EMERGING MARKETS SPECIAL: BRAZIL

Between 1992 and 2004, Brazilian firm GP Investments made 25 exits, of which only one was through an initial public offering on Bovespa, the Brazilian stock exchange. Since 2004, the firm has made an additional ten exits, of which eight were in the form of a Bovespa IPO.

GP Investments' experience mirrors that of the overall market. The booming Brazilian public equity markets are one of the hottest developments in a much-hyped region. The IPO market reopened in 2004 following recession, a year that saw R$4.5 billion (€1.7 billion; $2.5 billion) of IPOs. In 2005 a total of R$5.5 billion was recorded, and in 2006 the figure reached R$16.3 billion, according to data from Brazil's Center for Private Equity and Venture Capital Research (FGV Cepe). The first half of 2007 has already seen R$19 billion of flotations in the country.

It is a phenomenon driven by many factors. In 2000, Brazil instituted a new corporate law that improved corporate governance for publicly listed companies (see tables p. 82) and better protected the rights of minority shareholders, and a new bankruptcy law that created additional protections for creditors. In addition, the country has experienced macro-economic stability and strong growth. Interest rates have come down from highs of 30 percent to 40 percent in recent years to around 11.25 percent today, driving some investors away from fixed income for the first time.

Then there was the creation of Bovespa MAIS, which provides early-stage companies with access to public market listings, playing the same role as NASDAQ in the US or the Alternative Investment Market in the UK.

Some private equity firms see the increasing accessibility of IPOs as bad for business in one respect, says FGV Cepe researcher Leonardo Ribeiro. They say that companies wanting to go public no longer need private equity assistance to do so.

But the benefit to the private equity industry far outweighs the downside, Ribeiro adds, because studies have shown that globally the size of the IPO market in a country is the single most important determinant of how much private equity capital that country attracts. Perhaps this helps to explain the greatly increased amount of capital that private equity firms focused on Latin America have raised this year. Advent International and GP Investments alone raised $1.3 billion each – sums of a larger scale than the region has ever attracted in the past.

QUALITY TARGETS
The possibility of raising capital on public markets has also had a positive effect on the quality of targets that private equity firms have to choose from, as companies improve their corporate governance and financial accounting standards, says Darby Overseas managing director Fernando Gentil.

“You have a new generation of Brazilian entrepreneurs who can do the math. They understand that $1 of EBITDA is worth $7, $8 or $9 in an IPO,” he says. “So it has become worth it to improve governance, to make the business formal, to pay taxes and social benefits for employees.”

Another benefit of the IPO market is that it increases the strategic options available to a private equity firm, said Álvaro Gonçalves, a partner at Sao Paulo-based Stratus Investimentos.

“We have the capital markets not only as an exit, but also as an intermediate exposure alternative,” he said. “We can refinance our portfolio companies, acquire a competitor or raise capital to expand, enter a new market or launch a new product.”

Gentil said the availability of the IPO exit has made Darby “more aggressive”.

“Given the option of an exit via an IPO, we can consider more aggressive valuations, because the business plans can be implemented more aggressively. There is more capital available and the companies can be more highly leveraged,” he says.

Further, the existence of a healthy IPO market improves returns. GP Investments' first two funds had average holding periods of nearly seven years, says president, co-founder and co-chairman Antonio Bonchristiano. By contrast, the firm's third and fourth funds will likely have holding periods of between three and five years, because it will be able to make partial exits via IPOs and return LP money faster, improving the funds' internal rates of return. In addition, the public markets frequently offer more attractive valuations than sales to strategic investors.

MORE SELECTIVE
What is unclear, Bonchristiano says, is whether the market will continue to offer such high valuations for much longer. He has seen signs that investors are becoming a bit more selective.

Overall, though, he is positive. “My view is that given the momentum, the increasing appetite for equity investments by Brazilian and foreign investors, I see IPOs becoming a permanent feature of the market, which clearly was not the case before 2004,” he says.

Certainly, private equity-backed companies have accounted for a large percentage of companies that have achieved IPOs on Bovespa since 2004 (22 percent in the first half of 2007). Private equity-backed companies that list on Bovespa have better corporate governance and financial reporting, Ribeiro says, and consistently outperform the market as a whole after listing.

Private equity has made a positive impact by introducing nine new industries to Bovespa – including commercial credit card administration, cosmetics and medical diagnostics – helping investors to diversify their holdings.

While IPOs enhance private equity returns and the GP's ability to raise capital, private equity success stories in turn mean a stronger public equity market. In Brazil, the public and private realms appear to be establishing a mutually beneficial relationship.