Solid ground: Pursuing regional integration and boosting equity are key focuses

A coming of age is reflected in Colombia’s increasingly deep, diverse and sophisticated capital markets. Its well-established sovereign fixed-income and foreign exchange markets have been complemented in recent years by a developing derivatives market, increased domestic corporate debt issuance and a stock exchange that has taken off since the flotation of Ecopetrol in 2007. Domestic and international investor appetite remains strong across a range of asset classes, with more primary market issuance and increased secondary market liquidity high on their wish list.

PENSION FUNDS: Since 2001 assets under management by Colombia’s private sector pension fund managers have experienced a compound annual growth rate (CAGR) of 30%, surpassing $80bn by late 2012. This has been a crucial driver of demand for financial assets among local institutional investors. Employer and employee pension contributions are mandatory for all private sector workers in the formal labour market, ensuring a steady stream of new contributions, which could accelerate once recent reforms aimed at increasing labour market formality are fully implemented. Since March 2011 Colombia has operated a “multi-fund” system, following the Chilean model, whereby clients can choose from four possible investment allocations with varying risk-return profiles.

The vast bulk of funds are currently allocated to moderate risk portfolios that have upper investment limits of 5% local private equity, 5% foreign private equity, 35% local public equity, 10% foreign public equity and the remainder in bonds, of which not more than 50% should be domestic sovereign bonds.

A rapidly growing sub-sector of the pension fund industry is that of voluntary contributions over and above mandatory commitments. These are able to attract tax relief on income of up to 30%, or $50,000 per annum, while the portfolios are not constrained by asset allocation limits. The national savings rate has also ramped up significantly since the turn of the century, which has provided further demand for financial assets.

PUBLIC EQUITY: The 2007 flotation of Ecopetrol, Colombia’s largest oil company, proved to be a watershed in the development of the capital markets. Previously, the stock market had been something of a backwater, with limited liquidity and narrow sector focus. The Ecopetrol initial public offering (IPO) also proved a boon to retail investors, generating widespread interest. The company has half a million shareholders and its annual general meeting regularly attracts over 20,000 people. This had a powerful knock-on effect, encouraging a succession of Colombian firms to go public in the years that followed. Pacific Rubiales, Banco Davivienda, Cámara Colombiana de la Construcción, Terpel, Biomax Colombia, Mineros and ISA were among those to join market stalwarts like Argos, Nutresa, Grupo de Inversiones Suramericana (GRUPO SURA) and Bancolombia. This breakthrough not only increased the number and diversity of issuers, it also greatly increased liquidity and caused the market to behave more like its international counterparts responding to fundamental economic developments both locally and globally.

Despite having taken these great strides in recent years, the stock market is still characterised by a relatively small number of liquid issuers. Although there are 84 shares on the bourse, only a quarter of these are actively traded and the aggregate free float is just 20%.

Since 2010 corporates have raised $9.5bn in equity on the primary market, $7bn of which was raised in 2011 alone. The most notable offerings in that bumper year were GRUPO SURA (finance, $1.87bn), Grupo Éxito (retail, $1.36bn), Ecopetrol (petrol, $1.29bn), and Grupo Aval (finance, $1.13bn). At $1.1bn, the offering of CEMEX, the Mexican cement producer, accounted for half of all issuances in 2012.

The Colombian Stock Exchange (Bolsa de Valores de Colombia, BVC) envisages four to six primary market offerings per year until 2015, with the infrastructure sector expected to figure particularly strongly on the back of the government’s investment plan. While Bancolombia ($2.6bn) and Argos (cement producer, $1bn) are among the big players to have secured regulatory approval for secondary equity offerings, it is as yet unclear to what extent these will be exercised, particularly given the attractive alternative of local or international debt financing at historically low interest rates. There is scope for much future growth in listings and liquidity on the back of strong macroeconomic fundamentals, but a global market correction has the potential to dim the prospects of potential issuers. Since 2001 the stock market has seen a CAGR of 53%, with total annual traded volume peaking at $40bn in 2012, or about $163m per day. The share of transactions accounted for by international investors has also been doubling year-on-year to reach 14% in 2012, a year in which total market capitalisation hit a record $270bn.

CHANGES: Colombian stocks have seen volatility in recent years. With the onset of the global financial crisis, the market fell 28% over a five-month period in late 2008 before roaring back with a 53.5% gain in 2009 and a further 33.5% gain in 2010. Having peaked in October 2010, stocks fell by 18.3% over the course of 2011 before bouncing back with a 16.2% gain in 2012, despite a 4.2% loss during November 2012 following the Interbolsa scandal, a drop from which the market managed to recover fully from within two months. By the end of July 2013 Colombian stocks were still some 12.3% off their October 2010 peak, but they stood at more than double their October 2008 cycle low.

The mid-2008 collapse in prices saw the price-to-earnings (P/E) ratio of COLCAP – the 20 most liquid stocks on the BVC – spike to over 50 before settling back down to the late teens or early 20s. The strong run-up in prices in 2010 saw the P/E ratio peak at nearly 28 before trending downward to a cycle low just below 15 in mid-2012 on the back of strong earnings growth. Late 2012 and early 2013 saw the P/E ratio trend higher again, reaching 20.7 by end-July 2013, as buyers drove prices higher. COLCAP’s price-to-book value has been trending upwards since it hit a low of 1.2 in February 2009, peaking at 2.2 in October 2010 but remained relatively steady, at below its medium-term trend level of 1.7-1.8 for the 18 months to end-July 2013.

PRIVATE EQUITY: If the public equity market was underdeveloped prior to 2007, private equity was virtually nonexistent. Colombian pension funds currently invest around $1.2bn in local private equity, far less than the implied maximum investment limit for this asset class. This would suggest scope for future growth in domestic private equity’s share of assets under management. To date, 37 private equity/venture capital funds have been raised in Colombia, accounting for $3.6bn in raised capital, with infrastructure ($859m), real estate ($773m) and multi-sector funds ($1.18bn) predominating.

Although private equity is still a relatively recent fixture in Colombia, local players expect funds to generate a 2.5x or 3x return, implying a healthy internal rate of return of 25-30%. Until recently, limited competition for deals has allowed early movers to make acquisitions at attractive prices. This is changing, as more foreign players are attracted to the market by strong potential returns and robust institutional and investor protection.

The Latin American Venture Capital Association ranked Colombia as the fourth-friendliest environment for private equity investors in 2012, behind Chile, Brazil and Mexico. Its “2013 Scorecard” highlighted the steps the government has taken over the past year to promote entrepreneurship, while noting that Colombia faces issues relating to a perception of high levels of corruption and a complex tax environment. Infrastructure projects offer an important new direction for local private equity investment, with international investors like Brookfield and Ashmore already showing interest.

CHALLENGES: As the local stock market is not yet mature enough to support mid-market IPOs, strategic and trade deals will continue to represent the most viable opportunities for private equity players to exit their investments and secure returns. Finding appropriate exit opportunities remains a challenge in Colombia, as it is elsewhere in Latin America. The economy has faced multiple challenges and opportunities on the back of its recent currency strengthening, and private equity is no exception. Luc Gerard, the founder and CEO of Tribeca Asset Management, told OBG, “The appreciation of the peso has affected private equity in Colombia in two ways. On the positive side, a lot of transactions are carried out in US dollars, which means that if revenues are in pesos, when the company is sold, the profits will be higher. On the other hand, if you are a Colombian investor who is investing in pesos, the opposite occurs.”

Since 2009 the state development bank, Bancóldex, has been playing an increasingly active role in supporting the fledgling private equity industry, committing $46m as a cornerstone investor to five multi-sector tourism, venture capital, information and communication technologies, and infrastructure funds. In addition, Bancóldex has developed a technical assistance programme aimed at nurturing the private equity/venture capital ecosystem.

As it has done in other segments of the sector, Bancóldex aims to support the development of the market to the point where the private sector no longer needs its assistance, so that it can withdraw and concentrate its resources elsewhere.

GLOBAL EQUITY: The Global Colombian Market ( Mercado Global Colombiano, MGC) is an initiative of the BVC to facilitate the purchase of internationally listed shares. These shares are traded, cleared and settled through the system administered by the BVC. Although activity on the MGC was initially confined to individual shares, it is envisaged that operations will be expanded to incorporate exchange-traded funds (ETFs). Although the MGC increases the diversity on offer to Colombian investors, local brokerages face challenges in terms of costs, communication, research capacities and local presence, limiting their ability to advise local investors on internationally listed equities.

FIXED INCOME: Colombia’s bond market is well established, accounting for $840bn in traded volume in 2012, 75% of the total volume traded on Colombian capital markets that year. Of this, four-fifths relates to sovereign bonds – this market being far more developed and liquid than its corporate counterpart. With $1.7bn of corporate debt issued in the first two months of 2013, activity appears to be picking up, as firms make the most of the potential for cheap debt financing. While trading volumes have fallen back from their 2010 peak, loose monetary policy in developed markets coupled with domestic developments relating to inflation, interest rates, tax reform and pension funding have combined to drive demand for Colombian fixed-income assets higher and their yields to record lows.

FOREIGN EXCHANGE: Although Colombia’s foreign exchange market is long-standing, activity has fallen slightly in recent years from its 2010 peak of $257bn to $200bn in 2012. Of the average daily trade volume of $820m, 60% is accounted for by the spot market, with the remainder relating to the forward segment. Having weakened significantly in late 2008 and early 2009 with the onset of the global financial crisis, the exchange rate of the peso to the dollar reached a maximum of $1:COP2255 during this period, and the currency has since gradually regained strength on the back of strong foreign investment and a booming oil sector. These factors contributed to making the Colombian peso one of the strongest currencies in Latin America in 2012. That said, the peso dropped in value in early 2013 following central bank dollar purchases being stepped up to at least $30m per day. The dollar-peso exchange rate traded within a relatively narrow +/- 5% band of 1800 in the 12 months to end-March 2013.

DERIVATIVES: Foreign exchange derivatives are wellestablished in Colombia, although it is only in recent years that transactions have evolved from being of an over-the-counter (OTC) nature. The year 2008 witnessed an important development in the derivatives market with the introduction of the standardised OMX trading platform as well as the establishment of the Cámara de Riesgos Centrales de Contraparte, a private sector clearing house that serves to reduce counterparty risk. Standardised futures have since been introduced for equity indices, individual equities, inflation, interest rates and some bonds. Credit default swaps are currently available on an OTC basis, but they are often used for information purposes rather than for hedging credit risk. Prior to 2010, international investors were not permitted to engage in the trade of money market derivatives, but this restriction has since been removed, ensuring equal treatment of domestic and foreign investors alike. Annual traded volume has experienced a CAGR of 33% since 2007, peaking at $47bn in 2011. The total volume reached $36bn in 2012, or an average of approximately $147m per day.

MUTUAL FUNDS & ETFS: Carteras colectivas (“collective portfolios”) have become an increasingly prominent feature of Colombian capital markets in recent years, and this growth appears set to continue as brokers and fund managers move further away from the “own resources” trading model to “execution only”. There is a range of options for investors, including those that aim to replicate the aggregate performance of the entire Colombian stock market, the top 20 companies by market capitalisation and stocks in the petroleum, financial, energy or infrastructure sectors. In mid-2011 US-based BlackRock, the world’s biggest money manager, launched its iShares COLCAP ETF, which is denominated in Colombian pesos and tracks the 20 most liquid stocks on the stock exchange. Attracting $800m in the year after its launch, the ETF exceeded expectations. As well as being an attractive way for retail investors to get exposure to Colombian equities, such funds also allow pension fund managers to bypass investment limits on exposure to domestic equities.

NEW PRODUCTS: COLTES, a futures contract on specific Colombian sovereign bond tenors, is expected to generate significant demand when launched; this is expected to take place in 2013, but it had yet to occur as of the middle of the year. Given Colombia’s infrastructure deficit, the government’s ambitious investment programme and recent efforts – including a new publicprivate partnership law – to mobilise private sector investment in infrastructure, this sector looks set to add considerable depth and diversity to Colombian capital markets in the years to come, with new issues and products expected across the public equity, private equity and corporate bond landscapes.

BVC: Although other entities are legally entitled to establish a stock exchange in Colombia, subject to the relevant conditions and regulations, the BVC is the only exchange existing in the country. It operates markets on equities, fixed income, foreign exchange and derivatives, and its trading hours are aligned with those of the NYSE. The BVC is itself a listed company, and it is regulated by the Superintendence of Colombia ( Superintendencia Financiera de Colombia, SFC), which has overarching responsibility for supervision of the country’s banking and capital markets. All share issues on the primary market also require approval from the SFC.

QUALITY SEAL: Drawing inspiration from Bovespa’s Novo Mercado model in Brazil, the BVC has introduced an initiative to promote the adoption of best practices in information disclosure and investor relations. These guidelines make up a voluntary code of corporate governance to which issuers are invited to adhere. In return for compliance, they receive an issuers’ recognition stamp of approval from the BVC. The core aims are to increase foreign investment in the Colombian stock market and to raise awareness of the importance of investor relations and corporate governance practices. By early 2013, the initiative already had 10 adherents, with more expected to join.

TRANSACTION CHARGES: The BVC applies a flat $1 fee per side of each executed transaction, plus an ad valorem (or compound) charge that is dependent on volume but averages 20 basis points. While this is more expensive than such charges in regional leaders like Chile and Mexico, it is lower than those in either Peru or Brazil. Moreover, as the Colombian markets are not yet fully integrated vertically, the BVC is not yet in a position to reap the benefits in terms of economies of scale. However, given that vertical integration appears promising over the medium term, one would expect this to lead to an eventual reduction in transaction charges.

PROMOTION & TECHNOLOGY: May 2012 saw the first road shows hosted by the BVC, Central Security Depositary Company (a subsidiary of the BVC) and Citi for institutional investors in New York and London. The Inside Out conferences featured high-profile speakers, interactive panel discussions and networking opportunities. After the road show’s successful debut and continuing strong investor interest, the format was rolled out again in June 2013 with a high level of government engagement at events in London and New York City.

Similar to many major financial players in Colombia, the BVC itself has invested heavily in the latest technology and associated human capital. Its OMX trading platform has sufficient capacity to handle 5000 transactions per second if necessary, while it is backed up by three redundant systems. Out of the BVC’s 220 employees, 120 are in its IT department, signalling the extent of automation and available technical support.

TRAINING & E-TRADING: Following the launch of the standardised derivatives market in 2008, the BVC engaged in extensive training courses with local brokers with the aim of ensuring that they were able to use and profit from derivative products on their own behalf or on behalf of their clients. They also maintain 29 sites for retail investor education across the country, providing training courses for free or for a small fee.

As Colombian retail investors become more sophisticated and educated in the ways of capital markets, they are also gaining confidence and becoming less dependent on the investment advice of their brokers. With a pool of 1m retail investors and growing, electronic trading has been a facet of investing in Colombia since 2008 but really began to take off in 2010, and it now accounts for 11% of all retail transactions. While some brokers see the rise of electronic trading as a threat to their bottom line, others have tried to grab a slice of the action by incorporating electronic trading platforms into their business model.

REGIONAL INTEGRATION: Since mid-2011, the Colombian, Chilean and Peruvian equity markets have been participating in a shared platform: the Integrated Market of Latin America (Mercado Integrado Latinoamericano, MILA). By marrying three small exchanges, MILA has helped achieve critical mass and now ranks as the second-largest stock market on the continent, after Brazil but ahead of Mexico (see analysis).

Success in terms of extra trading volume generated has been relatively modest to date. Preparation is at an advanced stage for Mexico to join MILA, which could prove to be a game-changer, by positioning the exchange to vie with Brazil’s Bovespa. For MILA to reach its full potential, however, further work is needed to harmonise the fiscal, regulatory and operational rules of the game, while market players will have to develop either a regional presence or certain strategic partnerships in order to adequately cover all markets.

In addition to broader regulatory changes for the financial sector in 2013, permitted leverage levels are to be reduced and the cap on exposure to any one stock is to be dropped from 60% to 20% for brokers using their own equity. In the wake of the Interbolsa scandal, temporary restrictions remain in place in relation to brokers’ maximum permitted transaction sizes, and it is widely expected that more permanent measures will be introduced in due course. There is concern within the brokerage community that such measures could prove onerous, by restricting operations and hitting brokers’ bottom lines. As stands to reason, this is thought to be a threat particularly to smaller players.

TAX REFORM: Late 2012 saw several wide-ranging tax reforms, including measures affecting fixed-income and derivatives investors. While Colombia generally imposes no tax on either foreign or domestic investors for dividends or capital gains on equities, a withholding tax of 33% had traditionally been imposed on gains derived from transactions on the bond market, until this rate fell to 14% for all investors not originating from a tax haven (the rate was only reduced to 25% for them). This distinction was made for the first time to discourage hot money flows from offshore financial centres.

FINANCIAL TRANSACTION TAX: All financial transactions in Colombia are subject to a 0.4% charge. First introduced as a temporary measure at a rate of 0.2% in 1998, it has since been increased and extended. For obvious reasons, this charge is intensely disliked by financial players and their clients. The government has committed to phasing out the financial transaction tax at a rate of 0.1% per year beginning in 2014, subject to any policy changes arising in the aftermath of the legislative and presidential elections in 2014.

BROKERS: There are 27 brokers operating in the Colombian capital markets. There has been a certain degree of consolidation in recent years, particularly as banking groups have acquired brokers, while a number of foreign players have entered the market.

Peru’s Banco de Crédito, for instance, is now the country’s second-largest broker, having acquired a majority stake in local player Correval in December 2011. LarrainVial, Chile’s largest broker, has also established a foothold in the Colombian market, while CorpBanca, another Chilean outfit, is acquiring Helm Bank’s brokerage unit in a deal that will create the sixth-largest banking group in the country.

In December 2012 Brazil’s BTG Pactual completed its takeover of Bolsa y Renta to form Latin America’s leading investment bank. Finally, global banking group BNP Paribas, US multinational banking and financial services holding company J.P. Morgan and Brazil’s Itaú have either set up or are currently establishing footholds as custodians in the local market.

INTERBOLSA: Colombia’s financial community was shaken in November 2012 when Interbolsa, the country’s largest broker (with a 50% market share), overextended itself trying to finance a bid for Fabricato, the country’s largest publicly traded textile producer, by securing loans against Fabricato stock as collateral. On the eve of its collapse, November 2, 2012, Interbolsa had exposures amounting to $84.2m on the equity market, $345.6m in repo transactions, $106m in derivatives transactions and $835m in government bonds. Questions have been raised as to the quality of the regulatory oversight that allowed Interbolsa to enter into this arrangement. María Inés Agudelo, executive director of the Guarantee Fund for Financial Institutions, told OBG, “Interbolsa was not insured by our deposit insurance, so it is not an example of how our mechanisms work. The regulator decided to directly enter to liquidate the institution to pay back creditors.”

Once the extent of the issue came to light, the authorities moved quickly and efficiently to address this challenge, with the majority of Interbolsa’s positions being liquidated in the first week. By end-January 2012 71% of Interbolsa’s clients and 77% of its portfolios had been transferred to other brokers. The collapse hit retail investors hard, undermining their trust in the integrity of Colombian capital markets. To rebuild confidence, the BVC has begun an information campaign aimed primarily at local investors.

The affair has not been as damaging internationally, failing to detract from Colombia’s strong macro and investment fundamentals. The authorities, moreover, adopted a deliberate damage mitigation strategy that prioritised the resolution of the positions of international investors. Since the Interbolsa scandal, transaction size limits have been imposed on brokers, which has resulted in many counterparties no longer being able to trade. These temporary measures have particularly impacted smaller, independent brokers.

OUTLOOK: With Colombia’s fixed-income markets already relatively mature, the immediate priority is to further develop the equity and derivatives markets. One key tenet of the BVC’s strategy in pursuing this is boosting internationalisation – the thinking being that more regular interaction with foreign firms and investors will serve to enhance the sophistication of domestic market players. Internationalisation takes several forms: regional integration through the MILA; partnership with exchanges further afield, such as Canada; foreign listing and debt-raising of Colombian firms; Colombian listing of foreign companies; and facilitating access of local investors to foreign-listed financial instruments. Regional expansion may even be moving beyond MILA with prospective full-scale mergers and acquisitions.