. It also demonstrated that no one in authority at Banorte had knowledge of or had facilitated the suspect accounts or transactions.
In fact, more banks are putting controls in place to ensure that suspect transactions are weeded out. Accounts are also becoming more transparent and reliable in response to pressure from foreign investors. As Reid says, “There is more sophistication on both sides of transactions. More companies are being listed and information is getting better.”
But not in every case. FTAA Consulting’s Castillo-Triana has been involved in a recent case in Mexico, where a large company with a cellular telecoms franchise refused to disclose accounting details to institutions that were providing finance. It offered the accounts of its parent group, but refused to give a guarantee from the parent company and insisted that the financiers treat it as a stand-alone credit.
There is a general point here. Due diligence in a major international transaction often stops at the overall corporate level. But as Carlson points out, “In Latin America, the practice at the local subsidiary may be at odds with overall corporate policy.”
Castillo-Triana adds that tax issues can be a “mess and a maze.” No buyer wants to run the risk of finding unfunded tax liabilities in an acquisition target. Given the number of taxes in Latin America-53 in Brazil, for instance-this can be a significant risk. MCI found this out to its cost after it paid $2.3 billion for a 51.79% share of Embratel, a state-owned long distance telephone company. Soon after it took control of the company, it received a demand for payment from the national tax authorities on back taxes owing from the period in which it was a federally-owned enterprise. The Federal Tax Department says Embratel is liable for 25% withholding tax on payments to foreign operators and also for a similar 25% tax on payments for incoming traffic. Embratel is resisting the claim for back taxes from 1994 to 1998, and the case is making its way through the courts. In June, Embratel made a R$433 million ($240.6 million) judicial deposit “to protect the company from further penalties” pending a final ruling. The company “continues to believe that ultimately it will prevail in this matter.”
There are ways to deal with this issue. Clearly, investors must review the company’s tax returns and make an assessment of the risk that these will be challenged where, for example, there is insufficient documentation to back up a claim for a deduction. Reserves should then be created to cover the possibility of both unpaid taxes and penalties. Such reserves will, of course, reduce the value attached to a company in negotiations.
The threat of retroactive taxes is receding, says Castillo-Triana because they are usually unconstitutional, and more Latin American states are signing up to international double taxation treaties. In a growing number of countries-Chile and now Peru and Colombia-it is also possible to sign binding agreements with the government to ensure tax stability.
Environmental liabilities are, nevertheless, an increasingly prominent part of the landscape for investors in many Latin American countries. “In Costa Rica,” says John Wade, senior Americas analyst with Control Risks Group in London, “extractive companies need to check the extreme environmental sensibilities.” Castillo-Triana admits that there is little that companies can do when faced with a class action for environmental damage, except prepare for litigation and an eventual settlement. Litigation can, he insists, be successful, as when he defended the use of a particular pesticide on Colombian coffee plantations on the grounds that it was acceptable to the US Environmental Protection Agency and the EU.
The outcome of a case involving Spain’s Dragados y Construciones-the concessionaire of Bogota’s noisy and centrally located airport-is less certain and illustrates the perils of encountering Latin America’s new-found environmental consciousness.
Unlike in other civil law cases, says Castillo-Triana, it is not possible to anticipate the outcome of the case because it rests on technical assessments of the effectiveness of noise reduction methods. The only good news for investors is that environmental liability insurance is becoming available in the region and may be worth considering.