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In Brazil, No Room for Leverage at Buyout Firms

28 March 2011

(DealBook) March 28, 2011 – “We use zero leverage.” Luiz Otávio Magalhães, the founding partner of one of the most successful private equity firms in Brazil, was trying to explain his business model to me. His leveraged buyout firm, Patria, easily garners more than 20 percent returns annually.

That kind of performance attracted the attention of Steven Schwarzman, whose Blackstone Group bought a 40 percent stake last year.

Yet this L.B.O. fund is, uniquely, missing the “L.”

“Zero,” he said again, as if to underscore the point.

Billions of dollars are rushing into Brazil’s economy. International private equity firms like Blackstone and the Carlyle Group are scrambling to capture of a piece of this emerging market before it has fully emerged. JPMorgan Chase recently bought 55 percent of Gávea, a seven-year-old investment fund with $6 billion under management co-founded by Arminio Fraga, the former president of the central bank of Brazil from 1999 to 2002.

But perhaps the most unusual aspect of the private equity industry here is that its success thus far has had nothing to do with burdening its acquisition targets with heaps of debt. Indeed, this version of the private equity business is exactly the opposite: improving a company’s operations instead of turning to financial engineering to squeeze out performance. It is a mantra that many private equity firms in the United States and Europe pay lip service to but do not follow in practice.

The reason that private equity firms in Brazil do not use debt is simple. In Brazil, money does not come cheap, Mr. Magalhães explained over coffee in the firm’s offices along one of the main sections of downtown São Paulo.

A private equity firm looking for a loan from a bank in Brazil might have to pay as much 20 percent interest annually. A loan in the United States, on the other hand, might pay only about 6 percent. The reason for the lack of leverage, at least for now, becomes obvious.

“That’s just the way we do it. This is not an environment where leverage plays a meaningful role,” Mr. Fraga said in an interview.

So how does Mr. Magalhães’s firm, with about $4.3 billion under management, make such huge profits? For starters, he does not pursue elephant-size deals that are popular in America.

“There is always room for improvements in smaller companies. Family-owned companies, as we usually say, ‘Their kitchen is a mess,’ ” he said. “Usually when you are talking about bigger companies, the room for improvements within the company are smaller because the company needs to be already better organized, otherwise they will not have survived.”

He also focuses almost exclusively on buying family-controlled businesses, which, are often more difficult negotiations than with public companies.

““We had dinner with the wife of this guy because he wanted her to know the guys with whom he would be associating,” Mr. Magalhães said about a recent acquisition target. “It’s fair that she wants to know us.”

He added, “These companies are still under the radar, they do not mandate JPMorgan or Goldman Sachs to find me.”

If his principles sound like what the fledgling private equity industry circa the 1970s in the United States pursued, that’s because they are. Mr. Magalhães isn’t bidding for companies in auctions or forming consortiums with other firms. He spends years developing relationships with small companies until they are willing to sell to him.

He bought a medical diagnosis company in 2000 that had 18 outlets with $90 million in revenue. By 2009, when Patria exited, the company had more than 300 shops with $1.6 billion in revenue.

Among his, other attributes, Mr. Magalhães is uncharacteristically casual for a private equity boss. Forget about pinstripes; he is dressed in jeans and a work shirt. To prepare for a meeting with Mr. Schwarzman in 2010, he hurriedly reminded his staff the day before to come in a dark suit.

Mr. Magalhães made a deal with Mr. Schwarzman after a courtship that is similar to the one he often has with his own acquisition targets, as it took almost decade before a deal was reached. For Blackstone, the deal allows the firm to tap into Brazil’s fast-growing market using local expertise. Patria’s $4.3 billion under management includes money allotted for traditional private equity, real estate, infrastructure, a small hedge fund and a small advisory business. It is, in other words, a mini-Blackstone.

The big question facing Mr. Magalhães and others in his industry is whether they can sustain their performance as bigger players enter the market, looking for even bigger prey.

For now, Mr. Magalhães says he is not worried. With the Brazilian economy growing at a rapid clip, the wind is at his back.

But he and Mr. Fraga acknowledge that the business is becoming more competitive. As the cost of debt comes down, they worry that Brazil’s private equity industry may resemble the buyout shops in the United States.

“There will be more leverage, for sure,” Mr. Fraga said. “Hopefully, we won’t do anything too stupid when the opportunity becomes real.”

By Andrew Ross Sorkin