US M&A in the emerging markets
December 2013 | COVER STORY | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
US interest in emerging market M&A has increased, with US companies completing 116 emerging and high-growth market acquisitions in the first half of 2013, compared to 110 in the second half of 2012, according to a recent KPMG report. In addition, the US remained the favourite target among developed markets for acquisitions by high-growth market companies. At a time when M&A activity in the emerging markets is reportedly on the decline, what is driving the appetite of US firms and financiers to invest in the region, and what sectors are receiving the most attention? More importantly, how can investors take advantage of this trend, and how long can it be expected to last?
In the first half of 2013, says the KPMG study, US-based companies increased M&A activity in emerging and high-growth markets. This came against the backdropof a slowdown in overall developed-to-high-growth deals. The study found that US firms completed 116 emerging and high-growth market acquisitions from January to June 2013, a slight increase on the 110 seen in the second half of 2012. Overall, however, developed-to-high-growth deal volume dropped 13 percent.
With US companies exhibiting higher levels of confidence domestically, this is starting to translate into increased acquisition activity in emerging markets. “The slow recovery of the global economy and the debt ceiling crisis that has affected the US in the past years have drawn US players to look towards emerging markets for target companies,” says Francisco Ugarte, a partner at Carey Abogados. “This is especially true ofcountries with abundant natural resources thathave strengthened their regulatory framework in recentyears. No longer merely seeking resources or low-cost labour, they are seeking growth in regions where the middle class is expanding rapidly and disposable incomes are rising.”
In terms of target regions, the most popular for US firms in the first half of 2013 were Brazil, India, South American countries excluding Brazil, South and East Asia, and Central America and the Caribbean. This marks something of a shift in investment strategy. In 2008, US businesses took an ownership stake in twice as many companies from China as from any other emerging market, including Brazil and India. This trend, however,has reversed. In more than one in five deals involving a US acquirer in 2013, the target was a Brazilian business, and 15 percent involved Indian firms. Currently, Brazilian businesses are the targets innearly four times as many US-originated M&A deals as Chinese companies. “We are seeing a growing interest in the Brazilian market by American companies, which have been and continue to be the largest group of investors in Brazil,” says Carlos Alexandre Lobo, a partner at Veirano Advogados. “Out of 617 M&A transactions in Brazil up to the third quarter of 2013, 83 involved US companies. The US is also the preferred jurisdiction when Brazilian companies go abroad. Out of 35 outbound M&A deals, 10 involved US targets.”
Brazil’s current popularity may also be due to the depreciation of the country’s currency. The real has dropped 15 percent this year amid wider turmoil in the emerging markets, explains Marcelo V. de Moura, a partner at Pinheiro Neto. “Recently we have noticed that the appreciation of the US dollar against the Brazilian real has had an impact in cross-border M&A deals, as this represents an actual reduction in the price of Brazilian companies for foreign buyers. Countries like Brazil present many opportunities for foreign companies. Provided they are well assisted, such companies will certainly be able to do great business in these markets, which are not as mature as the US.”
Indeed, while M&A activity in the region is trending lower thanlevels reached in previous years, Latin America as a whole remains a major target for US originated M&A. “US acquirers have been amongthe most active in pursuingtransactions in the majorLatin American countries, after local and regional players,” says Alejandra Elias, a senior manager at Ernst & Young. “During 2012 and as of October 2013, the most active buyers pursuing transactions in the region were strategic investors, accounting for 61 percent of total announced deals in this period. Financial investors accounted for the remaining 39 percent of total announced deals.”
A major driver of deals has been the grim situation on the home front. A struggling US economy, coupled with strong bright spots in emerging markets such as Latin America and China, has ledUS firms to focus their growth on these regions. In view of the financial crisis and resulting sluggish economic growth, emerging markets presentan attractive investment alternative, which is true for all developed countries, not only the US. Indeed, even supposing the domestic deal market was buoyant, the rapid growth of the emerging market economies would most likely continue to drive US buyer interest, for a number of reasons.
For one, the rise of a stable middle class throughout the emerging markets has driveninvestment in companies that service domestic markets. With a growing base of potential customers, opportunities abound in the consumer-targeted sectors. According to the Financial Times, Africa is expected to becomea huge market in this respect. The continent is home to 1 billion people, of which two-thirds are consumers. This number is expected to rise to 500 million by the mid-2030s as living standards improve. It is no surprise that developed-country firms including, most recently, Barclays and Vodafone, are moving in.
The abundance of natural resources in many emerging regions has also fuelled investment and will continue to do so for the foreseeable future. “Latin America’sabundant natural resource reserves have been,and will continue to be,a driver and attract US investors seeking to capitalise on the rise in commodity prices and continuing demand out of India, Brazil, China and other fast developing economies,” says Francisco J. Cerezo, a partner and chair of the Latin America practice at Foley & Lardner LLP. “This continued demand,coupled with infrastructure development needs,is attracting significant interest from US investors.” Another important factor is gaining access to an abundance of qualified human labourat a reasonable cost.
Another major deal driver has been the continued growth of Latin American and Asian groups as significant regional and global investors. Such investors, seeking opportunities beyond their home markets, often team up with US-based players looking forM&A opportunities in emerging markets. This comes at a time when other traditional investors are retreating. “We have witnessed many US private equity firms take advantage of the great investment opportunities presented in Latin America due to the eurozone’s debt crisis,” says Mr Ugarte “In this sense, US private equity firms have been very active in raising billions of dollars to buy European high-quality assets in Latin America from distressed European companies desperate for quick liquidity. A relevant acquisition was Bain Capital LLC’s recent purchase of Telefónica’s Atento for approximately US$1.3bn.”
A further driver of deals has been the favourable financing environment in many emerging regions. Leveraged buyouts have increased in the recent years, particularly in Latin America, largely as a result of the higher lending capacity of local banks and the easing of monetary restrictions. Foreign investors have been attracted by the option of financing M&A purchases with locally-sourced debt, rather than their own capital.
US companies have targeted a broad range of sectors, though M&A activity has focused mainly on the energy and consumer-related industries, where multinational companies have played significant roles as buyers. “Natural resources and consumer products are sectors US acquirers continue to focus on, both linked to some degree to the increasing middle class in many markets fuelling demand,” says Susan Failla, a partner at Hunton & Williams. “Focusing on Latin America, the country which has shown a remarkable turnaround over the last 10 years or so is Colombia, because it has become a safer and more predictable place to do business and as a source of previously unexploited natural resources.”
While the emerging middle classes have also driven investment, such activity has not been limited to the consumer sector. Education and healthcare are also experiencing rapid growth as living standards improve. Theinsurance and pension fund sectors have also been highly sought after by US players, particularly in Chile, Colombia, Peru and Brazil. In 2012, these sectors represented the highest foreign direct investments made by the US into Chile, and in 2013, MetLife Inc., the largest life insurer in the US, purchased the Chilean pension manager AFP Provida S.A. in a deal valued at approximately $2bn. Elsewhere, Africa’s young and increasingly wealthy population represents a vast potential market with great opportunities. Urbanisation is an upward trend across the continent, bringing small-scale industrialisation and improved infrastructure to major cities – all of which is attractive to investors. The region’s natural resources are also a draw.
In addition, US acquirers have focused on the IT sector in recent years. “The technology sector is behind a large number of transactions in Brazil this year,” says Mr Lobo. “As a result of growing access to computers, broadband services and smart phones, internet, software and IT services companies are experiencing an accelerated growth and attracting a lot of interest. The infrastructure sector is also receiving large sums of money, benefiting all companies in the supply chain. The World Cup in 2014 and the Olympic Games in Rio in 2016 are contributing to this trend.” This focus on IT extends throughout the major economies of Latin America, according to Ms Elias. “US acquirers have focused on the IT sector in 2012 and 2013, with this sector accounting for 18 percent and 19 percent of announced deals, respectively. In 2013, the IT sector was followed, in order of importance, by industrials, financials, consumer discretionary and materials. During 2012, the top five target sectors in terms of announced deals were the same as for 2013; however, in a different order of importance and with more deal activity concentrated within this group of industries.”
US China-bound M&A has increased yearly, by value, since 2010. In 2012, US investors poured over $10bn into the Chinese economy. Companies and investors have targeted entertainment, advertising and digital media opportunities in the country, with most investors considering companies and assets valued at US$250m or less. Going forward, however, dealmaking and investment activity between the US and China will likely be significantly impacted by the two countries’ uncertain political relationship.
India’s aviation sector has seen increasing interest from US companies, encouraged by recent changes to the regulatory environment. The Indian pharmaceutical sector has also been a focus, as multinational firms use M&A as a route to enter this growing market. Abbott’s acquisition of Piramal is an example of the US interest in gaining a foothold in the Indian market. The healthcare sector has also proved a popular target in Brazil. “In 2012, UnitedHealth Group acquired control of Amil, one of the largest health management operators in Brazil,” says Mr de Moura.“This transaction represented the first investment by a foreign group in this industry. Considering the size of the Brazilian health management market and the low quality of Brazil’s public health system, there is plenty of scope for foreign companies to invest in this industry.”
Challenges and risks
The appetite of US firms for acquisitions in emerging markets belies the difficulties that firms can face in the dealmaking process and beyond. Success in an emerging market does not come easily. US firms involved in large scale M&A transactions can expect to face political and legal risks, complex tax environments, cultural differences and a lack of corporate transparency.
Emerging nations, todiffering degrees, are often exposed to social, political and economic uncertainty and instability. This can be reflected in unstable currencies, inflationary contexts, weak and changing legal frameworks and a lack of solid institutions. Evolving legal systems and a lack of target transparency give rise to issues that foreign buyers may not encounter when conducting M&A in developing markets, at least not to the same level. Firmshoping to do business in such regions need tobe aware ofthe risks.
Firms should remain conscious of the increased levels of bureaucracy they can expect to come up against in emerging regions, stresses Mr de Moura. “Although the world’s economy is becoming increasingly globalised, and firms are becoming aware of how business is done in each of the emerging countries, foreign companies are still frequently surprised by the level of bureaucracy in Brazil. Industrial companies, especially, have a tendency to want to do things in Brazil exactly as they do at home. This is not the best approach to follow, and sometimes can be detrimental.”
With particular reference to the energy and natural resources sectors, political risk is a key concern. The emerging markets heavily influence today’s energy landscape in terms of both supply and demand. The BRIC countries consume 30 percent of the world’s fossil fuel sources, and on the supply side, many emerging and frontier markets provide opportunities for new sources of energy supply to meet growing global demand.
Energy deals are typically characterised by high initial capital expenditure and realisation of return on investment over long terms. Political and economic stability is therefore essential. However, in many emerging markets, such stability cannot be guaranteed, and firms face a raft of risks, including politically motivated violence, loss of assets due to host government expropriation, cancellation of government licences and concessions, government imposed changes to exchange controls preventing extraction of profits from the host country, and the enactment of new legislation which adversely affects investment returns.
The increasingly-connected world in which we live places further pressure on firms. In today’s highly-regulated and scrutinised business environment, companies must be acutely aware of the social implications of their activities.“Increasing informal disclosure, through social media empowering activist groups using global communications channels, has increased companies’ sensitivity and aversion to risk,” says Ms Failla. “US companies targeting business opportunities in emerging markets are now subject to greater expectations for corporate responsibility and citizenship. A current example of these trends is the ability of indigenous groups to either halt natural resource projects or impose significant restrictions or extract concessions by achieving wide publication of their concerns through social media.”
Being sensitive to local considerations, cultural and otherwise, and understanding local markets, iscrucial to successfullystructuring, negotiatingand closing a transaction. “Many deals fail to realise their potential after closing or never reach closing due to a lack of knowledge of the local market,” says Mr Cerezo. “As such, it is of utmost importance that foreign buyers and investors rely on the advice of seasoned advisers with deep knowledge of the local market. Beyond the advice leading up to a successful closing, US and other international investors are well served by having a clear management plan in place,which also includes the participation of persons with deep knowledge of the local market.” Expert advice will not only assist the acquirer witha successful closing but, more importantly, will helpthe venture thrivepost-deal.
As in any deal, thorough due diligence is of paramount importance. Due diligence is always crucial, but in the emerging markets it is particularly important as there tends tobe less transparency and access to information. Those performing the due diligence investigation need to be ever more thorough and resourceful in order to complete a comprehensive review. Beyond the accounting and legal due diligence, acquirers needto learn as much as possible about the local market, including potential partners and competitors.
Going forward, it is unclear how US activity in emerging markets will develop in the long term. The continuation of current trends depends largely on global economic stability, which remains a major concern. There are many reasons, however, for assuming that the US appetite for deals in emerging markets should continue for some time. These regions, of course, offer incredible growth prospects. “Emerging markets are key to any company’s growth outside of the US,” says Mr Cerezo.
“Globalisation is here to stay and if US investors fail to pursue M&A opportunities in emerging markets they will be doing so at their peril. A number of US firms have positioned themselves well to capitaliseon emerging marketgrowth opportunities as a means of generating future revenues. Those which have not already implemented an emerging markets strategy need to act quickly or risk missing out on tremendous growth opportunities which are far greater than the opportunities available solelyin the United States.”
Indeed, given the opportunities that such regions present, particularly with respect to energy resources and required infrastructure investment, it is hard to see why US firms would want to scale back their activities. We expect US M&A activity within the region to continue focusing on the energy sector owing to the vast natural resources that many Latin American countries have and their continuous demographic growth, which have led to an increase in demand for electricity and gas,” says Mr Ugarte. “Moreover, considering that many emerging markets still present development delays in their infrastructure, we expect M&A activity in this area to also increase over the next few years.”
The US, however, is not the only market with an interest in these regions. Acquisitions among the emerging markets are increasing rapidly, as they make the transition to becoming ‘developed’ countries in their own right. Indeed US companies themselves remained the most popular targets for emerging and high-growth market companies within the first half of 2013, according to KPMG’s report.“Competition is increasing among local and regional companies that are growing, expanding geographically, and have better knowledge of the market and its challenges,” says Ms Elias. “In some industries locals have an advantage with respect to large foreign companies headquartered in developed markets when it comes to factors such as quality standards, and minimum profitability and investment returns thresholds.” In addition, new research from the Boston Consulting Group suggests that acquirers from emerging markets generate higher returns on emerging market deals than acquirers from developed economies. Such acquirers are generally more familiar with the culture, language and market of their targets than acquirers from developed countries, and that familiarity translates into a deal-making advantage.
Does this mean, though, that US companies may find themselves being forced out of the emerging markets? Not necessarily. “Although we are observing a growing interest from Asian companies in Brazil, especially from China, there is still a great cultural gap between those two countries and the focus from that end appears to be restricted to the commodities and energy sectors,” says Mr Lobo. “Brazilians have a long standing relationship with the US and there is a great interchange in the business community. Most of the large US companies are already established in the country, which will help them to take advantage of the coming opportunities.”
Ultimately, however, the ability of US firms to operate in these regions may prove a hurdle to the expansion of their M&A activities. Amplified regulatory requirements are already hurting US companies, and in future, operations in the more risk-laden emerging markets may not be worth the effort. “To mitigate the changing and increasing risk environment, US companies are using less traditional M&A structures with greater frequency – for example, distribution agreements, joint ventures and contract manufacturing,” says Ms Failla. “The hurdle for US companies is compliance, both at home and abroad. The recent FCPA litigation, both regulatory enforcement actions and shareholder class actions, will cause many companies to pause before entering into jurisdictions where the business culture does not adhere to similar compliance standards. This may put US companies at a disadvantage compared to companies operating elsewhere.”
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