Published: January 01, 2000
Latin America’s improving macro-economic and political stability is encouraging multinationals to consider establishing a presence in the region. In addition to Latin America’s traditional strengths in commodities and energy, the growing prosperity of many of its citizens, positive demographics, and market liberalisation are creating new consumer markets that offer attractive growth opportunities, especially when compared to many OECD countries.
However, despite huge improvements across the region, doing business in Latin America still carries numerous risks: including price, transaction, regulatory and counterparty risks. These risks, which can occur in many different circumstances, need to be understood, anticipated and effectively mitigated using escrow services if global companies are to achieve their strategic objectives in Latin America.
For companies buying into Latin America through mergers and acquisitions (M&A) activity, a number of risk-related challenges must be overcome. For example, during the transaction itself, it is essential to ensure that the funds are transferred from one company to another at the correct time and concurrently with the transfer of ownership.
Commonly, funds are held by a neutral third party in an escrow facility to mitigate risk in such circumstances. Transfer can take place on a same-day basis, although longer periods of up to six months are not uncommon if, for example, a buyer needs to satisfy itself that know-your-customer requirements have been met. Holding funds in a joint control account in such circumstances demonstrates a clear commitment to a successful deal.
Given the volatile business environment in Latin America (compared to the US or Europe) it may be important to ensure that the pricing of the entity reflects various uncertainties. One way to do this is to specify that part of the acquisition price is determined by future performance. Performance-related pricing is common in Europe and the US, and as international companies enter Latin America, its use is increasing.
As much as 10% of the proceeds of an acquisition might be reserved for representations and warranties linked to performance, including financial targets (up to five years) and retention of important employees and clients. Performance-related pricing is usually used in circumstances where buyers and sellers are unfamiliar with each other. Terms for performance-related pricing must be agreed by both the buyers and suppliers and efficient escrow facilities are important for such an arrangement to function.
Another M&A-related circumstance in which funds may be held in escrow for a prolonged period is if a bond issue is specifically used to fund the acquisition. A bank may act as both escrow agent and trustee for bondholders to ensure that funds are used for the specified purpose.
Funds held in escrow in Brazil, by far the most important M&A market in Latin America, pay no interest, so it is important to work with a bank with a broad range of investment options for escrow funds. Given the high rates on offer for Brazilian reals compared to dollars, funds are usually held in the domestic currency, which also reduces currency risk related to the acquisition. Typically, escrow funds are invested in Certificado de Depósito Bancários, other public bonds or funds. The choice of investment is usually negotiated between buyer and seller, although Brazilian entities are likely to be more familiar with the domestic risk environment.
In Latin America, as in other regions of the world, governments require companies in some sectors – such as oil and gas, natural resources, airlines and many other sectors, depending on the size of the company – to hold specific funds for tax payments, to cover the cost of environmental damage, or for employee claims. Generally, these funds act as a guarantee that the company will have funds available in case of disaster or litigation. Funds used to cover this sort of regulatory risk, which varies in scale widely depending on the sector and country, are usually held in an escrow account held between the government and the relevant corporation.
Escrow is flexible and can be adjusted as the requirements of the parties change. For example, if an oil and gas company expands its operations, it may trigger a greater regulatory fund requirement. Reducing the amount of funds held in the account requires agreement from both parties.[[[PAGE]]]
There may be other circumstances in which escrow can be used in relation to legal proceedings. For example, if a corporate’s counterparty, from which it had bought goods, went bankrupt, the corporate might remain eager to receive the goods and willing to make the necessary payment. However, it might be unwilling to take the risk that its counterparty’s creditors would seize the funds without delivering the goods. One solution is to utilise an escrow structure, with the account in the name of the beneficiary, but with joint control/release that leaves some control in the name of the payer to ensure funds are used appropriately.
Latin America is experiencing a huge infrastructure boom as Brazil engages in projects related to the World Cup and the Olympics and countries across the region invest in road, rail and energy infrastructure to meet the needs of their growing economies.
Infrastructure projects are typically large undertakings with significant budgets and long build periods. Necessarily, the entity that is paying the bills to contractors – including construction firms and other suppliers – does not want to pay everything upfront. Instead, payments are usually released in stages. Equally, contractors want to be sure that the funds are available for their future payments.
An escrow account enables funds to be held in a control account, visible to both parties. This provides comfort to contractors that they will be paid and ensures that funds are only released once an administration agent determines that the agreed conditions have been met, helping to protect the project sponsor. Project finance-style staggered payments are also used on smaller scale projects, such as apartment block construction.
In situations where a bank enters into a transaction and is concerned about risk, such as with a company with a low credit rating, it will typically seek collateral to reflect the risk of default. This collateral can take the form of cash or securities, which is held in escrow, with the cash sometimes being provided by a parent company. If securities are used as collateral, they would typically be market-traded instruments (typically US bonds with a good credit rating), or could also feature physical certificates that are held in the name of the beneficial owners of the security, but with a securities control agreement ensuring that securities are only released or moved at the request of both parties or the lender, depending on the agreement between the parties. The escrow agent will usually act as custodian when securities are used as collateral.
Once the bank’s client’s anticipated receivables are in hand, the proceeds can go into an account controlled by the bank to ensure that the obligation is met. Money can then be automatically moved from the control account into the client account. Alternatively, in a pledge arrangement (also known as a springer or lien) the lender can act to stop money going to the client’s account and direct it to the bank instead if necessary.
As an independent third party tasked with keeping assets safe, it is critical that a bank offering escrow services is financially beyond reproach: a high credit rating is essential to provide comfort to all parties involved in an escrow arrangement that there is no risk of bankruptcy.
When corporates select a bank for escrow, experience is critical. Escrow is seldom thought about until the last minute in M&A transactions, for example, despite being complex. Only a handful of experienced banks have the capabilities to put an escrow arrangement in place in short time frames. Moreover, long experience, commitment, and sustained investment are essential to structuring customisable and flexible solutions for risk mitigation. Banks with scale are likely to be able to offer a competitively priced service.
An effective escrow agent needs to take a global approach and ensure it can offer flexibility regarding currencies. Ideally, it should also offer additional fully-integrated capabilities, working closely with other areas of the bank including FX, M&A advisory and debt financing as necessary, so that transactions are executed as seamlessly as possible. As well as being global, an escrow bank needs to have strong local capabilities, so that it can offer a wide range of investment options in Brazil, for example.
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