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Journal of Applied Corporate Finance SPRING 1992 VOLUME 5.1 Equity Investment in Latin America by Alberto Luzárraga, Continental Bank

EQUITY INVESTMENT IN LATIN AMERICA

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Page 1: EQUITY INVESTMENT IN LATIN AMERICA

Journal of Applied Corporate Finance S P R I N G 1 9 9 2 V O L U M E 5 . 1

Equity Investment in Latin America by Alberto Luzárraga,

Continental Bank

Page 2: EQUITY INVESTMENT IN LATIN AMERICA

JOURNAL OF APPLIED CORPORATE FINANCE55

EQUITY INVESTMENT INLATIN AMERICA

by Alberto Luzárraga,Continental Bank

55CONTINENTAL BANK JOURNAL OF APPLIED CORPORATE FINANCE

Since the mid-1980s, the development of a number of financing alternativeshas enabled capital providers to reduce debt exposures in the region. Butrecently, investors’ motives have begun to shift from simply reducing LatinAmerican exposures to generating profits. Today, investors are recognizing thatthe painful economic “crisis” experienced in Latin America over the past twodecades was actually part of a natural development process—one experiencedby such countries as the U.S., Great Britain, and Japan during their owntransformations into developed economies. As a result, investors have becomemore confident about the region and have begun taking solid equity positionsin some of its promising businesses.

Interest in equity investments in Latin America started, of course, for apurely pragmatic reason. Swapping out of debt into equity allowed lenders torecoup at least a portion of loan portfolios that otherwise would have beenwritten off. Today, however, investors are building their equity portfolios foranother reason: increasing optimism about the investment opportunitiespresent in many Latin American nations, in large part because of a recentliberalization of the region’s investment laws.

Many of the barriers that previously restricted direct equity investment inLatin American countries resulted from their long-standing philosophy thatforeign investment serves only to further enrich developed nations at theexpense of developing ones—a theory actively promoted by, among manyothers, the late Raul Prebisch, an Argentine economist who headed both theUnited Nations Economic Commission for Latin America and the U.N.Conference on Trade and Development. The prevalent thinking at the time wasthat the region’s underdevelopment was due largely to its “dependence” on richcountries, especially the U.S. On the basis of that belief, many economistsadvocated import substitution and state socialism—two policy approacheswhose flaws were soon exposed by the onset of cross-border trading, and whichcontributed significantly to the chain of events in the 1970s and 1980s thatdrastically weakened the region’s economic structure.

fter years of pouring unsecured debt into Latin America, bankstoday are finally replacing lending bets with investment belief, andputting their money where the profits are: equity investments.

A

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Prebisch, however, later changed his view offoreign investment, as its benefits to developingnations became increasingly clear. At the same time,a new generation of economists, many of whomwere educated at American universities, has promptedmany countries in the last several years to rewritetheir investment laws, lift limits on capital repatria-tion, and promote deregulation to spur financialmarket development. Chile, which had long beenmore open to foreign investment, has been a leaderin attracting foreign investment. But many othercountries are stepping up their reform efforts inorder to attract foreign investment. For example, in1989 and 1990, Argentina, Costa Rica, Mexico, andVenezuela all introduced major changes in theirforeign investment codes that liberalized regula-tions on the operation of foreign-owned firms.

The reform process has been gradual and muchstill lies ahead. Nevertheless, Latin American gov-ernments now recognize the role foreign investmentcan play in building their domestic economies.Specifically, it can encourage local private invest-ment, provide access to foreign markets, promotethe transfer of technology, and help develop localmanagerial expertise.

In response, investors worldwide attracted byhigh potential returns are sending a wave of newcapital into Latin American markets. Investments aretaking the form of common and preferred stock inlocal businesses, shares in local mutual funds, andpublic and private sector Eurobond issues. Forinvestors who prefer the security of U.S. markets,there are American Depository Receipts (ADRs),which are equity securities representing shares indesignated foreign corporations.

In 1991 alone, approximately $7 billion inforeign capital was invested in Latin Americanstocks. This kind of capital inflow contributedgreatly to the remarkable surge in value of theregion’s markets over the past two years. In 1991, theBuenos Aires market was the world’s top performer,providing a return of more than 400% to U.S.-dollarinvestors.

Traditionally, most foreign investment in LatinAmerica has been targeted to manufacturing, reflect-ing past and present restrictions on investments inmining, petroleum, the financial sector, and otherservice industries. In Mexico, for example, billions ofdollars have been invested in the auto industry,largely because foreign investors are permitted 100%ownership of auto assembly plants and have fewer

regulations and labor demands to contend with thanin their own countries. The big three U.S. manufac-turers—Ford, General Motors, and Chrysler—all makecars or trucks in Mexico, and Volkswagen and Nissanhave plants there as well. Many investors foreseefurther expansion of foreign manufacturing intothese markets as businesses from more developednations continue to seek less regulated environmentsin order to meet global competition.

In some countries, investments in the servicesector have also begun to increase. Sears Roebuck,for example, recently invested $480 million inMexico, and a number of McDonalds’s restaurantsand U.S.-operated hotel chains are on the horizon.

The U.S., moreover, continues to be the largestsource of investment capital in Latin America, ac-counting historically for nearly 50% of all directforeign investment there. Given current U.S. interestrates, U.S. capital flows to the region are likely toincrease as investors seek higher returns and compa-nies seek longer-term capital. The improved creditstanding of Latin America generally and increasedavailability of capital have also encouraged borrow-ers to attempt to lock in lower-cost, low-term money.

THE SHIFT TO EQUITY FINANCING

The lending and borrowing excesses of the1970s and 1980s, which continue to temper theinvestment climate and add caution to debt andequity financing decisions alike, can be traced backto the dramatic rise in oil prices and other rawmaterials in the early 1970s. Between 1970 and 1975,for example, the value of oil exports shot from $1billion to more than $18 billion, an increase paralleledin the prices of other commodities. Rising prices andthe resulting increases in wealth led the oil-producingnations to flood American and Western Europeanbanks with their petro-dollar deposits.

This excess liquidity in the bank market, coupledwith the then generally accepted premise thatcountries could not “go broke,” paved the way fora frenzy of unsecured lending to developing coun-tries eager to modernize and advance their econo-mies. Banks and governments, without focusing onthe fundamental risks of wealth tied to commodityprices and to the financial impact of the vast amountof new debt on its borrowers, entered into aborrowing and lending free-for-all. By the end of1982, outstanding foreign debt in Latin America hadballooned to nearly $250 billion.

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JOURNAL OF APPLIED CORPORATE FINANCE57

Shortly thereafter, the world economic situationbegan to deteriorate rapidly, commodity prices fell,the dollar strengthened, interest rates soared, and thedemand for manufactured goods dropped. In LatinAmerica, governments and businesses, saturated withdebt and facing staggering domestic inflation, wereunable to retain the confidence of the internationalinvestment community. As a result, foreign and localcapital sought other havens and the foreign currencyreserves of the nations were diminished.

The fall in the price of oil and other rawmaterials took a heavy toll on the region’s exportrevenue, making it impossible for many countries tomeet their large interest obligations to foreigncreditors. The situation reached crisis level in August1982, when Mexico announced that it was unable topay its debts, which at the time totaled approxi-mately $65 billion. Brazil, Argentina, Bolivia, Vene-zuela, and the Philippines followed suit shortly after.

In subsequent years, banks worked to arrangeshort-term financing packages to meet the immedi-ate needs of debtor countries. Their efforts reliedlargely on debt rescheduling and reduction de-signed to ease the burden on borrowers and diver-sify creditors’ risk exposures. By the mid-1980s,banks also began to explore ways to restructure theirrisk exposures through measures such as debt-for-debt, debt-for-equity, and debt-for-goods exchanges.And, in 1987, many banks wrote down their loansand established reserves, thereby increasing thevolume of debt available for trading.

Latin American governments began to adjusttheir policies to these changes in the internationaleconomy by instituting privatization and debt con-version programs and lowering barriers to foreigninvestments. These developments, along with thestimulus provided by the Brady Plan in 1989,gradually encouraged the return of capital to theregion, albeit in a much more conservative mannerthan before. To better compensate for the risksinvolved and provide the opportunity to captureupside gain, these investors moved away from theunsecured lending of the past and toward securitizeddebt and equity-driven vehicles.

NEW SOLUTIONS BRING BETTER RETURNS

Lending in Latin America continues, but wehave seen several important developments thatdemonstrate new risk-sharing partnerships betweenborrowers and lenders. Today’s financial structures

link repayment to project or company performanceand often reduce convertibility risk by includingoffshore collateral. Also, the availability of interna-tional capital for sovereign borrowing is moreclosely tied to a country’s balance of payments.

Because countries and investors differ in theirability and willingness to bear different risks, thereare gains from transfering risks among them. But theability to take advantage of improved risk-sharingarrangements depends on the extent to which thevarious risks can be unbundled and assigned to theparty best able to bear them. For example, issuingcommodity-linked debt enables some developingcountries to reduce their commodity price risks byhaving their interest payments rise and fall with thelevel of such prices. Such financing is also generallydesigned to compensate lenders for below-marketinterest rates (on average) by offering them “kickers”that amount to options on commodity prices. So-phisticated hedging tools also now offer borrowersprotection against fluctuations in world interest ratesor currencies.

While debt offerings still account for most of thevolume of placements in Latin America, private-sector equity deals are also on the rise. Favorablepolitical and economic reforms such as deregula-tion, privatization, and lower corporate taxes haveprompted new confidence and interest amongforeign investors. Many of these investors hope tocapitalize on the undervalued assets of Latin Ameri-can companies, many of which have weatheredsevere domestic difficulties during the 1980s toemerge as stronger competitors as the region’seconomies continue to rebound.

Although success in attracting investment var-ies widely from country to country, debt conversionprograms have also generally provided a tremen-dous boost to investment flows. For example, in1987, Mexico retired about $2.1 billion in debtthrough conversions, which in turn contributed toa 57% increase in foreign investment to the coun-try—a substantial amount of which was in the formof equity.

Much recent foreign equity investment, inMexico and elsewhere in Latin America, has takenthe relatively new (for the region) forms of portfolioequity investments and “quasi-equity” securities.The latter entitle lenders to an income stream thatdepends in part on the success of the project, butwith a narrow claim to participate in ownership andcontrol.

To better compensate for the risks involved and capture potential upside gains,foreign investors have moved away from the unsecured lending of the past andtoward securitized debt and equity-driven vehicles... Today’s financial structures

link repayment to project or company performance and often reduce convertibilityrisk by including offshore collateral.

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58JOURNAL OF APPLIED CORPORATE FINANCE

But this brings us to a more traditional, evenold-fashioned, form of investing in overseas mar-kets—direct foreign equity investment, which offersinvestors the opportunity to share in the risks,rewards, and decision-making processes of LatinAmerican businesses. My own institution, Continen-tal Bank, saw the potential benefits of making suchequity investments in Latin America early on. In 1986we developed a strategy designed at once to reducedebt exposure and generate profits. The first stepwas to use standard asset valuation analysis toidentify companies with high profit potential. Then,by means of debt-to-equity conversions, we achievedboth greater returns on the face value of our debtpaper than was typically available in the secondarymarket and exceptional returns on our resultinginvestments.

As conversion spreads narrowed, however, wegradually moved from formal conversions to infor-mal exchanges that involved several debt-for-debtswaps using various governments’ issues. Thesetransactions can proceed in one of two ways: eitherthe paper is eventually converted to cash for directinvestment in a company, or the company takes thedebt paper in exchange for the shares and then sellsthe paper on the secondary market itself. In somecases, Argentina for example, we completed swapswith the government’s development bank by ex-changing our loans to the government for thegovernment’s loans to the company in which wewere investing.

Continental’s investment approach uses bothspecific and general criteria. Because each invest-ment opportunity has its own requirements andcircumstances, we tailor our approach to fit theframework of each country’s debt reduction pro-gram. At the same time, we follow fundamental assetvaluations based on uniform guidelines for directinvestments. To be considered for an investment, acompany must be profitable on an operating basis,provide quality products, and have a solid reputa-tion in the marketplace; and its industry must haveadequate growth potential. Furthermore, we alsolook for undervalued assets, as well as opportunitiesto improve performance through the financing andoperating assistance we provide.

While the basic criteria are relatively clear, thedifficulty comes in identifying those companies thatproduce worthwhile goods and have the equipmentinstalled to allow them to produce at a satisfactoryrate when and if the economy of the country

improves. We also insist that these companies havecompetent management. If they do not, we ensurethat they are willing to get the right people in place.

All of this, of course, takes time. Most of thesecompanies are family-held, and investors must bewilling to sit down and speak with the patriarch ofthe family to sort things out. That requires both anunderstanding of the region’s culture and values aswell as a willingness to commit time and capital onthe part of the investor.

To date, Continental has executed nine debt-to-equity conversions and made 17 direct investments.We maintain a physical presence in five LatinAmerican countries: Mexico, Venezuela, Brazil, Chile,and Argentina. In the remainder of this article, Iprovide brief accounts of several of Continental’sequity investments in Latin America, highlightingthe costs and rewards of each.

A CASE INVOLVING DEBT-TO-EQUITYCONVERSION

In 1987, we put our investment strategy intoplay in Chile. The country had the most transparentconversion program in the region, a privatizationprogram already in place, and a fair set of rulesgoverning foreign investment.

One company Continental chose for invest-ment was the Chilean power utility company,Chilgener, a government-owned business that wasslated for privatization. In December 1987, wepurchased shares accounting for 20% of the com-pany at a cost of $11 million. The book value of theshares was approximately $80 million.

To purchase the shares, we first exchanged ourdebt for cash through the official debt-for-equityexchange program. In this exchange, we received 85cents on the dollar for our loans—a 25% increaseover the rate we would have received in thesecondary market. In addition to this exchangepremium, we initially projected 30% returns on theresulting equity investment.

In fact, our realized return on investmentturned out to be significantly higher. Because of thehigh liquidity of the Chilean stock market, we wereable to exit our investment easily. In 1991, we soldour shares and recognized more than $35 million incapital gains. Furthermore, between the purchase ofthe shares in 1987 and the sale of the shares in 1991,we received $9.4 million in dividends, which wereinvested for additional profits of $7.5 million. In

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JOURNAL OF APPLIED CORPORATE FINANCE59

total, in less than three and one-half years, we madeover $52 million in profits, a gain of 473%.

As part of our investment in Chilgener, we alsoprovided the company with financial guidance,participating actively with management in theirfinancial planning and capital budgeting process.

A CASE INVOLVING DEBT-FOR-EQUITYCONVERSION AND DIRECT INVESTMENT

In June 1991, Continental, through its subsidi-ary PDE, Inc., participated in a joint-venture invest-ment that involved the debt-to-equity conversion ofVenezuelan restructured debt into preferred sharesof Olefinas del Zulia, S.A., a petrochemical venturein the state of Zulia sponsored by PDVSA (theVenezuelan state-owned oil company). The total netconversion amount was more than $127 million.Other investors were Petroquimica de Venezuela,S.A.; Citibank, N.A. (through its subsidiary Interna-tional Equity Investment, Inc.); Dresdner BankLuxembourg, S.A., and Swiss Bank Corporation.Continental’s share amounted to more than $20million.

The transaction began with a series of debt-for-debt swaps. As the first step, we swapped Mexicansovereign debt, which was not eligible for preferen-tial conversion rates in the formal debt exchangeprogram, for eligible sovereign Venezuelan debt. Atthe time of this swap, the secondary market was notaware that a swap of this size, which would increasethe demand for Venezuelan debt paper, was pend-ing. As a result, debt prices were still low and theswap rate was quite favorable. Thus, Continentalwas able to swap approximately $23 million in facevalue of Mexican debt, at a slight premium, forVenezuelan debt eligible for the conversion. Thisnewly acquired Venezuelan sovereign debt wasthen combined with a small piece of “superiorgrade” Venezuelan sovereign debt, which we had inour portfolio and would ultimately convert at 125%of its face value.

At the same time, negotiations among theinvestors, PDVSA, and the Central Bank of Vene-zuela resulted in an agreement that allowed varioustypes of Venezuelan debt to be redeemed, con-verted, and exchanged for preferred shares ofOlefinas del Zulia at an average of 120% of marketvalue. The mix of debt instruments converted byContinental ultimately yielded a conversion intopreferred shares with a face value 25% greater than

the secondary market value, and 2% greater than theface value, of the debt instruments converted.

In this transaction, Continental thus convertedapproximately $23 million (face value) of relativelyunattractive Mexican debt—in terms of yield, tenor,and secondary market value—into redeemable pre-ferred shares of a well-capitalized, PDVSA petro-chemical venture. The preferred shares have a facevalue greater than the amount of debt exchangedand, ultimately, will be more liquid than the Mexicandebt. In the meantime, although less liquid, theshares offer superior value in terms of yield, riskprofile, and tenor.

ANOTHER VENEZUELAN CASE

As mentioned earlier, Continental has con-ducted a series of debt-for-debt swaps in which weexchanged portions of the bank’s portfolio for localcurrency funds earmarked for direct investment incompanies throughout Latin America. In one suchcase, the targeted investment was a small, family-owned fish processing company in Venezuela thatsells tuna and sardines—primarily domestically, butalso to a lesser degree for export. Although thecompany’s stock was registered on the local stockmarket, it was rarely traded.

After reviewing the company’s history andprospects, we concluded it was a fundamentallyprofitable operation that was being stifled by toomuch expensive bank debt. We also felt that theimage of Continental as a shareholder and boardmember, combined with a few years of goodfinancial results and an adequate dividend policy,would make the stock more attractive to a broaderuniverse of investors.

We negotiated with the company’s owners andmanagers an agreement whereby Continental sub-scribed, in February of 1991, to 19.9% of thecompany’s shares through a new stock offering. Thenew capital was used to repay the most expensivebank debt and to allow the company to completemost of its capital expenditure program. As part ofthis deal, the parties signed a new shareholders’agreement giving Continental an important voice inthe future capital structure and capital spendinglevels of the company.

Now, approximately one year later, the com-pany is showing improved operating results andvastly improved financial performance. A dividendequal to nearly 50% of 1991 net income has been

After reviewing the company’s history and prospects, we concluded it was afundamentally profitable operation being stifled by too much expensive bank debt.

We also felt that the image of Continental as a shareholder and board member,combined with a few years of good financial results and an adequate dividend

policy, would make the stock more attractive to a broader universe of investors.

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60JOURNAL OF APPLIED CORPORATE FINANCE

declared and paid. Continental, while receiving anattractive dividend yield, has also made headway inimproving the liquidity of the stock. We have sold9% of the shares to which we initially subscribed atseven times our original purchase price, therebyrecovering 63% of our original investment.

LATIN AMERICAN FUNDS

For institutional investors seeking the prospectof higher returns, Latin American funds are anattractive route. While this kind of equity investingdoes not afford the same type of control as directinvestments, it does enable investors to tap into therewards of the region’s soaring stock markets

To meet investors’ demands, regional indexeshave been created to track market prices in U.S.dollars. The International Finance Corporation (IFC),an arm of the World Bank, publishes a LatinAmerican index, as well as individual countryindexes, using 1984 as the base year and measuringperformance in terms of prices and total returns.These indices alone may stimulate investment in theregion, as some fund managers seek to replicatethem in their portfolios.

The funds come in all varieties: open- andclosed-ended, listed and unlisted, blue chip andhigh-yield, cash-based and debt-driven and coun-try-targeted, mixed securities and pure equity ves-sels. Continental’s Latin American Capital fund,which is managed by Fidelity Investments, is one ofmany funds capitalizing on the high returns andliquidity of the region’s markets. Created last year,the fund concentrates investments in Mexico, Brazil,Chile, Argentina, and Venezuela—all of which havegood industrial bases and strong market potential,but which were hit hard in the 1970s and 1980s byinflation and debt. In addition to investments in

shares of large, publicly held companies, the fundalso can invest up to 60% of its assets in the sharesof smaller public companies and up to 20% in privatecompanies that plan to go public in the near future.

IN CLOSING

The rapid improvement of Latin Americaneconomies has prompted optimism among foreigninvestors, who formerly viewed investments in theregion purely as a means of reducing debt expo-sures. In the process, many foreign investors havedispelled previous misconceptions about the coun-tries. Investors have realized that the events leadingto the “debt crisis” were not unique to Latin America,as once believed, but were instead similar to manyof the difficulties experienced by such countries asthe U.S., Great Britain, and Japan during earlierphases of economic growth.

Today, analysts forecast that the prevailingoptimism about Latin America will continue andperhaps even gain momentum, as historical barriersto foreign direct investments fall and political re-forms encourage growth and prosperity within theregion’s business sector. Thus, investors who con-tinue to shun Latin America may find they havemissed a major opportunity.

Much of Latin America is expected to shed itsthird world status in the near future. Countries suchas Mexico, Chile, and Argentina are already consid-ered to have achieved “second world” status. Thecontinuation of Latin America’s successful turn-around is no longer dependent upon economics,but rather on “politics.” With stable, peacefulgovernments to encourage internal growth andhealthy international relations, there is every reasonto believe this region will be a powerful worldcompetitor in the next century.

ALBERTO LUZÁRRAGA

is a Managing Director of the Continental Bank and runs thebank’s Latin American operations. Prior to joining Continental,Mr. Luzárraga was Executive Vice President of AmericanExpress International Banking Corporation of New York. Hehas a Ph. D. in Civil Law from the University of Villanova (Cuba),

a C.P.A. from the University of Havana, and an M.B.A. from theUniversity of Miami. Mr. Luzárraga is an active member in mostof the Latin American countries’ Chambers of Commerce in theU.S. and serves on the Advisory Board of the Council of theAmericas.

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