Can Mexico Develop a Local High-Yield Bond Market?

Transcription

1 ... as appeared in... Published by WorldTrade Executive, a part of Thomson Reuters Volume 17, Number 9 September 2009 Can Mexico Develop a Local High-Yield Bond Market? By Marc Rossell (Chadbourne & Parke LLP) The ability of non-investment grade companies to raise money in the United States in the form of bond financing has been an attractive feature of the U.S. capital markets. When credit markets are behaving normally, both U.S. and foreign issuers with less than investment grade ratings have frequently used this market to raise funds for general corporate purposes as well as for acquisition financing. The development of the local capital markets in the larger economies of Latin America, such as those in Brazil and Mexico, has resulted in many companies having primary recourse to those markets as opposed to tapping dollar-based funding in the U. S. and international capital markets. However, in markets such as Mexico, the ability to raise bond financing for most companies with less than investment grade ratings is severely limited due to various legal and regulatory impediments, as well as a general reluctance of many local investors to accept higher risk. This article outlines some of the salient attributes of the U.S. high-yield market, explores some of the reasons currently impeding the development of a similar market in Mexico and outlines some changes that would be needed to allow such a market to develop. Key Features of the U.S. Market Prior to the 1980s, very few non-investment grade companies in the United States had access to the bond markets. During the leveraged buyout boom of the late 1980s and early 1990s, these companies began to issue securities in the so-called high yield market, often as direct financings for acquisitions or as refinancings - or Marc Rossell is a partner in the Latin America and the Corporate practice groups at Chadbourne & Parke LLP. He is also a newly named member of LALBR's Advisory Board. Assisting in the preparation of the article were Boris Otto, a partner, and Brian Minutti, an associate, in the Mexico City office. Mr. Rossell can be reached at or mrossell@chadbourne.com take-outs - of bridge loans made by banks to fund acquisitions. The development of the local capital markets in the larger economies of Latin America, such as those in Brazil and Mexico, has resulted in many companies having primary recourse to those markets as opposed to tapping dollar-based funding in the U. S. and international capital markets. Private Offerings These so-called junk bonds were typically sold in private offerings without registration with the U. S. Securities and Exchange Commission (SEC), using the private offering exemption from registration under the Securities Act of SEC registration and review creates timing uncertainty for issuers, thus creating impediments to raising money quickly or completing acquisitions on a fast track. Because privately placed securities are subject to transfer restrictions, resales can only occur in the institutional market. Thus there was less liquidity for these bonds than for SEC-registered bonds. Issuers consequently had to pay a slight premium to issue the bonds without SEC registration. The SEC then allowed offerings of non-convertible bonds completed on a private placement basis to be subsequently registered with the SEC by exchanging the privately placed bonds for essentially identical bonds that were registered with the SEC, so-called A-B exchanges. This allows the initial offering to be completed quickly without the delay of SEC registration and review, but also provides bond holders the liquidity of SEC-registered bonds within a short time after the initial offering.

2 Broker-dealers who have unsold bonds they have initially purchased in a private offering must rely on a different exit strategy because the SEC takes the position that they are still underwriters for those bonds, and so the exchange offer concept is not available for those bonds. Consequently, the broker-dealers usually require the issuer to file a shelf registration statement with the SEC allowing the broker-dealers who are holders of bonds to resell in the public markets from time to time. The downside to this approach is that the selling brokerdealers are then subject to underwriter liability under the securities laws, whereas in an exchange offer there are no underwriters or selling holders and only the issuer is liable for the disclosure. When credit markets are behaving normally, both U.S. and foreign issuers with less than investment grade ratings have frequently used this market to raise funds for general corporate purposes as well as for acquisition financing. The exchange offer approach endorsed by the SEC in a series of no-action letters allows companies to quickly do a private offering of bonds and then worry about the SEC registration later. Because of the initial transfer restrictions on the bonds sold in the private offering, issuers often give investors in the private offering contractual registration rights that commit the issuer to register the securities after the offering and, if it fails to so within certain specified periods, the interest rate on the bonds increases as liquidated damages - a rough calculation of the discount that privately placed securities without registration would command in the market compared to registered securities. Deep Investor Base There is a large institutional investor base in the United States for non-investment grade debt consisting of mutual funds, hedge funds, pension funds and other investment vehicles seeking higher yields than bonds issued by investment grade companies. Although many funds have limits on how many of these restricted securities they can hold at any particular time, the market is relatively deep and there is ample demand, with few legal restrictions on institutional investors as to what type of security they can buy and own. Contractual Credit Protections Investment grade companies have traditionally been able to issue bonds without many of the investor protections that are customary in either the bank loan market or the high-yield bond market. Because the risks of default are higher with non-investment grade issuers, investors require more protections against the removal of cash and other assets from the issuer s asset base as well as limits on the conduct of the issuer s business. Guarantees from the issuer s subsidiaries are often required and the ability to move cash and other assets among the different parts of the corporate group outside the focus of the credit (the issuer and its guaranteeing subsidiaries) is constrained. Investors also worry about a change in control of the issuer and extract a premium and demand a right to put the bonds back to the issuer if such an event occurs. There are sometimes equity kickers that are negotiated, such as warrants to buy common stock, and the bonds and warrants may be packaged as units. Although the contractual terms for a non-investment grade bond offering are complex and highly negotiated, there has developed a pattern of generally accepted market practice that has somewhat standardized the terms and managed expectations. Relatively Predictable Enforcement Regime One of the major considerations for the U.S. investor base is the relative predictability of outcome in exercising legal remedies in U.S. courts, including bankruptcy courts. Subordination terms are generally respected and legal rights to accelerate maturities, claim for payment of moneys dues and make claims in a bankruptcy proceeding are all taken for granted to a certain extent. While actual recoveries are always hard to predict, the predictability of the process as well as the integrity of the judicial system are essential underlying components of the high-yield bond market. The existence of a deep institutional investor base, a legal regime allowing a private offering to be made without regulatory approval, contractual protections which are well-understood and a predictable enforcement regime are all factors that have allowed the U.S. high-yield market to flourish and create capital raising opportunities for many companies below investment grade. Fundamentals of the Mexican Bond Market Limits on Eligible Investments The Mexican market for peso-denominated bonds is characterized by a relatively small number of frequent issuers and investor demand is concentrated mainly in the investment companies (Sociedades de Inversion Especializada en Fondos para el Retiro or SIEFOREs) that manage the investments of the pension funds (Administradores de Fondos para el Retiro or AFOREs). These funds have significant cash on hand from employee and employer contributions. There are small pools of private risk capital with the private banks as well as some investment funds and institutional investors such as insurance companies, but these sources tend to be less heavily invested in the local bond market. The SIEFOREs have virtually no ability to invest in securities of issuers with less than the highest September 2009 LATIN AMERICAN LAW & BUSINESS REPORT 2

3 credit ratings. Thus, the high-yield, or non-investment grade bond, is not a viable investment product for a significant portion of the Mexican capital markets investor community. There have been a few non-investment grade bonds sold in the local market by issuers with recognized names, but these have been the exception rather than the rule, and the size of the offerings has generally been small due to the lack of participation by the SIEFOREs. Furthermore, banks that fund themselves by entering into repurchase agreements with other banks find themselves unable to include non-investment grade bonds in their repurchase arrangements because these securities are generally considered ineligible as collateral. Exemption for Private Offerings Substantially all of the bond offerings in Mexico are registered with the Comision Nacional Bancaria y de Valores (CNBV), the national securities regulator, and The private offering exemption in Mexico is not seen as offering the same advantages as the private offering exemption does in the United States. are also listed on the Bolsa Mexicana de Valores (BMV), the Mexican stock exchange. Once registered, an issuer must comply with certain reporting obligations and other requirements, although they are less stringent than those which are applicable to companies with publicly traded equity. Although an issuer can undertake a private offering without registration or listing subject to certain conditions (such as limiting the number of investors to less than 100 persons or offering only to qualified investors), many institutional investors are not allowed to invest in securities that are not registered. In addition, there are some tax disadvantages for investors if the securities are not listed. Because the burdens associated with CNBV registration and a BMV listing are not as heavy as those that are generally borne by issuers facing an SEC registration, and due to this more limited investor universe and less favorable tax treatment, the private offering exemption in Mexico is not seen as offering the same advantages as the private offering exemption does in the United States. Less After Market Support Another consideration to be noted is that Mexican financial institutions do not engage in market-making in the Mexican fixed income market to the same extent that U.S. underwriters do in the United States. In the noninvestment grade area, the absence of meaningful aftermarket support for the bonds can in some instances be an impediment to a successful offering because initial investors will be left with little choice but to hold the bonds after they buy them, particularly if the pension funds cannot be buyers. Light Covenant Packages Most bonds offered in the Mexican market are issued in the form of certificados bursatiles. These bonds have historically not included any restrictive covenants, subsidiary guaranties or some of the other protective provisions customarily found in U.S. high-yield debt offerings such as change of control puts, non-call periods or make-whole premiums. Some bonds even lacked acceleration remedies and cross default provisions. The corporate culture for fixed-income securities in the Mexican capital markets is thus not accustomed to the more rigid credit analysis and credit protection engineering that occurs in the U.S. market for noninvestment grade issuers. Some more recent offerings have included restrictive covenants and other credit protection provisions and there has been recent movement by investor groups in Mexico to include more protective provisions in bond documentation. However, many local bond offerings in Mexico still do not include them. Less Predictable Enforcement The ability to accurately define credit risk of U.S. issuers is in large measure facilitated by a relatively predictable legal regime, including the ability to enforce contractual remedies and to have relative confidence in the efficiency and integrity of the bankruptcy process, the real end game when it comes to defining credit risk. In Mexico, the uncertainty of enforcement remedies, as well as a general reluctance to resort to bankruptcy as a means of corporate restructuring, is also a factor to consider when evaluating whether the local market has the appetite for investing in non-investment grade, i.e., more risky, debt securities. The absence of any significant credit protections in many of the local bond offerings only serves to underscore these risks. What Changes are Needed for this Market to Develop? Investment Eligibility Before a market can develop for non-investment grade debt, there needs to be a sufficient demand for the product. Under the current rules, the SIEFOREs cannot purchase non-investment grade bonds, which puts issuers in this category at a significant disadvantage compared to the higher rated companies. Although there are policy reasons why SIEFOREs may need some form of restriction on their ability to freely invest in higher risk securities, if the eligibility criteria could be broadened slightly to allow some small percentage of their assets to be invested in non-investment grade securities, this flexibility might enable some demand to emerge from these institutions that control a majority of the investment power for fixedincome securities in the Mexican market. 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4 Although there are fewer fixed-income focused funds in Mexico than in the United States, if the SIEFOREs were allowed to invest in non-investment grade securities, some smaller offerings could come to market and thereby create enhanced investor interest in this type of product, thus fostering the establishment of more funds with the capacity to invest in these securities. U.S. high-yield funds with an emerging markets focus might also have an interest in investing in specified peso-denominated local bonds if properly structured. In other words, it is hard to find buyers for a product before the product actually exists. If the SIEFOREs were allowed to invest in non-investment grade securities, some smaller offerings could come to market and thereby create enhanced investor interest in this type of product. Increased Credit Protection in Public Securities Lack of familiarity with the more detailed and restrictive covenant packages that are associated with high-yield bond offerings is another educational process that would take some time to develop. Contractual terms under Mexican law would have to be prepared and analyzed under this different legal regime. Many Mexican companies have issued dollar-denominated high-yield bonds in the U.S. market so presumably the inclusion of similar contractual terms in a purely peso-denominated local bond offering would not be so unfamiliar. But the investor base in Mexico may not be as accustomed to reading and understanding these provisions and there are relatively little court decisions interpreting these types of contract terms. Underwriters who bring these offerings to market must also be able to understand and convey the covenant package to investors, sometimes negotiating modifications to the terms to address concerns voiced by investors and the ratings agencies. The rating agencies in Mexico are not accustomed to rating non-investment grade bonds simply because the product category does not exist. Although there is no restriction on the ability of rating agencies to rate this type of security, the analysis they would need to undertake in order to develop relatively predictable rating guidelines may take some time to develop. In July of 2009, the Mexican trade associations representing the AFOREs and the insurance companies published a joint white paper communication to issuers and underwriters outlining the covenants and credit protections that they expected to see in local bond documentation in order to consider investing in the securities. Curiously, financial maintenance tests were included in the list, provisions which are not typical in U.S. bond offerings which rely mostly on incurrence tests. Although the communication has been greeted with some resistance, some recent offerings by investment grade issuers have included some of these requirements and one can assume that any non-investment grade issuers would be faced with similar if not more stringent requirements from investors. The Private Offering Exemption The ability to sell securities privately without regulatory review is a key feature of the U.S. market because the offering can be prepared and completed through the efforts of the issuer and the underwriters without worrying about the timing constraints of SEC review and approvals. In Mexico, the advantage of avoiding regulatory scrutiny does not appear to weigh as heavily in the decision making. However, the private placement option comes at a price. Trades executed over the Mexican stock exchange are generally exempt from capital gains taxes while trades over-the counter off the exchange are not. Although this may not be as meaningful in the debt area as is the case for equity securities, changes to the tax regime to ensure that there is no tax disadvantage for sales of bonds in the over-the-counter market would be a beneficial adjustment to allow a private market to develop. There may be need for certain changes in the way the settlement system (Indeval) works. In the United States, the Depository Trust Company (DTC), the principal clearing and settlement system for securities issued in the capital markets, accepts delivery of debt securities that are offered and sold in reliance on the private offering exemption and can assign restricted trading positions to these securities. This facilitates secondary market transfers. Although there is no legal restriction on the ability of Indeval to accept securities issued in a private placement, it generally only accepts securities into its clearance and settlement system that are registered with the CNBV. Accordingly, some adjustments may be necessary to Indeval s operational rules to enable privately placed bonds to clear and settle in a manner similar to other publicly traded securities. Why Should Mexico Promote the Development of this Type of Investment Product? The Mexican local market has been dominated by a few well capitalized companies with investment grade ratings. The result has been that many non-investment grade companies have no access to the local peso bond market for all of the reasons outlined above. Fostering the establishment of a non-investment grade bond market would open up financing capabilities to a whole range of new companies, some of which may not be ready to have publicly traded equity or whose current owners may not want to start the process of public ownership. Allowing pension funds to invest at least a small percentage of their assets in a more diversified, higher yielding pool of fixed income securities would afford them September 2009 LATIN AMERICAN LAW & BUSINESS REPORT

5 some opportunity to enhance their returns. Although there would inevitably be opposition by certain groups, perhaps labor unions and others with monies invested in the funds, to increased exposure of the funds to a more risky investment instrument, the SIEFOREs currently have some ability to invest in equity securities and these as we have seen are sometimes just as risky as fixedincome securities, if not more. A transitional approach where the modified investment eligibility criteria are phased in over time might also ensure that these risks are adequately addressed and protected by a more educated investor base. The Mexican bond market has proven to be an attractive and liquid alternative for many companies in Mexico. If the peso bond market were to open up for the non-investment grade issuer, the Mexican capital markets would be given an added boost of depth. The analysis required for a successful non-investment grade bond offering would encourage a culture of better credit protections for investors that are customarily accepted in other developed markets. Investors, underwriters, companies as well as rating agencies would be driven to paying closer attention to credit protection mechanisms. Lawyers drafting terms of bonds and other agreements would need to pay closer attention to the detail of the restrictions imposed on or by their clients. In short, the financial community would as a whole become more developed because the analysis of credit structures is more complex and requires an analysis beyond mere reliance on credit ratings. The July 2009 white paper is a positive step in this direction. The existence of a viable high-yield bond market, even on a smaller scale than in other countries, would foster the continued growth of the domestic peso market and contribute to the overall enhancement of Mexican capital markets and its attractiveness as a source of funding. The need to access the U.S. dollarbased market with its inherent currency risks, despite the availability of derivative contracts, would diminish. Less exposure to foreign currency liabilities would also have a macroeconomic benefit for the country as a whole. Companies in neighboring countries with which Mexico has strong cultural and economic ties, such as Central America, might find the availability of peso-denominated bond funding an attractive opportunity as well. Conclusion The Mexican bond market has proven to be an attractive and liquid alternative for many companies in Mexico. If the peso bond market were to open up for the non-investment grade issuer, the Mexican capital markets would be given an added boost of sophistication and depth. However, it remains to be seen whether the necessary regulatory reform and market structures can be implemented. Furthermore, even if the necessary reforms were forthcoming, critics might argue that the relatively unpredictable enforcement and bankruptcy regime would restrict the financial community in Mexico from fully embracing the added risks as well as higher returns associated with the issuance by lower rated companies of these bonos chatarra, or junk bonds. o Reprinted from Latin American Law & Business Report 2009 WorldTrade Executive, a part of Thomson Reuters September 2009 LATIN AMERICAN LAW & BUSINESS REPORT