Managing the Risks of Doing Business in Latin America

Part Two of a Two-Part Series

This is the second article of a two-part series about managing the risks of doing business in Latin America. Last month's installment described Latin America as a region blessed with impressive worker productivity and natural resources, but also troubled by pockets of political and economic unrest. The article concluded that Latin America represents a fertile business frontier for equipment leasing and finance companies that are willing to manage risks proactively. It covered potential market entry risks and suggested strategies for reducing exposure.

This month's article explores operational and exit-strategy risks to consider before expanding into Latin America. Risks are summarized in the Risk Map for Doing Business in Latin America (Table 1), published last month, which I developed based on experiences in the region. The map is intended as a checklist that outlines typical risks and management strategies. However, as every business is unique, companies should also attempt to identify additional risks and/or their own approaches.

Operational Risks

Operational risks are possible threats that can arise whenever a company establishes a presence in a Latin American country. These risks include the following.

Market Risks

Companies should try to gauge the potential equipment leasing and finance market in a given country by assessing the nation's Gross Domestic Product (GDP), population size, volume of equipment imports, overall level of investment, capital expenditures and other indicators. Focusing on only one or two indicators does not provide an adequate overview.

For example, Brazil and Mexico combined house 52% of Latin America's population, according to the World Development Indicators database. They also generate 65% of the region's GDP. A simplistic approach would suggest that Brazil and Mexico should be the natural strategic markets for business expansion. However, a major leasing company that did just that has achieved disappointing market penetration. This is because other major players followed suit, thereby saturating the marketplace. Two other companies have enjoyed better success by venturing not only into Brazil and Mexico but also Colombia, Argentina and Peru. When comparing population versus GDP, in fact, it appears that Colombia, Peru and a third country, Chile, have the greatest potential for equipment leasing market growth.

Funding Risks

Will a company depend upon cross-border funding for its operations or instead rely on domestic capital markets? There are risks inherent in using either option that businesses should consider.

Large multinationals typically have access to cross-border funding at competitive rates. However, cross-border funding is subject to stricter regulatory barriers than domestic funding. Exchange risk factors can also be a deterrent to cross-border funding unless an affordable and competitive hedge structure is in place.

On the other hand, companies need to assess the size and sustainability of domestic capital markets before opting for local funding. Panama, Chile, Brazil and Argentina currently have the best potential for funding leasing transactions, according to FitchRatings Sovereign Data Comparator. All other countries bear a higher domestic funding risk.

Competition Risks

Companies should evaluate the competition before expanding into a Latin American country and continuously monitor their peers as the market shifts. They should also keep in mind the changing nature of competitive risks as a leasing market enters maturity, including increased pressures to lower prices, margins and/or approve unacceptable credit risks.

Credit Risks

Credit risk is a gamble undertaken by every equipment lessor. In Latin America, however, it is more difficult to assess credit risk based on the famous three Cs (character, capacity and collateral) because the quality and accuracy of data there lags behind the United States. Latin American countries that do the best job of adapting technology for credit decisions include Brazil, Mexico, Argentina, Colombia and Peru. These countries have credit bureaus and regulations that are improving credit information. In situations where central information is not readily available, companies granting credit must undertake additional research using the Internet and other resources, usually through their local outside counsel.

Residual Risks

Residual risks occur not only at the end of a lease, but throughout the lease term since there is always the possibility that equipment will have to be repossessed. Residual risk curves that compare residual exposure with fair market value throughout the lease term are a sound strategy for managing these risks. Figuring out residual risks in Latin America is a more time-consuming process than in the United States because there are fewer data tools available. However, lessors there also enjoy advantages because the region has customers clamoring for used equipment. Fax machines, for example, are becoming obsolete in developed countries but are still needed in rural areas of Latin America.

Deal Structure and Documentation Risks

Lessors should structure and document their contracts in a way that minimizes legal risks without sacrificing competitive advantage. This can be a difficult balance to achieve in countries where the leasing industry is still in its infancy. Therefore, it is essential to 1) hire attorneys knowledgeable about local laws and 2) make sure there are frequent communications among legal counsel, sales and business development teams.

Variables that should be considered when structuring and documenting deals include whether the country has: ad hoc regulation for equipment leasing; domestic courts familiar with equipment leasing structures; a leasing association that defends the industry; government regulators of financial markets and, if so, their attitudes toward equipment leasing. All these elements are in place in Brazil and Mexico. However, lessors operating there still run the risk of having innovative deal structures misinterpreted by courts, so it's always wise to submit new structures to government regulators for testing. Colombia, Peru, Costa Rica and Guatemala have all the elements in place and are improving but are not as advanced as Mexico and Brazil. Chile lacks only one of the elements ' legislation for leasing transactions ' but its courts do consistently favor the enforceability of leasing arrangements.

Portfolio Service Risks

A lessor's success is directly linked to its capacity for billing, collecting, liquidating and receiving payments. Portfolios can quickly lose value if service capabilities decline. This occurred recently in Brazil, where an investment-grade securitized portfolio experienced temporary increases in delinquencies due to the lessor's servicing problems. When managing portfolio service risks, lessors should assess: staff talent, motivation and training; internal procedures; information technology systems; domestic banking infrastructure and banking relationships; and whether domestic portfolio management firms are available for handling outsourcing needs.

Indirect Tax Risks

Increasingly, governments worldwide are using indirect taxes as a primary funding source for public spending. Indirect taxes can have an especially detrimental impact in Latin American countries, which frequently insist that new laws apply to deals created before their passage. One solution is for lessors to insert a tax indemnity clause in their master or boilerplate agreements. However, in certain jurisdictions such as Brazil and Mexico, Consumer Protection Laws extend to lessees and thereby enable them to dismiss such clauses in certain cases. Lessors can better protect themselves by monitoring indirect taxation trends and adjusting pricing and documentation accordingly.

Regulatory Operating Risks

Ideally, government regulators understand the industry they are regulating and work to stimulate its orderly development. No countries in Latin America yet meet this ideal, but Brazil and Mexico come close. Colombia and Peru are improving. Regulatory operating risks are also relatively low in Argentina and Chile, where most lessors (except those controlled by banks) can be incorporated without regulatory intervention.

Regulatory operating risks can include: expensive reporting obligations and/or inadequate auditing procedures; excessive limits on permissible business offerings and deal structures; and disorderly exits and/or turmoil in the leasing industry caused by these regulatory problems, which impair the confidence of vendors, funding sources and lessees. To minimize risks, some lessors may chose to only enter markets that are not regulated or those where regulators are highly educated about the industry. Lessors venturing into other markets should manage risks by supporting the local leasing association in educating regulators. Lessors should also make sure to always deal with regulators in an intelligent, strategic manner to avoid creating adversarial relationships.

Legal Collection Risks and Repossession Risks

What is the likelihood that lessees will honor their obligations? How much money and time will it cost to collect payments and repossess equipment if a deal goes bad? The answers to these questions depend on three variables: the Rule of Law concept, which describes the willingness of players to honor their legal commitments; the efficiency of the legal system; and the level of political and judicial corruption.

Fortunately, the World Bank has developed indices to assess the Rule of Law concept and judicial effectiveness in various countries. These indices can help lessors craft a sound risk management strategy for collections and repossession. Two other indices created by The World Bank and Lex Mundi chart the average time it takes to enforce a contract in different countries, and related costs. (Tables 3 and 4)

Another source of data, Transparency International, publishes a Corruption Perceived Index (CPI) that ranks the level of government and court corruption in various countries. Most Latin American countries have a low score compared with the United States. But Chile comes close, with a score of 7.5 compared with the United States' 7.7.

One interesting finding to note is that courts and liquidators worldwide tend to accept the preferential range of a lessor's rights in bankruptcy proceedings. A lessor's rights to collect rentals under an automatic stay are usually treated as operational expenses of the reorganization, thereby paid with preference. Friendly repossessions are ordered by bankruptcy courts in cases where leased assets are not essential for the continuation of the business. This has been extensively documented in Mexico, Brazil, Chile, Colombia and other jurisdictions.

End-of-Lease Risks

Equipment leasing industries in Brazil, Mexico, Chile, Colombia, Peru and Argentina are evolving from the pure finance or capital lease-based model, in which lessees tend to purchase equipment at end of lease for a nominal value, to a more mature operating leasing environment. Lessors that have a presence in these countries need to consider the typical end-of-lease risks, albeit with a Latin American twist.

Some lessees, for example, may return their equipment at end-of-lease in poor condition, or the equipment may need to be refurbished, present logistical problems or have become obsolete. Other lessees may want to extend their leases, which renews a lessor's exposure to associated credit risks. Even equipment returned in good condition carries some risks when sold, since the lessor will have to pay taxes and consider the buyer's credit risks.

A few lessees refuse to exercise any options and simply withhold their equipment. This is a special concern in Latin American countries where lessees have a statutory right to keep possession of equipment, under certain pretexts, if their contracts do not state otherwise. To prevent this from happening, all contracts should include a well-drafted provision spelling out terms of the equipment's return at end of lease. Careful attention should also be given to evaluating the character of lessees, to minimize the potential for court challenges.

Exit Strategy Risks

Prudent companies plan for the possibility that they may someday need to shutter their doors or change their business models. There are two main categories of exit strategy risks. The first is country risk, which is the potential for political and/or economic volatility to affect operations. Country risk was discussed in Part One of this series since it is a deciding factor in a company's decision to enter a marketplace. The second risk is the potential for industry collapse.

Industry Collapse Risks

The collapse of Venezuela's equipment leasing industry provides a telling example of internal and external forces that can combine to doom companies. Venezuela's leasing industry flourished from 1969 to 1996, when investment in capital equipment was flowing and competition was intense. Then financial turmoil affected some of the major Venezuelan banks, leading to government intervention, legislative changes, enactment of the Universal Banking model and the indiscriminate application of all Basel Rules to financial institutions. Today, it is hard to find independent leasing companies in Venezuela, and even more difficult to find equipment leasing portfolios among Venezuelan Universal Banks.

What is the lesson in this for lessors venturing into Latin America? Interestingly, some of the key factors that have led to the demise of leasing companies South of the Border mirror those experienced by U.S. companies. These problems ' including poor business models and indiscriminate growth ' were identified in The Alta Group's report “The Perfect Storms,” commissioned by the Equipment Leasing and Finance Foundation in 2000 to determine reasons why so many U.S. leasing companies had gone belly up in a short time frame.

Leasing companies with operations in Latin American can use existing research like this to help bulletproof their businesses. They should continually monitor industry and country conditions for signs of volatility, adjusting their business model accordingly. One warning of industry problems is an ineffective domestic leasing association. Therefore, leasing companies in Latin America can serve their own interests best by cooperating together to build a strong trade group.

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Part Two of a Two-Part Series

This is the second article of a two-part series about managing the risks of doing business in Latin America. Last month's installment described Latin America as a region blessed with impressive worker productivity and natural resources, but also troubled by pockets of political and economic unrest. The article concluded that Latin America represents a fertile business frontier for equipment leasing and finance companies that are willing to manage risks proactively. It covered potential market entry risks and suggested strategies for reducing exposure.

This month's article explores operational and exit-strategy risks to consider before expanding into Latin America. Risks are summarized in the Risk Map for Doing Business in Latin America (Table 1), published last month, which I developed based on experiences in the region. The map is intended as a checklist that outlines typical risks and management strategies. However, as every business is unique, companies should also attempt to identify additional risks and/or their own approaches.

Operational Risks

Operational risks are possible threats that can arise whenever a company establishes a presence in a Latin American country. These risks include the following.

Market Risks

Companies should try to gauge the potential equipment leasing and finance market in a given country by assessing the nation's Gross Domestic Product (GDP), population size, volume of equipment imports, overall level of investment, capital expenditures and other indicators. Focusing on only one or two indicators does not provide an adequate overview.

For example, Brazil and Mexico combined house 52% of Latin America's population, according to the World Development Indicators database. They also generate 65% of the region's GDP. A simplistic approach would suggest that Brazil and Mexico should be the natural strategic markets for business expansion. However, a major leasing company that did just that has achieved disappointing market penetration. This is because other major players followed suit, thereby saturating the marketplace. Two other companies have enjoyed better success by venturing not only into Brazil and Mexico but also Colombia, Argentina and Peru. When comparing population versus GDP, in fact, it appears that Colombia, Peru and a third country, Chile, have the greatest potential for equipment leasing market growth.

Funding Risks

Will a company depend upon cross-border funding for its operations or instead rely on domestic capital markets? There are risks inherent in using either option that businesses should consider.

Large multinationals typically have access to cross-border funding at competitive rates. However, cross-border funding is subject to stricter regulatory barriers than domestic funding. Exchange risk factors can also be a deterrent to cross-border funding unless an affordable and competitive hedge structure is in place.

On the other hand, companies need to assess the size and sustainability of domestic capital markets before opting for local funding. Panama, Chile, Brazil and Argentina currently have the best potential for funding leasing transactions, according to FitchRatings Sovereign Data Comparator. All other countries bear a higher domestic funding risk.

Competition Risks

Companies should evaluate the competition before expanding into a Latin American country and continuously monitor their peers as the market shifts. They should also keep in mind the changing nature of competitive risks as a leasing market enters maturity, including increased pressures to lower prices, margins and/or approve unacceptable credit risks.

Credit Risks

Credit risk is a gamble undertaken by every equipment lessor. In Latin America, however, it is more difficult to assess credit risk based on the famous three Cs (character, capacity and collateral) because the quality and accuracy of data there lags behind the United States. Latin American countries that do the best job of adapting technology for credit decisions include Brazil, Mexico, Argentina, Colombia and Peru. These countries have credit bureaus and regulations that are improving credit information. In situations where central information is not readily available, companies granting credit must undertake additional research using the Internet and other resources, usually through their local outside counsel.

Residual Risks

Residual risks occur not only at the end of a lease, but throughout the lease term since there is always the possibility that equipment will have to be repossessed. Residual risk curves that compare residual exposure with fair market value throughout the lease term are a sound strategy for managing these risks. Figuring out residual risks in Latin America is a more time-consuming process than in the United States because there are fewer data tools available. However, lessors there also enjoy advantages because the region has customers clamoring for used equipment. Fax machines, for example, are becoming obsolete in developed countries but are still needed in rural areas of Latin America.

Deal Structure and Documentation Risks

Lessors should structure and document their contracts in a way that minimizes legal risks without sacrificing competitive advantage. This can be a difficult balance to achieve in countries where the leasing industry is still in its infancy. Therefore, it is essential to 1) hire attorneys knowledgeable about local laws and 2) make sure there are frequent communications among legal counsel, sales and business development teams.

Variables that should be considered when structuring and documenting deals include whether the country has: ad hoc regulation for equipment leasing; domestic courts familiar with equipment leasing structures; a leasing association that defends the industry; government regulators of financial markets and, if so, their attitudes toward equipment leasing. All these elements are in place in Brazil and Mexico. However, lessors operating there still run the risk of having innovative deal structures misinterpreted by courts, so it's always wise to submit new structures to government regulators for testing. Colombia, Peru, Costa Rica and Guatemala have all the elements in place and are improving but are not as advanced as Mexico and Brazil. Chile lacks only one of the elements ' legislation for leasing transactions ' but its courts do consistently favor the enforceability of leasing arrangements.

Portfolio Service Risks

A lessor's success is directly linked to its capacity for billing, collecting, liquidating and receiving payments. Portfolios can quickly lose value if service capabilities decline. This occurred recently in Brazil, where an investment-grade securitized portfolio experienced temporary increases in delinquencies due to the lessor's servicing problems. When managing portfolio service risks, lessors should assess: staff talent, motivation and training; internal procedures; information technology systems; domestic banking infrastructure and banking relationships; and whether domestic portfolio management firms are available for handling outsourcing needs.

Indirect Tax Risks

Increasingly, governments worldwide are using indirect taxes as a primary funding source for public spending. Indirect taxes can have an especially detrimental impact in Latin American countries, which frequently insist that new laws apply to deals created before their passage. One solution is for lessors to insert a tax indemnity clause in their master or boilerplate agreements. However, in certain jurisdictions such as Brazil and Mexico, Consumer Protection Laws extend to lessees and thereby enable them to dismiss such clauses in certain cases. Lessors can better protect themselves by monitoring indirect taxation trends and adjusting pricing and documentation accordingly.

Regulatory Operating Risks

Ideally, government regulators understand the industry they are regulating and work to stimulate its orderly development. No countries in Latin America yet meet this ideal, but Brazil and Mexico come close. Colombia and Peru are improving. Regulatory operating risks are also relatively low in Argentina and Chile, where most lessors (except those controlled by banks) can be incorporated without regulatory intervention.

Regulatory operating risks can include: expensive reporting obligations and/or inadequate auditing procedures; excessive limits on permissible business offerings and deal structures; and disorderly exits and/or turmoil in the leasing industry caused by these regulatory problems, which impair the confidence of vendors, funding sources and lessees. To minimize risks, some lessors may chose to only enter markets that are not regulated or those where regulators are highly educated about the industry. Lessors venturing into other markets should manage risks by supporting the local leasing association in educating regulators. Lessors should also make sure to always deal with regulators in an intelligent, strategic manner to avoid creating adversarial relationships.

Legal Collection Risks and Repossession Risks

What is the likelihood that lessees will honor their obligations? How much money and time will it cost to collect payments and repossess equipment if a deal goes bad? The answers to these questions depend on three variables: the Rule of Law concept, which describes the willingness of players to honor their legal commitments; the efficiency of the legal system; and the level of political and judicial corruption.

Fortunately, the World Bank has developed indices to assess the Rule of Law concept and judicial effectiveness in various countries. These indices can help lessors craft a sound risk management strategy for collections and repossession. Two other indices created by The World Bank and Lex Mundi chart the average time it takes to enforce a contract in different countries, and related costs. (Tables 3 and 4)

Another source of data, Transparency International, publishes a Corruption Perceived Index (CPI) that ranks the level of government and court corruption in various countries. Most Latin American countries have a low score compared with the United States. But Chile comes close, with a score of 7.5 compared with the United States' 7.7.

One interesting finding to note is that courts and liquidators worldwide tend to accept the preferential range of a lessor's rights in bankruptcy proceedings. A lessor's rights to collect rentals under an automatic stay are usually treated as operational expenses of the reorganization, thereby paid with preference. Friendly repossessions are ordered by bankruptcy courts in cases where leased assets are not essential for the continuation of the business. This has been extensively documented in Mexico, Brazil, Chile, Colombia and other jurisdictions.

End-of-Lease Risks

Equipment leasing industries in Brazil, Mexico, Chile, Colombia, Peru and Argentina are evolving from the pure finance or capital lease-based model, in which lessees tend to purchase equipment at end of lease for a nominal value, to a more mature operating leasing environment. Lessors that have a presence in these countries need to consider the typical end-of-lease risks, albeit with a Latin American twist.

Some lessees, for example, may return their equipment at end-of-lease in poor condition, or the equipment may need to be refurbished, present logistical problems or have become obsolete. Other lessees may want to extend their leases, which renews a lessor's exposure to associated credit risks. Even equipment returned in good condition carries some risks when sold, since the lessor will have to pay taxes and consider the buyer's credit risks.

A few lessees refuse to exercise any options and simply withhold their equipment. This is a special concern in Latin American countries where lessees have a statutory right to keep possession of equipment, under certain pretexts, if their contracts do not state otherwise. To prevent this from happening, all contracts should include a well-drafted provision spelling out terms of the equipment's return at end of lease. Careful attention should also be given to evaluating the character of lessees, to minimize the potential for court challenges.

Exit Strategy Risks

Prudent companies plan for the possibility that they may someday need to shutter their doors or change their business models. There are two main categories of exit strategy risks. The first is country risk, which is the potential for political and/or economic volatility to affect operations. Country risk was discussed in Part One of this series since it is a deciding factor in a company's decision to enter a marketplace. The second risk is the potential for industry collapse.

Industry Collapse Risks

The collapse of Venezuela's equipment leasing industry provides a telling example of internal and external forces that can combine to doom companies. Venezuela's leasing industry flourished from 1969 to 1996, when investment in capital equipment was flowing and competition was intense. Then financial turmoil affected some of the major Venezuelan banks, leading to government intervention, legislative changes, enactment of the Universal Banking model and the indiscriminate application of all Basel Rules to financial institutions. Today, it is hard to find independent leasing companies in Venezuela, and even more difficult to find equipment leasing portfolios among Venezuelan Universal Banks.

What is the lesson in this for lessors venturing into Latin America? Interestingly, some of the key factors that have led to the demise of leasing companies South of the Border mirror those experienced by U.S. companies. These problems ' including poor business models and indiscriminate growth ' were identified in The Alta Group's report “The Perfect Storms,” commissioned by the Equipment Leasing and Finance Foundation in 2000 to determine reasons why so many U.S. leasing companies had gone belly up in a short time frame.

Leasing companies with operations in Latin American can use existing research like this to help bulletproof their businesses. They should continually monitor industry and country conditions for signs of volatility, adjusting their business model accordingly. One warning of industry problems is an ineffective domestic leasing association. Therefore, leasing companies in Latin America can serve their own interests best by cooperating together to build a strong trade group.

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