Role of Capital Markets in Firm Financing

Stijn ClaessensWorld Bank

Capital Markets ConferenceMedellin, ColombiaMay 5 and 6, 2005

I would like to thank (all of the World Bank) Felice Friedman and Tadashi Endo for valuable discussions and inputs and Augusto de la

Torre and Sergio Schmukler for providing some of material used here

Outline of presentation• One:

– The importance of capital markets for growth, the basic messages

– The reforms and outcomes in Latin America; and – Recent twists on what matters for capital markets

• Second: – How capital markets can be important for currently non-

listed firms reviewing the roles conceptually; and – Reviewing some recent data on non-listed firms financial

structures and performance • Third:

– How one may need to adapt the model for capital markets to the needs of smaller firms, also given the “withering”

– More open questions• Conclusion, policy implications and overall lessons

Role of capital markets: general theory and evidence

• Theory– Provide access to capital at low cost for large and small

enterprises, governments and households– Facilitate the transfer of risks, enabling the assumption of

risks by more appropriate agents and diversify– Facilitate price discovery, asset valuation, monitoring and

governance, thus more efficient resource allocation• Evidence

– Capital markets and growth: yes, just as for other financial markets. Most evidence on capital markets focused on raising of financing, diversification, with liquidity to matter especially, and only some on other functions (monitoring, corporate governance)

While generally markets determinants known, development is not easy

• “Complications”, some of which more recently: – Financial structure (mix banking/capital markets), not key

to growth, rather financial functions matter most– Basics (legal, accounting, disclosure, etc.) essential for any

forms of financing – Macro: overall stability, no crowding out; still hampering

corporate bond and equity markets, especially in LAC – Globalization, internationalization, migration, withering,

economies of scale in markets, newer risks– New technology, also of trading systems; and for profit,

questions on governance of market infrastructure– Older: enforcement and capture of capital markets

• These should affect model for capital markets development

• Significant progress in macro stability• Sweeping financial liberalization since the late-1980s,

followed by financial and other reforms– Domestic markets; Stock markets; Capital account;

• Promotion of securities markets intensified in the 1990s– Rules: legal, regulatory, accounting & disclosure,

governance– Infrastructure: trading, custody, clearance & settlement– Demand: pension reform and emergence of

institutional investors– Supply: privatization of public enterprises

Latin America has had no shortage of capital markets reforms

11.21.4

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1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Ave

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Rest of Western Europe

Financial liberalization lagged in 80s but accelerated in 90s

More liberalization

Less liberalization

G-7

Southeast Asia

Latin America

Reforms in securities markets also intensified in the 1990s

Percentage of Latin American Countries Having Implemented Reforms

3125

15

0

5663 64 62

33

8894 91

100

27

92

Supervisory agencycreation

Establishment ofinsider trading laws

Custodyarrengements

Trading systems Clearing andsettlement

Before 1990 By 1995 By 2002

Yet, disheartening results: small and illiquid capital markets

• Equity markets– Growth in market cap far less than in Asia or G-7– Illiquid secondary markets

• Bond markets– Significant deepening of government bond markets, but

still fragmented and insufficiently liquid– Market for corporate bonds small and extremely illiquid

• Repo and derivatives markets– Repo market tends to be liquid, often the “securities

market” in small countries– Embryonic or non derivatives markets, except:

• Mexican forward FX market; Brazil’s paradox: liquid derivatives, illiquid cash; Chile’s OTC for FX hedges

Market capitalization in Latin America dramatically behind Asia and G-7

G-7 countries Asian countries

Latin American countries

Latin American markets caught in a persistent low liquidity equilibrium

G-7 countries

Asian countries

Latin American countries

Stock of private bonds in Latin markets pales compared to Asia and G-7

37.8

8.3

38.8

0

5

10

15

20

25

30

35

40

45

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Amount Outstanding of Private Sector Domestic BondsPercentage of GDP

G-7 countries

Asian countries

Latin American countries

Domestic Stock Exchanges: Number of Companies

Number of listed companies has beenflat or declining (de-listing)

0

100

200

300

400

500

600

Argentina Brazil Chile Colombia Mexico Peru Venezuela

1990 1995 2000

Latin America leads in internationalization

Interim implications/conclusions on capital markets development in LAC

• One answer: more reform is needed– More patience needed and reforms to be deepened

• But reforms have been significant and template-based approach has been followed already

– Sequencing might need to be adjusted• But openness is key to dislodge resistance to reform

• Better answer– Reforms need to be rethought in light of basic issues– Expectations need to be adjusted– Comprehensive approach needed integrating financial

development, open macro/int’l finance and real reforms • Questions on capital markets development particularly

pertinent for smaller firms

Role of capital markets in financing for Non-Listed Companies (NLC)

• Direct role, for the same reasons as above – NLC come to public market to get financing. NLC more

leveraged than Listed Companies (LC): NLC need equity – NLC are often also involved in capital markets as

“intermediaries” (raising CG-issues) • Indirect, other channels, can also be important for NLC

– Indirectly: NLC can benefit from better financing, improved performance, corporate governance, etc. of LC

– Through competition: when banking system dominates, equity and bond markets can break links and force commercial banks to go downstream to NLC

– By diversification: reduce systemic risks and indirectly help access to finance for NLC

Specific links of capital markets and NLC

• Demand: – Willingness of closely held, family-owned firms to go

public depends on degree of capital markets development • Supply:

– Existence of VC-funds and institutional investors willingness to take on private equity depends on capital markets development, affects NLC-firm-financing directly

• Other:– Although for smaller firms, bank financing more important

and thus link indirect, scope of corporate bonds, even if privately placed, depends on capital markets development

– Some experiences with pools of securitized SME assets suggest that capital markets can help in financing.

But “market” for NLC may have to look different for market for LC

• NLC can not satisfy same requirements– Listing standards too tight; rules too costly and time to IPO

too long; also expected delisting costs too high – When having choice, firms select exchange to minimize

total issuance costs (and also choose legal location to trade-off access to financing with costs/private benefits)

• NLC are also looking for something different– Benefits of liquidity not as high as control still tight(-er)– Price discovery through markets not as relevant as

investment guided in other ways– Disclosures too costly as more to the insiders directly and

competitive effects too large– Management gives up some autonomy on investment

What do we see in practice?Comparisons of a sample of European

(East and West) NLC and LC firms • NLC differ not so much from LC in most (developing)

countries in terms of financing structures and performance • Ownership structures

– While ownership is more concentrated for NLC, fewer differences in emerging markets between NLC and LC

– Family-owned firms dominate LC, industrial NLC• Investment and external financing

– LC are larger and older than NLC, while NLC more into trading activities and have less fixed assets

– More non-public access to financing for NLC, higher leverage of NLC and less long-term debt than LC

• Yet overall performance of NLC better than LC– Higher rates of return, higher turnover, lower margins

In most countries, NLC more likely have a blockholder over 50%, compared to LC

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In most countries, LC more likely to have no blockholder over 25%, compared to NLC

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Ultimate owner over 50% is more likely industrial in NLC and family in LC

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LC are larger and older than NLC, while NLC are more into trading activities and consolidate less

Listed Non-listed

Oper. Revenue (mean) - in $m 2861 450 Oper. Revenue (median) -in $m 356 148 Employment (mean) - in 000s 11.6 1.5 Employment (median) - in 000s 1.7 0.4 % Manufacturing firms 32.0 36.1 % Trade firms 9.5 27.4 Firm age (mean) 43 30 Firm age (median) 30 21 % Consolidated firms 88.3 28.1 % Western Europe firms 58.8 65.3 % Eastern Europe firms 6.1 3.6

Similar type NLC have higher rates of return, lower margins, higher leverage, less fixed assets, higher

turnover, and less long-term debt than LC do Listed N on-listed

Return-on-Assets 2.6 4.8 Return-on-Shareholders 4.5 12.6 EBIT m argin 7.0 5.6 Debt-to-equity ratio 2.0 5.5 Fixed assets as a % of total assets 46.6 39.5 Sales/(Fixed assets) ratio 7.3 13.7 N on-current debt as a % of total debt 31.6 28.7

# obs. 664 664

Implications: external financing key factor for NLC to come to market

• Many LC are similar to NLC in developing countries in terms of ownership concentration and financial structures– Means overall institutional environment (laws,

enforcement, accounting/auditing) crucial for both types • Capital markets role for NLC will largely be a function of their

(perceived) access to cheaper financing– Banks, creditors and other financiers (and other

stakeholders) need to want to let NLC go– Need to keep transition costs from NLC to LC (and from

LC to NLC) low. Requires certain “capital markets”– Since NLC major growth source, adapt markets model

Reconsider capital markets development and model to be pursued

• Global trends, lessons and needs of NLC require reevaluate the objective. What is being pursued: Access to financing? Stability? Price discovery? National flagship?

• Reprioritization for (private sector) “development” means:– Back to basic infrastructure: legal, accounting, basic

corporate governance, macro-stability, etc. – Consider more primary markets to raise financing, which can

require quite different approaches– Consider overall approach: a pickup-truck or a cadillac? Less

emphasis on the front-end/trading systems parts

Back to basics and sequencing

• Back to basics. Stress corporate law instead of securities markets law. Also, avoid the transplant effects, e.g., adopt laws and regulations suitable for local circumstances. Be willing to adapt IOSCO-principles to emerging markets/smaller markets. Be flexible, e.g., allow more short-selling: was the norm, implicit (Europe) or explicit (US).

• Revisit sequencing. Look at history, current model not used in past in many now developed countries. From money markets, to bond markets to equity markets. More gradual approach, with private placements, larger role of banks (although watch universal banks), private placements instead of (I)Pos; other?

Capital markets in developed countries

Market serving private interests only

Market serving public & private interests

• Who has financed reaching these points in developed countries?

• Who should pay for positive externalities in developing countries?

Discovery of public interestsin capital markets

Short period (10-20 yrs)

Long period (100-200 yrs)

Financing of market regulation & infrastructure building

Capital markets in developing countries

Make adoptions in issuanceto needs of smaller firms

• Lower all-in costs and reduce barriers for new issuance in main and other markets– All-in costs still very high in LAC (locally often higher

than int. and higher for equity than bond) as countries are amortizing costs of infrastructure. Time delays also long

• Consider alternative offering regimes– OTC, small caps, adjust listing requirements, etc. AIM,

Kosdaq, Nasdaq type models may be useful– But: tradeoffs with signaling on main local markets, how to

graduate from Neuer Markets (not Brazil Novo Mercado)– And consider economies of scale (regulation/supervision,

back-office, etc.) with multiple markets

Make adoptions in trading systemsto needs of smaller firms

• Consider the economics of running a market.– What is business model? Seek synergies among various

markets (bond, equity), in front & back parts, over time• Consider other type of trading systems

– Lessons from smaller markets suggests that order driven is being circumvented by side-transactions

– More dealer, uniform price auctions, shorter hours, upstairs-type markets: can help lower/defer costs

• Watch political economy– Capital markets often captured in some countries due to

insufficient accountability, weak institutional infrastructure, combined with waves of investors’ (foreign/domestic) sentiment. National flagship can increase this risk

Capital markets and other reforms & developments, and risks

• Make clearer the links between capital markets development and other reforms and developments– Links between housing finance, infrastructure, project

financing, contractual savings and (corporate) bond markets tighter way to develop markets

– Also can be easies from a political economy • Think in terms of financing and risk management tools

– Longer term instruments and investors which reduce liquidity risks and mismatching risks

– Local markets for debt which reduce currency risk– Derivatives markets which can help manage duration

mismatches and related asset price risks– Corporate governance, legal reform to reduce systemic risks

Make clearer the links between capital markets and other reform and developments

Pension and Insurance ReformMaintaining replacement rates,

asset integrity, A/L management annuities

Housing FinanceMortgage bonds and

securitization

Government FinanceDebt sustainability and stable

redemption profiles

Health and EducationFinancingPrivate ventures,

innovative products

Infrastructure Finance

PPP initiatives and structured finance, bonds

Agriculture Finance

Warehouse receipts and storage finance, catastrophic

insurance, agricultural derivatives

Transmission ofMonetary PolicyEffective money market and

liquidity operations

Debt, Equity, and Derivatives

Markets

Conclusions and policy implications– Get sequencing right, do basics first

– Information and contract enforcement key– Some of the institutional environment can be imported or

sourced abroad, but still needs some local markets– Wait for the fruits of reforms

– Liquidity, efficiency, depth can not be assured quickly– Pay a premium for domestic financing for some time

– Revisit basic issues and reshape expectations– Capital markets need not be uniform across the globe– Intermediate markets can serve many of the purposes, e.g.,

OTC-markets, private equity, VC, etc.

End of presentation