April 13, 2005 | Chicago, IL United States – Flows of venture capital in Mexico have long been disproportionately low compared to the size of the Mexican economy. Could several recent initiatives mark a change to that trend?
In 2004, Mexico received only US $347 million in funds dedicated to venture capital and private equity (VC/PE), as compared with Brazil’s $479 million. Some industry professionals feel that weaknesses in Mexico’ regulatory framework are to blame for Mexico’s lower VC/PE capital allocation. Mexico’s economy is of comparative size to Brazil’s.
According to a new tool scoring the VC/PE investment environments for 11 Latin American and Caribbean (LAC) nations, Mexico’s investment environment ranks 3rd in the region, behind both Chile and Brazil. The tool, a 2005 Scorecard on the Private Equity and Venture Capital Environment in LAC, was recently developed by the Economist Intelligence Unit (EIU) for the Latin American Venture Capital Association (LAVCA) and the Venture Capital Network of the Multilateral Investment Fund (MIF).
Mexico’s economic and regulatory conditions scored just 54.4 out of a possible 100 points. This score is based on twelve different criteria identified by fund managers as important to making investment decisions, including capital markets development, restrictions on institutional investors, laws on VC/PE fund formation and tax treatment of funds.
“Historically there have been three main issues slowing down the development of the industry in Mexico,” said Christina Kappaz, LAVCA Board Member and author of the 2004 report Review and Action Plan for the Development of the Venture Capital Industry in Mexico. “These three issues are a poor legal framework for corporate governance, the lack of a fund vehicle that permits fiscal transparency and the difficulty of fundraising derived from the previous two factors.”
SAPI: NEW LEGAL STRUCTURE A STEP IN THE RIGHT DIRECTION
The Mexican government has not been indifferent to calls from industry professionals to improve Mexico’s regulatory environment for venture capital and private equity. For the last four or five years, the government has floated several initiatives aimed at boosting private capital investment.
In a major modernization of its corporate governance procedures and minority rights, The Mexican Congress recently enacted the new Ley de Mercado de Valores in which a new legal structure is created to improve minority rights. The new law, passed in December 2005, allows for the incorporation of companies into sociedades anónimas promotoras de inversión, or SAPIs.
The SAPI is a new legal structure that increases the legal certainty of instruments commonly used in the venture capital and private equity industry to improve governance, such as preferred stock, warrants, put rights, rights of first refusal, tag-along and drag-along rights.
“The new law fills a void in the Mexican legal system that had long prevented the development of the industry,” said Eduardo Mapes who, as an investment director for Mexican development bank Nacional Financiera S.A. (Nafin), was involved in the recommendations for the new legislation.
“In the past, investors went so far as to draft and sign agreements in the U.S. to get around the legal limitations,” said Mr. Mapes. “Now, the new regulation provides more certainty.”
The new law also aims to increase the availability of exits. By creating an exception regime, SAPIs can register with the Comision Nacional Bancaria y de Valores without fulfilling all of the requirements for publicly listed companies for up to three years.
“The ability to register before the CNBV will provide SAPIs with an opportunity to start complying with listing requirements early, develop better corporate governance practices and increase the chances of an IPO,” said Mr. Mapes.
Several fund managers share Mr. Mapes’ optimism on the new regulations.
“The law is going to be very helpful for investors for a variety of reasons, but mostly because it helps enforceability of corporate governance and allows for greater exit options,” said Alexander Rossi, Managing Director of Mexico City-based fund manager Latin Idea.
Luis Harvey, Managing Director of local private equity powerhouse Nexxus Capital, also sees SAPIs as a positive development.
“In the future, any company seeking private capital will have to convert to a SAPI,” said Mr. Harvey. “It will become a requirement to make any transaction.”
But smaller funds may not be able to benefit immediately from the new regulatory environment.
For León-based Fondo Guanajuato, which currently invests in equity, quasi-equity and loan instruments in small and medium enterprises, the size of the enterprises makes corporate governance and controls one of the main deterrents to equity investments. Manuel Alegre, manager of Fondo Guanajuato, doubts that SAPIs will have an immediate impact in their investment decisions.
“Even in cases when we have property as collateral,” said Mr. Alegre, “it is difficult to predict what the judge’s resolution is going to be. The new law is definitely a step in the right direction to allow investors greater control, but it will be necessary to wait until the new regulations have been tried in court.”
FIDEICOMISO: MIXED RESPONSE FOR NEW FUND VEHICLE
While the SAPI will likely have a positive impact on Mexico’s legal framework for corporate governance – and therefore on Mexico’s 2006 Scorecard ranking – the lack of an appropriate fund vehicle to provide fiscal transparency may continue to be an important barrier to industry’s development.
Currently, many funds operating in Mexico achieve fiscal transparency by incorporating in Canada. While Canadian structures have been recognized as valid by Mexican authorities, thus diminishing legal risk, the costs of incorporation in Canada remain prohibitively high for smaller funds.
In an effort to create a better local vehicle, the Ley del Impuesto sobre la Renta was modified in December 2005 to allow for the creation of a new legal structure that can be used for fund formation.
Specifically, the law allows for the formation of special fideicomisos (trusts) that will provide fiscal transparency to avoid double taxation of corporate earnings as dividends are distributed to investors. The new structure provides numerous benefits as compared to previous structures and also reduces the level of regulatory oversight needed to operate the trusts. However, some investors feel that the fideicomiso falls short of expectations.
“This fideicomiso is not an appropriate structure to ensure optimum management of the fund,” said Mr. Rossi. “The law calls for separate capital accounts for individual distribution to be managed by the trustee, which hinders flexibility and increases costs.”
According to Mr. Rossi, Latin Idea does not expect to use the fideicomiso in the near future, although his firm will continue to carefully evaluate the new vehicle.
While Nexxus Capital also plans to keep its Canadian structures for a new fund closing in May, Mr. Harvey did express some optimism for the new structure.
“We are considering establishing a local fideicomiso that would be an investor in the Canadian vehicle,” said Mr. Harvey. “This way we would open the doors to local investors that might be restricted from off-shore vehicles.”
Mr. Mapes acknowledged the limitations of the current structure, but stated that the fideicomiso might aid smaller funds to establish more transparent vehicles.
“While larger fund managers might continue to use the Canadian limited partnership as a vehicle, smaller regional players that currently don’t have a transparent vehicle might benefit from the changes,” said Mr. Mapes.
According to both fund managers and public agencies, there appears to be consensus that while the new fideicomiso represents a good starting point, the vehicle will need to improved to encourage more local fund formation.
FUNDRAISING: COULD A FUND-OF-FUNDS RAISE THE BAR?
Local fundraising efforts could see a boost via another government effort to promote the industry.
In order to increase the impact of official investments, Nafin S.A., Bancomext and other government entities are pooling resources to create a new fund-of-funds dedicated to making investment decisions.
“The fund-of-funds has been established as an independent, private company owned by the government,” said Mr. Mapes. “It is designed to be administered by an independent manager to increase its ability to respond quickly to changing investing conditions.”
According to Mr. Mapes, the aim of the fund-of-funds is “to create a platform that will make Mexico more attractive to foreign and local investors by improving the investment climate. We want to have a multiplier effect; ideally, the $500 million we are investing in the fund will generate $4 billion from other investors.”
Ms. Kappaz reflects that the new fund-of-funds will definitely be beneficial.
“The new fund will increase the sophistication of the local investors, which in turn improves the environment for all investors by increasing the awareness of private equity and raising the bar on governance expectations,” she said.
Fund managers generally agreed with the impact this development is going to have. Mr. Harvey stated that “the new fund will provide one-window shopping for government funds and increase the transparency with which decisions are made.”
According, however, to Mr. Alegre of Fondo Guanajuato, the final prize remains in the future.
“The key to developing the industry in the country lies in modifying the legislation to allow institutional investors to invest in private equity funds,” he said. “Even if only 1-5% percent of the $60 billion in funds controlled by Siefores, the public pension fund scheme, were invested in private equity funds, the industry would receive an incredible boost.”
According to Luis Antonio Márquez, Executive Director of the Mexican Private Equity Association (AMEXCAP), established in June 2003, the local association is working hard to encourage friendlier regulations for pension fund involvement in venture capital and private equity.
Related AMEXCAP activities also include institutional investor education, the development of a data bank containing statistical industry information, and a benchmarking study of funds active in the region.
Ms. Kappaz stated the Mexico’s score will likely improve with future Scorecards as new developments begin to impact Mexico’s private equity and venture capital industry.
“The government has been working very hard to improve the environment,” said Ms. Kappaz, “and as regulations improve, the sophistication of investors should improve, contributing to a virtuous cycle that will eventually lead to higher levels of investment.”