M&A due diligence in Latin America
July 2013 | COVER STORY | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
The rapid growth of Latin American markets presents firms and investors with attractive business opportunities. But while M&A opportunities are plentiful, so too are the countries in the region viewed as ‘corruption prone’. Latin America, as a whole, rated poorly on Transparency International’s 2012 Corruption Perception Index, with only Chile and Uruguay standing out as shining lights. Investment opportunities in Latin America, therefore, are not without considerable risk – but could this risk be overblown, and how can it be combated by pre-deal due diligence?
Key trends and drivers
In the past few years, the economies of Latin America have grown steadily, making the region one of the world’s most important emerging markets. A burgeoning consumer market and a wealth of commodities and raw materials are attracting acquirers from across the globe. “This is especially the case in countries with investor friendly economies, such as Brazil, Mexico, Chile, Uruguay, Colombia and Peru,” explains Ricardo W. Beller, a partner at Marval, O’Farrell & Mairal. “But even countries that have a higher degree of legal uncertainty due to greater government intervention in the economy – such as Argentina, Ecuador and Bolivia – are managing to grow and attract investments. The growth of the region may be explained by globalisation, which has also brought about a greater demand for commodities that Latin America offers in abundance, such as energy, mining and agricultural products,” he adds.
Latin American citizens are also seeing increased living standards and associated purchasing power, which make these countries attractive markets in their own right. This has led to increasing investment in commodity producers, financial institutions, media and telecoms companies, as well as companies operating in the food and automotive industries. Increasingly, multinational companies are recognising the importance of Latin America, and the opportunities it presents for growth. Global firms are now making acquisitions to establish their presence in the region, with a great deal of interest coming from other emerging countries, such as China, India and Russia. Domestically, Brazil is increasingly active, and consolidating its position as the leading economy of the region.
This is not to say that growth in the region has followed a straight line, though, and trends within Latin America have shifted in more recent years. “M&A activity in Latin America suffered a slowdown in 2012, which became more acute in the first quarter of 2013, compared to the outstanding years of 2009, 2010 and 2011,” states Marcelo V. de Moura, a partner at Pinheiro Neto. “On one hand, this has been driven by a significant reduction in Brazilian deals, which have accounted for a large majority of transactions in preceding years. For the first time in many years, in the first quarter of 2013, Mexico saw a larger portion of deals than Brazil, probably due to the acquisition of Compania Cervecera de Cohauila for US$2.9bn. A comparison between the first quarters of 2012 and 2013 shows a decrease of 63.2 percent of all Latin American deals, while Brazil suffered a decrease of 74.4 percent. Mexico has attracted a lot of attention recently, but we do not see it overtaking Brazil as the major player in Latin America in the near future.”
Undoubtedly, the vitality of the region has secured it as key player in the world economy, and one which is looking beyond its own borders for growth. Distressed M&A opportunities created by the economic crises in Europe and the US have brought many Latin American companies into the global playing field, and companies based in Asia-Pacific and Africa are also becoming likely targets for Latin American companies. Mexican and Brazilian companies are among the most active acquirers of assets and companies outside of Latin America, led by the energy and mining sectors, along with consumer products.
A ‘high-risk’ environment?
While investment in the region is hitting new highs, there remains an inescapable perception that transactions in Latin America come laden with risk. Although all transactions carry some uncertainty, and can expose a buyer to strife further down the line, is it fair to paint the region as a ‘high-risk’ environment? The truth is that some countries do pose significant issues for investors, but the larger regions are relatively safe, and regulation in the region is improving. “Large scale M&A transactions always involve political risks for investors, especially when they contemplate investment in protected sectors such as energy or natural resources, or regulated sectors such as utilities and financial services,” says Francisco Ugarte, a partner at Carey y Cía. “These types of risks are, however, very low in Chile, Brazil, Colombia and Peru,” he adds.The 2013 LAVCA Scorecard analysing the private equity and venture capital environment in Latin America shows that regional regulators are continuing their efforts to provide a stable climate for foreign investment. Many Latin American countries have improved their transparency and disclosure regulations and provided a healthier framework for local and foreign investors.
It is, however, a common mistake to look at Latin America as a whole, rather than a collection of individual countries, according to Mr de Moura.“Brazil, for instance, is very different from the rest of Latin America, not only culturally, but because of the size of its economy, the importance and dynamism of its private sector and the strength of its institutions.The political risk in countries such as Venezuela, Ecuador, Bolivia and, unfortunately, Argentina is very high, and this does drive investors away. On the other hand, countries such as Brazil and Mexico, and, on a smaller scale, Colombia and Chile, offer much lower risk to investors and great opportunities. A certain degree of corruption exists in all Latin American countries, which varies according to the cultural differences between them. In Brazil, corruption is becoming less and less accepted in the corporate environment and transparency requirements make it difficult for large companies to engage in such activities.”
But even within individual countries, the risk environment is not uniform. Each country brings unique challenges. In Brazil, for instance, the main risks that should be analysed by foreign acquirers are hidden liabilities, especially those associated with tax, labour, social security and environmental concerns. Such issues may be less of a hurdle in neighbouring countries. “Certain sectors of the economy may be heavily regulated and supervised by local authorities, while others may be considerably unregulated,” says Mr Beller. “In several jurisdictions, transactions require, at minimum, the approval of antitrust authorities. Approval may be complicated in sectors which are considered strategic or which for other reasons the local government considers sensitive to its political interests, such as energy. Greater government intervention will imply a higher degree of risk, especially if the judicial system is not adequately independent. In countries such as Venezuela the local courts do not accept claims against the government.” The degree of risk, therefore, varies with each country and each sector, with some being safer than others. Firms and investors should carefully analyse the particular country and sector they wish to enter, and plan accordingly. Though cultural differences and lack of corporate transparency may raise corruption concerns for potential investors, these issues must be addressed and clarified in the due diligence process.
Thorough due diligence
Regardless of the risk environment, due diligence should be an integral part of any deal. If a proper analysis is made of the company, its assets, activities, and how the country regulates these, the potential risks may be properly assessed and the corresponding rates of return required for the investment may be calculated. Often, the potential return justifies any risk. In the changing regulatory environment of Latin America, due diligence is doubly important. And with issues such as transparency and access to information causing some concern, acquirers would be foolish to hold back. “The main concerns on due diligence issues are related to the availability of data, due to the lack of corporate transparency in certain Latin American countries, the cultural differences with foreign investors, and the compliance with local regulations,” says Mr Ugarte. “For example, labour issues often raise red flags due to the fact that many companies use service agreements instead of labour contracts, and therefore are subject to sanctions by the labour authorities due to the non-payment of social security benefits, severance payments and vacations, among others. Also, the informal economy of certain countries within Latin America presents risks that acquirers should consider.”
Due diligence should always include accounting due diligence performed by an audit firm, which should also review the practices and routines of the target, in order to identify potential hidden liabilities. It should also involve legal due diligence, which will analyse risks associated with contracts and litigation, including civil, tax and labour litigation. Environmental due diligence is a must, giving acquirers the chance to analyse the site where the company is located and asses any potential liabilities associated with its activity. Going beyond the target, it is also critically important to learn as much as possible about the local market, including potential partners and competitors. Due diligence should exceed what the books and records may show from a legal and accounting perspective. In this context, as Mr Ugarte points out, foreign investors should be aware of corporate governance regulations and regulatory frameworks. Hiring local financial and legal advisers with knowledge of the country’s legal and business environment and market practice is, therefore, highly advisable.
Acquirers should also monitor any legal developments in target countries, in order to ensure that they can comply and even benefit from the respective M&A regulatory frameworks, which, again, are characterised by their diversity. Countries including Venezuela, Argentina and Ecuador are considered among the most challenging regulatory environments, while Brazil, Mexico and Colombia are seen as conducive to dealmaking. Chile has, for the past few years, drawn plaudits as the most favourable regulatory environment. The LAVCA’s 2013 Scorecard on the private equity and venture capital environment placed Chile at the top of its rankings for the eighth consecutive year. That said, even in the ‘safest’ of countries, foreign bidders seeking to acquire Latin American companies still encounter difficulties throughout the merger process due largely to the uncertainty surrounding FDI policies, foreign exchange, corporate securities and labour law. Understanding the target is also made difficult by cultural differences, which can heighten corruption concerns.
The recent vigorous enforcement of the US Foreign Corrupt Practices Act (FCPA) is further cause for concern for acquiring companies, as acquirers can be held liable for FCPA violations committed by target companies. With corruption a source of anxiety for firms buying into Latin America, FCPA enforcement has had an obvious impact. “Over the last three years, we have noticed that US companies involved in cross-border M&A transactions in Latin America have been more concerned with FCPA due diligence procedures,” Mr de Moura explains.“They have been extending anti-corruption compliance programs to their target companies as well as requiring certain representations and warranties from target companies in order to protect themselves against potential liabilities in connection with the FCPA.” To unify accounting principles and ensure FCPA compliance, many Latin American countries are now making the move to IFRS standards. Firms committed to FCPA compliance can avoid liability with the aid of thorough due diligence processes.
Despite a once shaky reputation, Latin America as a region is becoming a more hospitable place for business and, in the coming years, is expected to continue along this trend, further integrating itself as a member of the global community. “M&A activities will continue to focus on natural resources, considering the vast natural resources that many Latin American countries have, especially those related to the mining and energy sectors,” predicts Mr Ugarte. “In addition, we expect that many mid-level deals will continue to develop in Latin America, especially in Brazil, Mexico and Chile as the dominant players in the region. Considering the macro environment across Latin American countries, we believe that regulatory improvements could be made in order to enhance foreign investment, and such opportunities could be used to strengthen local economies.”
Countries across the region are currently reforming their legislative frameworks, bringing them into line with global norms. “In most cases, this will result in deregulation to facilitate commerce and investments,” says Mr Beller. “However, this will not be an absolute rule. In sectors which certain countries consider strategic – such as energy, land or natural resources – legislation and regulation may increase to prioritise the defence of national interests, to the detriment of foreign investment. In the coming years, the demand for commodities will only increase, as will the growth of Latin American countries. This will lead to an increase in M&A transactions in the region, not only during the next 12-18 months, but for many years to come.” Firms wary of doing business on the continent should avoid tarring the entire region with the same brush. While some Latin American countries carry certain risks for businesses, the larger economies are much safer, and almost all regions are taking measures to improve their legal and regulatory structures in a bid to stamp out fraud and corruption. In the meantime, firms can take steps to protect themselves when entering into a deal, and perhaps the most important measure is thorough due diligence prior to closing the transaction.
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