A visitor to Brazil, curious about the country's private equity opportunity, will repeatedly encounter two things – cafezinho, the diminutive coffees that are served at every conceivable occasion; and “the history”, an exhaustive overview of the setbacks that have prevented Brazil's private equity industry from flourishing beyond its current state, followed by a presentation of the perfect-storm set fundamentals that have now gathered to lift Brazil to its rightful place among the most important private equity opportunities in the world.
Propelling the recent private equity success in Brazil has been an unprecedented IPO market, which has been hungry for just the types of companies that experienced private equity firms groom. “Until two years ago our only exit possibility was to a strategic buyer,” says Eduardo Buarque de Almeida, the co-founder of Sao Paulo private equity from TMG Participações. “The two-year surge of IPOed companies proves free market principles are now firmly rooted, taking advantage of a large pool of talented young managers and the existence of hundreds of private, middle-sized companies.”
De Almeida predicts that this surge has made a likely that TMG will exit all of the portfolio companies from its debut, $100 million fund, raised in 1998. After weathering “crisis after crisis”, de Almeida says: “The time is ripe for educating pottential investors as to the country's economic and institutional assets, which have been somewhat overlooked vis-à-vis the other BRICs.”
If you are an experienced Brazilian GP, the time is also ripe for fundraising. Most major groups targeting Brazil are in the market or planning to come to market with new funds in the next year, and they are planning to counter skeptical and distracted foreign LPs with the compelling macro story, as well as with strong track records generated over the last several years.
Alvaro Gonçalves, a partner in Sao Paulo-based private equity firm Stratus Investimentos, and the former president of the Associacao Brasileira de Private Equity & Venture Capital (ABVCAP), says that the Brazilian private equity industry is being much more aggressive about telling its story. “Brazil has consistently been very bad at marketing itself,” says Gonçalves.
Stratus Investimentors recently established its first off-shore private equity fund to better cater to the needs of foreign investors.
Some globally minded foreign GPs have already decided to get serious about the region, which is already increasing the flow fo private equity capital to the region. According to several sources, The Carlyle Group, Goldman Sachs Capital Partners, Fortress Investment Group and Eton Park all are either actively pursuing private equity opportunities or have begun to lay serious groundwork of investment activity in Brazil.
These groups and other interested parties are discovering a market well stocked with connected, local GPs. While still small by US and European standards, Brazil is home to Latin America's largest private equity market, with more than 70 groups active in the region, according to a recent survey conducted by Antonio Gledson de Carvalho, Leonardo Ribeiro and Caludio Furtado, all three of the Fundacao Gerulio Vargas Business School's Center for Private Equity and Venture Capital Research (Gvcepe).
THE B IN BRIC
The case for Brazil begins with its demographics. With a population of more than 180 million people, Brazil is the fifth largest country in the world. But its gross domestic product, at $790 billion, puts it in eleventh place as an economy, just behind South Korea, with one-third Brazil's population.
Clearly there is room to grow. But in recent years, Brazil has not kept pace with the other catch-up countries heralded in Goldman Sachs' famous 2003 BRIC (Brazil, Russia, India, China) report. Since the report was issued, Brazil's GDP growth has not cracked six percent. This year, Brazilian GDP is forecasted to grow only 3.2 percent. In the meantime, India and China are nearing 10 percent and 12 percent, respectively.
In a way, it is not fair to expect the same kind of rapid-fire growth from Brazil as is currently seen in India and China (and to a slightly less extent, in Russia). Brazil went through a major development spurt in the post-War period, and developed a middle class and many institutions that India and China do not currently enjoy to the same degree.
Importantly, Brazil's capital markets are deeply established in the highly entrepreneurial business culture. The Sao Paulo Stock Exchange (BOVESPA), is 116 years old. As Stratus' Gonçalves points out, even during three decades of military dictatorship, Brazil's leaders never imposed controls on the capital markets.
The professionals who provide services to private equity firms are world-class, a by product of a country with a long history of high finance, if a family-centric one.
As the 1990's drew to a close, it appeared to many observers of and participants in the Brazilian market that the stars were finally aligning for private equity opportunity. A number of groups affiliated with US banks and US private equity firms arrived in Brazil looking for deals and consummating transactions that, in hindsight, were poorly considered, say local GPs. “In the 1990s, if you could speak Portuguese, you could speak Portuguese, you could raise a fund,” says one GP derisively.
They came a series of setbacks that Brazilian GPs recite with weariness.
First up was the Asian economic crisis of 1997, then the Russian debt crisis in 1998, both of which roiled most emerging markets as Western investors withdrew capital from all developing economies. In 1999, the Brazilian real was devalued and eventually sank nearly to 4 to 1 against the dollar (the exchange rate today is just over 2 real to the dollar). The year 2001 brought the collapse of the internet hubble, which affected Brazil's nascent venture capital market. In 2002, Luiz Inacio Lula da Silva was elected, and the international market reaction was that a leftwinger had seized the country.
One GP calls the 2001 to 2003 period “the dark years” for Brazilian private equity. Another Sao Paulo-based GP says: “If you invested in a Brazilian private equity fund before 1998, by definition you did not do well.”
During this “dark” period, however, Brazilian regulators and lawmakers were pursuing reforms and debt reductions that would lay the groundwork for today's more buoyant market. Many Brazilian market observers predict that these changes will soon earn the country an investment-grade rating, which will trigger a flood of incoming foreign capital.
Brazil's economy is growing much more slowly than the other BRIC countries largely because of high interest rates, instituted following the real devaluation to control inflation. Brazil's overnight lending rate stands at 13.75 percent, although this is down from the mid-20s in 2003. In fact, the government's determination to control inflation through monetary and fiscal policy – policies maintained by “leftist” Lula – has many observers hoping that a new era of macroeconomic maturity has arrived in Brazil.
Although many private equity professionals in Brazil privately favoured Lula's campaign rival, centrist Geraldo Akkmin, most are confident that Lula, who last month won a second presidential term, will continued to follow a path toward macroeconomic stability, or at the worst, of macroeconomic benign neglect.
Eduardo Buarque de Almeida
At the micro level, Brazil's Development Bank (BNDES), already a force behind several similar initiatives, instituted a programme in 2002 to encourage medium sized businesses to adopt better corporate governance policies, using a suite of financing packages as incentives. The effort bolstered an earlier initiative from the Brazilian Stock Market (Bovespa), which created three classes of corporate governance for public companies to voluntarily adopt. Fourteen percent of companies have adopted one of the three levels, representing 55 percent of the total market capitalisation of the Bovespa, according to the Associacao Brasileira de Private Equity & Venture Capital (ABVCAP). The market premium awarded to companies that adopt the Bovespa corporate governance practices has gotten many private-company CEOs interested in private equity ownership prior to a listing, in that they understand a key value of private equity sponsorship to be the implementation of corporate governance best practices.
In an attempt to provide a better legal environment for local and foreign investment firms, in 2002 a new corporate law was signed into effect that improved corporate governance for publicly listed companies. In particular, the new law improved the rights of minority sharcholders.
Key to these changes were the reinstantement of tag-friendly rights, as well as more minority-friendly rules for delisting of stocks. Aloysio Miranda, a partner in the Sao Paulo, office of law firm Ulhow Canto, notes that Brazil's securities regulator, the CVM, has been gradually instituting reforms to make Brazil's markets more attractive to outsiders.
“Over the past eight years, your can see that the CVM has gradually been more on the side of minority shareholders,” Miranda says. “They want foreign investors to know that they will be treated fairly.”
The enhanced rights for minority shareholders also makes it more acceptable for selling shareholders to revert to a minority position in a private equity deal, notes Marcelo Fonseca, a vice president in the Sao Paulo office of private equity firm Darby Overseas Investments.
In 2005, new bankruptcy laws came into effect which created additional protection for creditors. This is having the effect of freeing up additional debt financing for private equity deals, spurred along by the falling interest rates.
Among the biggest advocates for change Brazil has been the ABVCAP. According to its president, Stratus partner Gonçalves, the ABVCAP played a major role in persuading Brazilian tax authorities earlier this year to drop a 15 percent local capital gains tax imposed on foreign investors.
The convergence of all these positive developments, fueled by an the anticipation that Brazil may become investment grade within two years, has reopened the Boviespa IPO market in a big way, spelling major opportunities for private equity firms with solid, corporate governance-practicing businesses in their portfolios.
After years in the doldrums (see chart), two years ago IPOs were back in Brazil. The year 2004 saw seven, the next year saw ten, and at press time there were 22 IPOs in 2006 with an aggregate value of nearly $6 billion. Many of these listings were backed by local and international private equity investors. Of the first 14 IPOs of 2006, as counted by ABVCAP, seven were backed by private equity firms.
The biggest of these was the IPO of Gafisa, a 50-year-old home-building company backed by Sao Paulo private equity firm GP Investiments and Chicago private equity from GP Investimentos and Chicago private equity firm Equity International. Gafisa raised $350 million in its IPO and currently has a market capitalisation of roughly $1.2 billion.
The steady parade of IPOs, as well as the rising market generally, has given many business owners in Brazil a keener interest in partnering with groups that know how to get there from here. “When we were knocking on doors in 2000, people couldn't equity',” says Erwin Russel, a partner in the Sao Paulo office of Advent International, a major investor in Brazil. “Now entrepreneurs give value to the fact that we can prepare them for an IPO. To tell you the truth, if we were not involved, many of them probably wouldn't go public.”
As of August 2006, the Bovespa had only 387 companies in total. This is in a country with thousands upon thousands of medium-sized, mostly family-owned businesses, many of which are beginning to feel the pressure of generational change issues as well as global competition. “There are more companies than you would guess where you can put $100 million to work,” says a GP currently pursuing several deals of this magnitude.
Of course, there remain many obstacles to private equity penetration of the vast Brazilian market. Setting aside a still widespread misunderstanding about what exactly private equity firms do, private equity firms sometimes encounter competition on the deal fron that is unique to the country. First is the BNDES itself, which sometimes invests directly in private companies but more often will offer a low-interest rate loan to a business in need of financing.
The second form of competition is a unique feature of the Brazilian tax regime that government officials and GPs alike find annoying – tax amnesties. It is common practice in Brazil for companies in need of capital to simply stop paying taxes, with a confidence that the government will not impose any penalties under an amnesty deal. One Sao Paulo GP noted that he has evaluated three potential portfolio companies this year owed more than one year in back taxes. “One thing they're all sure of is that the government won't pull the trigger,” he says.
Darby's Fonseca says he doesn't view tax amnesties as competition, per se, but as something to structure deals around. Darby may accept that a company use a tax holiday to clean up liabilities, but will demand that a potential portfolio company end the practice of accumulating further tax liabilities on the expectation of further tax holidays.
LOCAL LPS NOT LOVED
Brazil is home to a collection of enormous, state-run pension funds. The good news for local GPs is that they recently gained the ability to allocate to local alternative asset funds. The bad news is that they can be hard to deal with, say many Brazilian GPs. With a hopeful eye on the rapid expansion of private pension plans in Brazil, the current situation has nevertheless left Brazilian GPs very eager to tap foreign LP capital.
Gonçalves estimates that Brazil's entire pension system oversees roughly $120 billion in assets, spread across 365 systems. Only about 20 of these have invested in alternative assets, and today only five are actively investing.
Among the biggest pensions are Previ, the employee pension fund of the Banco do Brasil, Fucef, affiliated with Caixa Econmica Federal, and Petros, tied to oil giant Petrobras. Because of previously hard experiences investing in private equity (see “Squandered opportunity”), officials at Brazilian pensions now demand many invasive controls, including investment approval and veto rights, in exchange for capital commitments, a condition that few Brazilian GPs are willing to grant.
“Fundraising with local pensions is a challenge,” Says a GP who says he routinely bumps into fellow local GPs in the reception areas of the major plans. “They have been hurt in the past, but it's got to the point where I have to say, “Look, you're hiring me to be a manager”,”
GP Investimentos, for one, has sourced its capital commitments entirely overseas. Advent alos manages no Brazilian LP money. Advent's Russel says local pensions that demand investment controls are “seeking the wrong remedy” to investment risk. He notes that it is unfortunate that Brazilian pensions are getting cut off from participating in homegrown private equity success. “It's a missed opportunity for both parties,” says Russel.
Several GPs expressed concern that the major Brazilian pension funds may end up suffering from adverse selection criteria – in other words, backing first-time and under-qualified managers, the only managers willing to consent to LP controls.
Others take a longer-term view, and point out that it is only natural that a group of institutions less familiar with private equity will require time to come in step with international standards. “The situation will evolve,” says Gonçalves of private equity's sometimes testy relation with local public pensions.
“The situation is currently a concern, but not an impediment” to pension involvement in the growth of private equity in Brazil.
Private equity GPs in Brazil would love to tap the vast pools of capital controlled by Brazil's public pension funds, but not with the kinds of controls these investors demand. A particularly bitter experience with a Citigroup-affiliated private equity fund has convinced a handful of powerful Brazilian pensions that private equity GPs need to be kept on a short leash.
The offending vehicle in question is CVC/Opportunity Fund, formed in 1997 between Citicorp Venture Captial and Opportunity Asset Management, a Brazilian private equity firm run by Daniel Dantas. The fund raised $728 million and included commitments from Previ, Funcef and Petros, three major government pensions,
The fund was the largest private equity vehicle ever raised for Brazil, but what followed has left a bad impression among its LPs. Under Dantas' leadership, Opportunity invested in a string of high-profile telecom deals in Brazil. The firm also became embroiled in a string of conflicts with Citigroup, Opportunity employees, limited partners and coinvestment partners.
One disgruntled former Opportunity investment professional almost succeeded at having Opportunity liquidated in a Cayman Islands court. The pension funds, who claimed to be displeased Opportunity's management of the fund, sued the firm for greater control over operation of the portfolio companies.
But the headline-grabbing dispute in Brazil has been between Opportunity and Telecom Italia, which coinvested alongside the pension funds and Opportunity in newly formed Brasil Telecom, part of the privatisation of the Telebras state telephone monopoly.
Opportunity and Telecom Italia became locked in a complex battle over control of the telecom company. At one point, federal police stormed several Brazilian offices of Kroll, which Dantas had hired to investigate Telecom Italia executives. In the midst of this, Citigroup, claiming mismanagement, fired Dantas as manager of the fund.
In nationally televised testimony last year, Dantas claimed in court that his pension fund partners had exerted “politically inspired interference” in his management of Brasil Telecom. In April, Dante won a new ruling that re-established his firm's right to manage the telecom company. Legal proceedings remain ongoing.
According to several Brazilian private equity sources, the major overlooked aspect of the Opportunity affair are the fund's returns, which are “extremely good”, according to a source. But even this stellar IRR is unlikely to make the fund's pension LPs forgive and forget.