Adapting Financial and Accounting Due Diligence to Uncover Value in Latin America
This article first appeared in ABL Advisor.
Latin America is widely recognized by U.S. investors and businesses as a region for growth. Due to geographic proximity, a growing population, abundant natural resources, and an emerging middle class, Latin America is increasingly a choice for U.S. investors seeking to expand abroad. Despite recognizing this opportunity, the desire to expand often meets reality once financial and accounting due diligence begin. How should an investor analyze different reporting methodologies? What is the true impact of foreign exchange movements? What are the known unknowns?
Financial and accounting due diligence
Financial and accounting due diligence go hand-in-hand. Financial due diligence assesses the investment case, including cash flow sustainability, capitalization and financial projections. Accounting due diligence assesses the accuracy of financial data, including reporting methodology, the audit, and accounting procedures and controls. While in developed markets, seasoned investors are often familiar with standard due diligence of cash flow projections, capital expenditure budgets and financing structure, with Latin American transactions, there can be challenges.
Very often historical financial information does not fully adhere to U.S. Generally Accepted Accounting Principles (“US GAAP”) or International Financial Reporting Standards (“IFRS”). This in and of itself may not be an issue, but an investor must understand cause and effect. In a best case scenario, low quality financial reporting may be due to inadequate controls, inadequate personnel, or a lack of knowledge or expertise. In the worst case, poor quality financial information may indicate underlying problems with operations. For example, we have been approached several times by Latin American companies seeking strategic advice on approaching investors. Initially, financial results are quite impressive, but upon further diligence, we find inconsistencies, off-balance sheet accounts or adjusting items (e.g. unconventional expense allocations) that lead to lower EBITDA numbers. Investors should aim to identify such accounting issues as a first step–understanding the cause will inform whether to adjust or terminate a deal.
Foreign exchange (F/X) movements need to be considered as well. Take the example of a manufacturing company that buys raw materials in U.S. dollars, but sells products in the local currency. Absent price increases, any appreciation of the U.S. dollar will lead to margin compression. Part of the due diligence must include an evaluation of the ability to pass on these costs. Whereas competition and increasing customer concentration normally limit a company’s ability to pass on these costs, under certain conditions (i.e. monopolies or oligopolies, high changing costs, high barriers to entry) there may be an opportunity to pass on price increases, maintain margins and preserve value.
Reconciling and normalizing a financial statement to IFRS or U.S. GAAP will likely be required. Particular attention should be focused on potential adjustments to quality of earnings for related party transactions, pension accounting adjustments, and consolidation methodologies. Also, assessing transparency and governance factors, such as the composition of the board of directors and its independence, the quality of the relationships with lenders, the credibility of a company’s auditors, etc. will be critical to establishing a true picture of a target’s financial profile and deepen an investor’s understanding of its assets and liabilities.
Successful due diligence in Latin America entails a review of other non-financial matters that are equally important to consider:
Taxes are always a material consideration in an acquisition. While tax fraud or tax evasion are obvious areas any investor will investigate, the more challenging part of tax due diligence in Latin America is assessing the impact of taxes post close. Successor liability is a constant concern and Latin American companies often operate in geographies with convoluted tax regimes and a myriad of reporting requirements. Even when local tax laws have been adhered to, unanticipated liabilities may arise post close. For U.S. investors, ensuring the free transfer of assets (i.e. intercompany transfers) is often a priority; thus tax efficient deal structures, such as joint ventures or foreign subsidiary acquisitions, may be used. Finally, tax due diligence has both upside and downside, and tax attributes such as tax loss carry forwards, tax credits (e.g. tax benefits for local investment), or tax deductions, should be part of the due diligence scope as well.
When analyzing a Latin American target, U.S. investors must be keenly aware of the potential for corruption. The Foreign Corrupt Practices Act (“FCPA”) prevents U.S. businesses from making payments to foreign government officials in order to obtain business. Investors in cross-border transactions must ensure compliance or risk civil or potential criminal charges by the U.S. government. While the FCPA originally dates to 1977, in Latin America there has been a more recent wave of ant-corruption enforcement. One illustrative example dates back to 2015: Grana y Montero S.A.A. (“GyM”), one of the most well respected engineering and construction companies in Peru, partnered with Odebrecht S.A. (“Odebrecht”) and Enagas S.A. on gas pipeline in southern Peru. The GyM interest was financed by Credit Suisse and Natixis. Odebrecht was under investigation for corruption in its home country of Brazil and was unable to obtain the required financing needed to continue building the pipeline. Once construction stalled, the GyM loan went into default. In connection with the Odebrecht investigation, Peruvian officials announced an investigation into payments by GyM to former Peruvian President Alejandro Toledo; these payments assisted GyM in obtaining the pipeline concession. As a result, between 2015 and 2019 Grana y Montero equity value has declined approximately 70%, from $1.6 billion to $450 million today. For investors, compliance risk remains a threat to any deal and any lapse may ultimately impact value.
Local labor regulations are another tricky area for foreign investors. Latin American countries are well-known for their strong employment protections and complex labor laws. Coupled with unions, collective bargaining agreements, strict requirements for employee termination, favorable benefit plans, differing pension rules, government mandated profit sharing and a host of related issues, employee hiring and terminations are challenging. However, perhaps the most challenging aspect is the cultural differences; Latin American countries view employment differently, and perks such as car allowances or free employee lunches may be viewed as essential by local employees. Indeed, one notable difference that many U.S. investors may not even be aware of is mandated profit-sharing. For example in Chile, a company must distribute 30% of its annual profits to employees and several others including Argentina, Brazil, and Mexico, have profit sharing rules as well. The labor environment in Latin America can be quite daunting, and U.S. investors that are committed need to be aware of the resources and insights required.
Latin American companies operating in politically sensitive industries (i.e. agriculture, oil and gas, mining, etc.) must be aware of corporate social responsibility expectations or risk the consequences. A notable example is the world’s 2nd largest gold mining company, Newmont Mining Corp. (“Newmont”). Newmont is U.S. based company with over $7 billion in revenue and a $17 billion market capitalization. In 2011, construction on Newmont’s $5 billion Minas Conga project in northern Peru was suspended due to environmental activists. Protestors expressed concerns about the impact on local water supplies and challenged claims regarding benefits provided to local indigenous communities. By 2016, the company announced it no longer anticipated being able to develop the project due to local opposition. Latin American countries have unique views of corporate social responsibility and companies operating in political industries may have additional burdens such as local infrastructure investment requirements or reclamation demands. U.S. investors need to review these issues; to the extent a company is out of compliance, investors may be liable or even put their entire investment at risk.
Finally, following due diligence, the transaction culminates in a purchase agreement. When post-closing issues arise, it is important to ensure sellers remain committed to a positive outcome as contractual rights are different. Latin American countries operate under civil law (precedent court decisions are not weighed when interpreting contracts), proceedings can be time-consuming and quite costly, and courts typically will not provide the same remedies available in the United States. Indeed, while the World Bank ranks the United States #16 globally in “contract enforcement,” it ranks Mexico #43, Brazil #48, Argentina #107 and Colombia #177 (out of 190 countries). Financial advisors may provide a solution by negotiating the purchase price downward, adding seller financing, or utilizing minority equity. Indeed, in the case of post-closing risks, given the lack of contract enforceability, the best defense is a good offense.
The importance of working with a trusted advisor in Latin America cannot be overstated. It is critical to explain the purpose of due diligence to the seller early on in the transaction. Many Latin American conglomerates are family owned and are often not experienced in institutional M&A. As such, they may be surprised at how rigorous the process of due diligence can be and, absent proper communication, this can cause an erosion of trust. Additionally, while it is possible to negotiate the transaction solely in English, key matters (operational, law, etc.) will need to be in local language (i.e. Portuguese or Spanish). Working with dedicated Latin America professionals that have the ability to navigate the local terrain can mitigate these risks; offering a clear perspective and proper path forward.