Brazil: Cooling off period

These days, Brazil is generally considered to be the premier destination in Latin America for private equity. But it did not have the happiest of years in 2012. Anti-inflationary measures have contributed to a rapid decline in annual gross domestic product growth, which has in turn led to a lot of hand-wringing about whether Brazil’s economy has overheated (even though the country’s budget and planning minister Miriam Belchior reportedly admitted that such a cooling-down was a possibility as early as July 2011).

To be sure, Brazil’s stunning 7.53 percent GDP increase in 2010 – way ahead of the European Union’s meagre 2.06 percent and the US figure of 2.39 percent – was arguably not a sustainable annual rate of growth. 
But at the time, private equity firms were quick to sing Brazil’s praises. While the US and developed Europe were enduring an historic economic slowdown, Brazil offered a rapidly growing middle class, an expanding consumer sector and an extremely underpenetrated private equity market – all of which made it ripe for private equity fund managers.

LPs liked what the country had to offer as well. One Coller Capital and Emerging Markets Private Equity Association (EMPEA) survey in 2011 even suggested that private equity investor appetite for China-focused funds was waning in favour of Brazilian vehicles.

But as growth has slowed, Brazilian deals have become less attractive – deal volumes have fallen, while total deal value, at $4.38 billion, was lower last year than in 2010, according to EMPEA. With fundraising totals also down markedly, there’s some speculation that Brazil’s private equity market grew too big too fast. 

As Ralph Keiter, the International Finance Corporation’s head of private equity in Latin America and the Caribbean, puts it: “The question over whether there is a little bit of a bubble building in Brazil has been around for over a year.” 

RISING MULTIPLES

Latin America and Brazil had a small but not insignificant private equity market prior to the recent boom. 
Private equity funds raised more than $10 billion in capital for the region between 2008 and 2009, according to PEI’s Research & Analytics division. Local deal volume was a fraction of what was transacted in the US, Europe or Asia at the time, but also considerably more than in Middle Eastern-North African or Sub-Saharan African markets, according to EMPEA data.

Surprisingly, despite being the largest economy in the region by a distance, Brazil made up a relatively small fraction of Latin America’s overall deal volume. Between 2003 and 2008, Brazil’s percentage of Latin American deal volume broke 50 percent only once – in 2007 (by comparison, Brazilian deals constituted 88.4 percent of regional deal volume in 2012, according to analysis of EMPEA data).

As Brazil’s GDP growth began to outperform that of the region between 2007 and 2010, the country’s share of local private equity deal volume began to increase. That coincided with a spike in Brazil and Latin American-focused fundraising, peaking in 2011 when a record $11.2 billion was raised for Brazil and Latin American focused vehicles, according to PEI figures (so more than twice as much as the current annual dealflow).

Of that total, more than $8 billion was dedicated to Brazil-focused funds, according to Latin American Private Equity and Venture Capital (LAVCA) president Cate Ambrose.

Unfortunately, the spike in available private equity capital – coupled with growing competition for deals – has led to swollen multiples on large market deals, sources say.

“Valuations for large-cap deals [$100 million-plus tickets] are high compared to five years ago,” says Ambrose. “Managers are having to work harder to identify proprietary dealflow and focus on the mid-market, or less developed parts of the country such as the northeast.” 

Part of this is due to overcrowding, as many of Brazil’s traditional mid-market firms “graduated” to large-cap deals with their latest funds, says Maureen Downey of Pantheon.

The resulting pressure on valuations and multiples could have consequences on returns when those firms try to exit their holdings over the next few years.

“If you’re buying companies at multiples of 10x -12x, it’s unclear how you will generate an IRR of 30 percent, particularly if you’re not taking out leverage,” says Keiter. “You’re relying on company growth; you’re relying on GDP growth.”

And generating those sorts of returns will be especially difficult if GDP growth continues to flag. Even though the IMF expects Brazil’s economy to grow at a healthy 3.95 percent in 2013, it’s important to remember that this is only an estimate. As a cautionary tale, the IMF’s September 2011 projections had Brazil’s GDP growing by more than 3.6 percent in 2012 – but it actually grew by less than half of that (1.47 percent).

GO (NORTH)EAST, YOUNG MAN

However, a continued economic slowdown does not necessarily mean doom and gloom for Brazil-focused fund managers. 

The mass influx of large-cap firms and funds into Brazil has actually led to a dearth of players in the lower and mid-markets, sources say. While multiples have ballooned to as much as 10x or 12x EBITDA for big businesses in Rio de Janeiro and São Paolo, the mid-market remains underpenetrated by private equity.

“The slowdown in GDP growth may mean that Brazil sees a decrease in inflows from more speculative PE investors, which would translate into lower valuations and a more realistic assessment of the overall state of the Brazilian market,” says Ambrose.

“Managers are having to work harder to identify proprietary dealflow and focus on the mid-market, or less developed parts of the country such as the northeast. But there is still great growth potential in the Brazilian market in the mid to long term.” 

Although the private equity fundraising boom may have led to a rather daunting wall of capital, many sources are also quick to point out that the bulk of private equity investment to date has taken place in large-cap deals in Rio and São Paolo, which ignores the bevy of (smaller) deals available in Northeast Brazil.

“Despite being a very large area with low population, [Northeast Brazil is] still a very large market compared to other Latin American markets,” says Javier Arocena of emerging markets investment group Gramercy.  “The Northeast has a lot of infrastructure deficits [as well as consumer related sectors] – you’ll get a lot of deals where there isn’t a lot of competition.”

Private equity has yet to seize on this opportunity fully. One source estimates that $9 of every $10 invested in Brazil is directed at the country’s most developed regions, suggesting that GPs typically cite difficulties commonly associated with investing in underdeveloped areas – a lack of infrastructure (financial and physical), inexperienced deal professionals and lack of a local presence – as reasons for avoiding less penetrated regions.

“If you ask many of the established GPs why they’re not investing outside the big areas, they’ll say that they still see significant opportunities … in the markets that they know [or] the regions that they know,” says Keiter. 

With so much of its geography still untapped, Brazil remains relatively underpenetrated by private equity (EMPEA estimates that private equity investment constituted only 0.18 percent of Brazil’s GDP, compared to 0.86 percent in the US). But as deals in more established Brazilian markets dry up, expect a greater number of firms to start trekking beyond their comfort zones – geographically as well as financially.

As a development finance institution, the IFC’s investment mandate includes managers that focus on Brazil’s underpenetrated markets. Fortunately, it is starting to see a few private equity firms move beyond the cities. It recently committed $29 million to Gávea Investimentos R$1 billion (€372 million; $503 million) Crédito Estruturado FIDC fund, which will provide long-term debt financing to Brazilian private companies. The idea is to address “the deficiency of long-term lending from private sector entities in Brazil, which exposes many strong companies to refinancing risks and reduces their efficiency and competitiveness”, according to an IFC release.  

“It is exactly that sort of capital market development we have [in mind] when we invest in that sort of strategy,” says Keiter. “[We hope] that it will have a knock-on effect, and encourage other groups to do similar things.”

A powerful incentive could also come from two sporting events: the 2016 Olympics and the 2014 FIFA World Cup both create a tantalizing opportunity for fund managers looking to cash in on the much-needed development of Brazil’s northeast. The latter, in particular, involves a number of venues along the northern and eastern coasts.  

“The combination of two upcoming high-profile sport events and outdated infrastructure means that the country will need significant investments in this regard,” says Arocena. “[Though this] will not necessarily affect the competitive landscape in the long run, [it] could indeed increase the funds raised.”

However, even if the World Cup and Olympics boost fundraising, Ambrose says that we shouldn’t expect another year where fundraising outpaces dealflow.

“We’re seeing a reversal in that trend this year, with preliminary 2012 data showing higher deployment of capital than capital raised,” she says. “This is a natural part of the fundraising/investing cycle, and we are in the moment where firms are using the record-breaking fundraising during 2011 to do deals in a more stable market environment.”

STILL HOT ENOUGH

Even with slowing GDP growth, some firms continue to like what they see in Brazil (and Latin America in general). 
In January, Kohlberg Kravis Roberts appointed Jorge Fergie – previously the head of McKinsey & Company’s Latin American private equity practice – to lead the firm’s São Paulo office, which it opened in 2012. 

The Carlyle Group, which raised $1 billion for Brazilian and South American deals in 2011, has also been very active in the country over the last year. Carlyle invested in three deals in 2012, two of which ranked in mergermarket’s top-10 largest Brazilian deals of the year. 

LP enthusiasm for the country also hasn’t disappeared. A Probitas Partners survey released earlier this year found that LPs are still broadly supportive of Brazil-focused funds: 33 percent of respondents said that they believed Brazil to be one of the two most attractive emerging markets, up from 28 percent the previous year (Brazil placed second behind China).

It’s clear that private equity in Brazil is – perhaps not surprisingly – going through a bit of a cooling-off period, after a couple of red-hot years. But there’s still plenty of heat there for investors – particularly if they’re willing to go a bit off the beaten track. ?