2023: A Convoluted Market

Depending on which side of the table you are seated, inflation, high interest rates, geopolitical re-alignments, tumultuous financial markets and excess cash (or the lack thereof) have been the gravitational forces driving your private equity activity.

When facing a convoluted market, these forces will make you enjoy or suffer low valuations, distress situations, and high or low returns.

Additionally, Mexico has been impacted by the subsequent resulting forces:

• a well-structured and efficient flow of cross-border investments - both inbound and outbound - between Mexico and the United States;
• a boom in nearshoring opportunities; and
• the appreciation of the Mexican Peso.

So, what is trending in these post-pandemic times? Private equity has creatively evolved to address these circumstances and the Mexican market has seen an increase in corporate venture capital; liability management transactions; direct lending; alternative/special situation funds; public buyouts; Delaware “flips”; relocation of assets; and other innovative structures.

Mexico–USA, a Single Private Equity Market

Historically, access by Mexican companies to the US financial markets had been limited to big companies or companies exporting goods to the USA but the times they are a-changin’. 

Integration between Mexico and the USA is inevitable. Sometimes it slows down, sometimes it picks up. Save for politics and government, integration is happening in every other major aspect of life: business, trade, financial, educational, cultural, and labour.

US and Mexican private equity funds are competing against each other. Now more than ever, US private equity funds are investing in Mexican entities or assets. Likewise, investment in the USA by Mexican private equity funds and family offices is gaining traction.

The goal is always the same: profitability and, consequently, maximising returns. Investors in both countries are aware that bigger markets and better competitiveness can result in lower costs and higher sales. 

In the current market, geopolitical and integrating-related circumstances have fostered a single and competitive market for private equity financing for Mexican companies, from start-ups to big corporations, that allows them to reach out to private investors in either country.

Nearshoring, mainly due to geopolitical factors, has become the new kid on the block and is an evident effect of global integration. This trendy phenomenon involves foreign companies (mainly from the USA, China, or the EU) relocating their manufacturing assets from unreliable, disrupted or far-away jurisdictions to closer and friendlier ones, in order to secure their supply chain and facilitate access to the North American market. While nearshoring is traditionally conceived as a relocation of manufacturing assets, it may also include the relocation of human resources and talent within Mexico, especially in the tech industries and other mobility-friendly industries, which allows for enjoyment of the benefits of being next-door to the USA while avoiding its high labour costs and work visa constraints.

As expected, the money flowing into nearshoring projects has been deployed more expeditiously from private equity funds rather than from traditional financing sources.

US HoldCo’s, Delaware Flips, and US Listings

When investing in Mexico, US private equity firms (US investors in general) are usually concerned about certain Mexican domestic issues: rule of law; enforceability; and corruption. 

To mitigate these risks, the following investment structures are being implemented ever more often: 

US HoldCo’s; Delaware flips

This structure involves incorporating a US corporation, in a well-known jurisdiction, such as Delaware or New York, for the purposes of being the holding company of the Mexican operating subsidiaries. Sometimes, there would be existing shareholders holding direct interests in such Mexican entities, in which case they would exchange their shares in such entities for shares in the newly incorporating US holding company. Any new money would thereafter be invested in the US holding company. 

The main reasons behind this structure are: (i) to be under the umbrella of Uncle Sam, who provides assurance to US and other foreign investors with respect to legal and contractual provisions, agreements and structures and their enforceability before US courts; and (ii) in terms of potential “exits”, a US company with Mexican assets would be, for the same reason, more attractive for a potential sale. 

Under certain circumstances, incorporating a holding company in other jurisdictions, such as the Cayman Islands or the British Virgin Islands, has become standard as well.

US listings

It goes without saying that the NYSE and NASDAQ are premier public markets, and Mexican businesses are starting to realise the benefits of incorporating a US holding company (or from the Cayman Islands, et al) and listing it in US public markets.

The main reasons behind this structure are: (i) to allow companies to access better capital for their growth; (ii) provide liquidity for their investors; and (iii) enhance the information rights of the investors through reporting obligations. 

Transaction documents

Again, for purposes of seducing private equity firms, whether the US or Mexican, transaction documents have (slowly) adopted standard US provisions. Practicality and efficiency in negotiating and closing a transaction have become a must. Therefore, standard buyer-friendly provisions, such as full reps and warranties; full indemnities; reasonable protective and liquidation rights, as negotiated in the USA, from time to time, have been mirrored and adopted in Mexico. 

Corporate Private Equity/Venture Capital; It Is Not Always About Returns

The private equity and venture capital boom in Mexico in the last decade has led large Mexican companies to set up their own corporate private equity/venture capital funds. These corporate funds are: (i) managed internally by an especially assigned team of officers and employees of the company; and (ii) funded both by corporate resources and/or by private equity investors. 

Corporate private equity/venture capital has become more relevant in the current times due to lower valuations that incentivise big companies to invest in start-ups or small and medium-sized businesses, with the goal of incorporating such businesses into the big companies’ growth.

Though corporate private equity/venture capital investments have a success rate similar to ordinary investments (only 10%-20% are successful), they are not always about returns. Incorporating the promoted business into the big company’s structure is the main objective, rather than a high-return exit; and if such company is publicly listed, private investors would gain liquidity after such incorporation.

The following are the main drivers of each party involved:

• Private equity investors, LPs (Limited Partners): These investments are a mix between growth private equity and venture capital. The big company acts both as a GP (General Partner) and a strategic partner/manager, with proven and successful experience (in most of the cases) in its relevant industry. 
• Promoted businesses: Synergies with a strategic partner; faster growth when given access to the big company’s infrastructure, supply chain and/or customer base and distribution channels. The big company becomes the natural potential acquirer. A downside of this is that promoted businesses become practically off-the-market when engaged with the big companies. 
• Big companies: Acting as a GP and deploying corporate resources or raised private capital. This is cheaper and faster than internal R&D or organic growth; can lead to the acquisition and retention of entrepreneurial talent and; can encapsulate failed investments while incorporating successful ones.

Liability Management; Out-of-Court Restructurings; Alternative/Special Situation Funds

Due to prolonged inflation, slow economic growth, high interest rates, et al, many companies have struggled to satisfy their cash necessities, whether by a lack of revenue and/or by being unable to obtain traditional financing. Consequently, many of these companies have fallen into distress situations, not being able to pay their debt as they become due and payable.

While risk aversion and high interest rates have kept traditional banking on the bench, creative private equity managers have stepped up either to protect their current positions or to fill the void left by traditional banks. With a record amount of dry powder and a strong negotiating position vis a vis the distressed companies, private equity managers have been able to cherry pick their cash deployments and secure very protective provisions.

These restructuring transactions are (usually) intended to occur outside of bankruptcy court and have been characterised by a notion of “team spirit” among the PE managers (or ad hoc groups of PE managers) and the distressed companies in order to achieve a “win-win” solution and/or avoid a “lose-lose” outcome, by providing an effective, creative and flexible approach to obtain liquidity and restructure the company’s liabilities.

With respect to structure and fundraising, PE managers (and even traditional banks) have made use of alternative or special situation funds, under which they have raised and allocated resources to satisfy these market opportunities.

Direct Lending

Historically, access to bank financing in Mexico has not been easy for small and medium-sized companies and current market conditions have worsened it.

Again, PE funds have stepped into the ring. Though traditionally more expensive than traditional bank financing, direct financing is more flexible and creative in terms of structure, covenants and collateral. Furthermore, direct financing is more expedited in terms of approvals and risk assessment. 

Keeping in mind that private equity funds are not in the banking business, direct lending has become a trendy financing structure to protect the downside of an investment while maintaining traditional PE perks (such as equity kickers, conversion rights, and appointing board observers) as options to participate in any potential upside. Combining typical provisions of bank lending and of private equity, respectively, has resulted in very competitive price offerings for direct financing. 

Going Private Transactions

In the past couple of years, a fair number of Mexican companies have de-listed from the Mexican stock exchange. These going private transactions have seldom been related to the performances of each de-listed company but rather have been triggered by multiple extrinsic factors including low trading volumes, a practically non-existent retail trading and a high concentration of institution trading in a handful of AFORES (Administradoras de Fondos para el Retiro - Mexican pension funds) and other institutional investors, and few legal and tax incentives to go or stay public. The sum of these factors results in low to very low valuations and, thus, a tempting opportunity for the relevant controlling groups to tender, repurchase and go private.

As mentioned above, private capital is all about returns and taking private profitable companies for a cheap price is a no-brainer. 

The financing of these transactions depends highly on the creditworthiness of each buyer and the tendered price. If the purchaser is creditworthy and can secure a relatively low interest rate, bank financing has been a good alternative that avoids sharing any upside with private investors. Otherwise, teaming up with private investors to raise sufficient capital has become the only alternative to follow through with these transactions. 

Added Bonus – Amendment to the Mexican Securities Act

As of August 2023, an amendment to the Mexican Securities Act was being discussed by the Mexican Congress. This amendment seeks to incentivise listings in the Mexican stock markets by easing up the legal framework of public companies and simplifying the process for small and medium companies.

In a nutshell, the amendments involve, among other things, the following:

• Allowing the issuance of multiple classes or series of shares with differentiated rights. These capital structures provide further assurance to the founding and/or controlling shareholders that they can become public while retaining control of their companies.
• Allowing the increase or decrease of the capital stock with the approval of the board of directors (and not of the shareholders, as currently provided).
• Introducing an exceptional and simplified process to list securities issued by small and medium companies with less supervision by the Mexican securities authority but restricting the offer and sale of such securities to qualified and institutional investors, only. 

These amendments, if/when enacted, should benefit private equity activity in many ways. By increasing the number of public companies, you also expand the number of potential investors. For instance, facilitating small and medium-sized companies to access the public markets also means facilitating an exit for private equity investments in these types of companies. At the same time, with respect to private equity funds that would rather invest in public companies for reporting, liquidity purposes, or otherwise, these amendments would allow companies to reach out to such funds while making use of dual-class structures to retain control of their companies.

These amendments, while they may not resolve all the hurdles that the public and private markets face, certainly are a starting point to improve the public equity market in Mexico and, indirectly, the private equity market.