Debt–equity Conversions in Venezuela

In summary

This chapter illustrates the legal, political and cultural issues that may arise in the context of any debt-to-equity conversion initiatives in Venezuela in which Venezuela’s creditors acquire claims against the country or its instrumentalities in the secondary market and use them as a currency to make productive investments in Venezuela.

Discussion points

• Debt–equity swaps
• Swapping debt for local currency: a big non-starter
• Debt–equity swaps and foreign direct investment
• Debt–equity swaps and privatisations
• Valuation and reconciliation
• Discrimination of local investors and incumbents
• Market-timing issues
• Afterthought on possible critiques

Referenced in this article

• Bolivarian Republic of Venezuela
• Petróelos de Venezuela, SA
• National Assembly

Fui quod es, eris quod sum

(I was what you are, you will be what I am)

Introduction

In the sixteenth century, after 250 years of war, Florence bought Siena from the Habsburgs. That acquisition was settled via a debt-to-equity (debt–equity) swap. In the 21st century, a successful debt–equity swap programme could very well turn out to be an important element to help reduce Little Venice’s mountain of debt and, more importantly, to promote much-needed investment.

Venezuela’s oil and gas reserves as well as the considerable stock of businesses currently under government control could be deployed to pare down Venezuela’s foreign external indebtedness, even after a successful renegotiation is completed, without further depleting Venezuela’s extremely low foreign exchange reserves.^[1] This programme could also help reignite foreign direct investment into the country.^[2]

Aggregate claims against Venezuela, Petróleos de Venezuela, SA (PDVSA) and other government-owned entities have been estimated as high as US$175 billion,^[3] so even if foreign direct investment starts flowing into the country en masse and oil exports are restored to levels last seen almost a decade ago, the resulting foreign currency proceeds will amount to only a fraction of Venezuela’s mountain of debt. In our view, a portion of Venezuela’s debt will have to be converted into productive investment in order to restore the country’s viability and debt sustainability.

Debt claims could be used as currency to pay for hydrocarbons exploration and exploitation rights, bonus payments to enter into new or existing oil joint ventures, to acquire additional participations in existing oil joint ventures, and pay for oil and gas royalties.

In addition to the oil and gas sector, as a result of government policies deployed over the past two decades,^[4] the Venezuelan public sector owns or controls businesses in virtually all sectors of the economy, including agribusinesses, airlines, aluminum, banks, brokerages, cement, commercial and residential real estate, dairy, forestry, float glass, hotels, insurance, iron ore, mobile telecommunications, power utilities, staples, steel mills, supermarket chains as well as vast tracts of land that can be used to produce anything from sugarcane to cattle.

This chapter tries to illustrate the legal, political and cultural issues that may arise in the context of any debt for equity conversion initiatives in Venezuela in which Venezuela’s creditors acquire claims against the country or its instrumentalities in the secondary market and use them as a currency to make productive investments in Venezuela.^[5]

Debt–equity swaps

A debt–equity swap would require the holders of claims against Venezuela or PDVSA (eg, bonds, promissory notes or other debt claims, arbitration awards, judgments or commercial receivables) to voluntarily exchange them for other assets, such as Venezuelan currency, internal debt securities, shares or other equity interest in joint venture companies or other state-owned companies, debt or equity securities issued by an investment vehicle or oil or gas licenses.^[6] More specifically, under a debt–equity swap programme, the holder of defaulted Venezuela or PDVSA bonds that, at the time of writing, traded at huge discounts, would agree to voluntarily exchange the bonds for the productive asset using an exchange ratio mutually agreed between the claimholder and the Venezuelan state-owned entity that holds the shares or the asset.

Under the current Hydrocarbons Law,^[7] oil exploration and production activities can only be carried out by:

• the Venezuelan state;
• companies wholly-owned by the Venezuelan state; or
• joint venture or mixed companies in which the state retains control of its decisions through the ownership of more than 50 per cent of its capital (the Oil JVs).^[8]

To implement a debt–equity swap in the oil sector, it is likely that the Hydrocarbons Law will need to be amended to:

• allow payments for shares in existing or new Oil JVs with reconciled debt claims against Venezuela or PDVSA;
• authorise the use of reconciled claims for entry bonus payments and bid bond payments;
• permit private ownership of more than 50 per cent of Oil JVs’ capital stock;
• enable Oil JVs or private enterprises to market crude internationally;
• reduce the total government’s take from the current 80 per cent to levels that are more in line with international standards; and
• allow the payment of royalties with reconciled claims.

If the original bond or claim is directly against the Republic of Venezuela and the Republic of Venezuela holds the productive assets being swapped, then the swap should automatically vaporise the claim. If the bond or claim is against PDVSA or any other public sector entity and the productive asset is held by the Republic of Venezuela, then the Republic of Venezuela, upon exchanging the productive asset for the claim or shortly thereafter, should cancel the claim in its capacity as the new creditor of the public sector entity debtor. Conversely, if the bond or claim is against the Republic of Venezuela and the productive asset is held by a different public sector entity, upon exchanging the productive asset for the claim, or shortly thereafter, the public sector entity party to the swap should cancel the resulting claim against the Republic of Venezuela. It would be important to articulate these debt cancellations and assignments on an omnibus agreement among the relevant public sector entities to help prevent the bonds and other claims that are intended to be cancelled from somehow finding their way back to the secondary market and hence defeat the goal of debt reduction.^[9] Venezuela’s and PDVSA’s bonds are book entry securities; however, most of the other claims are represented in physical documents, such as commercial invoices and promissory notes, and should therefore be formally cancelled.

The holder of the bond will want the bonds to be exchanged at par and the Venezuelan government will want the bond-to-share exchange ratio to be closer to the bond’s market value. The final exchange ratio will probably lie anywhere between the market value of the bonds and their par value. The economic driver for Venezuela would be to retire the debt at a price that is lower than its par value and the debt holder’s incentive would be to exchange the debt for equity that has economic value higher than the cost basis of the cancelled debt acquired in the secondary market.^[10]

A debt–equity swap programme’s success in reducing Venezuela’s external obligations will depend on whether the programme harnesses the discount in the secondary market of the exchanged debt.^[11] Successful debt–equity swap programmes are very difficult to achieve because of the countervailing forces represented by the simultaneous desire to reduce debt, protect foreign reserves and promote foreign direct investment.

The long-term success of the programme will also depend on Venezuela’s growth prospects, debt sustainability post-restructuring and its ability to generate foreign currency capital inflows and export proceeds. Ultimately, the participating investors will be replacing one type of claim (a debt claim) for another (an equity claim with repatriation rights).^[12]

Swapping debt for local currency: a big non-starter

Debt–equity conversion programmes were originally implemented by Latin American debtor countries during the 1980s. All of them involved the conversion of debt into local currency or internal debt that would later be used to acquire equity or pay local suppliers and general contractors.^[13]

In the case of Venezuela, exchanging eligible claims for local currency will probably not be economically attractive for investors given Venezuela’s history of hyperinflation and maxi-devaluations. In fact, Venezuela attempted to implement a debt–equity swap programme in the late 1980s but was largely unsuccessful. The programme involved the exchange of financial indebtedness for bolivars and, given that at the time (and at many times during its history) Venezuela had a dual foreign exchange system, where an official controlled rate was substantially more expensive vis-a-vis US dollars than the floating – sometimes grey market – exchange rate, there was no incentive to convert debt acquired in the secondary market and then exchange it for expensive bolivars at the official rate, when dollars, let alone debt securities, could be exchanged for local currency at the ‘better’ grey market rate.

In addition, Venezuela’s monetary aggregates are minimal when calculated in dollar terms.^[14] Therefore, the exchange of even a small fraction of the US$175 billion debt into bolivars will have catastrophic inflationary effects.^[15] Likewise, it does not seem advisable to convert foreign external indebtedness into internal debt (ie, financial indebtedness denominated in local currency issued by the Republic of Venezuela or by PDVSA in the local capital markets). This would not help reduce Venezuela’s debt stock and could potentially stress Venezuela’s foreign reserves in the future when and if the holders of the internal debt wish to repatriate the principal repayments and interest payments paid on the local debt.^[16]

Hence, in our view, any successful debt–equity swap will need to involve the direct swap of debt for equity investments without having to go through an initial exchange into bolivars (or any future local currency). In fact, a Venezuelan debt–equity swap programme would have to be the cornerstone of a privatisation programme. It will not be sufficient to implement a programme similar to those implemented in the 1980s by Argentina, Brazil, Chile, Mexico and Venezuela itself. The programme will ideally have to be placed within the larger context of a titanic reconstruction effort.

Debt–equity swaps and foreign direct investment

Debt–equity swaps will not increase Venezuela’s foreign exchange reserves. However, they have the potential to help reduce the country’s and PDVSA’s aggregate debt and increase the country’s capital stock.^[17] If the programme is well executed, it can also help promote foreign direct investment that in turn will increase the country’s reserves, capital stock and export capacity.^[18]

An interesting structure to explore would be to swap eligible claims (eg, claims that have been reconciled or that have been exchanged for new bonds issued by Venezuela in a restructuring) for capital goods outside Venezuela that are then imported into Venezuela to be deployed in projects. This structure would not have an impact on foreign reserves, would increase the country’s capital stock and would not have inflationary effects. The debt reduction, however, would be a function of the discount of the new claims and any debt relief agreed in the restructuring.

Foreign investors will hesitate to invest in Venezuela (whether via debt–equity swaps or directly through capital contributions) if they feel that capital controls may be around the corner. This is one of the limitations that affect debt–equity swaps in general. As explained by Paul Krugman, ‘once one realises that the ability to reduce net obligations through debt equity swaps depends on seniority of equity (which is itself a fairly weird idea), the limitations become apparent.’^[19] The counter argument is that payouts on equity are contingent on there being profits.

There will be a tug-of-war among debt investors and equity holders. Foreign external debt holders may be amenable to capital controls, particularly if they feel that the controls will help increase the country’s foreign currency reserves available to service debt, at the expense of the reserves available for foreign equity investors to repatriate capital distributions.

On the other hand, Venezuela has entered into multiple bilateral investment protection treaties which protect foreign investors’ repatriation rights.^[20]

Any debt–equity programme will have to be undertaken in the context of a much broader macroeconomic adjustment programme that massively restores confidence.

Debt–equity swaps and privatisations

Venezuela has a privatisations law that dates from 1997.^[21] Under this law, the sale of shares in ‘basic’ or ‘strategic’ companies requires approval from the National Assembly.^[22] The sale of shares in other government-owned companies requires the approval of a privatisation policy by the President and the Finance Commission of the National Assembly.^[23] We draw attention to this long forgotten law because it will require that the country’s leaders take complete ownership of the programme, as well as the required structural reforms, and shepherd them through the required regulatory approvals.^[24]

Pursuant to the privatisations law, the sale of shares in state-owned companies (ie, companies in which the Republic of Venezuela directly or indirectly owns 50 per cent or more of their outstanding capital stock) must be carried out either through a public auction or through one of the mechanisms regulated under the Venezuelan Securities Markets Law, namely an initial public offering (IPO).^[25] In our view, public auctions and IPOs would be desirable for their transparency and price formation mechanics.

We like to believe that the privatisation of businesses can be handled smoothly, successfully and would very likely be understood by the general population. In fact, there are myriad companies that are now in the government’s hands that were originally privately owned companies.^[26]

With respect to the oil and gas sector, allowing majority ownership of Oil JVs by the private sector and later allowing the use of debt instruments or reconciled claims as a currency of payment for shares, or other forms of participation in the oil and gas sector, will require amendments to the legal and regulatory framework and a cohesive effort by enlightened leaders to take ownership of the programme and convince their respective constituencies of its benefits.

Valuation and reconciliation

The market value of bonds is easily determined because there is a secondary market for bonds in distress. However, the valuation of the businesses eligible for a debt–equity swap will be challenging.

To add another layer of complexity, out of the estimated total of claims against Venezuela and PDVSA, only approximately US$70 billion arise from international debt securities or other forms of foreign external indebtedness owed to international financial institutions. The rest relate to claims that arise from unpaid commercial invoices, executory contracts, physical promissory notes and arbitration awards rendered in favour of expropriated private investors. This means that a debt–equity conversion programme will need to be preceded by an immaculate reconciliation process. Furthermore, the valuation of business enterprises that have only generated local currency income over the past few years, that operate in an economy whose GDP is a fraction of what it was only five years ago and that require sizable capital expenditures, will be very challenging.

Therefore, a transparent valuation mechanism that is agreed upon by all the relevant stakeholders will be required to improve the political viability of the programme.^[27]

Discrimination of local investors and incumbents

The temptation may exist to disallow local holders of bonds and other claims to participate in debt–equity swap programmes.^[28] This temptation will arise to appease criticism that the people who ‘took their money out’ should not be allowed to buy productive assets in Venezuela at discounted prices.^[29] In our view, this would be a mistake. Discrimination will open the programme to legal and political challenges. Venezuela needs closure and a clean slate to grow and move on. In addition, it is estimated that up to 25 per cent of the aggregate principal amount of Venezuela’s and PDVSA’s bonded debt is held by Venezuelan investors, including widows and orphans. Also, holders of expropriation claims could hardly be seen as having taken their money out of Venezuela and should hence not be discriminated against. This is where the reconciliation process will also play a fundamental role.^[30]

Market timing issues

As explained, the viability of debt–equity swaps depends on whether the investors are able to take advantage or harness the discount of the eligible claims in the secondary market. Deep discounts have the potential to incentivise investors to capitalise discount debt purchased already at a discount. Lower discounts will have the opposite effect. Then again, if eligible claims are not trading at a discount, it will likely be because the country’s debt sustainability and overall economic outlook have substantially improved.^[31] One criticism lobbed at debt–equity swaps is that they subsidise investment that would have been made anyway without the discount. Although Venezuela’s long-term outlook may be encouraging, in our view, jump-starting investment in the short term will require many forms of incentives.

One scenario is that only bonds and reconciled claims would be eligible to participate in the debt–equity swap programme. Presumably, there will be a secondary market for reconciled claims that would probably trade initially at a discount from their nominal value, specially during the period from their reconciliation until a new instrument or instruments are voluntarily exchanged for the reconciled claims in the context of a restructuring. In this case, interested investors could purchase reconciled claims at a discount and try to harness the discount when they exchange them for productive assets or shares in companies in Venezuela.

This could also be achieved after the new instruments are issued as a result of the restructuring if they trade at discounts in the secondary markets. Otherwise, there will not be incentives for investors to participate in any debt–equity swap programme.^[32]

Conclusion

A debt–equity swap programme for Venezuela could have the potential to reignite the country’s economy and could also help reduce the country’s debt stock. Such a programme will be confronted by numerous political and idiosyncratic challenges that will call for an immaculate reconciliation, valuation and execution process. The programme will pose a philosophical tug-of-war between those allowing investors to harness the secondary market discount of eligible claims and those permitting a fair exchange of productive assets currently owned by the government.

Debt–equity swaps will not work standing alone. They need to be one of the several items on the menu for a comprehensive debt restructuring and, more importantly, they will need to walk hand in hand with the structural reforms that will promote reconstruction of the ­country’s infrastructure, privatisations and foreign investment. Leaders must take full ownership of the programme.

Afterthought on possible critiques

The following critiques to debt–equity swap programmes should be anticipated in Venezuela:

• The programme subsidises investments that would otherwise be made anyway with cash or capital goods.
  • Rebuttal: The country’s capital stock increases and new investments will come as a result of the programme. Better management, know-how and modernisation will benefit the economy.
• There is no real foreign investment.
  • Rebuttal: The country’s capital stock increases and new investments will come as a result of the programme.
• There is no debt reduction. Venezuela is exchanging debt liabilities for equity liabilities.
  • Rebuttal: Debt claims are fixed income claims with stated maturities and interest payment dates. Equity’s income is variable and inherently riskier. Maximising shareholder value is preferable than capital distributions.
• Investors should commit to make additional real money investments to be eligible to participate.
  • Rebuttal: This has been done in other jurisdictions with limited success. If the macroeconomic outlook improves, new investment will flow into participating sectors and other sectors.
• Capital repatriations should be subject to compliance with additional investment requirements.
  • Rebuttal: Investors will hesitate to invest via the programme or otherwise if they believe that capital controls are around the corner.
• The programme promotes the transfer to foreign investors of strategic industries.
  • Rebuttal: The country needs strategic partners to promote reconstruction and growth.
• Strategic or valuable industries are being sold at bargain basement prices.
  • Rebuttal: Auctions and initial public offerings will ensure fair prices and valuations.
• Local investors should receive preferential treatment. Foreign investors should partner with local investors to participate in the programme.
  • Rebuttal: A transparent and competitive process is the only way to ensure its success. Preferential treatment will tarnish the programme and may give rise to challenges. Forced marriages are very complicated.

Notes