i Deal activity
Private equity in Mexico is focused on investment in primarily small and medium-sized companies that are not traded on the stock market, with horizontal investments made over three to seven years, during which time investors seek to build the companies up to later sell their investment either to a strategic investor or, in some cases, through a public tender offer on the Mexican stock exchange. Both public and private entities try to create incentives for a more open culture towards private equity. Nonetheless, it is still seen as an objective that is hard to reach for most small companies, or as a way to lose control for family-run companies, so it is not used as often as desired.
These perspectives, among other factors, mean that private equity in Mexico has less importance than it has in other emerging countries. However, in recent years, Mexico has grown rapidly in this area and since 2015 it has become, along with Brazil, according to a special report by Financier Worldwide magazine, one of the most popular countries for private venture capital in Latin America.
One noteworthy reason for the increase of investment activities in Mexico is the steady growth of gross domestic product (GDP), which increased at an annual rate of approximately 2.5 per cent between 2013 and 2018, and the several pro-growth aggressive reforms made since 2012. According to recent studies by the Organisation for Economic Co-operation and Development (OECD), prices in the country have decreased significantly, especially in the telecommunications sector, where the prices of mobile telecommunications (using the OECD mobile broadband basket comparator), fell by 61 per cent in the medium-usage category and 75 per cent in the high-usage category. Consequently, Mexico is becoming a more competitive market.
Furthermore, the Mexican authorities continue to legislate to make the country more competitive, and to strengthen and promote the growth of private investment, both national and foreign, in sectors to which there was previously no access. The government's support for investment is already showing results, giving Mexico a clear advantage over other emerging-market peers.
This support can be seen both in the opening up of the energy sector to private investment (with committed investments having now reached US$175 billion in this sector, according to the OECD) and in the creation of public funds to encourage the development of small and medium-sized companies. However, one of the primary challenges facing private equity is the reluctance of entrepreneurs and families managing many of the companies in Mexico to surrender control of their companies by accepting external investment by capital funds as partners or shareholders. Despite this adverse 'cultural' issue, private equity has been rapidly gaining importance in the country in the past few years.
For example, fundraising activities have been increasing since 2007. Between 2007 and 2017, the number of private equity funds in Mexico increased from 41 to 177, and the capital invested increased from US$11 billion to US$51 billion. This represents an annual growth of 10 per cent in the private equity industry. Moreover, trust in alternative funding schemes has soared recently because of financial stability and increasing return rates. Financial growth and well-publicised successes, together with the latest amendments to the applicable laws, have broadened the base for private equity operations. The range of opportunities for private equity has been expanded beyond the usual targets to incorporate a wide variety of projects. Consequently, the possibilities for aggressive expansion in the future seem very promising.
The greater part of private equity in Mexico comes from foreign investors, and there is, therefore, a tendency to engage in cross-border transactions. Mexico's regulations tend to generate interest from global investors, and there are several industries that offer great opportunities for private equity investments. The energy sector is a good example, with regulatory benefits even for cross-border transactions. The ending of the state monopoly in this sector following the 2013 energy reform, and the introduction of new regulations, have opened the sector up to private investment, allowing Mexico to become an attractive market for private equity.
Apart from the high-profile energy sector, other sectors such as health, telecommunications and consumer goods and services have also been targeted by both national and international investors interested in entering the Mexican market. Mexico has also made a series of significant reforms in telecommunications that have created a more attractive environment for private equity.
The fintech industry in Mexico has also been the subject of considerable growing interest. Following publication of the Fintech Law and the first round of its implementing regulations, covering crowdfunding, electronic payments, fund institutions, cryptocurrencies and financing operations carried out using new models, the fintech sector has been targeted by both national and international investors interested in entering the Mexican market, and has become a focus for private equity activity and investments in the country.
The development of new ways to carry out transactions in Mexico is undoubtedly making the Mexican market more attractive to foreign investors. Additionally, private equity M&A in the country is also continuing to grow, fuelled by expectations that exit options will increase in the next few years.
As markets and needs grow, there is an equivalent need for managing parties to be able to respond rapidly and efficiently. Consequently, private equity sponsors that may add value with hands-on expertise and many other management skills are now preferred to pure capital investments. Generally speaking, private equity sponsors are not subject to specific supervision or treatment under the law, although certain matters require regulatory compliance, and tax issues must be addressed carefully because of the nature of these operations. Nonetheless, every financial participant must be aware of the importance of having well-prepared legal counsel for the design and review of operations. From the supervision point of view, authorities do not intervene in the day-to-day business of a company as long as there has been careful planning and design in the early stages of the project, and only in regulated industries.
In other schemes, as with publicly listed corporations, issuers of capital development certificates (CKDs) are subject to stricter regulation relating to disclosure, directors' duties, corporate governance and minority rights. Hence, the need for legal advisers is also increasing, and more specialisation is required. In the area of private equity, the main challenges facing legal advisers in Mexico are knowing and understanding the practical requirements of the legal structures and of the investors and other parties involved in private equity transactions, as well as being familiar with the Mexican company culture. As previously mentioned, many Mexican enterprises are family businesses and tend to be reluctant to surrender control of their companies. There are also various challenges to be overcome in international transactions that have implications regarding labour, finance and other areas.
ii Operation of the market
Mexican companies looking to obtain funding to develop their business can do so primarily through:
- capital contributions from partners or shareholders;
- government financing;
- private equity;
- project finance;
- financing by banking institutions; and
- financing through the securities market.
Each of these options requires the preparation and negotiation of different legal instruments necessary to carry out these types of transactions, and the time required will depend on the complexity of each transaction.
Mexico's private equity industry is basically composed of funds with different investment strategies. Generally speaking, there are four types of funds: private equity funds, venture capital funds, real estate funds and infrastructure funds.
Private equity funds normally utilise one of the following investment strategies:
- growth, through investing in companies looking for expansion, entering new markets or financing strategic acquisitions;
- leveraged buyouts, namely specialising in acquiring companies via external capital;
- mezzanine capital, which allows for more flexibility as fewer guarantees are required (meaning more risk and higher costs); or
- distressed or special situations, namely investing in companies or assets facing difficult situations.
Venture capital funds seek to invest in companies in their early stages, known as start-ups. Real estate funds invest specifically in real estate for residential, touristic, commercial or industrial use. Finally, certain funds specialise in infrastructure for transport or energy.
Typically, there are several stages in the creation of a private equity fund. First, the interested investors would generally form a team to identify and structure the fund, and plan the process for investment and exit or disinvestment. The people concerned, therefore, have to establish a clear investment strategy, which will vary depending on, inter alia, the investment strategy or goal, the sector and participants, as noted above. They must then appoint an investment committee, which will be in charge of administering the fund. To finance the internal structure, funds can receive income from the following sources: management fees (generally from 1.5 to 2.5 per cent, depending on the size of the fund and the sector); carried interest or carry returns that correspond to the fund administrator; and other sources.
Once the goals have been established, the team to achieve them appointed and the internal financing scheme settled, the next step is fundraising. This step is usually fairly complicated and might take a long time, as different scenarios must be considered in the planning phase in case goals are not achieved within the expected time frame. Fundraising implies a process of advertising and selling to investors (natural persons, corporations, other funds, etc.), and the administrator of the fund is in charge of this process.
After the fund has secured the commitment of the necessary investors, it can proceed to the third step: the legal formalisation of the work done to date. This means, basically, incorporating the fund operator and the investment vehicle, and the structure will vary (again this will depend on a large number of factors – see Section II).
Finally, the fourth step is the investment phase. The process usually starts with the administrator of the fund and the representative of the company in which the fund will invest signing a letter of intent, to be followed by a due diligence process and the signing of a term sheet in the event that all is found to be satisfactory.
The due diligence process consists of, among many other factors, a strategic analysis of the company's business model, a market analysis, study of the distribution and offer of products, economic competition, financial standing of the company, investment needs and legal implications. Conducting a proper due diligence process is a key step to making a well-informed decision. By means of the due diligence checks, the administrator should have a clear overall picture of the company, the market in which it competes, its needs, the risks it faces, and the costs, goals, etc. affecting the business. Legal advisers are also key players in this process, as they guarantee, inter alia, the validity, adequacy and legality of the company, its businesses and licences. An in-depth study of the situation of the company may prevent future problems. As mentioned before, once all this is found adequate and fitting within the fund's investment parameters, the company and the fund will establish the investment terms and sign a term sheet, which normally express the type of investment, dividend rights, voting rights, preference in payment, protection clauses, conversion options, future contributions, selling clauses and any other terms that the parties agree upon.
Depending on the type of investment, once the fund has completed the previous steps and the investment is effectively done, the administrator would normally get involved in the operation of the company. For example, some administrators ask to become board members, or to be granted authority to designate their own board member or members, depending on their total participation in the company – in short, whatever is deemed to be required, and always keeping in mind the common goal of increasing the company's value as much as possible within a given period.
To close the cycle, the fund must establish, inter alia, an exit strategy, deadline, conditions and policies with very clear terms that should always be respected.
A key factor in achieving all the above-mentioned goals, and in the whole process, is obviously that the fund must be run correctly. In this context, investors in private equity funds have the most important role as controlling agents. Therefore, the investors and the fund meet regularly, with the investors receiving reports at established intervals and undertaking other activities to promote a good relationship between the investors and the fund.
Another key feature of private equity transactions is ensuring that management, who will be asked to deliver on the company's business plan, are appropriately incentivised and aligned with the sponsor. This is typically achieved with incentive equity arrangements put in place at the time of the sponsor's acquisition of, or investment in, the company. There are different schemes, including sweet equity, performance rights, and options that are exercisable into ordinary or profit interests. The choice between these alternatives depends on the type of private equity fund and is often driven by exit structures and tax considerations.
ii LEGAL FRAMEWORK
i Acquisition of control and minority interests
Mexico does not have any specific laws applicable to private equity. Hence, private equity transactions are regulated indirectly through the commercial, civil and securities law and regulations. Nevertheless, legal developments have taken place as the market has continued to evolve. For example, the 2014 financial reform acknowledged CKDs, legal instruments that allow asset managers to channel the resources of domestic pension funds (AFOREs, which previously could only legally invest in publicly offered securities) into projects. Hence, through CKDs, AFOREs now have a way to invest in private equity.
The regulation of CKDs has been amended several times to adapt to the needs of the market and to make the process easier and faster. Along with CKDs, which have been successful, there have been other legal developments in favour of private equity, namely the recently developed CerPIs and Fibra E financing instruments (see Section IV). In less than 10 years, these have raised around 566,900 million Mexican pesos, which represents 2.4 per cent of Mexico's GDP for productive and infrastructure activities.
As detailed above in Section I, the third step in the process of creating a fund is designating the fund operator and an investment vehicle. Since there is no specific regulation of the matter, generally the fund's operator is incorporated as an SA or a SAPI, which are regular corporations that can enter into shareholder agreements and have drag-along and tag-along rights, unlike other types of companies in which these agreements or rights are not valid in court. After incorporating the operator, the fund must establish the investment vehicle, examples of which include:
- a limited partnership (similar to the Mexican sociedad comandita por acciones);
- a private equity investment trust (FICAP) with a maximum duration of 10 years, whose purpose is to invest in or finance Mexican-resident companies not listed on the Mexican stock exchange;
- a non-business trust, which has fewer restrictions than a FICAP; and
- a capital investment company, which might be inefficient for certain purposes on account of inherent legal restrictions, such as not permitting first-refusal rights.
Consequently, within this framework, as in any other type of company, national or foreign sponsors would have to ensure control over their investment through, inter alia, shareholders' agreements, assuring majority percentages and board representation. Negotiations will depend on the amount to be invested and the needs of the company; in other words, on the leverage each party can exercise on its own behalf.
Before investing, consideration must be given to making clear the limitations applicable to foreigners. According to the Foreign Investment Law, foreigners are subject to certain limitations as to their ownership and control of, and participation in, the companies and sectors in which they can invest (usually related to national security). There are also certain sectors in which they cannot invest at all, as they are exclusively reserved for Mexicans: for example, the national transportation of passengers, tourism, loading, development banking and certain professional services. In other activities, foreign participation is limited to a maximum percentage.
That said, Mexico is a fairly open market and the aforementioned limitations in fact imply very few, and specific, restrictions. As previously mentioned, the legal regime has been created with the specific intent of facilitating foreign investment into the country and, notably, Mexico has many commercial treaties and agreements with other countries; furthermore, indications are that the trend is towards maintaining this situation.
ii Fiduciary duties and liabilities
The fiduciary duties and liabilities of sponsors are no different than they would be in any other business relationship. Their scope will first be drawn up and delimited in the letter of intent. Once the investment agreement is reached, they will be set in a term sheet or a shareholders' agreement, depending on the existing structure and the steps to follow to make effective the investment.
There are several crucial elements in every relationship that may give raise to complaints or problems in the future. Private equity funds usually have relatively short to medium-term objectives, which might not coincide with the company's objectives. This said, when negotiating, it is very important that the deadlines and objectives of each party are well known, if not aligned. What might interest one party in the short term might not interest the other party, but might be complementary, because when the time comes to exit, the fund might seek a completely different strategy to exit the investment motivated by different objectives and goals, and it will probably be facing different responsibilities before its own investors.
The most common ways for a private equity firm to exit an investment are an IPO, a secondary deal (acquisition, sale), repurchase by the promoters or, in a last-resort (and probably undesirable) scenario, a liquidation. The structuring considerations will depend on many factors, and every deal will be unique. However, common to all deals is the importance of bearing in mind that time is of the essence, and all requirements must be very carefully considered to avoid problems and misunderstandings; in addition, a disinvestment operation might take quite a long time.
Indeed, foreign investors should give particular consideration to matters from a timing perspective, as all the processes involving foreign companies might require extra time. Due diligence processes usually take longer, and verification of documents requires coordination between several parties, which always results in more time and money being expended. Otherwise, as previously mentioned, apart from there being some tax considerations, Mexico is a fairly straightforward and dynamic country in which to invest and disinvest.
iii YEAR IN REVIEW
According to the Latin American Private Equity & Venture Capital Association (LAVCA), KKR, a subsidiary of Kohlberg Kravis Roberts & Co, a global private equity and venture capital fund, listed a US$500 million CERPI on the Mexican stock exchange to invest in private equity, energy and infrastructure projects.
Fortem Capital, a Mexican real estate fund, placed a CKD vehicle for up to 5 billion pesos on the Mexican stock exchange, and plans to use the capital to develop between 13 and 16 projects in the retail, residential and health sectors.
Private equity fund Fondo de Fondos listed a CKD on the Mexican stock exchange, with a view to investing in private equity funds and projects that target the infrastructure and renewable energy sectors.2
Grupo O'Donnell registered a CKD with a maximum issuance of 2 billion pesos on the Mexican stock exchange, aimed at industrial and urban real estate, and the development of industrial logistics infrastructure.3
BlackRock Mexico Infraestructura III raised a US$500 million CERPI on the Mexican stock exchange for investments in energy, transportation, water and social infrastructure projects.
Avant Energy, a Mexican company backed by US private equity firm Riverstone Holdings, announced it will increase its previous investment in the SUPERA project, a network of terminals to supply refined petroleum products in north-central Mexico, from US$200 million to US$500 million.
Private equity firms are looking at Mexican targets as a base from which to develop their Latin American business, and are interested in Mexican firms already doing business in other countries. This results in very interesting projects that involve not only Mexican operations, but also other operations in other countries in the region. Overall, investments from 2000 to 2018 focused principally on energy, e-commerce, telecommunications and financial services. However, as previously mentioned, two more sectors are now gaining more investment: health and consumer goods and services. In addition, private equity funds are tending to invest and raise capital through new financing instruments, such as CKDs, CERPIs and the FIBRA E.
Private equity activity in Mexico is increasing significantly as a result of several financial reforms that have taken place in recent years. The government's developments have had a favourable impact in the market, even promoting investment in sectors that were previously exclusively reserved for the state, such as the oil sector. In less than a decade, private investments have grown rapidly and they now multiply year on year. For the past four years, Mexico has been a leading market in Latin America for general partner investment; however, the market is still performing below expectations. Nonetheless, capital funds continue to grow within the market and regulatory reforms are expected to continue with the growth of private investment.
The structural reforms that have entered into force have already had consequences. The energy reform, for instance, has been closely followed by private equity participants because of the opportunities created by the opening up of this sector. Even though oil prices have fallen, benefits from the energy reform of 2013 have emerged in Mexico. Because of the opening up of this sector to foreign and private investment, it has assumed an important role in the country over the past four years. Capital funds have expanded their investment asset classes to include the energy sector in both direct majority acquisitions and minority-stake investments. Additionally, and as a direct result of the opening of these industries to foreign and private investment, both Petróleos Mexicanos and the Federal Electricity Commission, officially 'productive state enterprises', can now enter into alliances, associations or joint venture schemes with foreign investors to develop certain energy sector-related activities in the different downstream, midstream and upstream sectors. This will, in turn, play an important role in the market by allowing capital funds to participate in these types of transactions.
ii Key terms of recent control transactions
In January 2018, Adobe Capital's Mezzanine Fund II announced its first impact investment in Instituto Profesional en Terapias y Humanidades (IPETH), a Mexican enterprise specialising in physiotherapy and offering quality higher education to low-to-medium-income students. Adobe Capital's investment, made together with Auria Capital, continues its innovative approach to mezzanine instruments and is intended to support IPETH's national expansion and maximise the education company's contribution to improving health and education in Mexico.4
In March 2018, Latin American Partners LLC (LAP), a private fund manager, and IGNIA, a venture capital fund manager, announced the completion of a mezzanine investment by the Central American Mezzanine Infrastructure Fund (CAMIF II) in Procesamiento Especializado de Alimentos SAPI de CV (Grupo Procesa), a vertically integrated tuna producer and market leader in its main segment. As part of the transaction, MANIF II acquired IGNIA's entire participation in Grupo Procesa. LAP acts as the CAMIF II fund manager.5
In November 2018, Discovery Americas, through its investment vehicle DAIV, invested in Mas Air, a leading participant in the Mexican cargo industry, and consequently the LATAM Airlines Group is no longer a shareholder of Mas Air.
During Q1 2018, there were several exits of note in the Mexican private equity market. In February 2018, Nexxus Capital completed a partial exit from Mexican real estate developer and operator Grupo Desarrollador ZKC, 27 months after its initial investment and a return of 45 per cent. In the same month, Nexxus Capital announced another partial exit, this time from Maak Arca Holding, SAPI de CV (Maak) a consolidating platform for the acquisition and operation of businesses within the construction and decoration industries in Mexico. This exit was made through the spin-off and sale of Maak's subsidiaries Marmoles Arca SA de CV and Madarca SA de CV.
In March 2018, Mexican.VC announced a partial exit from Yogome, a Mexican edtech start-up creating videogames for children, making an eight-times cash-on-cash return to the fund.
In December 2018, Riverstone Holdings, ENCAP Investments and BlackRock exited Sierra Oil & Gas, a Mexican exploration and production company, in a sale to Deutsche Erdoel AG, an international independent exploration and production company.
iv REGULATORY DEVELOPMENTS
Notable among the recent legal developments with relevance for the investing environment in Mexico were the introduction of the Fibra E, a real estate trust structure aimed at the energy and infrastructure sector, and CerPIs, investment project securitisation certificates. Fibra E vehicles are investment vehicles similar to Fibras (Mexican real estate trusts that have been successful in recent years) and can increase the financing of projects in the energy sector, while CerPIs are certificates issued through restricted public offerings, and whose issuance resources are used to finance projects and invest in stock, directly or indirectly through investment vehicles.
In October 2016, the Fibra E vehicle Fibra Vía issued by Pinfra concluded the first public offering in Mexico of 394.5 million energy investment trust and infrastructure certificates. The placement raised a total of 11,835.07 million pesos and was considered very successful because of its acceptance among investors. Regarding CerPIs, on 30 September 2016, the first CerPI was listed on the Mexican stock market by Mira Manager, a real estate company focused on the development of urban mixed-use communities in Mexico, for a maximum amount of 4 billion pesos, with the first issue raising 800 million pesos.
While CerPIs and Fibra E vehicles have not yet been widely used, these instruments have consistently gained popularity and are expected to boost capital investments in Mexico.
Another noteworthy regulatory development became effective in January 2018, in relation to AFOREs. In an effort to broaden pension fund investment options, the Mexican authorities modified the investment regime to allowing AFOREs to use mutual funds as investment vehicles. Although this area has seen some significant regulatory developments in recent years, the legal regime for private equity is expected to continue evolving.
In recent years, private equity in Mexico has steadily become a more competitive sector for investment in the country. Following reforms in various sectors and industries, such as energy, telecoms and, most recently, fintech, Mexico has become a leading market for investments in Latin America. Despite the potential for uncertainty over the past months as a result of the North American Free Trade Agreement negotiations and the presidential election, the outlook for the Mexican private equity industry is positive. Over the next year, investments in the energy and telecoms sectors are expected to continue to increase and the fintech industry is set to become a hotspot for national and foreign investments; an increase in the use of the recently developed financing instruments, CKDs, CERPIs and FIBRA E vehicles, is also anticipated, combined with greater participation by private equity sponsors. There is a lot of expectation for the country's private equity market over the next few years, given the tendency in government policies for a shift towards a larger role for private investment in the industries and sectors discussed here. According to AMEXCAP, should conditions remain as they are at present, with growth remaining at current levels, private equity in Mexico is expected to have raised over US$80 billion by the end of 2020.
1 Andrés Nieto Sánchez de Tagle is a partner at Von Wobeser y Sierra, SC.