A Major Milestone in the History of Mexican Financial MarketsPublished: April 20, 2009 in Knowledge@Wharton
Improving access to capital inevitably appears as a top policy prescription in any economic stimulus geared towards growing small- and medium-sized businesses. This is no less true in Mexico, where small-to medium-sized enterprises (SMEs) employ half of all workers and account for approximately 70% of GDP, according to figures from the Organisation for Economic Co-operation and Development (OECD). The question that remains, however, is how to implement improved financing and through which institutions.
Despite liberalization of the Mexican banking sector over the past decade, banking service penetration remains low. Mexico's stock market -- the Bolsa Mexicana de Valores (BMV) -- remains an exchange for only the largest companies. As the Financial Times recently pointed out, the BMV has "fallen woefully behind" its Brazilian counterpart in terms of generating new listings. Aiming to replicate the successes of small exchanges in other countries, a group of Mexican businessmen under the leadership of founder Salvador Guerrero has established Negocios Extrabursátiles, an over-the-counter market designed to spur venture capital funding.
Though a closer look at Negocios Extrabursátiles reveals that it remains primarily an online bulletin board for small companies to list investment opportunities, its establishment and development to this point mark a major milestone in the history of Mexican financial markets. The next goals for the market will be to generate more transactions and begin electronic trading. The challenges it will face as it continues to grow demonstrate the underlying difficulties of improving financing opportunities for small- and medium-sized businesses in Mexico.
Mexico has more than 200,000 SMEs, yet the country's banking system does not typically provide these organizations with the financial and advisory support they need to grow and develop. According to Luis de Garate, director of the graduate finance department at the EGADE business school in Monterrey, Mexico, less than a quarter of all Mexican companies receive funding from the Mexican banking system. "Although credit has become more available for businesses," Garate states, "these loans are [generally] not for investment, but rather for operations." Almost 60% of companies receive their financial support from private sources -- mainly family, friends or personal savings, which severely limits growth opportunities for most entrepreneurs. The BMV, meanwhile, is an inaccessible platform for these organizations. Listing costs are high, and only 20 new companies have been listed over the past five years -- including just four IPOs in 2007.
Recognizing the market potential for small- and medium-sized businesses, Mexico enacted a new Securities Market Law in June 2006 (Ley del Mercado de Valores). This legislation was the critical cornerstone that Negocios Extrabursátiles needed to launch. The law permits businesses to issue securities without the registration and regulation requirements typically associated with public offerings as long as they restrict the sale of their shares to a limited number of qualified investors. Participants in the market are able to issue shares, obtain loans and sell companies outright.
Negocios Extrabursátiles addresses the lack of formal funding options for private companies by creating an alternative capital market for these businesses. At the first stage in the process, the firm's directors receive notification of interest either directly from a small company or through government agencies involved in supporting small businesses. Unless basic financial statements already exist, Negocios Extrabursátiles directs the candidate to an auditor so that current finances can be reviewed and summarized. The business is then listed on the website (www.negociosextrabursátiles.com) for review by potential investors who have registered with the organization.
Increasing the Number of Transactions
Negocios Extrabursátiles has been working hard to generate interest among private investors and venture capital funds. To date, 218 companies are listed, but fewer than 10 transactions have closed. Increasing the number of successful transactions represents the firm's greatest challenge. Although the company generates income through subscription revenue from companies listed -- and accounting and advisory firms that advertise on the website -- Negocios Extrabursátiles will need to generate more income from transaction commissions to remain economically viable in the long term.
Negocios Extrabursátiles has two key advantages: its close relationship with the Mexican government and related small business associations, which provide a flow of clients at the correct growth stage; and the pure market logic inherent to small-business growth profiles. Two government organizations, Nacional Financiera (NAFIN) and the Consejo Nacional de Ciencia y Tecnología (CONACYT), provide a valuable feeder system of SMEs that are ready for the next stage of private capital to fuel their expansion plans. "The great majority of [the listed companies] come from NAFIN and CONACYT," notes Gabriela Basurto, director of financial development projects in the Secretariat of the Interior and Public Credit. The partnership is a symbiotic one: Negocios Extrabursátiles gains access to small businesses that are likely candidates for listing, while its government partners help clients receive growth capital and access to institutional investors. Should the new market prove to be a successful financing alternative, these agencies' goals to foment economic growth and innovation through small enterprise will be more easily attainable.
From a pure market-logic point of view, the market is ripe for success in attracting investors looking for high-potential returns. Small businesses typically have higher growth profiles than larger, more mature companies (though with a concurrent increase in risk). As over-the-counter markets have focused historically on these smaller businesses, they have also had a history of higher average returns relative to other markets. Investors may be enticed by the high return opportunities afforded by this new market. In addition, as more companies list on Negocios Extrabursátiles, potential investors can diversify their holdings more readily.
Significant challenges remain for Mexico's young financial market. First and foremost, small businesses in Mexico continue to lack the necessary transparency to attract potential investors. The transparency question is arguably the largest, most challenging problem -- not only for the success of Negocios Extrabursátiles, but also for any kind of formal financing for small businesses. Much of the problem is the result of the apparent cultural barrier within the companies, which are typically family-owned and unaccustomed to revealing financial data to outsiders.
The passage of the new securities law sought to address this issue by creating a new legal framework for small business transparency. When these companies meet certain defined levels of corporate governance, they receive a specific associated legal designation and become exempt from regulation by the National Banking and Securities Commission (Comisión Nacional Bancaria de Valores). Investors in these organizations then receive additional minority shareholder rights and protection -- an enticing prospect. As Basurto explained, the law's intention is to encourage investment in small businesses from banks and private investors. Unfortunately, however, few companies have actually attained the legal requirements of transparency. According to Basurto, "Only a minimal number [of companies]" have satisfied the requirements to achieve the designation.
The transparency issue must be remedied in order for Negocios Extrabursátiles to be successful. If a greater level of transparency among small businesses does not become more highly institutionalized, investors will continue to shy away from making significant investments, especially given the higher risk profiles of these businesses.
The second major issue for Negocios Extrabursátiles is one of market awareness. With only 218 companies listed, the firm and its government partners must do more to generate awareness -- especially within the small business community. Messaging should focus on established companies where transparency is less of an issue, and standard bookkeeping and planning practices are in place.
In addition, Negocios Extrabursátiles should move beyond its advertising partnerships with advisory and auditing firms to develop a standard package of accounting and consulting services for new clients. Such an offering might help small businesses that are hesitant or unaccustomed to opening their financials to outside investors, while ensuring a competitive market among advisories to keep the review costs low.
Given the newness of the exchange, Negocios Extrabursátiles should focus on working closely with investors and small businesses to finalize a few more investments in order to demonstrate the market's potential. The website currently relies on investors to reach out and connect with potential portfolio companies, rather than making formal outreach to the investor community. Although the exchange currently has almost 100 registered investors, Negocios Extrabursátiles does not maintain contact with any of them, nor does it have knowledge regarding their investment interests. The authors of this article, for instance, signed up for the website but have yet to be contacted in the months since registering.
Unfavorable Tax Laws
Next, there remain certain unfavorable tax laws in Mexico that make investing in public companies preferable to private ones. Under Mexican tax law, investors in privately held companies are subject to a capital gains tax withholding upon the execution of a sale of their investment, rather than being permitted to claim any gains only once on their annual tax returns. This withholding does not apply to investments in publicly traded companies, however, creating a significant difference in the cost of capital between the two markets. According to Basurto, the Mexican government is currently reviewing the BMV exemption, but no immediate action has been declared. If the government were to change the law to make the tax costs equal, investors might be more willing to participate in the over-the-counter exchange -- with a clear trickle-down effect benefitting SMEs.
Finally, Negocios Extrabursátiles lacks a secondary trading market, which severely limits the exit opportunities for investors. A secondary market would allow investors to liquidate their investments when desired rather than having to negotiate a complicated private transaction. The firm's ultimate objective, as envisioned by Guerrero, is to open a secondary electronic market for the resale of the shares and the debt that originates in the primary market. "The plan is to have a robust electronic platform by 2011 once we have shown that the primary market can function," Guerrero states. "[W]ithout the secondary market, it will be difficult to attract investors."
Negocios Extrabursátiles is addressing a clear market need. With small- and medium-sized businesses representing the largest portion of the Mexican economy, the sector's continued growth and development are critical for the country's economic well-being. Thus far, the commercial banking sector has been unable or unwilling to provide these businesses with the necessary growth capital, and public listings remain an alternative limited to very few organizations. And although wealthy individuals, small venture capitalists and investment arms of large corporations may be able to provide some support, they are neither a scalable option nor a long-term solution.
To date, however, Negocios Extrabursátiles has seen little investment activity, and its future outlook is unclear. While both the firm's managers and its government partners should push for greater market awareness, further growth will be hindered if larger structural issues in Mexico are not dealt with, including the culture of financial non-disclosure among small businesses, unfavorable tax laws and an overall unfamiliarity with over-the-counter markets in Mexico.
The extent to which Negocios Extrabursátiles, the Mexican government and various government agencies can effectively confront these issues will have a long-term impact on the over-the-counter market concept and small business financing in Mexico. Negocios Extrabursátiles could start by defining certain requirements for listed companies, such as dividing them by different levels of governance and transparency -- a tactic that has proven successful in increasing market trade in other countries. The firm could also better communicate its advisory and education services offered through its consulting partners. Given the market's innovative nature in Mexico, even if Negocios Extrabursátiles is limited by its size and resources, giving more aid to listing companies may be a necessary first step. All parties would benefit from a stronger hand connecting investors to the Mexican small business community.
At the same time, however, it does appear that the long-term success of Negocios Extrabursátiles is contingent on the creation of the secondary, electronically traded market -- yet there is currently insufficient activity in the primary market to warrant a secondary platform. This presents a chicken-and-egg-type of problem. Only time will tell whether enough investors will be attracted, incentivized and matched within the market to allow the successful launch of a secondary market. The evolution and development of Negocios Extrabursátiles should continue to be watched. Even if it fails, valuable insights will be gained about how financing opportunities in Mexico and in other developing markets can be improved.
This article was written by Geoffrey Moore, Diego Moreira, Mateus Panosso, Christopher Thornsberry, Gregory Wallace, and Jessica Webster, members of the Lauder Class of 2010.