Long-Distance, Local Service

It’s no secret that US and European investment funds dedicated to Latin America are increasingly scarce. Their disappearance means Wall Street banks that manage money in Latin America are eyeing a potentially larger, and steadier source of business for their brokerages: the local investor.

Institutional investors from Chile to Argentina to Brazil, particularly the privatized pension funds, are growing fast. In 1994, professionally managed pension funds in Brazil, Argentina and Mexico totaled $59 billion, according to J.P. Morgan. They now exceed $100 billion and are expected to grow to $140 billion by 2003.

The temptingly large monthly inflows of pension funds must be invested through brokerages. Wall Street’s top banks claim that the local brokerages are unable to provide the sophisticated research, deploy the technical systems and develop the products these big funds need. Foreign banks think they can, but often recoil at the cost of establishing operations in local markets, which gives local brokerages the edge in pouncing on new clients. Foreign banks now are increasingly faced with the dilemma of how to best serve the region.

Every major bank is in Brazil, the region’s largest market by far. But it is a different story in the rest of the region. While many foreign banks have commercial operations in Argentina, the country is also widely considered too small to warrant setting up a fully-fledged sales and trading operation. And if Argentina is small, Chile is tiny. Finally, Mexico has considerable barriers to entry in investment banking.

“We’ve looked at it every year in Mexico, and we simply can’t make it pay for itself,” says Nicolaas Millward, UBS Warburg’s head of Latin American equity capital markets. “You can’t expect any business to be subsidized on a continuing basis by some other part of the business. It has to be self-standing, you have to be able to make it profitable in its own right.”

Part of the problem is that while Latin America may one day become an attractive market as fund flows increase, it is still too small – with the exception of Brazil – for the multinational banks. For instance, Spain’s Banco Bilbao Vizcaya Argentaria owns the Consolidar private pension fund management company in Argentina and has a majority stake in Chile’s Provida pension fund manager. BBVA says that the $18 billion its two funds manage account for almost 30% of the market in Argentina and Chile, the trailblazers in Latin America’s shift to private pension fund provision.

And banks want a foothold in Latin America, few want to lose money while doing so. “Profitability is a key aspect,” says Alberto Sánchez, head of Latin American equities at Banco Santander Central Hispano. He says investment banks claim they are in the Latin market for the long run to increase their market share. “But the head office is going to say they don’t care,” says Sánchez. “An accountant will say. ‘What the hell are these guys doing over there, they keep losing money, let’s close it down.’ Their level of patience is not very high.”

It’s not easy to make money in Spanish-speaking Latin America from sales and trading operations, especially for European or smaller American banks. “An international client, you can charge them 35 basis points on average, on every trade you make. A domestic guy can go as low as three basis points, and the average I would say is around seven basis points,” says Sánchez. “Why? Because they tell you, ‘you really have a lot less to add for me.’ You’re telling a local guy in São Paulo what’s going on in São Paulo, he’s telling you, well, thank you very much, I went to school with this guy also. In these countries, everybody knows everybody.”

At UBS Warburg, Millward likes to think of himself as breaking out of that paradigm, adding a dash of New York discipline to Latin market practices. “Most of the business is done by word of mouth,” he says. “Local institutions want to see proper research. That is where we add value. The ability to combine our derivative expertise is very important to some of those institutions. But they want good, solid, consistent research.”

Eduardo Cepeda, head of J.P. Morgan’s Mexico City office, says local institutional investors need derivative products. “They need synthetic products and we can produce them, such as creating [indexed] UDIs from peso [securities],” he says. J.P. Morgan claims top-ranking in Mexican equity trading in 2000, ahead of a field dominated by bulge bracket firms.

Different Markets
Brazilian houses say they feel no threat from Wall Street’s giants. Luis Damato, a partner at Hedging-Griffo, Brazil’s largest independent brokerage, says “The type of target markets they go after are very different. They are going for asset managers. We are a discount brokerage with an execution-only service. They have a higher cost structure to support because they provide research and so they are more expensive. We don’t do research so we have lower commissions.”

Institutional investors tend to share out their orders: simple execution deals go through the local no-frill brokerages. More sophisticated operations go to the bulge bracket firms, which also provide the research portfolio managers need. Few Brazilian houses are left in the high-end brokerage business following last year’s sale of Banco Bozano, Simonsen.

Latin America’s markets are still a very long way from a world of perfect information, where the team with the best analytical skills will necessarily produce the best research. Analysts and investors alike still believe, with reason, in the importance of knowing the right people or coming from the right family. Says Ariel Siegal, Deutche Bank’s head of emerging markets for the Americas, “The type of businesses in which I am involved do not demand that much capital, but demand a highly skilled, motivated and well-coordinated team of people, with the right skill set and the right contacts in each country.”

The problem is that market professionals who can deliver don’t come cheap. “Volume is not large enough to sustain an investment banking [team],” says Sánchez. The difficulties extend all the way to the largest bulge bracket firms. Merrill Lynch, for instance, had asset management operations in Brazil for three years, before giving up. “Merrill Lynch is a big animal, and in order for us to be adding value for our clients, we have to have a critical mass,” says Bernardo Parnes, country head for Merrill Lynch in Brazil. “We are not able to attain this critical mass here. The markets are way too competitive.”

And for all Millward’s optimism about the desires of domestic investors for first-class research, he’s not about to open up any offices outside São Paulo and Rio de Janeiro. “Brazil, at the moment at least, is the only country in Latin America where it’s worthwhile building and developing a domestic equity franchise,” he says. “We don’t see that anywhere else. Argentina is too small. Even though it has an institutional investor base, we don’t see the business there. Chile’s too small. Mexico, right now, every time we look at it we conclude that to have a securities license there is too expensive in the absence of a much more developed institutional market.”

It’s a similar story at CSFB, which runs its Latin American operations out of Brazil, following its acquisition of Banco Garantia. The bank has no presence in Santiago, for instance, despite the fact that it is the largest broker in Chile, both of ordinary shares and ADRs.

Andrew Shores, who runs the bank’s Latin American equity operations, uses such facts to demonstrate that foreign banks don’t need a domestic presence in order to be able to provide liquidity and make markets. “You’re going to have to remunerate your local brokers,” he says, but CSFB is not about to start opening offices around the region. “These are markets which are too small to justify a local presence, so we use local brokers to execute orders for us.”

The bank covers the whole region with research groups in Brazil, Mexico and New York; it has trading operations in New York and Brazil only. And even after buying Garantia, CSFB still gives roughly a third of its business in Brazil to other brokers. “At times we have more business than we can handle with our floor traders and we have to remunerate our counterparts that show us flows,” says Shores.

Local Presence Not Critical
Banks don’t need local presence in order to get significant volumes in a country. Even without any sales and trading presence in Mexico, and even though CSFB is the world’s biggest dealer of Brazilian equities, “so far this year, we’ve had more volume in Mexico than we’ve had in Brazil,” Shores says.

Goldman Sachs, which is certainly no slouch when it comes to Latin America, has no local research anywhere in the region, and while it plans to start sales and trading operations in São Paulo, it hasn’t done so yet. For the time being, it services Brazil and Argentina with peripatetic bankers from New York and rep offices in São Paulo and Buenos Aires. Chile doesn’t even justify a rep office. Only in Mexico does Goldman have a fully licensed up-and-running broker-dealer.

There’s a strong case to be made that as the world financial markets are globalizing and liquidity is moving from local bolsas to ADRs in New York, owning a brokerage in every Latin country is becoming increasingly irrelevant. “If you have people spread all over the place in fairly small markets, I don’t think you get that economy of scale, that synergy. I think you’re better off in these two markets, Mexico and Brazil, covering the region, than you are anywhere else,” says Shores.

To be sure, houses such as Santander and Citibank fight over commercial banking operations in the region. But, says Sánchez, “this kind of brokerage activity is just a collateral side of the business of a big commercial bank. So when Santander buys Banespa or Banco Río or Banco Santiago, the last thing they’re thinking about is in the brokerage business.”

Even J.P. Morgan, which has a strong local presence just about everywhere in the region following its acquisition by Chase, can see the writing on the wall. “The small, under-regulated, opaque-as-opposed-to-transparent bolsas in many of the cities of the countries of South America are in peril and may go the way of the dodo,” says Brian O’Neill, head of the firm’s Latin American operations. “I doubt that will be the case in Mexico, but in the case of South America, these may very well end up that way. And the equities of the companies domiciled in South America? The liquidity that their shares find may be best expressed in ADR form.”

All the same, O’Neill stresses that “we believe that the best practice is to be a big market-maker in the global centers, London and New York, and the regional centers, Buenos Aires, São Paulo, Santiago, Mexico City.” So how do they market from these places? J.P. Morgan of course, does not rely on the bolsas for its profits from the region. For one, it’s a major player in the domestic bond markets in Argentina, Mexico and Brazil; and it parlays its name into regional merger and acquisition or primary-issuance mandates.

Fees Drive Profits
But you don’t need to be an American bulge bracket bank to make most of your money from fees as opposed to bid-offer spreads. While no one is turning away the institutional investors in Latin America, no one is making a lot of money out of them either. “The big money in this business is made when you start providing companies with IPOs and with capital markets activity. That improves the volumes, so it’s a virtuous circle,” says Santander’s Sánchez.

Lorenzo Weisman, head of Latin American corporate finance at UBS Warburg, notes that “everybody raves about Chile, but the reality is that the AFPs [the privatized pension funds] hold everything, they never trade anything, so it’s a dead market.” Chile’s AFPs, and Argentina’s AFJPs, are long-term investors, and know full well that trading in and out of relatively illiquid instruments isn’t going to help their returns.

“Pension funds don’t trade very much. They buy and they sit on the position for years,” says Santander’s Sánchez. “Trading out of pension funds is quite low. Trading is expensive for them. Unless they have a real strategic change they want to make in their portfolio from one sector to another, they don’t do it.”

If you’re J.P.Morgan, however, those pension funds might be more receptive to you, if only for your expertise in US markets. “We’re in Santiago, we’re in Buenos Aires and we have large on-the-ground dealing rooms and sales forces,” says O’Neill. “And because both of those countries have large, growing and prospering privatized pension fund management, there is a significant institutional investor base. We cover and provide these clients with research, liquidity and trading. The strategy of our firm is to be a banker to AFPs, AFJPs and pension funds. It’s a big part of our business and a growth part of our business.”

Enough of a Draw?
It is certain that those pension funds are growing, and it is also certain that they won’t turn around and flee the country the next time an emerging-markets crisis hits. That’s the good news. But it may not be enough to persuade many other banks to open up trading operations across the region. And the reason is not only because the deal flow from these relatively small funds is insufficient.

“What investors are focusing on are more and more are the top-listed ADRs which global and international fund managers can look at because those are liquid enough that they can hold positions which are big enough for their portfolio,” says CSFB’s Shores. “As a result of this, domestic institutional investors are also realizing that they should focus more attention on these names, because that’s where liquidity will be. And when foreign investors become enthusiastic again in these markets, that’s where they’re going to put their money.”

So while Latin institutional investors can provide a revenue stream for foreign investment banks in the region, they are unlikely to be big enough players to entice houses to set up trading operations in a country. If, like Citibank or Santander, a bank has retail distribution and healthy corporate relationships through its commercial banking operations, then it will be able to leverage that into extra deal flow for its trading floor. And if, like J.P. Morgan, a bank has top-tier investment bankers and dealmakers, as well as US research, then local trading operations become not only a necessity but also a profit center.

But for the foreseeable future, Latin America’s institutional investors, at least outside Brazil, are going to be tiny compared to the largest US and European banks. And that will make them nice clients to have, but not necessary ones. LF