Latin American equities are notoriously volatile, and the market correction in May wiped 25% off the valuation of some bourses. But though hedge funds fled, there is now a solid group of international and local funds dedicated to Latin equities, and they have underpinned a swift recovery. As Danielle Robinson reports, issuance is in full swing again, though at more moderate valuations.
Latin American investment bankers and their corporate clients know the drill well: when the market is hot, raise money as quick as you can, because tomorrow it could all be gone.
That's exactly what the region's equity issuers did earlier this year, selling more than $8bn of stock in just the first four months of 2006, the vast majority of which came from Brazil.
Much of the issuance was done by small and medium sized Brazilian companies that have discovered equity is the cheapest form of capital raising in a country where double-digit interest rates have priced them out of the local debenture market.
By April the market had reached such heady levels that five deals were being done in a week, when only two or three years ago the market was lucky to get that many in a year.
Then in May the market's unprecedented surge in popularity was followed by one of the region's worst equity market meltdowns.
In just a few weeks valuations had plunged by up to 25% across the region and hedge funds that had poured billions into the region's securities markets rushed for the exits.
The speed and severity of the correction was so great that even some of the market's most optimistic observers were rattled.
"The correction scared the daylights out of everyone," says Gregg Nabhan, managing director in charge of Latin American equity capital markets at Morgan Stanley in New York.
He and other underwriters feared that such a severe markdown in valuations would dry up demand for IPOs and shut the market down, at a time when there were still about 20 deals worth more than $5bn in the pipeline.
Instead, the correction revealed something the Latin equity markets have never experienced before. Once the dust had settled, there stood a small but stalwart group of dedicated international and domestic institutional investors, committed to the equity markets.
"Before the correction, a lot of investors who didn't know anything about Latin America were coming into the equity markets just for the flow," says Rodrigo Lowndes, head of investment banking in Brazil at Morgan Stanley in São Paulo. "They were just trying to get momentum for their portfolios. Right now we don't see those investors any more. But what we do see is a group of very experienced and sophisticated investors dedicated to the region coming into deals because they believe in the fundamentals."
Getting back to work
Rather than closing down for months as many had feared, the market was back in action by late June, with initial public offerings and follow-on equity raisings, albeit at reduced valuations and with much smaller books.
It has definitely become more of a buyer's market now that hedge funds are not as prevalent in the investor mix. But the fact that a foundation of dedicated investors was visible has given market-makers confidence that Latin equity markets now have a resilience they have never enjoyed before.
"I think you will see a continuous growth in the equity business," says Pedro Chomnalez, managing director in charge of Latin American investment banking for Credit Suisse, the dominant equity underwriter in the region.
"There are plenty of companies looking to raise equity, even after their IPOs and several follow-on offerings. There is a long-term trend toward using the equity market to either fund organic growth or pay for acquisitions. The equity market is particularly important to financial sponsors and minority investors, who will use it as a standard exit mechanism," adds Chomnalez.
Bankers report strong pipelines of deals ready to come to market in September and thereafter. As August drew to a close there were about 20 deals worth about $5bn in the pipeline and the autumn and winter are expected to be as busy as the period from January to the end of April.
Without the hedge funds clamouring for shares, institutional investors are demanding valuations that some underwriters privately admit are at more realistic levels than where they were before the correction.
At the beginning of this year IPOs were being oversubscribed eight to 10 times.
From January to May, Brazil produced 18 equity deals, which got done at valuation discounts to their peers of only about 10%.
Before the market hit that pitch of excitement, the usual IPO discount was about 15%, with a further discount of another 10%-20% for Brazilian companies.
IPOs were also becoming increasingly speculative. By late April companies like BrasilAgro were being brought to the stockmarket successfully. BrasilAgro is what lead manager Credit Suisse calls a "cash-box" company — a shell set up to raise venture capital funds through an IPO.
BrasilAgro was able to increase its placement of shares to raise R$518.4m ($246m), which it will invest in agricultural properties.
Also in April, Credit Suisse brought to market GP Investimentos, a leading private equity firm in Brazil, to raise $300m in an IPO.
Doing without hedge funds
Hedge funds typically accounted for more than 20% of the international portion of a Brazilian IPO book and more than half of the local book.
But now, with most of those buyers gone, the small group of dedicated institutional investors have been able to take the reins.
By July, new issue discounts had returned to normal levels and companies were being forced to accept lower valuations.
"Through to May there was so much money coming into these markets that investors were looking for ways to put money to work and the valuations were being pushed up," says Will Landers, senior portfolio manager at Merrill Lynch Investment Managers in New York. "Now investors are being much more selective in terms of what they are willing to pay for these companies."
Abyara Planejamento Imobiliário, a Brazilian real estate brokerage firm, was brought to market in late July by Morgan Stanley. It raised R$163.7m ($74m) after cutting the IPO price to R$25, compared with an indicative range of R$33-R$35.
The deal was a challenge, since Abyara had a shortage of audited financial results and was offering only a small freefloat of 6.55m shares representing a 33% stake. But the fact that the deal got done proved that the hard core of mainly international dedicated investors would take a deal seriously if it deserved attention, even if the story was unusual.
The demand for Latin American equities has stayed strong because they are cheap by world standards and because investors were comforted to see that the correction was caused by concerns about global interest rate movements, not by any economic problems in Latin America.
"There hasn't been anything in Latin America specifically that caused the correction," says Landers. "Latin America's major economies have done their homework in terms of improving the scenario for investments in the region and countries have been very fiscally prudent. Valuations are also very attractive. Brazil has been trading at a p/e [price/earnings ratio] of around 10 times, which compares with the US market at a p/e of 14 times."
Landers adds that investors are impressed with the quality of companies coming to market, especially in Brazil, where the Novo Mercado platform on the Bovespa encourages corporate governance and transparency at a level comparable with other countries.
Many investors also believe in the long term positive story surrounding the growth of China and India, the subsequent demand for commodities and therefore the strength of economies in commodity-rich Latin America.
"The big emerging market economies are going to be the drivers of growth over the next generation or two, if not longer," says one senior portfolio manager in the US who is a dedicated equity investor in Latin America. "Regionally, the commodity story remains supportive... Chinese demand for commodities is going to remain very robust so that will underpin Latin fundamentals and in the long term that will be supportive of equity valuations in the region."
By August the Brazilian market had jumped 16%-17% from its May lows and underwriters were looking forward to a busy round of IPOs and follow-on offerings in September and the fourth quarter.
"We are very optimistic. We have a huge pipeline, with about 16 companies in Brazil alone that have requested registration with the local SEC and another 10-15 that are thinking about it," says Lowndes at Morgan Stanley.
Between July 5 and August 9, Latin American equity funds received cash inflows of $632.4m, keeping net inflows into Latin-dedicated funds positive at $2.2bn for the first seven months of the year.
Indigenous demand grows
Foreign institutional investors have also been encouraged by the sight of a healthily growing equity culture among local investors. This in turn has encouraged more smaller companies to come to the local equity markets for capital.
"Before 2003 only the well-established companies were able to tap the markets," says a senior banker in Citigroup's equity capital markets group. "Now smaller companies are coming into the market. The fundamentals are there, the equity culture has been developing and we are in a very good moment."
In 2004, when the IPO market started gathering force in Brazil, local investors made up about 20%-30% of a typical order book.
Today it is more like 40%-50%, although deals immediately after the correction were dominated by international investors.
The $22.6bn of Latin American primary and secondary equity offerings that have been sold in the past two years would have been impossible without strong support from local investors.
Demand in the local markets is deep enough that even substantial issuers can raise funds in their own currency, including large offerings like Banco do Brasil's R$1.97bn ($885m) secondary offering in late June this year, the biggest equity deal by a Brazilian company for more than four years.
In Mexico, the pension funds, known as Afores, are brimming with cash and have a desperate need to diversify their investments. They have been given the right to invest in their local markets and have been behind the surge in Mexico's market in the past year.
The vast majority of Latin American stock offerings in the past two years have been done locally and although books are traditionally split into local and international portions, that is more out of curiosity than necessity. All deals, even those with 144A tranches, are denominated in the local currency. Often the 144A tranche is only there so issuers can do roadshows in the US.
"This was the complete opposite in the 1990s," says Carlos Martinez, a partner at law firm Proskauer Rose in New York. "Then there were no local equity markets to speak of and issuers had little choice but to offer their equity securities in the United States and list on the NYSE or Nasdaq, because they would have to offer such a large discount for lack of liquidity on a 144A deal."
Avoiding New York
US-listed deals are now the exception rather than the norm, mainly because most Latin American companies do not want to deal with the time, cost and frustration of trying to comply with the new Sarbanes-Oxley corporate governance rules, often referred to in the market as Rule 404.
In the last two years less than a third of the stock offerings by Latin American companies were listed on the New York Stock Exchange. Of the 24 biggest non-US IPOs last year, only one was publicly listed on the NYSE.
Companies going through the process of complying with Rule 404 have discovered that scandal-traumatised auditors from top global accounting firms can take more than a year to clear their accounts, charging as much as $50m to make sure every last paper clip is accounted for.
To ease the burden, foreign companies have just been awarded an extension on the deadline for complying with Rule 404, and in June the NYSE submitted to the SEC a list of recommendations for modifying the rule. The initial response from the SEC was encouraging, but as yet nothing has changed.
The argument over Rule 404 has also unwittingly exposed other risks of a US public listing. Some Latin American companies which listed on the NYSE long before the Sarbanes-Oxley Act have sought to de-list, only to discover that SEC rules on that are almost impossible to meet.
"You have to prove you have less than 300 US shareholders worldwide, and that's tough to do when you have an IPO that you sold to retail," says Martinez.
Many Latin American banks have even been able to lure business away from their US rivals by claiming that the liquidity on the local markets is more than enough to get a good IPO away, and that the claim of a liquidity price premium awarded to companies that listed on the NYSE was getting weaker by the day.
"The perception of many chief executives of Latin American firms is that it [a US public listing] is not worth it," says Martinez. "The market has been speaking for itself — Latin companies have been walking away from IPOs in the US, so clearly the premium argument is not persuasive enough."
It may only be a matter of time before Brazil and Mexico's bourses start to compete directly with the NYSE for IPOs from other parts of the region.
"If you ask about [companies] in other smaller countries, I think a lot of them would have to rely on the US markets," says Lowndes. "But in the future, who knows, the Brazilian market or the Mexican market might try to finance their operations."
There are still many firms, however, that have found an NYSE listing to be invaluable, especially when the US investor base understands their sector better than the locals.
Gol, the low-cost Brazilian airline which chose to list on the NYSE in July 2004, gained significant valuation advantages and prestige from clearing the Rule 404 hurdles and being compared with international equivalents like Jet Blue and Southwest.