By Jason Mitchell
March 15, 2011— Global private equity funds flocked to Brazil in the mid-1990s, attracted by the vast potential of the domestic economy, the pegging of the real to the dollar and market-oriented policies that included the country’s first big wave of privatizations. It turned out to be a brief fling rather than a lasting love affair, however. Rising deficits and capital flight sent stock prices tumbling and forced the government to devalue the currency in 1999. Most private equity players got burned, and many foreign firms pulled out of the country.
Today the big money is coming back, and this time it looks likely to stay. The economy seems to be set on a sustainable upward trajectory thanks to the market-friendly policies of former president Luiz Ignácio Lula da Silva and his successor, Dilma Rousseff. Growth is likely to exceed 5 percent this year, according to economists at Goldman Sachs Group, down from 7.5 percent in 2010 but well above the 3.3 percent annual average from 2000 through 2009. A favorable regulatory environment that allows domestic pension funds to invest in private equity and provides tax exemptions for foreign investors is encouraging the industry’s expansion. Private equity also enjoys support from BNDES, the state-owned development bank, and Financiadora de Estudos e Projetos, the state-run foundation for research and development, which provide financing for many deals. A vibrant corporate sector containing more than 15,000 companies with annual revenues greater than $150 million provides plenty of investment targets, according to Advent International Corp., a Boston-based private equity firm. And a buoyant market for initial public offerings is making it easier for private equity firms to exit investments and realize gains.
“A sustainable PE industry requires the right ecosystem,” says Janusz Heath, senior investment manager for emerging markets at Capital Dynamics, a Zug, Switzerland–based private asset manager that has invested more than $20 billion globally. “Today, Brazil has many of the necessary ingredients in place: strong, active pension funds; a sound regulatory environment; government support; dynamic capital markets; and an increasing pool of professional and experienced private equity managers.”
Private equity investment in Brazil surged more than fourfold last year, to $4.6 billion, according to the Emerging Markets Private Equity Association. That total trailed only China’s $9.2 billion and India’s $6.2 billion among emerging-markets economies, and it was well ahead of the $1.5 billion invested in Russia and other former Soviet states. Brazil is now the second-most-attractive emerging market for private equity investors, after China, Empea says. In its 2010 members’ survey, 36 percent of respondents said they planned to either begin or expand investment in the country during the next two years. Ocroma Alternative Investments, a private equity fund-of-funds manager in São Paulo, predicts that private equity investment will hit $10 billion this year.
Last year alone, Apax Partners Holdings, Carlyle Group and Warburg Pincus reentered the Brazilian market. In September, Blackstone Group acquired a 40 percent stake in Pátria Investimentos, a Brazilian private equity manager and independent investment bank. In October, JPMorgan Chase & Co. bought a 55 percent stake in Gávea Investimentos, the Rio de Janeiro–based alternatives manager founded by Arminio Fraga, former president of the Brazilian central bank.
In September, Southern Cross Group, a Buenos Aires–based private equity outfit, closed its fourth buyout fund at $1.68 billion, a record amount for Latin America; of the total, $500 million is earmarked for investment in Brazil. Capital Dynamics, which opened an office in Rio de Janeiro last year, is currently raising its first Brazilian fund, which it aims to close at $350 million in August.
Foreign firms have arranged some of the biggest recent private equity deals, a notable development for a market whose sweet spot has traditionally been minority investments of less than $50 million. In January, Advent International acquired 50 percent of Terminal de Contêineres de Paranaguá, Brazil’s third-largest container port terminal. Advent did not reveal terms, but industry sources believe the deal values the port at $1 billion. In July, Carlyle Group acquired a controlling stake in Qualicorp, a Brazilian health services provider. Terms weren’t disclosed, but sources say Carlyle received a 70 percent stake at a price that valued the company at $1.2 billion. The following month, Carlyle snapped up Scalina, Brazil’s largest manufacturer of lingerie, for $160 million. In May, Apax Partners paid $921 million for a 54.25 percent stake in Tivit, an information technology and outsourcing company listed on Brazil’s alternative stock exchange, Novo Mercardo. It was the first Brazilian deal by a U.K.-based private equity firm since 1995.
These global investors are hoping to duplicate the stellar returns that Brazil’s domestic companies have generated over the past ten years. Although most foreign outfits withdrew a decade ago, local players remained committed, focusing on modest investments, in the tens of millions of dollars, in medium-size companies. They have benefited spectacularly from Brazil’s economic takeoff, generating gross returns averaging 30 percent a year, according to Ocroma.
“For PE investors, Brazil has the best risk-adjusted returns of any BRIC country,” says Joao Teixeira, who heads the São Paulo office of GTIS Partners, a New York–based global real estate investment firm. “Brazil combines many of the positives of an emerging market with much less of the risk that is usually associated with an emerging market. There have been property rights for foreigners since 1850. In India you have to partner up with local players if you want to invest in real estate. In China parts of the real estate equation are dependent on government policy. Russia has many risks: It has witnessed an unsustainable rise in the value of real assets.”
The key question for investors is whether the industry can continue to produce those kinds of returns. The recent influx of money raises concerns among some players that private equity risks becoming too much of a good thing. Deal prices have been rising, with large companies recently fetching as much as 10 times earnings before interest, taxes, depreciation and amortization, compared with 7 times ebitda in 2006, according to IGC Partners, a Brazilian investment banking boutique. By contrast, comparable multiples are currently about 7 to 8 times in Mexico and 6 to 7 times in Argentina, according to Advent International.
“There is a growing concern about overvaluations, especially for the bigger-ticket deals,” says Frederico Greve, a managing partner at DGF Investimentos, a São Paulo–based private equity manager that has raised $250 million since it was set up a decade ago. “But in the middle market, we do not see as much pressure on prices.” Recent private equity investments in midsize companies have been priced at about 8 times ebitda, while small companies have attracted multiples of roughly 5 times, says Advent International. Firms can also improve their chances of success by sourcing deals outside the industrial triangle of São Paulo, Rio de Janeiro and Belo Horizonte, where the economy is showing signs of overheating and valuations are the highest.
A potential shortage of investment professionals could also slow the industry’s growth, some executives say. Most recent entrants are looking to build up a local staff to generate deals, a marked change from the 1990s, when foreign firms tended to rely on executives flown in from New York or London. “It is very hard to find the right people,” says Ricardo Fernandez, head of investment in Brazil at Capital Dynamics, which aims to build its staff in Rio from five professionals to 15 by the end of this year. “It is also very difficult to agree on terms with someone you are hiring. Salaries are skyrocketing, and at the end of last year there was a lot of staff turnover at many PE shops.”
To some, the upsurge in activity looks like a bubble in the making. “Some of the foreign newcomers coming into the Brazil market have more local knowledge and local contacts than before,” says Leonardo Ribeiro, a co-founder and managing partner at Ocroma. “But in other cases there is a sense of déjà vu, where ‘fly in’ investors are entering it, don’t really understand local conditions and are pushing up valuations. A number of factors are compounding this problem: The Brazilian stock market has risen to very high levels, private equity funds investing in the country are now of a bigger size, and there is a huge amount of international liquidity available, enabling foreign PE managers to invest in emerging markets, including Brazil.”
Most players, however, are confident that the private equity party has plenty of life left. For one thing, the industry remains relatively small by international standards, with total investment amounting to 0.23 percent of gross domestic product at the end of last year, compared with 0.90 percent for the U.S., 0.44 percent for India and 0.16 percent for China, according to Empea.
Another positive factor is that private equity players in Brazil operate with very little leverage because of the country’s high interest rates, a legacy of the hyperinflation of the late 1980s and early ’90s. The central bank’s key short-term interest rate stood at 11.25 percent late last month. “Brazil is very different from other markets, where PE investors are leveraged to the hilt,” says Jerome Booth, head of research at Ashmore Investment Management, a London-based emerging-markets investor with $46.7 billion under management. “In Brazil there is hardly any leverage. It is a different model and presents less risk.” For their investments to succeed, private equity players need to make strategic or operational improvements rather than relying on financial engineering, says Cláudio Furtado, executive director of the Center for Private Equity and Venture Capital Research at the Fundação Getulio Vargas, a Brazilian think tank.
The industry has a sound domestic footing thanks to a number of recent regulatory moves facilitating private equity investment by Brazilian pension funds, beginning with the 2003 introduction of fundos de investimento em participações, known as FIPs or private equity investment funds. In 2009 the Comissão de Valores Mobiliários, Brazil’s securities regulator, simplified its rules to make it easier and cheaper to create FIPs. Also that year, Brazil’s National Monetary Council liberalized its rules to allow closed pension funds (those tied to employees of a specific company) to invest up to 20 percent of their assets in private equity and venture capital funds. Largely as a result, Brazilian pension funds account for one quarter of the capital raised by private equity funds.
“Pension funds gave the industry a huge boost in the U.S. in the ’80s,” says Cate Ambrose, president of the Latin American Venture Capital Association. “They are now doing the same in Brazil.”
The underlying fundamentals of the Brazilian economy also augur well for the industry, many executives believe. “Some of the valuations in Brazil may seem stretched, but I think you have to look at the whole movie, not just a clip,” says Fernando Iunes, director of investment banking at Itaú BBA, the wholesale banking arm of Itaú Unibanco Banco Holding. “If you take the longer-term view, the companies will continue to grow at a fast rate and offer very good results.”
Some of the best private equity opportunities can be found in Brazil’s fast-growing consumer sector. The country’s economic resurgence over the past decade has dramatically expanded the ranks of the middle class, creating millions of new buyers of everything from soft drinks and household goods to financial services. An estimated 32 million Brazilians have joined the middle class since 2003, according to the Fundação Getulio Vargas. The country is now the world’s second-largest market for cosmetics and wall and floor titles, the third biggest for mobile phones and the fourth biggest for chocolate, according to Ernst & Young.
“The rise of the consumer has created all sorts of opportunities,” says Christopher Meyn, head of illiquid funds at Gávea. “The economy has been growing at 4 to 6 percent a year, but consumer spending is up by 10 to 15 percent a year.”
In January, Alothon Group, a São Paulo–based buyout firm, teamed up with Partners Group, a Zug, Switzerland–based private equity outfit with more than Sf25 billion ($27 billion) under management, to acquire all of Casadoce Industria e Comercio, a Brazilian powdered-drinks company with about 100 million reais ($60 million) in annual revenues, for an undisclosed sum. “Healthier and more-natural products are becoming much more popular with the middle class,” says Ettore Biagioni, a former head of Latin American private equity for Bankers Trust and Deutsche Bank who founded Alothon in 2004. “This means that Casadoce has a great future.” The company’s Golly brand enjoys a strong position in the market. Alothon is recruiting experienced managers to buttress Casadoce’s CEO, Marcos Cardoso, and plans to overhaul management procedures and IT systems to enable the company to bring products to market more quickly. Biagioni aims to double the company’s size in four years and says Alothon intends to hold its investment for up to six years, most likely exiting through a strategic sale. Alothon raised a $250 million Brazilian private equity fund in 2009 and has committed half of the funds, investing in 11 companies, four of which it has already exited.
Actis, a London-based private equity manager, has also been active in Brazil’s consumer sector, making three investments late last year from its $2.9 billion Actis Emerging Markets 3 fund. In September it paid $58 million for a minority stake in Cia. Sulamericana de Distribuição, whose supermarket chains São Francisco and Cidade Canção are the leading regional retailers in the southern state of Paraná and the southwestern state of Mato Grosso do Sul. With the new capital injection, Sulamericana plans to step up the pace of store openings in those markets.
In November, Actis invested $53 million in Gtex Brasil, a maker of laundry detergent, soap bars, steel wool and other cleaning products whose brands include Amazon, UFE and Urca. Actis intends to expand the business by introducing new product lines, making acquisitions and growing its geographic footprint beyond its current base in the states of Maranhão, Mato Grosso, Pernambuco, Rio de Janeiro and São Paulo.
Also in November, Actis paid $58 million for an undisclosed minority stake in XP Investimentos, a brokerage firm that was launched in 2001 and now has more than 215 branches in 100-plus Brazilian cities, serving more than 70,000 customers. As impressive as that growth has been, Actis believes XP has only scratched the surface. It expects that the number of Brazilians investing directly in the stock market will grow to some 5 million people in coming years from fewer than 1 million currently. Actis plans to work with XP to prepare it for an IPO, which would make it Brazil’s first publicly listed brokerage.
Gávea, which has fully invested the $2.4 billion it raised in three private equity funds between 2006 and 2008, is also a big fan of the consumer sector. “We like to invest in the assets that best capture the strong economic growth in Brazil,” says Meyn.
One of the firm’s most successful recent deals has been its investment in Raia, Brazil’s third-biggest drugstore chain by number of stores. In September 2008, Gávea and Pragma Patrimônio, another local private equity manager, each acquired a 15 percent stake in the business. (Gávea focuses on acquiring minority stakes of between 10 and 25 percent because it believes the premium for control is too high in Brazil.) The firms did not disclose terms, but a source close to the deal says the two investors paid a total of 115 million reais. Raia used the capital to accelerate its expansion efforts, more than doubling its outlets, to 325 stores currently from 150 at the time of the investment. In addition to providing money, Gávea has been active on the company’s board, providing advice on how to restructure its debt and where to locate new stores.
“For us, this was a compelling investment to make,” says Meyn. “[Raia] wanted to raise fresh capital at a time when the international capital markets were very difficult. However, it had had tremendous historical growth and had already opened a lot of new stores.”
Gávea undertook the deal with a three-year time horizon, believing it would earn a fast payback on its investment because Brazil has only one other listed pharmacy chain, Drogasil. Sure enough, in December, Raia raised 654.7 million reais in an IPO that valued the company at 12 times this year’s anticipated ebitda. Gávea retains a 6 percent stake in the company. Overall, Gávea has made 32 private equity investments in Brazil over the past five years, in companies ranging from Aliansce Shopping Centers, one of Brazil’s biggest shopping mall managers, to the Latin American business of McDonald’s Corp. to Multiterminais, the main port operator of Rio de Janeiro.
Property development provides a way to get in on the consumer growth. Early this year, GTIS expects to fully commit its $510 million GTIS Brazil Real Estate Fund, which it launched in 2009 with backing from U.S. and European institutional investors. GTIS has made 14 investments so far and has a few more in the pipeline. The company builds residential properties that produce net operating income at a rate of 14 to 17 percent of costs. Brazilian leases are indexed to inflation, providing an additional layer of security for developers.
“The strength of the demographic reality in Brazil is very underappreciated,” says William Cisneros, a senior managing director at GTIS. “The percentage of the population in their most productive years, between the ages of 25 and 50, will grow steadily, from 35 percent now to a peak of 45 percent ten years from now. We expect the impact to be comparable to the wave of demand for U.S. real estate created by the coming of age of the baby boom generation.”
Infrastructure is another major focus of investment, and it’s not hard to see why. The country’s rapid economic growth is straining the capacity of its roads, railways, ports and airports, making increased investment an urgent priority. In addition, Brazil will host international soccer’s World Cup in 2014 and the Summer Olympic Games in 2016 — the first time any country has hosted both of those sporting attractions in such a short space of time. Brazil needs to invest heavily in everything from stadiums and hotels to highways and airports to accommodate the expected crowds. JPMorgan Brazil Investment Trust estimates that infrastructure spending for the two events could hit $50 billion by 2014. With such a huge price tag, the government is determined to draw on both public and private investment. Investors seem happy to oblige. Capital Dynamics is targeting infrastructure investments related to the World Cup and Olympics as one of the three themes of its new Brazilian fund, alongside consumer and natural-resource plays.
The biggest recent infrastructure deal is the investment by Advent International in Terminal de Contêineres de Paranaguá, which operates a port in the city of Paranaguá, about 300 miles south of São Paulo. The company plans to use Advent’s capital to nearly double its capacity, to 1.2 million 20-foot equivalent containers a year, compared with 700,000 currently.
Advent has also invested in Brazil’s financial infrastructure. In May 2009 the firm paid $131 million for a 30 percent stake in Cetip, the largest central depository for private fixed-income securities and over-the-counter derivatives in Latin America, with 2.6 trillion reais in assets under custody and average daily trading volume of more than 50 billion reais. To carry out the deal, Advent drew on its own experience in buying out BondDesk Group, a U.S. fixed-income trading platform, in 2006. Robert Slaymaker, an Advent operating partner and former BondDesk CEO, saw tremendous potential in transforming Cetip’s mutually owned nonprofit depository into a commercial, listed enterprise. Advent moved quickly after its investment to negotiate new governance arrangements with the Brazilian banks that had controlled Cetip and to install a new management team. In just five months that team took the company public in an IPO that raised $508 million and allowed Advent to sell its stake. The company’s share price has risen by about 50 percent since its flotation.
“What was critical to this deal was the governance we were able to negotiate with the main banks,” says Patrice Etlin, a managing partner for Latin America at Advent. “That’s what enabled us to put in place a new management team that carried out the IPO a few months later. We created value not through changing the capital structure or taking on cheap acquisition debt.”
Vision Brazil Investments, a local private equity player that manages $2.1 billion in assets, is investing heavily in electricity generation. The firm is financing the construction of six 30-megawatt hydroelectric power stations in the western state of Mato Grosso. It only starts to raise finance — mainly from U.S. endowments and pension funds — once it has obtained a government license to start construction on a project. The advantage of this type of investment, which has a time horizon of three to five years, is that 75 to 80 percent of the capital cost is typically refinanced by BNDES, minimizing the risk for Vision Brazil and its investors. “These are very solid investments because they have the support of BNDES,” says Amaury Junior, founding partner and CIO of Vision Brazil. “Brazil is booming, and electricity consumption is shooting up constantly.”
Since 1996, Darby Overseas Investments, the private equity arm of Franklin Templeton Investments, has done 16 deals in Brazil, totaling $350 million, and it has exited seven of those deals. The firm has profited handsomely from investing in the country’s fuel distribution business. It began in 2004 by taking a small stake in Satélite Distribuidora de Petróleo, which operated 380 gasoline stations in the northeastern state of Rio Grando do Norte. Two years later the company merged with ALE Combustíveis to create AleSat Combustíveis. Darby provided capital to help the company expand its network and make two acquisitions in 2008. Today, AleSat has 1,700 stations across Brazil, a 5 percent market share and annual sales of 7 billion reais, a tenfold increase since Darby made its first investment. Over the years the firm has put a total of $25 million into AleSat and now owns a 25 percent stake.
“We are active in AleSat,” says Fernando Gentil, Darby’s managing director in Brazil. “We are testing the market in terms of exits. An IPO is an option, or there is the chance to introduce another strategic investor. We are in a fortunate position because [AleSat] has become a very attractive target. There is strong potential for consolidation in the sector.”
The recent spurt of deal making looks likely to continue. So far more than 550 Brazilian companies have received venture capital or private equity investments, according to the Fundação Getulio Vargas. That’s just a fraction of the thousands of family-owned businesses in the country that are ripe for consolidation. Fund-of-funds manager Ocroma forecasts that the industry’s assets under management will surpass $50 billion this year, up from only $6 billion in 2004, and will double, to more than $100 billion, in five years’ time.
A robust IPO market is helping to sustain the industry’s growth by ensuring that fund managers can make timely exits from their investments. Half of the ten IPOs that took place in Brazil in the past year involved companies with private equity backing, including renewable energy company Renova Energia, building group Mills Estruturas e Serviços de Engenharia, developer BR Properties, mall operator Aliansce and Multiplus, which runs the frequent-flyer program of Brazilian airline TAM Linhas Aéreas. Itaú BBA projects that Brazil will have as many as 40 IPOs and secondary stock offerings this year, raising a total of as much as $30 billion. Roughly one third of the deals will involve companies backed by private equity, Itaú BBA predicts.
Already this year, Arezzo Industria e Comercio, Brazil’s largest women’s shoe retailer, with sales of 7 million pairs annually, raised 565.8 million reais with an initial public stock offering in January. The sale provided a lucrative partial exit for Tarpon Investimentos, a São Paulo–based asset manager that had acquired a 25 percent stake in Arezzo for 76 million reais in November 2007. “This was a consumer play for us,” says Eduardo Mufarej, a partner at Tarpon. “We expected demand for footwear to continue growing at a rapid rate because of the country’s expanding middle class.” The investment enabled Arezzo’s controlling shareholders, co-founder Anderson Birman and his son, Alexandre, “to concentrate on what they like doing most, which is designing great collections of shoes,” says Mufarej. “We focused on improving the managerial side of the business.” Tarpon reduced its stake to 12 percent after the IPO. If the firm had divested fully, it would have earned an 80 percent return on its investment.
As the Brazilian market matures, private equity firms are likely to shift from growth-oriented deals to more-conventional buyouts, says Heath of Capital Dynamics. “The private equity industry’s development across countries tends to follow the same pattern. It starts with what gets called ‘venture capital,’ essentially backing earlier-stage and smaller businesses, followed by growth capital, and then a buyout market develops. We saw this in the U.S. and historically have seen private equity markets across the world follow in the U.S’s footsteps.”