Top-tier private equity investors are circling Latin America’s energy and infrastructure assets, drawn by the potential for higher returns, as well as geographic diversification of their portfolios. As they do so, they are seeking to import some of the more flexible borrowing terms customarily only available in developed markets, putting pressure on international and local banks to be more accommodating in order to remain competitive.
The advantages are clear: fewer restrictive covenants and higher leverage limits give sponsors the freedom to increase borrowing, thereby fuelling the expansion of their asset bases. Doing so means that they can fulfil their ‘buy-and-build’ investment theses, without having to continually ask their lenders for waivers and approvals.
The past decade has brought both greater Latin American economic maturity and an increased number of infrastructure investment opportunities
While it is still relatively early days, there are examples of banks agreeing to leveraged buyout-style acquisition financings and loans for operating Latin American infrastructure assets, with terms that allow them to borrow and invest more as they grow. This is far from the norm in the region, where credit agreements tend to be more conservative, influenced by a historical need to mitigate a volatile cocktail of political, economic and currency risks.
As more North American and European investors import leveraged finance-style deal terms from their home markets, others will want to follow. Whether they succeed will depend on many factors — including their track record, the strength of their banking relationships, the merits of individual assets, currency risks, liquidity and the governing law underlying the financing.
Acquisitions increasing
The past decade has brought both greater Latin American economic maturity and an increased number of infrastructure investment opportunities. Economies have become less volatile and less dependent on the US, due to improvements in foreign exchange reserves and monetary policy, as well as economic diversification that has reduced reliance on commodity prices.
Large international investors, including private equity-backed infrastructure funds, have responded by acquiring an increasing number of assets across the region. As the developed world’s geopolitical stability, abundant capital and low-rate environment have fuelled intense competition for infrastructure assets, while pushing up asset valuations and tightening returns, investment firms are turning to Latin America. Here, the market is more challenging, offers higher returns and the contest for assets is comparatively less fierce.
Even so, inbound investors remain discriminating. They mostly focus on a select group of countries in the region, including, for example, Uruguay and Chile, which have been two of Latin America’s most stable economies. In addition, more and more investors have been looking to Colombia since the 2016 peace agreement with the Farc rebels, and many continue to search for opportunities in Brazil. Those playing the long game see Mexico and Peru as investment targets, although recent political and economic trends in both countries have many investors cautiously weighing their options.
Flexible agreements
Having obtained increasingly flexible credit terms in other markets, investors would naturally like to import this approach to Latin America infrastructure assets. Take a private equity fund acquiring an existing cable network in Brazil, for example, with an investment thesis based on building out the network. Having less restrictive covenants would remove the requirement (and the associated costs and delays) of getting the country’s banks to agree to additional debt incurrence for capital expenditures and bolt-on acquisitions. Such permissiveness, together with the ability to borrow at the holding company rather than the asset level, enables the fund to execute its expansion strategy like any mature company.
Credit agreement flexibility comes in several forms. Notably, borrowers want ‘incremental’ capacity to increase or add a credit facility without existing lender approval. In the most accommodating deals, this additional capacity is subject to an ‘incurrence test’, which allows borrowers to add further leverage, so long as debt does not exceed a stated multiple of earnings before interest, taxes, depreciation and amortisation (Ebitda). As the infrastructure assets’ revenues and earnings grow, the borrowings can increase in parallel.
The use of a negotiated ‘adjusted’ Ebitda measure of operating cash flow as the foundation for calculating leverage is also relatively new in parts of Latin America. Straight International Financial Reporting Standards-defined Ebitda is more traditional, but adjusted Ebitda gives sponsors more scope for customisation in terms of what gets included in the calculation, potentially allowing for greater leverage and lower risk of default.
Another way that credit facilities can be structured to facilitate asset expansion is with so-called ‘grower’ covenant baskets. Traditionally, credit agreements set a specific ‘fixed’ dollar amount as a ceiling for additional borrowings, investments and certain other transactions, whereas newer deals could set the limit as the greater of that fixed amount and a corresponding percentage of adjusted Ebitda. As the business grows, so too do the covenant baskets.
The legal perspective
While more investors may succeed in negotiating incremental capacity, bespoke Ebitda adjustments or grower baskets, it is likely that these will remain the exception rather than the rule for the foreseeable future. As even Latin America’s more stable countries continue to be perceived as higher risk, international lenders remain cautious and local lenders are inherently conservative. But in specific instances, funds may be able to negotiate leveraged finance-style terms, especially if they are well-known sponsors with strong banking relationships.
The legal perspective also makes a difference. International banks are more willing to compromise when credit facilities are governed by US or English law, taking comfort in contracts backed by a body of law they are familiar with and a judicial process they can rely on if there is a dispute.
As leading global private equity investors continue to be more active in Latin America, their involvement in negotiating credit terms will facilitate a shift for infrastructure assets toward more leveraged finance-type credit terms. Time will tell how dramatic that shift is and how quickly it becomes market practice.
Todd Koretzky and Dorina Yessios are New York-based partners at law firm Allen & Overy.
