Role of Capital Markets in Firm Financing Stijn Claessens World Bank Capital Markets Conference Medellin, Colombia May 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 nonlisted 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

Latin America has had no shortage of capital markets reforms • 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

More liberalization

Less liberalization

Average liberalization index (1-3)

Financial liberalization lagged in 80s but accelerated in 90s 3 2.8 2.6 2.4 2.2 2

G-7

Rest of Western Europe Southeast Asia

1.8 1.6

Latin America

1.4 1.2 1 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

Reforms in securities markets also intensified in the 1990s Percentage of Latin American Countries Having Implemented Reforms

88

91

25

92

64

63

56 31

100

94

62

33

27 15 0

Supervisory agency Establishment of creation insider trading laws

Before 1990

Custody arrengements

By 1995

Trading systems

By 2002

Clearing and settlement

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

Asian countries

G-7 countries

Latin American countries

Stock of private bonds in Latin markets pales compared to Asia and G-7 Amount Outstanding of Private Sector Domestic Bonds Percentage of GDP

45 38.8

40

37.8

G-7 countries

35 30 25

Asian countries

20 15 Latin American countries

10

8.3

5 0 1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Number of listed companies has been flat or declining (de-listing) Domestic Stock Exchanges: Number of Companies 600

500

400

300

200

100

0

Argentina

Brazil

Chile

1990

Colombia

1995

Mexico

Peru

2000

Venezuela

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 tradeoff 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

ed Kin

Country itz e

Ita ly rla Ru nd ss i an Fe d

Sw

Ne th

gd om erl an ds Sw ed en No rw ay Sp ain All co un trie s Fra nc e Cr oa ti a De nm ar k Po rtu ga l Ge rm an y Po lan Cz d ec hR ep ub Ro lic ma nia Gr ee ce Be lgi um

Un it

Percentage (%)

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

Listed

100

80

60

40

20

0

ed K in g

Country ly

m Sw itz erl an d Po la n Ru d ss ia n Fe d Ro ma Cz nia ec hR ep ub lic

Be lg iu

Ita

do Ne m the r la nd s Cr oa tia All co un trie s Sw ed en Sp a in No rw ay Po rtu ga l Ge rm an y Fra nc e De nm ark Gr ee ce

Un it

Percentage (%)

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

Listed

100

80

60

40

20

0

Ultimate owner over 50% is more likely industrial in NLC and family in LC 100%

80%

60%

40%

20%

In c H i . -N gh L In c. -L

Hi gh

L

L

Ea st -

-N Ea st

-N No L r th -L

No r th

N So L ut hL

So ut h-

-L es t

W

-N L es t W

Al lc ou n A l tr ie lc so u NL nt r ie sL

0%

Other Financial firm Industrial firm Family State

LC are larger and older than NLC, while NLC are more into trading activities and consolidate less Oper. Revenue (mean) - in $m Oper. Revenue (median) -in $m

Listed

Non-listed

2861 356

450 148

Employment (mean) - in 000s Employment (median) - in 000s

11.6 1.7

1.5 0.4

% Manufacturing firms % Trade firms

32.0 9.5

36.1 27.4

43 30

30 21

% Consolidated firms

88.3

28.1

% Western Europe firms

58.8

65.3

% Eastern Europe firms

6.1

3.6

Firm age (mean) Firm age (median)

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 L isted

N on-listed

R eturn-on-A ssets

2.6

4.8

R eturn-on-Shareholders

4.5

12.6

E B IT m argin

7.0

5.6

D ebt-to-equity ratio

2.0

5.5

46.6

39.5

7.3

13.7

31.6

28.7

Fixed assets as a % of total assets Sales/(Fixed assets) ratio N on-current debt as a % of total debt

# 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 shortselling: 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?

Financing of market regulation & infrastructure building • Who has financed reaching these points in developed countries? • Who should pay for positive externalities in developing countries?

Market serving public & private interests

Discovery of public interests in capital markets Market serving

private interests only

Capital markets in developed countries

Capital markets in developing countries Short period (10-20 yrs)

Long period (100-200 yrs)

Make adoptions in issuance to 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 systems to 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 Government Finance Debt sustainability and stable redemption profiles

Infrastructure Finance PPP initiatives and structured finance, bonds

Maintaining replacement rates, asset integrity, A/L management annuities

Debt, Equity, and Derivatives Markets

Agriculture Finance Warehouse receipts and storage finance, catastrophic insurance, agricultural derivatives

Pension and Insurance Reform

Health and Education Financing Private ventures, innovative products

Housing Finance Mortgage bonds and securitization

Transmission of Monetary Policy Effective money market and liquidity operations

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