Raising capital from Mexican pension funds
In recent years, Mexican government agencies, including the Mexican Banking and Securities Commission (CNBV) and the National Retirement Savings System Commission (CONSAR) have implemented regulatory changes with the intent of allowing investors in general and specialised retirement fund investment companies in particular, to better diversify their holdings while at the same time providing the private sector with additional fundraising alternatives.
Mexican pension fund managers (administradora de fondos para el retiro; AFOREs), are private financial institutions that manage retirement and savings funds from affiliated workers, with the stated mandate of protecting their retirement pensions.
With more than $240 billion of assets under management as of the first quarter of 2018 and more than $17 billion in available funds to invest in structured instruments, sociedades de inversión especializada en fondos para el retiro (SIEFOREs), which are funds managed by AFOREs, currently play a key role in the development and funding of many industry sectors, including infrastructure, real estate and others.
When the Mexican retirement fund system was created in the late 1990s, the investment options available to AFOREs was limited, and in practice resulted in them investing exclusively in public debt and foreign currencies. As available funds have grown and the Mexican market has become more sophisticated, Mexican regulators have sponsored a series of reforms allowing institutional investors such as SIEFOREs to invest in key sectors through the acquisition of public instruments known as certificados bursatiles de desarrollo (CKDs), certificados bursatiles fiduciarios inmobiliarios (FIBRAS or Mexican REITs) or, most recently, certificados bursátiles fiduciarios de proyectos de inversión (CERPIs) and special purpose acquisition vehicles (SPAC) units.
In addition to highlighting changes to securities regulations and investor investment guidelines, it is also important to mention that SIEFOREs are exempt from income taxes in Mexico. As a result, finding the proper vehicles that allow for tax-efficient investments has also shaped the regulatory framework under which such investments are structured. As of today, vehicles such as capital risk investment trusts (FICAPs), or passive income trusts, provide institutional investors with a tax transparent or pass-through treatment, which generally implies that the relevant investors should be taxed on the income derived by the vehicle as if they directly obtained it with no vehicle level taxation.
While FICAPs must meet a strict set of requirements (80% of the capital raised must be invested in capital or debt financing of Mexican companies; stock may not be sold before a two-year period; at least 80% of the income must be distributed each year. Among others, an important advantage is that they are regulated under the Mexican Income Tax Law, which can only be amended by Congress, therefore providing a strong regulatory framework.
Conversely, passive income trusts’ single most important requirement is that more than 90% of their annual income must be considered passive (i.e. dividends, interest, capital gains or rental income). However, they are regulated under the miscellaneous tax rules issued by tax authorities themselves and their amendment does not require Congress’s approval. This makes them more vulnerable from a regulatory perspective, although the regime has not suffered amendments since its inception. Trusts that issue CKDs and CERPIs may adopt a FICAP or passive income trust tax regime as described below.
Below is a brief description of the main terms of some of the most relevant structured instruments used by the private sector to raise capital from institutional investors in Mexico.
CKDs are publicly traded securities issued by trusts with the main purpose of raising capital, mainly from institutional investors, for the financing of investment opportunities in sectors such as infrastructure, real estate and technology through private equity or sector specific funds. CKDs were created with the intent of providing SIEFOREs with access to non-traditional investments. Returns to investors are linked to the performance of the underlying assets and are structured, in most cases, as reimbursements of capital, preferred returns and manager and investor allocations, as is customary for funds raised in other jurisdictions. Commitments are only partially pre-funded and are disbursed through capital call mechanisms.
CKDs were the first securities specifically created to channel funds from SIEFOREs into private equity, infrastructure, energy, real estate or other projects. Their regulatory framework, which was shaped by the desire of the CNBV to mirror that of publicly listed companies, although strong, was viewed by some as overly intrusive and not consistent with fund structures in other jurisdictions. The CKD regulatory framework provides for a wide array of minority rights to investors, including the right to appoint members to the technical committee of the issuing trust (which is similar to a board of directors and with more powers than an investor advisory committee), and the right to participate in investment and divestment decisions, whether at the level of such committee or directly as holders of the CKDs.
CKDs have traditionally been attractive for SIEFORES not only because of the strong corporate governance component but also because of the tax transparent treatment they may achieve by structuring them through vehicles such as the FICAP or the passive income trust. However, SIEFOREs are not permitted to acquire these instruments if capital is invested outside of Mexico (unlike CERPIs or SPACs), thus restricting their geographical diversification.
With more than 80 CKDs in the market, representing more than $8 billion in committed capital, CKDs have proven to be, albeit imperfect, an efficient alternative to raise and deploy institutional capital.
CERPIs, similar to CKDs, are public securities issued by trust vehicles in which SIEFOREs are also permitted to invest. Created by regulatory action in 2015 as an effort to recreate CKDs but with certain features more aligned with traditional private equity funds (such as discretion by the manager/sponsor in respect of the investment and divestment decision process, higher holding thresholds for the appointment of committee members, higher independence requirements and a significant reduction in the decision making authority of the technical committee and the holders of the CERPIs – whose role is more confined to supervision and participation in conflict of interest scenarios and more akin to an investor advisory board – CERPIs have not been as widely used as CKDs (only one CERPI offering has closed as of this date). That will most likely change soon as trusts issuing CERPIs are now allowed to invest outside of Mexico, unlike CKDs, and international fund managers seek to raise Mexican capital for such investments.
As set forth above, unlike CKDs, CERPIs allow for investments in non-Mexican projects. As a result of an amendment to the SIEFORE investment guidelines enacted in mid-2018, SIEFORES may now invest in private projects in other jurisdictions, as long as 10% of the CERPIs committed offering amount is invested in Mexico. The form in which such Mexico allocation is to be made and when it will be measured is still subject to discussions with regulators.
From a tax perspective, CERPIs may also be structured through either FICAPs or passive income trusts so as to achieve tax transparency. However, it is only through the use of the latter that this treatment would be achieved for investments in foreign projects, due to the local investment restriction applicable to FICAPs that is not applicable to passive income trusts.
Another interesting feature that makes CERPIs an attractive alternative is that it allows managers to implement and design adequate corporate structures beneath the issuing trust (i.e. by selecting an appropriate holding jurisdiction for foreign investments) that allows for efficient capital repatriation strategies, which is not necessarily the case for SPACs, as described below.
To date, only two SPAC offerings have been made on the Mexican stock exchange. In general, SPACs are public companies set up with no assets or business operations, and which rely upon the experience and track record of their managers to raise capital for their investments or to conduct financing activities, presumably in a more limited number of ventures. Capital is raised through the offering of ‘units’, the underlying value of which comprises shares and warrants. Among other benefits, warrants allow for investors to acquire the SPAC’s shares during pre-established time frames at preferred prices, permitting for progressive capital calls as agreed for each particular case.
Similar to CERPIs, Mexican regulators recently enacted different amendments allowing SIEFOREs to invest in SPACs, which will also permit them to diversify their investments in projects not only within Mexico, but in other countries.
Unlike CKDs or CERPIs (which may be structured through FICAPs or passive income trusts that allow for tax transparency for investors), SPACs are corporations resident in Mexico for tax purposes with no access to particular benefits from a tax standpoint. Therefore, SPACs are subject to the statutory 30% income tax rate, which effectively eliminates SIEFOREs’s income tax exemptions since they are not allowed to invest in or finance its projects directly. A 10% withholding tax rate should be applicable upon dividend payments made to foreign resident shareholders, and the applicable withholding tax rates should also be observed for interest payments made to foreign residents.
In addition, income derived from the sale of shares should also be subject to tax in Mexico, as is the case for any Mexican corporation. It is also important to consider that income derived by the SPAC’s foreign subsidiaries should be subject to the applicable local corporation taxes on income and distributions, which should in principle be creditable for Mexican tax purposes, although certain inefficiencies may exist.
For SPACs, regulation addressing FX fluctuations and inflation should be considered by regulators to allow the return of committed capital to investors without triggering inefficiencies for tax purposes (i.e. redemptions in excess of the contributed capital account).
Investors and companies alike should note that Mexico has a broad double tax treaty network that could mitigate tax leakage from the repatriation of proceeds derived from foreign investments or financing activities, many of which include benefits applicable to pension funds for interest payments (i.e. Canada, United States, Spain, the Netherlands, or Brazil), by exempting them from taxation at source.
Regulators are indeed providing alternatives which present different advantages to allow not only for the private sector to efficiently raise capital in order to develop important economic sectors in Mexico and abroad, but also to incentivise the diversification of SIEFOREs’s investments to provide affiliated Mexican workers with better returns upon their retirement.
Companies seeking to raise capital should carefully review the regulatory, corporate governance and tax considerations inherent to these alternatives in order to effectively attract institutional investors.
Oscar López Velarde (firstname.lastname@example.org)
Carlos Obregón Rojo (cobregón@ritch.com.mx)
Juan Jose Paullada Eguirao (email@example.com)
Ritch, Mueller, Heather y Nicolau