Innovate to grow

Author: | Published: 24 Apr 2015
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Radical innovation in the financial sector is at odds with a paternalistic, overcautious stance on the part of regulators, according to Michael Washburn

Mexico's superb economic performance has made it a powerful draw for investors in the wake of President Enrique Peña Nieto's easing of regulations, with foreign direct investment reaching $22.6 billion in 2014. That figure represents a slight dip from 2013's peak of $35.2 billion, but is markedly higher than 2012's figure of $15.5 billion and prior years. Meeting and improving upon 2013's stellar figures depends on a continued shift away from overregulation.

Much of Mexico's success has to with innovation in its financial sector. While reforms to the nation's energy regulations have received their fair share of attention globally, the hunger for upending old structures and shaking up the economy – to the extent that regulations allow – is most visible in Mexico's capital markets.

The $633 million IPO carried out by mortgage REIT FideicomisoHipotecario (FHipo) in November 2014 signals a new direction for the capital markets of Mexico and potentially other Latin American jurisdictions. The implementation of mortgage REITs, which might have been unthinkable a few years ago, is reflective of the growing sophistication of the REIT market globally as it branches out in new directions. Startling many observers, FHipo's hugely successful IPO came just months after the collapse of homebuilders DesarrolladoraHomex SAB, UrbiDesarrollosUrbanos SAB, and Corp. Geo SAB in 2013.

This is not the only recent example of innovation. Global law firm Paul Hastings, which advised FHipo in the IPO, also took the lead on the representation of underwriters in toll road operator PINFRA's $600 million equity offering of Series L shares in July 2014, a deal expected to inspire many more equity offerings in coming months.

But the continued success of such novel ventures is inconceivable without several steps including the further opening up of Mexico's underpenetrated investment regime; the related issue of getting investors, in Mexico and beyond, to dispense with antiquated views of Mexico's capital markets; and the liberalisation of tax policies.

In a recent exclusive interview with IFLR1000, Alfredo Vara Alonso, FHipo's CEO, described how he and his colleagues approached Mexico's largest mortgage lender, INFONAVIT, with the idea of developing the first mortgage REIT. INFONAVIT in 2008 had developed a program for financial institutions, and banks in particular, to take advantage of the loan origination program, and Alonso's radical notion was for such products to go through the capital markets and become available to investors, including local pension funds, more directly.

"That's how everything came together for us. It was quite logical in the international markets, and this is how we brought to local markets the evolution from traditional REITs to mortgage REITs," Alonso recounted.

"Regulators have lately engaged in some innovation of their own, applying new concepts in tax audits"

For all his success with this innovation, it was only half the battle, for Alonso had to contend with a steep learning curve in the local market, where people were far more familiar with INFONAVIT's workings than with those of mortgage REITs.

"In the local market, we needed to do a lot more work, explaining the concept, what a mortgage REIT is and how it works," Alonso recounted.

Part of the issue, in Alonso's view, was the serious underpenetration of a Mexican mortgage market accounting for only 9% of GDP, compared to roughly 45% for the US and Canada and 100% for Denmark and Norway.

Although the IPO came off quite well, in terms of revenue, Alonso and his colleagues had a negative carry for the first couple of months as they invested part of the $633 million from the IPO in mortgage portfolios, undertaking new originations.

In spite of these difficulties, Alonso sees potential for a continuing liberalization of the investment regime in Mexico. Reform at the regulatory level could make it easier for, say, a capital fund whose prospectus currently allows it to buy very narrowly defined number one titles, or in other words equity. Under current regulations, funds often do not have legal authorization to buy the number one FideicomisoHipotecario, or mortgage trust. Alonso and others yearn for the end of what he calls a "paternalistic" attitude on the part of regulators who are focused too narrowly on the events of 1994-1995, when Mexico's central bank took a huge hit.

"It is like a pendulum. We're on the other side now, too paternalistic at the regulatory level. We need to make CIO's and fund managers much more accountable, but at the same time give them more liberty," Alonso commented.

Mike Fitzgerald, head of the Latin America practice at global law firm Paul Hastings, has also handled his share of situations where innovation in the capital markets required educating market participants. Fitzgerald and his colleague Taisa Markus took the lead as advisors to the underwriters in PINFRA's $600 million equity offering of Series L shares, which are limited voting shares that last enjoyed a vogue among issues in Mexico more than ten years ago. The offering was particularly bold in light of the fact that the CNBV – Mexico's equivalent to the SEC – had pursued a policy of not accepting for listing any company that sought to list new Series L shares.

"I think the theory was one of corporate governance. They wanted all the shareholders to be on a level playing field with one vote per share," Fitzgerald commented.

In following this policy, Fitzgerald noted, Mexico's regulators had essentially adopted the same stance as the New York Stock Exchange, which has grappled over time with the question and ultimately decided to discourage limited voting shares in general while allowing them in certain circumstances.

The fact that the issuers were able to complete the transaction in the face of regulatory hostility – and more than ten years after such shares were widely in favour in Mexico – is remarkable, and the issuance is widely expected to encourage deals on the part of other companies in Mexico with a similar character to PINFRA.

"These are family-run companies, and to induce them to enter public markets, you need to provide something that allows families to continue to control even if they sell down below 50%," says Fitzgerald.

"They wanted all the shareholders to be on a level playing field with one vote per share"

The prospect of such control has proved immensely alluring and made the offering a major success. Nevertheless, as in the case of mortgage REITs discussed above, educating the public about a class of shares that fell out of favor ten years ago is not a task to take lightly.

"How to describe them, what is the investor going to get, making sure they understand that L shares are non-voting shares, those are the kinds of issues that [must] be dealt with," adds Fitzgerald.

But innovation in the financial sector can only go so far toward revitalising Mexico's economy, and luring foreign investment and trade, when the government pursues self-destructive tax policies.

In the view of Arturo Tiburcio, who rejoined Hogan Lovells BSTL in Mexico City as a partner in April, Mexico's regulators have been cracking down, with a view to increasing revenues, fighting tax evasion, and keeping profits from flowing out of Mexico. The country has been a member of the OECD since 1994, and has theoretically been bound since then by OECD guidelines with respect to tax treaties, royalties, interest, capital gains, and dividends. But Tiburcio describes how regulators have lately engaged in some innovation of their own, applying new concepts in tax audits. Officers at the Mexican SAT are applying BEPS criteria with a view to protecting the taxable base, he says. As a result, collection audits have metastasized into a common practice in the administration of President Nieto.

"One would think that there is some contradiction in the current government inviting foreign investors and multinational companies to invest in Mexico when at the same time and through complex audits, the SAT is engaged in increasing tax collections, notwithstanding tax treaties," Tiburcio observes.

Mexico's recent experience proves the adage that an economic downturn may not be a bad thing at all if it pushes people to ask questions and find solutions that would never have occurred to them before. But Mexico in 2015 is a country where radical innovation in the financial sector is continually at odds with a paternalistic, overcautious stance on the part of regulators. Its continued success – and its ability to meet the record FDI levels of 2013 – requires a convincing and permanent shift away from outdated statist policies.