Latin America is set to garner the attention of distressed investors with an eye for a bargain and an appetite for risk. Although M&A activity worldwide slowed down as the global economy went into lockdown amid the COVID-19 pandemic, we can expect to see a rise in the volume of distressed transaction activity in this region, most notably in Brazil and Mexico.
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Movers and shakers
The social and economic impact of the pandemic has been profound in the region. Latin America’s largest economies and top destinations for foreign direct investment (FDI), Brazil and Mexico, are among the world’s principal COVID-19 hotspots.
Foreign investors – including, for example, US-based private equity firms, Canadian pension plans and European sovereign wealth funds – are well-acquainted with the opportunities the region proffers.
Exchange rates are generally favourable for investors funded in foreign currencies, most notably the US dollar (although this could be offset by the adverse impact potential currency depreciations may have on target companies’ financial projections).
Private equity firms – buoyed by low(er) interest rates and market valuations and with dry powder to burn – will be the first movers, as they were in the immediate aftermath of the 2007-08 financial crisis. Their corporate cousins will be more circumspect, focusing on the wellbeing of their workforce (one would hope), their day-to-day operations and preserving cash. An exception will be well-capitalised companies seeking to exploit their economically imperilled competitors, partners and/or suppliers to increase their market share, diversify their service offerings and/or safeguard their supply chains. Chinese companies – state-owned or (nominally) private – will also likely be key players, above all in Brazil and the Southern Cone.
Ripe for picking
Capital intensive industries acutely vulnerable to the vicissitudes of global commodity prices and customer demand – such as oil and gas, and manufacturing – are likely to provide opportunities for corporate expansion. In the manufacturing sector, we’re likely to see moves towards supplier, and supply chain consolidation – above all in Mexico’s automotive industry – as companies look to buy up small-scale and middle market manufacturers. This will increase market share and reduce supply chain risk.
In the oil and gas industry, down-, mid- and upstream activities have all been hammered by the precipitous fall in global oil prices, above all for companies that have pursued ambitious expansion plans in recent years. From gas station operators; small-scale service providers that exist from day to day or contract to contract; to bloated and impecunious state-owned companies (Mexico’s Pemex being a prime example).
Big Tech and essential FMCG aside, it is perhaps axiomatic to say that few, if any, industries have been wholly unaffected by pandemic. Yet, this is especially true of Latin America, where lockdowns for people and businesses imposed by governments (albeit with the best of intentions) have depressed consumer demand and stymied commercial activity, in turn exacerbating the broader economic malaise that was already at play.
Demand in consumer discretionary sectors, a cornerstone of the regional economy and a major source of employment, has nosedived. Companies in rick-and-mortar retail, hospitality, the cruise industry, and air travel are on the brink and ripe for picking by distressed investors. The region’s flagship airlines – including Mexico’s Aeroméxico, Colombia’s Avianca and Chile’s LATAM –have filed for Chapter 11 bankruptcy in the US.
Risky business
Of course, such investments are not without risk at the best of times, particularly in Latin America. However, the pandemic and resultant regionwide downturn will compound an already complex political risk environment as governments concurrently attempt to contain the outbreak, mitigate the economic impact and assuage the fears and frustrations of an increasingly exasperated electorate. This in and of itself represents an opportunity for distressed investors, particularly when governments implement policies that directly impact a target company’s bottom line, for example, a freeze on electricity tariffs (Chile) and toll road charges (Peru). In Mexico, the administration of President Andrés Manuel López Obrador (AMLO) has offered little financial support to big business.
Corruption risks – including public procurement kickbacks and internal fraud – tend to increase in times of crisis. Meanwhile, some companies may engage in morally reprehensible practices – from insisting that employees go to work despite not implementing the requisite health and safety measures, to paying dividends to shareholders while benefiting from government relief programmes (as seen in Colombia, Peru and Chile) – underpinning legal and reputational risks.
Widening the lens
All this once again highlights the paramount importance of rigorous due diligence into target companies and the jurisdictions in which they operate. Given the current context, it is arguably more important than ever that due diligence should extend to a thorough evaluation of a target’s pecuniary position and financial performance projections. The latter can take into account as much the inimical impact of the economic malaise, as the potential beneficial impact of government largesse, tax breaks and investment incentives.
There are practical considerations to bear in mind. For example, restrictions on international travel will make it difficult for investors to conduct comprehensive due diligence in the near term – multimillion/billion-dollar projects cannot (or at least should not) be evaluated entirely from desktop – let alone hold in-person meetings and sign contracts. Temporary closure of government agencies is another obstacle to be negotiated. However, none of these are showstoppers – distressed investors that employ the smart use of technology and on-the-ground expertise can overcome these.
Bridging the gap
Distressed M&A activity will pick up in the coming months, though in a piecemeal fashion rather than at breakneck speed. We expect activity to begin in earnest in Q4 before picking up the pace in Q1 2021. Distressed investors must first embark on an evaluation phase whereby they:
1. Look to safeguard the continued operational and financial viability of existing portfolio companies.
2. Assess the economic impact of COVID-19 at the global, regional and national level and related implications for target sectors/industries and their supply chains, including from an environmental, social and governance (ESG) perspective.
3. Gauge the specific impact on target companies’ projected financial performance – including revenue, profitability and cash flow, while taking into account emerging tax risks – in both the immediate and long term to:
- Verify whether they represent a feasible investment opportunity,
- And, if so, how their valuation has, and will be, affected.
The latter borders on a fool’s errand given the uncertainty surrounding the trajectory of the pandemic in the region, as well as the economy. The valuation gap remains to be bridged – sellers are as unwilling to concede on pricing as buyers are willing to (over)pay. However, the shift from what was hitherto a seller’s market to a buyer’s one is imminent, if indeed it’s not already underway. This also poses a challenge to distressed investors: go too soon and risk paying too much (or being perceived as predatory); play the waiting game and risk missing out altogether.