Private Equity in Brazil: Entering a New EraPublished: January 26, 2011 in Knowledge@Wharton
The relatively youthful Brazilian private equity (PE) industry has undergone an unprecedented expansion since 2004 as investors have donned their samba shoes and tested the rhythm of fund managers focused on this emerging world power. Over the past six years, the amount of capital committed to PE in the region has grown nearly sixfold -- reaching approximately US$28 billion today. The retail, IT, and industrial sectors have received the greatest share of interest. So what has drawn all this investor attention to Brazil?
Encouraging macroeconomic policy, favorable market conditions, and effective regulatory changes have combined to entice investors to PE opportunities in Brazil. Recent developments -- such as an upgrade of the government debt to investment grade, massive oil discoveries, and plans to host both the World Cup in 2014 and the Olympics in 2016 -- have added to the hype for a region that was already on the rise. These encouraging events have allowed Brazil to stand out on its own merits. But they are especially compelling when juxtaposed with a relatively discouraging set of realities in other parts of the world. As José Augusto Carvalho, director of Axxon Group, notes, "investors are recalibrating what they define as 'risky' and realizing that Brazil is no longer as far apart as people once thought it was."
Important challenges remain, of course, such as the fact that Brazil's real interest rates continue to be among the highest in the world, the Brazilian judiciary system is relatively inefficient, and PE investors in the region generally lack experience. The PE industry may still have several stages of growing pains to overcome before it can reach a new era of stability in which investors and managers can truly master the rhythm of the samba. Overall, however, a tremendous opportunity exists for PE firms to both benefit from and contribute to the seemingly imminent expansion of the Brazilian economy in the years to come.
The last 30 years of Brazilian history can be broken down into two distinct periods to help highlight the radical changes the country has undergone and to explain the country's emergence as a highly attractive investment opportunity in the minds of investors. During the first period, 1980-1994, Brazil had 15 finance ministers, five presidents, and six currencies. This period was marked by low GDP growth (2.1% per annum), high interest rates (45% in 1994), and currency depreciation that led to extraordinary inflation (as high as 5,000% in 1993).
In stark contrast, from 1995 to the present, Brazil has had three finance ministers, two presidents, and one currency, the real. This period of impressive stability began with a sound economic policy that targeted inflation through the implementation of the plano real, developed by then-Finance Minister Fernando Henrique Cardoso. The success of this currency stabilization, combined with lower net debt levels and a rise in foreign currency reserves (up from US$49 billion in 2003 to US$239 billion at the end of 2009), led to a significant decrease in real interest rates (from 45% in 1994 to a low of 8.75% in 2009) and a general period of macroeconomic stability that have been the basis for Brazil's sustained growth over the past decade.
Consumer-led Growth: A New Middle Class
Brazil has long been one of the most inequitable countries in the world in terms of income and wealth distribution. The last decade, however, has seen considerable advancement of lower-class Brazilians into the middle class. Specifically, Brazil's Class C -- defined as Brazilians earning monthly wages between US$581 and US$2,508 -- has grown from 42% of the population in 2004 to 52% in 2008, now representing more than 100 million people. While social programs, such as Bolsa Familia, have received much publicity, the major contributors to Class C's growth have been the increase in real wages for workers and the extension of credit to consumers.
One of Brazil's leading economists notes that for each 1% increase in Brazil's GDP, the per capita income of Class C constituents on average increased by about 7% in recent years. Meanwhile, bank credit, which was virtually non-existent in times of macroeconomic instability, has expanded dramatically. In 2003, credit represented about 24% of Brazil's GDP; by June 2010, it had reached 46%. This credit, moreover, was extended to a record 48% of Class C in 2009.
The combination of increased real wages and the expansion of credit has fueled a new class of consumers looking to buy homes, cars, and other desirable consumer goods. The success of Positivo Informatica, Brazil's largest personal computer (PC) manufacturer, illustrates this phenomenon. From 2005 to 2009, the company's top-line compounded annual growth rate exceeded 108% as PC penetration among Class C consumers doubled from 16% to 32%.
The recent success and future potential of Positivo Informatica highlight the fantastic types of opportunities available to PE funds resulting from Brazil's consumer-demand-led growth. It is noteworthy that only 500 of the country's 12 million companies are publicly traded. The remaining private institutions represent a considerably large pool of potential star investments for PE funds and, ultimately, the public markets.
Key Regulatory Modifications
Several major changes in legislation have increased the country's attractiveness for both local and foreign PE investors. One of the most important improvements for PE investment in Brazil occurred in 2003, when the government passed several laws to legally adopt the registration of PE funds, to regulate such establishments, and to address their formal obligations in a method similar to that of the Limited Partner (LP) structure of funds in the U.S. and Europe. In the past, the funds had no clear legal framework on which to base their activity beyond acting as an offshore investor. This changed in 2003 with the introduction of FIPs (Fundos de Investimentos em Participações), investment vehicles that benefit from tax exemptions on capital gains, as found in other developed PE markets.
The Brazilian government has also approved several reforms in the last five years related to the regulation of majority and minority shareholder rights. These reforms have enhanced the rights (e.g., pre-emptive rights, tag-along rights) of minority shareholders and provided additional clarity and security for investors. As a result, there has been an increase in the number of minority investments in Brazil. Gávea, one of the most successful local PE funds in Brazil (it was recently acquired by JP Morgan), has benefitted from these reforms to execute a winning strategy based on minority positions. A recent example of such activity is the fund's investment in Odebrecht, a leading engineering and construction conglomerate, which opened the capital structure of its subsidiaries to attract investments into its businesses in the high-capital-demand industries of oil and gas and infrastructure.
New capital market regulations have also played a significant role in increasing liquidity opportunities for PE investments. In particular, these rigorous regulations were implemented through the creation of the Novo Mercado and the Mercado Mais, two stock markets (similar to the NASDAQ or the AIM) in which listed companies must adhere to stringent transparency and corporate governance rules as well as strict accounting standards. Investors have generally attributed greater valuations to companies listed on these exchanges due to their higher level of confidence in the quality and transparency of the information shared. The presence of better-regulated capital markets led to a widening of the IPO window as a viable exit option for investors.
Between 2004 and 2008, an unprecedented 113 companies went public on the Bovespa, representing nearly one-third of the 363 companies listed as of September 30, 2010. One of the most successful IPOs of this era was Equatorial Energia, which returned 32 times the capital invested to its investors, GP Investimentos and Banco Pactual. Since 2009, however, the market for IPOs has cooled, with only 27 companies going public. Despite the recent slowdown, PE investors remain optimistic about this exit strategy.
Another notable regulatory adjustment was the government's easing of restrictions on Brazilian pension funds. The government increased pension funds' limits on non-fixed income investments from 50% to 70%. With more than US$265 billion in aggregate pension-fund assets, this adjustment theoretically freed up US$53 billion in capital that can now be invested in PE. Similar to what occurred during the 1980s in the U.S., allowing pension funds to be invested more freely in alternative assets is boosting the capital allocated by these institutions toward PE investments. However, the fact remains that PE allocation by pension funds in Brazil is still well below the average of other developed markets (2% vs. 10%), suggesting there is still ample capital available to continue fueling the sector's growth.
Despite these favorable adjustments to its legal framework, Brazil faces two significant legal challenges. The first is to simplify the nation's extremely bureaucratic legal and tax systems, which inevitably lead to high transaction costs for PE investors. According to data from Veirano Advogados, a law firm, an average-size corporation in Brazil spends 6,000 labor hours per year to comply with all its legal obligations and tax payments (vs. approximately 200 hours per year in the U.S.). Second, Brazil must act to accelerate processes in its judiciary system. Legal experts indicate that, on average, competition lawsuits and patent conflicts typically remain unresolved for four to seven years.
The Evolution of Investor Appetite
The period of the late 1990s was the first real "trial run" for PE in Brazil. Unfortunately, this period of growth ground to halt around the turn of the century due to both substantial depreciation of the real and several instances of fraud or mismanagement (the most notable being Daniel Dantas' Opportunity Fund) that resulted in sub-par returns and caused investors to hesitate to commit to PE strategies in the region. The instances of fraud led many investors to view the PE industry in Brazil "skeptically at first -- almost as a dirty business," according to one fund manager. In recent years, greater transparency and standardization have allowed the sector to regain credibility with investors while currency exchange levels have remained relatively stable.
Investor sentiment has grown increasingly positive toward Brazilian PE since 2003, and this tendency continued, if not accelerated, through the financial crisis of 2008 and 2009. Kevin Johnson, of Liberty Global, an emerging-markets-focused placement agency, comments on this dramatic shift in investor appetite: "In 2003, limited partners ... were almost universally negative about investing in PE in Brazil; now, more and more people are enthusiastic about the macro situation." Indeed, the most recent LP survey, conducted by the Emerging Markets Private Equity Association, found that 17% of LPs with existing investments in Brazil planned to increase their allocations, while 11% planned to enter the country for the first time in 2010.
While the macro picture may be rosy, Todd Basnight, who specialized in emerging markets PE for Cambridge Associates, an investment consulting firm, notes that "investors need to first focus on the managers; bad managers in a great environment will still underperform."
Investors agreed at a recent roundtable in San Francisco on PE in Latin America that the main concern with investing in managers in Brazil is their limited experience. Few firms have realized returns to speak of, and historically returns have been sporadic. For these reasons, LPs investing in Brazil not only face the risk of sub-par returns, they also face, as one investment advisor describes it, the even more disparaging possibility of personal "reputation damage" when they back GPs that are relatively unknown and unproven. Only time and proven performance will give investors additional comfort to allocate more capital to the most talented managers in the region. For now, as Johnson notes, investors are analyzing GPs and are forced to wonder, "How deep of a bench do they have?"
Large international PE firms -- such as Carlyle, Warburg Pincus, Apax, Blackstone, and TPG -- having recognized the growing investor interest in the region, recently began ramping up their efforts in Brazil. These groups can offer investors a more proven alternative to local shops and the comfort of the franchise value their brands bring to bear. It is too soon to tell how international PE firms will fare in Brazil in comparison with Brazilian-born shops, but LPs agree that having a local team on the ground in Brazil is key to a successful outcome. International GPs are taking different approaches to getting on the ground. Some firms, such as Apax and Carlyle, are setting up greenfield offices while others, such as Blackstone and JP Morgan, have bought stakes in existing Brazilian players to establish a presence.
Not only is investor demand driving international GP interest, but some international funds believe they bring unique expertise that will allow them to succeed in the region. As Jason Wright, an executive from Apax Partners who led the firm's first investment in Brazil, notes, "large buy-out deals in Brazil are meant to be done by international funds because they have more resources available and a broader network of experts to analyze transactions." Apax Partners recently entered the region with a splash by purchasing TIVIT, a business-process outsourcing company, at a US$1 billion dollar valuation, making the deal the largest PE transaction in Brazil to date. So far, however, international funds have only a handful of executed deals to their names. Octavio Lopes, a Partner of GP Investimentos, with more than 15 years of experience in the sector, agrees that these international heavyweights may be the frontrunners to execute future "mega deals" (US$1 billion plus). But he adds a caveat: "They will probably win the deals at higher prices."
The rapid expansion of the PE sector itself has also sparked some concerns for investors. Several established PE groups in the region are now on their third or fourth consecutively larger fundraising, while international buyout funds are becoming increasingly active. Industry observers wonder if the large funds being assembled today can source and execute on deals of significantly larger size and also whether these larger funds will be required to shift their focus beyond what most specialists agree is the most attractive segment in which to invest: the middle market.
Another concern for investors is a general lack of specialization. This allows funds to throw money at the latest trends, perhaps in sectors that are overheated. According to one PE professional, "in 2006, everyone wanted to invest in ethanol; the result was that several deals were done that ended poorly." With growth, PE firms will need to implement size and sector discipline to satisfy investors.
A Question of Leverage
Although lower interest rates have increased investor confidence in Brazil's macroeconomic stability, they have not fundamentally changed the way deals are structured. That is, most deals continue to be financed entirely with equity, and those that are not tend to have relatively low debt-to-equity ratios.
In the U.S. and Europe, PE deals tend to be highly leveraged in the pursuit of attaining target returns of 20% for investors. In Brazil, many investors believe they can obtain rates of return of 25% (or higher) without any debt financing. Prior to 2005, prohibitively expensive interest rates took debt out of the equation. Presently, PE funds report borrowing rates of around 13%-15%, which continue to be very high, but well below the typical 25% rate of return. A key issue for PE firms, however, is accessing long-term credit.
Bank lending to companies in Brazil has increased, as have tenors. Certainly, more PE deals have been financed with some debt in recent years than in the previous PE wave of the 1990s, and some investors claim to be able to access tenors of up to seven years. However, most Brazilian banks tend to lend for two years at most (less than the typical three-to-five-year PE investment cycle).
In Brazil, BNDES, Brazil's national development bank, funds 65% of the nation's capital expenditures at subsidized rates. As Bernardo Gradin, CEO of Braskem, Latin America's leading petrochemical company, notes, BNDES is a "necessary evil," as it offers companies the long-term capital that private institutions will not because it is much more profitable for them to lend at high rates over the short term. To understand BNDES' significance in Brazil, consider that its budget currently accounts for 9% of the country's GDP.
According to Lopes, PE deals in Brazil are financed, on average, with 0% debt; when they do have leverage, it is limited to 2-2.5 times EBITDA. This compares starkly with multiples of 4-7 times EBITDA, seen in the heydays of the U.S. and European LBO markets.
In the boom years of 2006 and 2007, Brazil did see some significant leveraged buyouts. Two remarkable deals were performed by GP Investimentos, the largest PE fund in Brazil and Latin America. The first was the acquisition of Magnesita, today the world's largest player in the refractory industry, which was financed, according to industry sources, with 40% debt and 60% equity. Industry observers note that Banco Real lent US$500 million as a 1.5-year bridge loan and then Unibanco took on the loan for about five years.
The second notable deal was the purchase of San Antonio, a drilling company, that was perhaps the most leveraged transaction Brazil has ever seen. According to a company insider, the deal was financed with approximately 60% debt and 40% equity. Many industry experts doubt that such leverage ratios will be seen again anytime soon. Since the credit crisis, several highly leveraged deals have required restructuring, and both investors and banks have become more cautious when considering leverage levels.
It is interesting to note that, although equity markets have deepened significantly in Brazil over the past few years, local debt-capital markets (in the form of debentures) remain a capital-raising alternative only for large, well-known companies such as Vale and Petrobras. A former Carlyle executive believes that when Brazilian debt-capital markets take off, there will be a new boom for PE in Brazil, as more access to long-term financing will likely bolster returns on investment.
The Opportunity Ahead
The combination of sound macroeconomic policies for the past 15 years, the emergence of a new middle class, key regulatory and legal improvements, and a deepening of capital markets has enabled Brazil to stand out on an absolute and relative basis on the world stage and to gain investors' confidence. The outlook for PE investments in Brazil at this moment is positive, despite concerns about high real interest rates, legal inefficiencies, and a natural experiential learning curve that the industry must climb. According to Lopes, there are still many opportunities for PE funds to invest in companies and improve management, operations, and processes.
It is important to recognize that much of Brazil's historic and present progress has been made possible by the stability achieved within national politics and by subsequent policy decisions. With Dilma Rousseff as president, the general consensus of fund managers in Brazil is that a stable political environment and steady macroeconomic policy will continue.
There is a clear opportunity both for Brazil and for investors to take advantage of the momentum at hand. Brazil requires investment in almost every sector -- in particular, oil and gas, education and infrastructure -- to modernize the economy and to continue fueling sustainable growth. After relying for years on highly leveraged acquisitions concentrated in ultra-competitive, low-growth markets, investors are eager for opportunities with attractive growth perspectives, such as those that Brazil stands to offer.
Large players have understood this and have already established or are about to establish permanent offices. A new wave of actors and deals is expected in the coming years that will mature and consolidate the PE industry in Brazil and remain, even after Carnaval is over. Moreover, many expect that once debt-capital markets deepen and real interest rates fall further, there will be a greater opportunity for increased returns through leverage that will lead to a new wave of industry growth. For now, however, PE managers will need to make good on the mountain of capital at hand. An estimated US$9 billion in uninvested PE capital awaits deployment -- certainly too much to spend just on caipirinhas. Many deals and subsequent successes in the near future will most likely set the pace and rhythm of an established and influential sector of the Brazilian economy for years to come.
This article was written by Daniel de Souza, Porter Leslie, José Luis González Pastor and Carol Strulovic, members of the Lauder Class of 2012.