The Future of Brazilian Markets: A Private Equity Perspective

This year Brazil has outperformed the United States, both in financial markets and on the soccer field with a victory in the final of the Confederations Cup.

To understand the future of Brazil’s soccer team, you have to look beyond the big names currently playing and study the roster of the under-20 team, where up-and-comers with great potential exhibit their skills.

Likewise, to see where Brazilian markets are going, investors should evaluate the country’s private equity and venture capital markets which will produce the market leaders and IPOs of the future. This is especially true in Brazil, where only 500 of the country’s 12 million companies are publicly traded, leaving a large pool of potential stars in the antechamber to public markets.

Brazilian financial markets have been in the spotlight this year and the enthusiasm is equally strong in the country’s private equity and venture capital markets. The Emerging Markets Private Equity Association (EMPEA) conducts an annual survey on the plans and opinions of Limited Partners regarding emerging markets.

In the 2009 survey, Brazil was only surpassed by China in attractiveness for investment over the next 12 months.

This represents a move up of two positions from the 2008 survey, where Brazil was in fourth position behind China, India and Eastern/Central Europe. The survey also indicates that Brazil will see the largest increase in net investors over the next 1 to 2 years. Seventeen percent of current investors in emerging markets private equity plan to increase their stake in Brazil and another 11% plan to enter the market for the first time.

This positive momentum has occurred as the global economy is suffering one of the greatest crises of the past half-century. Brazil has been able to weather this economic storm thanks to prudently capitalized banks, large foreign currency reserves, low dependence on exports and a growing internal market.

Luiz Eugenio Figueiredo, President of ABVCAP (the Brazilian Private Equity and Venture Capital Association) and a Partner at Rio Bravo Investimentos, notes that the crisis has had less of an impact on private equity in Brazil because of the reduced role of leverage in the Brazilian market. He also adds that there remains a large base of institutional investors which still do not have significant participation in private equity.

On average, Brazilian pensions funds currently allocate 2% of their capital to private equity as opposed to the international average of 8 to 10%.

A beneficial side effect of the economic downturn has been a significant reduction in Brazil’s interest rates which have recently come down to a historic low of 9.25%. Of the R$1.2 trillion in Brazilian investment funds, 78% is invested in fixed income assets. The drop in interest rates should now motivate investors to look to alternative assets that can offer a higher rate of return.

The rise in appeal of Brazilian private equity can be attributed to two powerful forces which more than mitigate any negative effect the crisis might create. The first is an increasingly favorable regulatory and business environment and the second is a diversity and abundance of investment opportunities appropriate for private financing.

Álvaro Gonçalves, Managing Partner of the Stratus Group and former President of ABVCAP, explains that the increase in interest in Brazilian private equity is not a result of a sudden development but rather a consequence of an evolution over the last 10 to 15 years. Private equity in Brazil began in earnest in 1994 as hyperinflation was brought under control and the industry became regulated by the Comissão de Valores Mobiliários (Securities and Exchange Commission of Brazil) with the introduction of Instruction 209 (focused on Venture Capital) which was later followed by Instruction 391 (regulating Private Equity funds).

The initial years of this newly regulated industry would be fraught with difficulties as contagion from the 1997 Asian flu and wild currency fluctuations hampered growth. Inexperience and undue aggressiveness in privatization investments also resulted in additional setbacks. Only recently has macroeconomic stability coincided with regulation and professionalism to allow funds to realize their true potential.

A major step forward was the introduction at the beginning of the decade of a more rigorous public listing standard known as the Novo Mercado. Companies listed under the Novo Mercado must adhere to strict corporate governance practices, a higher level of transparency, minority shareholder safeguards and GAAP or IFRS accounting rules.

More recently, a similar listing standard for smaller companies called Bovespa Mais has been introduced. These initiatives have reinforced confidence in Brazilian public markets thereby invigorating the IPO market and creating a favorable exit strategy for private equity investments.

Another legal development is the legitimacy of arbitration as an effective form of dispute resolution in Brazil. Eduardo Buarque de Almeida, a Managing Director at the Brazilian private equity firm TMG, explains that his firm’s first fund only held majority interests in its investments. In its newer fund, TMG is more willing to enter a minority position since they trust that they can resolve potential disputes within three to six months, as opposed to being bogged down in the court system.

Enforcement of financial regulations has also been more prevalent as three corporate executives have recently been accused of insider trading. Yet, it is not just the threat of sanctions that are resulting in the acceptance of tougher regulations. The success of companies listed on the Novo Mercado is proving that strict standards result in higher valuations. Simon Olson, a partner at the Brazilian venture capital firm DFJ FIR Capital, explains that a “culture war” is at hand between the old way of doing business, based on cronyism and opacity, and the contemporary standards driven by the rule of law. The high correlation between increasing returns and strict corporate governance is putting into question the antiquated way of doing business.

Of all the BRIC nations, Brazil’s market is now likely the most transparent and regulated, which places the country in a privileged position among private equity in emerging markets.

An attractive legal and business environment is of little value without investment opportunities.

Many investors erroneously tend to view Brazil as a one-dimensional economy based on commodities. In fact, commodities represent less than 30% of GDP and there are many other areas where the country excels. Because of the diversity of industries and the size of the consumer class, many investment possibilities are appropriate for private equity and venture capital funds.

Traditionally early-stage financing is attracted to innovation sectors, such as technology and biotech, which offer significant returns. However, Olson notes that large emerging markets such as Brazil also offer potential in “low tech” sectors where a high degree of fragmentation can lead to growth through consolidation.

As an example, he offers the Brazilian auto leasing industry which is composed of over 1,000 companies, the largest of which holds only a 12% market share. Typically, these auto leasing companies purchase a number of vehicles from the manufacturer at a discount, lease them for a period to customers, and then sell them for an amount greater than the initial purchase price. Since this model benefits tremendously from economies of scale, consolidation can offer impressive returns.

Almeida also sees consolidation as a success story in Brazil. The first fund of TMG sought to benefit from fragmentation in the area of dental care insurance. Initially, there were over 700 small dental care providers, none holding more than 3% of the market. TMG acquired a company with 2% market share that they believed had the best management team. Through organic growth and acquisitions, the company obtained 30% of the market and completed a successful IPO on the Novo Mercado.

This model can be replicated in countless Brazilian industries including the enormous food and beverage industry. Although big players such as Unilever, Procter and Gamble and Sadia are already dominant in the Brazilian market, there remain over 2000 family owned companies with over $100 million in revenue.

Brazil also offers a number of investment opportunities in growth sectors that are based on innovation. The country has established a solid reputation as a leader in renewable energy with the most successful biofuel program in the world and huge potential in hydropower and thermal energy. This has garnered attention from global investors including renowned venture capitalist Vinod Khosla.

Less well publicized, but also very advantageous, is Brazil’s position as a technology player. Brazilians have a reputation as early adopters, which explains why the country has among the highest average internet-use time and one of the largest markets for cellular phones.

Brazil also has a remarkably efficient electronic voting system, with 98% of the population voting this way, and the high percentage of internet tax filings (annual federal tax applications also have a close to 100% adoption of the internet as the preferred mean by more than 40 million applicants). Private financing have deep resources to identify similar technological developments through a base of over 400 incubators throughout the country.

In an economy as large as Brazil’s, the list of potential investments is endless. For instance, real estate is also attractive as the government has initiated aggressive funding programs in this area. Figueiredo notes that in the near-term the sectors with the most potential include sectors that are minimally impacted by the crisis (such as food and beverage), sectors that are not capital intensive (services) and sectors that are traditionally attractive to private equity such as technology and infrastructure.

There is ample evidence that Brazilian private equity offers promise, particularly at a time when many other countries are more seriously afflicted by the economic crisis. The difficult question is deciding how to participate in this market and choosing among the numerous investment options.

Currently, over 80% of the available private equity capital is directed toward a small group of 3000 companies with over 1000 employees and over $200 million in sales. Gonçalves notes that this may create the appearance that too much capital is chasing too few deals.

However, he proposes that a look further down the ladder reveals that less than 15% of private equity capital is targeting middle-market companies with 250 to 1000 employees and $20 million to $200 million in sales.

This imbalance is even greater with respect to capital targeting smaller companies, indicating that the landscape for private equity and especially venture capital is ripe to flourish. Brazilian private equity may well encounter more challenges ahead but it is clear that the training wheels are off and the industry has sufficient maturity and depth to be relevant on a global scale.

Disclosure: BBD, CZZ, GFA

Comments

[Gravity404:]

This is a great comprehensive look at Brazil and reinforces my strong belief in this investment opportunity. Thanks for the article.

Unfortunately, ETFs are still the best way to take advantage of this market. Since EWZ is primarily PBR and VALE, US investors should already have these in their portfolios, but I really like BRF to invest in the macro economic growth potential of Brazil. The management fees are high, but worth it.

My only concern is the interest rates. I understand they are histrocially low, but 9.25%...?

Jul 06 09:18 AM

[Danny Furman:]

EWZ is a better trading vehicle than investment, as the author explained by telling the story in Brazil beyond commodities. Many of Brazil's ADRs trade here at a discount to their Bovespa price and pay tremendous dividends. Brazil's telecoms (TNE, BTM, BRP...) and utilities (SBS, CPL...) are fundamentally the safest and best priced stocks on any market today.

Jul 06 10:41 AM

[jayminho:]

my bets for brazil are;

ITUB, BBD, and STD
the first two, are two major brazilian banks.
credit is abundant, and bankings are lending for real state (yes, we are creating our own real state bubble, which, will eventually, burst. but for now, take advantages of it.)

then you STD (santander) a spanish bank, largest european bank, who offset all his losses in europe by.. (yep, exactly!) the investments in brazil real state. they are huge, acquired some minor banks, and are also in this new and being formed, brazilian real state bubble trend.
by the way: STD is also a dividend play; quartly paying about .10 to .20+ cents a share regularly, and trading at 11.xx its more than an opportunity.

with that said;

I now introduce SID
it is an infratructure play
SID, is responsible for a lot of the steel used in everything from citzen living buldings, to bridges, to roads, basically, everything they are in. governamental and non-governamental.
rumors, say they got picked to provide all the steel to the PAC project (PAC stands for PROGRAMA ACELERACAO CRESCIMENTO - sort of; SPEED GROWING PROGRAM) a type of stimus package, for infrastructure.

I believe brazil is living, what US lived during the 50s to 70s (in a minor scale of course, but still, its what we are living here) when US were building roads, paving streets, lending money to citzens purchase their first home, and so on.. way before, it transfered all it manufacture structure to eastern countries..
thats what brazil is living now.
it will be kind of a deja vu, as we all know, sooner or later, just like in US, all this things will end here, so, it will be time to short everything, and the country will have to reinvent itself, but by now.. ITUB, BBD and STD are the banks to go, and SID is the infrastructure/commodity to play.

good luck.

Jul 06 10:43 AM

[EUARTE:]

Another factor in Brasil is inflation. The government has lowered interest rates saying that inflation is low. Visit any supermarket and view the weekly rise in prices. There is higher inflation that the government is not catching or is ignoring.

The continued depression in the US and EU will effect Brasil over the long run. Brasil is counting on exports. China is decreasing it's pruchases and obviously so has US and EU.

The strength of the R$ against the U$ hurts the exporters. Brasil will have to weaken it's currency. This can be accomplished by lower the official interest rates even more. They have to do something about the carry trade. A tax on flows of carry trade money in and out would help.

Brasil always has to be watched carefully. It has made enormous positve moves over the last 15 years. However, there is still a 3rd world mentality there. Corruption at all levels is a way of life. You can not do business with the government or even the private sector without bribes. I do not mean small bribes.

After Lula what will happen. With all is left wing talk he allowed the capitalist system to work it's way to prosperity. Lula will soon leave office. There is no one out there with his vision and common sense. If one of the old type hacks gets in the game is over.

Jul 06 11:06 AM

[Gravity404:]

Jay, thanks for the heads up SID. At first glance I really like it, especially down over 5% today; good time to jump in maybe. Need to do some more DD. I am concerned about their debt, but they have good rev, cash flow and cash on hand.

Their business seems to be a lot more than just steel prod. Like VALE, which I have held for years, seems their getting into everything.

I guess their wetting the right beaks...

Jul 06 11:57 AM

[Stone Fox C...:]

GFA and MELI are the best plays.

Jul 10 04:41 PM