As global bond yields were hitting record lows by mid-2010s, Latin American corporates began reaping benefits of private placements, which offered quicker, more flexible credit at a slight premium, but with far fewer compliance and reporting demands than the public bond markets entailed. This was particularly opportune for some of the major exporters on the continent, including Mexico, Chile and Colombia, which were reeling from a global commodities downturn.
Private placements in Mexico, for example, first peaked in 2015 at MXN176bn amid faster economic recovery and stabilisation of the capital markets, and boosted by the emerging hunt for yield among highly liquid European and Asian investors who were forced to venture farther afield in search of wider margins.
Banks also tapped into this market, issuing subordinated perpetual notes – a relatively novel product in this region at the time. The market was supported by the region’s major supranationals and multilaterals, such as CABEI and CAF, particularly further down the credit scale, where institutional investors are more cautious.
“We’ve seen year-on-year increases in private debt issuance for the past decade; volumes have dropped this year but we expect them to catch up by year-end. It’s mostly driven by the US market, but we are seeing growth in Europe and Asia too,” noted Thomas Mulready, Manager, Private Capital Deals Research at Preqin.
With the false alarm about an apparent hawkish turn among the world’s central banks now firmly behind us, and global bond yields hitting rock bottom once again, investors are piling into private placements, and Latin America along with other emerging markets stands to benefit. But how is this new environment different from that seen three years ago, and where is it heading?
Known Unknowns
As Maria Zaheer, CFA, MUFG, explains, private placements have become an increasingly attractive tool for issuers and investors in Latin American projects as the buy- and sell-side become more familiar with each other, particularly on sub-USD200mn projects.
“Issuers would typically work with local advisory shops, which act as the go-between, to explore the bank and bond options that are bespoke to every country. It’s a learning curve for a lot of issuers – they need to understand the risks involved with this new source of capital.”
Significantly, the end-investor is usually known before the issuance – unlike in public markets – which offers certainty and clarity about the underlying terms. Thus, for example, one Mexican commercial bank that has recently completed a private placement in a foreign currency, did so on the back of a recent portfolio acquisition from a government entity, which was practically limited to wholesale funding. The bank was able to refinance the portfolio under its own credit, thus capturing more deposits and issuing on cross-border markets and bringing down the costs on those deposits.
“The advantage for us is not only the competitive rate offered by the private placement market, but also confidence there will be ample demand because we have a familiar pool of investors that know our credit,” a source at the bank explained. “Even with additional costs to swap FX into MXN, it is still a straightforward and easy process to control. And finally, we were also able to match the maturities on the new portfolio with the tenor we secured through the PP.”
Infrastructure a Key Driver
Several factors have contributed to the boom in private debt to support infrastructure development in Latin America over recent years. The underlying reasons stretch back to the aftermath of the 2009 liquidity crisis, where banks wound down lending operations and scaled back, selling some of their client portfolios to private investors.
But institutional investors’ purchasing of loan portfolios from liquidity-starved commercial banks was only a temporary trend, says Jorge Camina, Director, Infrastructure Debt, at Allianz Global Investors, because there was still no established channel between infrastructure sponsors and investors. Over the longer-term, funds emerged in Europe and elsewhere aiming to close that gap – Allianz being one of the pioneers in early 2010s. Today the market of direct institutional investor lending in Europe is very active.
The US experience was rather different: the market for infrastructure assets was always highly liquid and the sponsor-investor channels long established. While a handful of participants in the US private placement market would mostly invest in US assets via private placements, they began looking cross-border into the less crowded spaces in emerging markets as yields dropped and the environment deteriorated. Latin America became a prime target.
“Historically, project financing in Latin America consisted of two main routes,” says Camina. “Firstly, if a project was relatively small, and the tenor didn’t matter much, then bank financing [and refinancing upon completion] would be the first choice. Second, if a project is large enough, the typical option would be a 144a bond issuance.”
Mulready likens the Latin American market to that of Italy, which in the past didn’t allow for significant cross-border investment – it was in fact one of the underlying drivers to the formation of the EU.
“But what they do now is, rather than issuing full bonds, they issue mini-bonds, allowing smaller companies to tap the markets. That could represent a path to the market for Latin American SMEs too, but the pace of growth of private debt has created an alternative route.”
Indeed, private debt is emerging on the scene as the main alternative, with more private placements happening in Latin America over the past three years than in the previous 15. According to data from EMPEA, as of the end of 2018, Latin America accounted for the second largest portion of private credit fundraising in emerging markets, marginally behind Emerging Asia – though still far from the volumes seen in major developed markets. In an EMPEA survey of global investors, 39% of them participated in private credit markets in Latin America, just 3% behind Africa and Emerging Asia.
Zaheer notes that the private placement markets are currently most active in countries like Chile, Peru and Colombia, where infrastructure initiatives are in full swing, as well as some Caribbean economies (though volumes are still relatively small).
“We’ve seen investors take more interest in the asset class, especially in more mature markets like Colombia or Chile, with pre-established infrastructure and project financing models. For issuers, private debt can offer increasingly longer tenors and full amortisation with no tail, which can result in more leverage than the bank market. Crucially, in infrastructure, a number of projects are USD-denominated, providing a natural currency match with US investors compared to the local issuances that entail expensive swap rates,” Zaheer explains.
The asset class is also appealing to sponsors on infrastructure projects, who have gone through many credit cycles and therefore have acute appreciation of access to long term financing. This aligns with the requirements of North American investors that have already expanded into European and, to a lesser extent, Asian infrastructure space; as they venture deeper into emerging markets in search for yield, neighbouring South America and the Caribbean are presenting juicy opportunities. US-based sponsors and local ones do tend to approach these projects in slightly different ways, notes Camina.
“US sponsors are reluctant to do 20-year debt on projects as they’d rather do cheaper bank loans, than a more expensive – but also more attractive on the duration-adjusted basis – long-term financing, because they don’t expect liquidity to drop off in the foreseeable future. Meanwhile, Latin American sponsors, who have “been around the block”, wouldn’t miss a great window to close their long-term cost of capital because they know a liquidity shock could be right around the corner,” the Allianz director says.
One perk of the global private placement format for infrastructure programmes is the option of arranging staged or deferred drawdowns for issuers. While multiple drawdown windows, which can offer more flexibility to borrowers involved in various stages of projects, feature in a handful of deals, the added complexity of negotiating the terms of further disbursements exceeds the benefits of doing so. It is a common feature in the US, but as investors venture south their appetite shifts, reducing the hold amounts and increasing need for tighter structural elements and enhancements.
“In certain cases, it may be simpler just to negotiate a new follow-on investment when the company requires additional funding,” admits Daniel Eskinazi, Principal, Darby Overseas Investment.
Win-Win Situation
Direct lending, usually in the shape of bilateral loans and private placements, are the most popular instruments for institutional investors, allowing them to take advantage of the liquidity premium and providing access to long-term financing outside the traditional markets, often with the “first mover” advantage on top.
“We can manage the liquidity premium – as long term and “real money” investors we can adapt our portfolios to increase exposure to illiquid securities and gain extra spread on the credit exposure. We tend to do this with credits that are familiar to us, so we do not run any risk on misinformation or data-fraud; if we know the credit, we can manage the illiquidity of the debt, and thus would prefer the private debt,” Ricardo Torresi, Regional Investment Manager, Latin America at Zurich Global Investment Management Inc explains.
“This matches the issuers’ need for long term financing, so I think it is a win-win situation.”
In turn, Darby Oversees Investments tends look to extend cashflow-tailored loans in the USD20mn to USD45mn range with a tenor of up to seven years. The company manages private funds that require multiyear commitments from the borrowers. With smaller corporates lacking the size to enter the public markets, they step in to replace expensive working capital loans with short maturities provided by local commercial banks.
“In exchange for lower liquidity compared to a public bond, for example, we offer investors access to loans which, on a prospective basis at funding, offer a spread which is several percentage points higher than developed market high grade bonds,” Eskinazi adds.
Preqin, which includes a range of private credit assets in its estimates, sees the roots of growth of direct lending in the retrenchment of banks from funding SMEs.
“Private equity companies always will need leverage, traditionally provided by banks, but with new regulations such as Basil accords, increased capital requirements are impeding banks funding middle-market businesses – and fuelling investor appetite for this asset class. There are steady returns on such investments and clear cost analysis involved with direct lending,” Mulready notes.
In their bid to match long-term liabilities, investors traditionally had three main options: invest in US Treasuries, regulated utility bonds, or infrastructure, where the off-taker was often a utility that essentially guarantees returns. The match between investor preference and client tenor needs has strengthened as global markets become more familiar with Latin American infrastructure, and, crucially, extra spread can be found in specific economies with limited incremental risk – which forces investors to become more selective in terms of projects and sectors.
“In Latin America, we are seeing strong growth in energy and power sectors, renewables, transmission – and related infrastructure,” says Camina. “A lot of these sectors tend to have dollarized assets and revenues streams, which makes them attractive to foreign investors.”
Across the major exporting nations, the mining sector is another that has benefited from private debt, especially with North American companies carrying out exploration projects in the Andean region. Less constrained by regulation, private formats allow for smaller and more tailored deals that can be more quickly executed, without the need to register them with the SEC. USD2mn-USD5mn issuances by likes of Arena Minerals, Oroco Resource, Rio Silver, Condor Resources and many others have closed through non-brokered private placements in recent months.
“A large portion on private debt investment goes into raw materials – not just mining, but agribusiness, energy, utilities and, of course, oil and gas,” notes Mulready.
Hurdles & Risks
These deals come with caveats. A major disadvantage for the issuer is elevated interest rates (a premium on convenience or flexibility), as well as a growing but limited number of investors, which can present challenges for debut borrowers trying to woo the market. This can result in additional costs and resources being spent on attracting capital, as well as making concessions on the terms in order to placate investors.
Traditional risk factors in the public markets – FX volatility and rising interest – are also in play, though they may be easier to mitigate in the private debt space. For those doing US private placements for the first time, the conditions might be appealing when business is booming, but a lack of experience and awareness of all the terms and conditions, and broader complexity of US regulations means any potential restructuring could be skewed heavily in favour of the investors. For investors, too, turning to private placements does not alleviate the typical concerns around rule of law, political and country risk that are still native to emerging markets.
“Certainly investors don’t want to see a change in government affecting the rule of law in existing projects nor the pipeline of projects; of course, looking at some of the scrapped government projects in Latin American countries, we still see a lot of headline risk which will mostly impact availability of capital for future pipeline; still, in a lot of cases it’s just a matter of governments exercising their contractual rights to change direction on policies,” Camina concedes.
Due diligence and in-depth credit analysis are essential, especially when scaling up of activity in this space entails committing more resources and time. For investment banks with private placement desks, that kind of scaling is not always feasible as their resources become stretched and cover wider geographies.
Yet despite all these caveats, private debt markets are fast becoming a significant part of the global financial system, not least because they help fill the funding gap left by international banks and offer a way for small and medium businesses to transition towards corporate finance.
A wave of financings and refinancings approaching next year in Latin America’s major economies should to some extent indicate how heavily the political and headline risks are weighing on this market, says Zaheer.
But while political risk is a given in this region, observers agree the damage to economic performance and institutions – at least among the leading economies – has so far been minimal.
“Going forward, it will be interesting to follow a number of large projects in the region. We have 4g roads in Colombia, transmission assets in Chile – but will those be financed via private markets or public ones? Zaheer muses. “We still expect this market to grow because, despite the occasional missteps, borrowers in Latin America are becoming more sophisticated and familiar to the investor community, while low yields will continue to attract new issuers.”
Private placements and hybrid deals are just one of the topics covered at Project Finance & Capital Markets Latin America on 10th February 2020. Listen to BlackRock, Brookfield, Voya Investment Management, and many more to get the latest market insights on how private placements will impact funding for long term infrastructure projects – view the full agenda here
