The outlook for M&A in Brazil
June 2017 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2017 Issue
At the global level, mergers & acquisitions (M&A) activity was robust in 2016, showing resilience against economic and regulatory pressures and political shocks. According to JP Morgan, total deal volume was the third highest on record at $3.9 trillion, led by a jump in activity in the fourth quarter. The lower cost of funding helped accelerate deals. By the end of the year, the median weighted average cost of capital (WACC) for S&P500 at 7.6 percent was the lowest since 2004. Moreover, over 35 percent of M&A deals were cross-border in origin, a four year high which, according to Deloitte, highlights how investors are increasingly looking through a global lens. TMT, natural resources and industrials led deal activity rankings.
Nonetheless, macro uncertainty was evident. Deal flow was down 18 percent on 2015 in dollar terms and despite confirmed megadeals such as Time Warner/AT&T and ARM/Softbank, transactions of more than $10bn were down 39 percent year-on-year, while mid-cap deals, although still seeing negative performance, were more stable (FT data). 2016 also saw the largest withdrawn deal volume, totalling $805bn, since the midst of the global financial crisis in 2008. Key trends were greater regulatory hurdles for international deals and in the US, new tax policies targeted against ‘inversion’ deals. M&A dealmakers may have to accept increased political uncertainty as a new normal in the near term.
Macro uncertainty has certainly been a key theme in the Brazilian market over the last few years in function of myriad acute headwinds, such as commodity price falls, stagflationary pressure, large fiscal deficits and political turmoil. Average GDP growth slumped to an average of just over 1 percent between 2012 and 2014 and close to nominal decelerations of 4 percent in both 2015 and 2016. Inflation peaked at 10 percent. The principal stock market, the Bovespa, fell by 25 percent between 2012 and 2015. The country was flirting with depression level economics, compounded by a large corruption scandal – the ongoing ‘Lava Jato’ probe involving major Brazilian corporations and a presidential impeachment. When it rains, it pours, as they say.
Not surprisingly, Brazilian M&A activity saw downward pressure. The market, which had been on a steady upward curve since the start of the millennium, driven by economic growth and the BRIC paradigm, investment rating and improved access to credit, stalled by 2014 after growth of over 100 percent in deal numbers in 10 years (PwC data). BNDES, the state development bank, historically a key player in local project finance, itself faced severe financial pressures.
In 2016, announced deal flow was down to 597 from 879 two years previously. Nonetheless, based on announced transactions, the year’s M&A dollar volume of $37.6bn was $2.8bn higher than 2015 due to mega-deals such as the acquisition of Nova Transportadora do Sudeste by a consortium including Canada’s Brookfield and China Investment Corp, for $5.2bn. However, these figures are way down from the $160bn in dealmaking posted in 2010 (Bloomberg data), when the economy was growing at over 7 percent a year. That said, a broad range of economic indicators are starting to point to an upward swing in momentum. Michel Temer, Brazil’s acting president until the elections in 2018, is expected to deliver a set of policies that are pro-business and fiscally prudent.
Reform to make the Brazilian tax system simpler could result in new market opportunities. However, resistance to the reform agenda could be high. Nevertheless, the market consensus expects the economy to grow by around 0.5 percent in 2017 before expanding 2.2 percent the following year. Inflationary pressure in Brazil moderated through 2016 and the Real closed out the year around 20 percent stronger against the dollar. The expectation is that the Brazil Central Bank continues to accelerate the pace of monetary easing in 2017, positively impacting the M&A milieu. With central bank rates peaking at over 14 percent in 2016, together with a surge of corporate defaults, credit markets are prohibitively expensive for most Brazilian companies to fund acquisitions.
The benchmark SELIC rate is expected to close out 2017 at around 9 percent. This will help companies struggling with debt payments. By last year, financial leverage of leading listed Brazilian companies was at record levels, with over 40 percent classified as “extremely indebted”, according to the Estadão newspaper. Indeed, some of the country’s largest banks, such as Itaú, Bradesco and Bank of Brazil, are increasingly requesting that businesses put themselves up for acquisition to investment funds or strategic rivals as a condition to cut loan principal amounts. In the last quarter of 2016, around 15 percent of total deals have been related to restructurings (Reuters data).
Continuing confidence and visibility are essential in supporting M&A decisions – confidence in the corporate and political landscape making for a higher likelihood of dealmaking. From the third quarter of last year, investment activity picked up. Indeed, according to Bloomberg, M&A numbers were up 35 percent to $16.6bn year-over-year, in part driven by an aggressive programme of divestment by state controlled oil-major Petrobras – accounting for a third of M&A activity over the quarter – which has suffered from the industry’s largest debt pile and corruption scandals. The company plans to raise almost $20bn through divestitures in 2017 and 2018.
Moreover, there was also a jump in inbound transactions of foreign firms buying local assets which, at almost $11bn, nearly quadrupled from the previous year, the best performance since the last quarter of 2013. According to Bloomberg, Brazilian companies “battered by recession and weak commodity prices were desperate to sell assets, made relatively inexpensive for dollar-funded foreigners by the Brazilian real’s collapse”. Nonetheless, many investors remained hesitant to commit dry powder. The economy and currency could always fall further. After years of international acquisition plays, local companies were priced out and also cautious of domestic deals while uncertainty remained. Vale, the world’s largest iron ore producer, has also recently undergone a $21bn corporate restructuring to limit state interference, led by Morgan Stanley & Bradesco.
Despite some green shoots, Brazilian M&A is still below pre-crisis trend performance. From 2009 to 2014, M&A deal flow averaged around $24bn a quarter. Bloomberg estimated that in 2016 the quarterly average was around $9bn, based on the first nine months of the year. According to the Transactional Track Record report, 55 transactions were registered in February of this year, 25 percent less than the same month last year, albeit with an increase of 169 percent in value over 2016. Therefore, a V-shaped recovery in the M&A landscape should not be expected in the near-term. Brazilian executives though are feeling overwhelmingly optimistic about the domestic recovery and an M&A rebound in 2017 (EY data). The long drought in new IPO listings may also finally be ending. Still, the investment environment remains path dependent on limiting further shocks, such as ‘corruption lists’.
Aside from economic and political stress, regulatory concerns are also evident and could slow down deal making. Indeed, Thomson Reuters data revealed that at least 14 planned M&A deals or divestitures – totalling over $8bn – were delayed and carried over into 2017. Increased legal scrutiny and due diligence, due to corruption scandals in major firms, is expected, adding additional challenges to closing out deals. The tech sector has been the most active M&A sector for the last three years, making up around a fifth of total deals according to PwC research, followed by financial services, insurance and natural resources. The key geographical hotspots are the southeast – accounting for the Rio-São Paulo axis – with over 60 percent of all deals, the south (including key cities, Curitiba and Porto Alegre) with 17 percent and the north east with 10 percent. In 2015, the US and UK were the top international investors in the country. Canada and China are also key players.
According to Henrique Tarasiuk, a partner at Legacy Partners: “With better political stability, Brazil is once again becoming highly attractive to foreign capital. In addition to equity-oriented funds, we are seeing a large movement towards structured credit funds. Deals are focusing on the food, health, education and technology sectors, but there are also solid opportunities in retail and industrial businesses.”
Major sectors such as infrastructure and education have large investment gaps. Moreover, in a low-growth environment, M&A transactions can be fast-track routes to achieve significant revenue and earnings growth. Divestments can also help unlock shareholder value, not to mention help companies survive.
Recent uncertainty was priced into transaction values. The numbers now suggest that the market expects a return to growth and reduced risk. Valuation multiples have picked up since bottoming in 2015 and are on an upward trend. Using the Bovespa as a broader proxy, the P/E ratio of listed firms is at 12.2x, 10.6x and 9.4x for the years 2017, 2018 and 2019 respectively, relative to a fair PE ratio of 11.5x (Fund SuperMart data). Future earnings multiples may look explicitly overvalued, but based on CAPE, PSR and other fundamental metrics, Brazil is (for now) currently one of the cheapest global markets (Star Capital). Furthermore, based on one of Warren Buffet’s favourite valuation metrics – Total Market Cap to GDP – at 41 percent Bovespa is below its long-term average of 52 percent. In 2010, this indicator reached over 100 percent. With the USD/BRL exchange rate at 3.15 (as of 7 April 2017), 16 percent above its five-year average of 2.72, Brazilian assets are still relatively cheap, although the flip side is that cash flows are also currently less valuable. However, there is future upside potential if the real strengthens as expected.
As we move through 2017, the expectation is for an improved transaction outlook despite a lengthening M&A execution cycle. Divestments, corporate venturing and private equity activity in deals are all expected to accelerate, as is IPO activity. In investment, fundamental value drivers are key. Strategic pull factors for Brazil continue to be a dominant position in the Latin American economy, population size and extensive natural resources. Despite current market dynamics, Brazil still offers solid opportunities in multiple sectors for foreign investors with long-term strategies.
Adam Paul Patterson is a partner at ALFA Valuation & Advisory. He can be contacted on +55 41 99107 0765 or by email: email@example.com.
© Financier Worldwide
Adam Paul Patterson
ALFA Valuation & Advisory