Attracting foreign private equity to Brazil
April 2011 | TALKINGPOINT | PRIVATE EQUITY
FW moderates a discussion which covers attracting foreign private equity to Brazil between Bruno Robert at Lilla, Huck, Otranto, Camargo Advogados, Simon Firth at Maples and Calder, and Sergio Galvis at Sullivan & Cromwell.
FW: Reflecting on the last 12 months, how would you describe deal activity involving foreign private equity funds in Brazil? Is the country ripe for inbound PE investment?
Firth: Over the past twelve months deal activity has been very active and incredibly diverse. There is no question that Brazil is ripe for inbound PE investment. Evidence for this can be found in the large number of deals being done, the diversity of sectors attracting investment, the high returns that are being offered by Brazilian PE funds and PE funds investing into Brazil, and the sustained growth of foreign private equity investment in Brazil.
Robert: In recent years foreign investment has steadily risen in Brazil, especially in the form of private equity investment. Accordingly, foreign private equity funds play an important role, being consistently involved in major deals. Such participation can be perceived both through direct activity – buyouts and direct investments – and through the establishment of partnerships with national funds. Brazil is, in general terms, prepared for more intense activity from PE investments. On the one hand, from an economic perspective, one can say that the economy is robust, that fiscal policies are sound, that companies are, in general, performing well, and the population is eager to consume. On the other hand, from a legal standpoint, financial and securities regulations are both updated and consistent. In addition, some foresee an intensification of PE investment due to future decreases in interest rates in Brazil. Accordingly, such event would stimulate resources currently allocated in fixed income investments to be directed to private equity funds. Nevertheless, numerous aspects may obstruct the intensification of PE investments. For instance, poor infrastructure negatively affects the expansion of business in Brazil, and therefore poses challenges for both investors and companies acting in the country.
FW: What are the key drivers of PE activity in Brazil? What types of companies do foreign buyout firms seem to be targeting?
Robert: Brazil is a large economy with a growing consumption appetite and a large expectation, in the short term, for global expansion. These factors, along with a general feeling of economic stabilisation and inflation monitoring, contribute to create an investment buzz around all sorts of activities able to extract larger profits from both the risen of the lower and middle classes, and the sudden international interest in the ‘Brazil’ brand. Infrastructure companies are a current must. Brazil needs roads, railways, airports, and energy. Not only because of the expected inflow of foreigners to Brazil, for business and tourism purposes, but also to accommodate an increase on internal tourism, number of vehicles, and goods transportation. Real estate, including housing, business offices and rural areas, is another sector attracting foreign buyouts firms, as well as the health and education sectors.
Firth: Key drivers to PE activity in Brazil include, first, the broad spectrum of sectors attracting investment, which includes investment in Brazilian investment managers and Brazilian private equity houses themselves. The interesting thing for Brazil and for those who are looking to invest in Brazil is that Brazil is experiencing growth across all sectors which presents many and diverse opportunities for investment. The second driver is the strong returns being offered by investments in Brazil vis-à-vis other global opportunities, together with higher growth potential. The third driver is a market which is far more receptive to PE investment and much more sophisticated in this regard than its neighbours. Fourth, investments in Brazil pose much less political risk than other 'emerging market' opportunities. The final driver is the strong growth in the Brazilian consumer market which is presenting opportunities for retail finance and consumer finance which historically has not been a viable option for the Brazilian population.
Galvis: We understand that there are two main drivers of private equity activity in Brazil. One comes from investment opportunities in medium-sized companies providing consumer products and services. Such companies usually derive a significant portion of their revenues from the middle class, which has been growing steadily in Brazil and has benefitted from increases in both real income and credit availability. The other driver comes from sectors in which Brazil is a rising power: natural resources, energy generation – both clean, renewable sources and more traditional oil & gas – and infrastructure.
FW: To what extent is industry fragmentation creating opportunities for foreign PE firms?
Galvis: Industry fragmentation brings opportunities for foreign firms, but also for local firms. In fact, a fragmented market composed of smaller companies with less sophisticated management and consolidation potential tends to favour firms with local knowledge and ties, which are better positioned to identify and take advantage of such opportunities ahead of their competitors. Foreign firms seem to be aware of that and willing to adapt their business model to the local reality. It is not surprising that two of the largest players in the industry have decided to come to Brazil in association or through acquisition of local firms (Blackstone and Highbridge, respectively), which have an established presence in the market and knowledge of its specificities. Foreign firms are seeking to tap into such local expertise to have access to more attractive opportunities.
Firth: There is no question that there is growing industry fragmentation and that this is creating more and more opportunities. In the past twelve months we have structured PE funds investing in Brazil with investment objectives covering infrastructure, real estate, power, retail outlets, clothing manufacture, health care and agricultural commodities including sugar, coffee, beef, soya and corn and industrial commodities including steel, iron ore, gas, oil, bio diesel and clean energy generation. In addition, we have advised on PE funds that have acquired interests in a number of Brazilian based fund managers. That said, there is still room for further fragmentation, as sectors are not as narrowly defined as they are in other markets. As a result, some funds we have seen have had very divergent investment strategies while others have very broad investment objectives across a sector, for example investment in retailing opportunities or in travel.
Robert: Industry fragmentation crates opportunities related to consolidation for both national and foreign PE firms. That is to say, in fragmented industries companies and PE funds can benefit from attractive opportunities since there is considerable space for deals involving mergers and acquisitions. Such opportunities are strengthened due to the existence of high interest rates and difficulties in the access of credit and capital. Thus, PE funds find in Brazil an interesting scenario for stimulating and providing capital for consolidation processes. Nonetheless, it is worth mentioning that PE investment is dispersed throughout the Brazilian economy, not being concentrated in fragmented industries. Good examples of sectors that are currently attracting more intensive investments are: information technology; real estate; infrastructure; energy; pharmaceuticals; and services for low-income classes.
FW: How would you characterise current investment opportunities in infrastructure projects?
Robert: Brazil still needs huge investment when it comes to infrastructure. For the economy to expand to its full potential there must be significant investments in the expansion of highways, railways, waterways, and airports. In addition, the energy supply system must expand in order to support economic activity. Both transportation of persons and goods, and energy are critical bottlenecks for Brazil’s development. Hosting the upcoming 2014 World Cup and 2016 Summer Olympics makes the already overdue infrastructure improvement urgent. This scenario makes Brazil an excellent choice and a fertile field for opportunities of investing in infrastructure. As for the drawbacks, a large and yet not well connected territory, the extreme concentration of industrial activity on the southeast region of the country, and inconceivable levels of red tape intricacy, seriously increase costs and reduce margins of investments in infrastructure projects.
Galvis: Infrastructure investment in Brazil is getting a huge push from the 2014 World Cup and the 2016 Olympic Games. However, any long-term observer of the Brazilian economy knows that the infrastructure sector will also be generating opportunities in coming years that are not directly linked to major international sporting events. Brazil has significant needs in the transportation sector, as well as in energy generation, especially since the projected growth of the economy in the next decades will put pressure on the current infrastructure network. The Brazilian government is aware of this, and is willing to take measures to make the infrastructure sector more open to private capital. The enactment of Provisional Measure No. 517 in December 2010, which made infrastructure investment funds more attractive to private capital, is a recent and telling example.
Firth: With required investment in identified infrastructure projects in Brazil currently estimated at US$300bn over the next three years, there is no question that there are significant opportunities for investment in Brazilian infrastructure projects. While many are focused on the headline catching opportunities presented by the 2016 Olympics and the 2018 World Cup, this pales into insignificance when you consider all the other areas where infrastructure development is sorely needed. Brazil is beginning to be constrained by the limitations of its infrastructure which is resulting in higher costs associated with delivering products to market and, as a result, restricting Brazil's ability to develop and grow. In this regard, Brazilian investment in infrastructure trails significantly behind its BRIC contemporaries. Even within the Latin American region, Brazil has fallen behind both Mexico and Peru with respect to infrastructure development, the latter of which has structured some very innovative toll road and water projects over the past couple of years.
FW: Is there a noticeable level of activity in venture capital and growth markets?
Robert: The level of activity in venture capital and growth markets is consistently increasing in Brazil. Nevertheless, poor access to capital still affects small and medium-sized companies. Hence, there is plenty of room for further growth in these markets. Recent studies show that the level of investment in start-up companies increases at a rate of 35 percent per year in Brazil. Additionally, such investments account for 41 percent of the risk equity investments in the country. Further expansion in the venture capital markets is, to a certain extent, hampered by inefficient bureaucratic arrangements. Good examples are administrative procedures in both the Brazilian Industrial Property Office (INPI) and the National Health Surveillance Agency (ANVISA). Particularly, slow processing of registry applications within such bodies make investments in high-tech start-up companies less attractive in Brazil.
Firth: The biggest story is the growing presence of non-Brazilian managers in Brazil. Each of Blackstone; JPMorgan Chase Highbridge; Prudential; Evercore; Tarpon; Brevan Howard; York Capital; and KKR have either have recently acquired an interest in a Brazilian fund manager or set up a presence in Brazil. Other growth areas of note, other than infrastructure and Brazil's traditional export commodities, are retail finance, health, insurance and travel.
FW: Are there any specific government incentives and policies designed to attract foreign private equity into the country? What has been the impact of the reduction in Brazil’s Currency Exchange Tax and the new rules on investments in long-term securities?
Firth: An overheating economy, an overvalued Real and the ever present risk of inflation pose significant problems for the government. Recent attempts by government to control each of these has led to the implementation of capital controls and taxes on foreign investment. In this regard, government will continue to have to walk a tight rope between controlling the value of the Real and managing inflation while at the same time not taking action which will discourage foreign investment in the country. In addition, the imposition by the Brazilian tax revenue of onerous withholding taxes on the transfer of funds to certain jurisdictions continues to be an unnecessary obstacle to investment into and out of Brazil. The unfortunate reality of this policy is that investors' and fund managers' jurisdictions of choice for PE structures around the world are those that are most heavily affected by the withholding tax regime. This is one of the few examples where Brazil remains an emerging market as unlike the vast majority of its G20 contemporaries it still uses tax policy as a means to police money laundering and tax evasion.
Robert: ‘Decreto 7412’ and ‘MP 517’, both enacted at the end of 2010, are straightforward measures aimed at attracting productive capital to the country. ‘Decreto 7412’ brought innovations such as reducing – from 6 percent to 2 percent – the tax rate applicable to currency exchange transactions performed by foreigners for purposes of investing in Private Equity and Venture Capital Funds. ‘MP 517’ established rules which, for instance, may reduce to zero the withholding income tax rate applied to foreigners investing in bonds (debentures) issued by special purpose companies incorporated exclusively to develop certain infrastructure projects. Both norms have already provoked a clear reorientation of investment tendencies in Brazil, mainly regarding the infrastructure sector. Long term effects for the Country, however, still need to be proven, especially taking into consideration consequences to the control of the Brazilian currency appreciation and the speculative capital monitoring, both top priorities for the current Government.
Galvis: The Brazilian government is certainly aware of the importance of the foreign private equity industry as a source of capital for investment and has been acting accordingly. The reduction of the Currency Exchange Tax (locally known as IOF) levied on foreign exchange transactions executed in connection with investments in private equity and venture capital funds from 6 percent to 2 percent is an important step to make foreign private equity investment more attractive. Another recently implemented and important change with an already noticeable effect was allowing Brazilian pension funds more flexibility in their investment policies. This measure freed up an important pool of funds which is flowing to private equity investments in search of better returns. When it comes to government action, the private equity industry has reasons to be optimistic in Brazil.
FW: Would you say that Brazil’s legal and regulatory environment is suited to supporting private equity deal structures? Are there any pitfalls that investors need to consider?
Galvis: The legal and regulatory environment for private equity deals in Brazil has improved significantly over the past few years. There have been reforms in corporate law and capital market regulation. Brazilian companies, however, still grapple with a number of difficulties, including Brazil’s complicated tax system and its restrictive labour laws. These areas make it vital for the parties to involve experienced financial and legal advisors who can help them work through these issues.
Robert: In general terms, Brazil’s legal and regulatory environment is well suited to supporting private equity deal structures. In particular, it is worth mentioning that financial and securities laws and regulations are generally modern, clear and stable. On the other hand, such regulatory fields are often criticised for being excessively strict. Nevertheless, it is generally accepted that the referred regulatory arrangements have prevented major impacts to the national economy during the 2008 financial crisis. Notwithstanding this, Law enforcement may be considered a pitfall in the Brazilian legal environment. Accordingly, the Brazilian judiciary system is slow and, in several instances, has generated unpredictable decisions. Such unpredictability is, to a certain extent, related to the immaturity of the Brazilian private equity industry. Specifically, since there are no consolidated precedents referring most of issues involved in such sector, market participants are not able to anticipate how certain rules are to be interpreted and applied in concrete circumstances. Furthermore, foreign exchange regulation can be considered another pitfall, since it is unstable and often obscure. Finally, intellectual property rights protection is negatively affected due to inefficiencies in bureaucratic processes.
Firth: As one would expect from any emerging market, laws and regulation have not developed at the same pace as the market. As a result the legal and regulatory environment is not as adequately adjusted to the sophistication of the transactions that are currently being structured into and out of Brazil. With the exception of the CVM which has shown a willingness to relax certain constraints on funds, most notably through CVM 450 and 465 which now allow Brazilian funds (depending on the classification of the fund) to invest a certain portion of funds under management in overseas investments, generally the regulatory environment is more bureaucratic and cumbersome than most PE investors and investment managers are used to. The means by which investors can invest into Brazil can also be more complex than in traditional PE structures. The use of FIM's or FIP's which are commonly used for PE investment into Brazil have a number of restrictions and limitations which would not traditionally be seen in PE structures. This inevitably forces investors and managers to set up structures in other jurisdictions, most notably Cayman, which are used as feeders or conduits to the investment into Brazil. In addition, litigation can be a very slow and complex process in Brazil and, as a result of these factors, there remains certain jurisdictional risk. There is, therefore, a need to carefully consider the appropriate structure/vehicle when investing into Brazil.
FW: How do you expect Brazil’s PE market to shape up in 2011? What trends are already starting to emerge?
Robert: Consolidations and M&A activities through PE funds are already on the radar screen for 2011. Not far behind, it is foreseeable a sophistication and diversification on the PE industry in Brazil, pushing towards the expansion of funds with strategic minority stakes, activists funds, as well as an increase on the demand of internal and external governance for funds, following an enlarging base of potential individual investors. Investing in distressed assets is another very likely trend in the country. On the same step, Brazilian regulators have already announced special interest in 2011 and the coming years to small and new investors directly or indirectly affected by funds activities, and a commitment to improving the transparency of the sector.
Firth: I expect Brazil's PE market to continue to grow and attract further foreign investment through 2011 as international investors see the opportunities presented by investments in Brazil, and international managers see the opportunities of managing Brazilian investments. A continuing trend I expect to see for 2011 will be the growing presence of non-Brazilian managers in the Brazilian market either by way of acquisition of a Brazilian manager or by simply setting up a presence in Brazil. Brazilian fund managers will also continue to be active and this should not be overlooked as a growing trend in Brazil. As a result of the CVM deregulation, Brazilian managers are looking to diversify their portfolios through overseas investments by establishing fund structures out of Brazil and acquiring non-Brazilian assets. Brazilian fund managers are also looking to attract foreign investment into their fund structures and the use of Irish vehicles as a passport to Europe and European investors is a growing trend in that regard.
Galvis: Although it is unclear whether any specific trend will shape up the Brazilian private equity market in 2011, medium-sized companies in the consumer products and services area have a significant need for capital and management expertise, and this creates a natural opportunity for private equity firms. Also, as a number of commentators have observed, Brazil keeps comparatively high interest rates, making lower leverage more sensible as a business model than the pre-crisis levels in more mature markets such as the US and Europe.
Bruno Robert is a partner at Lilla, Huck, Otranto, Camargo Advogados. His practice includes: capital markets; corporate; corporate governance; hedge funds and private equity funds. He is a member of the Brazilian Bar Association, São Paulo section, holds a specialisation degree in Economics from the School of Economics of Fundação Getulio Vargas, a Master’s degree in Corporate Law from the University of São Paulo and a LL.M. in Securities and Financial Regulation from Georgetown University. Mr Robert has also worked for the Brazilian and the US Securities and Exchange Commissions. He can be contacted on +55 11 3038 1010 or by email: firstname.lastname@example.org.
Simon Firth is a partner at Maples and Calder. Mr Firth is co-head of the Maples and Calder Latin American practice group and advises clients both originating from Latin America and investing into the Latin American region. He has extensive experience in all aspects of offshore finance; structured finance; investment funds (both mutual and private equity); corporate structures including joint ventures; and acquisitions. He has particular expertise structuring investment funds, project finance, securitisation and structured transactions into and out of Latin America. He can be contacted on +1 (345) 814 5536 or by email: email@example.com.
Sergio Galvis is a partner at Sullivan & Cromwell. He heads its Latin America Group and coordinates its practice in Spain. He is also head of Global Recruiting. Mr Galvis is widely recognised for his broad-based international experience and represents a diverse group of clients including government bodies, corporations, investment banks and other organisations. For more than 25 years, he has advised clients on significant matters in a number of practice areas and industry sectors, including: Mergers and Acquisitions; Private Equity; Project Finance; Securities; Sovereign and Corporate Debt Restructurings; Oil and Gas; and Metals and Mining. He can be contacted on +1 (212) 558 4740 or by email: firstname.lastname@example.org.
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