Sampa session

Anyone raised in Brazil can tell you with a wry smile about the many times he or she was told growing up that theirs was the “country of the future”. The subsequent disappointments of Brazil's economic maladies led many Brazilians to tack on to this slogan a cynical punchline: “… and always will be”.

A visitor to Brazil today, however, cannot avoid the sense that many locals, including the tight-knit group of private equity market participants in the country, believe that, finally, a brighter Brazilian future may be about to arrive.

Not only is Brazil's economy looking stronger than it has in anyone's memory, but it would appear that private equity, if it plays its cards right, is primed to have a starring role in this unfolding success story.

The four veterans of the Brazilian private equity market who gathered in Sao Paulo (the locals call their city “Sampa”) last month to discuss these developments dutifully issued warnings against irrational exuberance (exuberância irracional), but were unable to fully mask their genuine excitement about what they were seeing in their market and the broader economy.

A telling indicator about the state of the Brazilian market was the great difficulty involved in getting these four individuals into the same room at the same time. All reported being busier than ever before. One GP only confirmed his participation the night before the roundtable – the major deal he was closing in on had been delayed and so he could spare the two hours.

After the four men exchanged greetings, one observed that all of them were from the “first vintage” of private equity professionals in Brazil, having started their involvement with the nascent industry in the 1990s. This conferred on all of them the title “veteran”, although all readily admitted that 10 years of private equity experience would not make someone an old-timer in the US or Western Europe.

Still, our four Brazilian roundtablers have seen enough history and survived enough economic hazards to know that today looks very, very different from the late 1990s, and in only good ways.

Describing a macroeconomic and actuarial trend that is perhaps the most talked-about phenomenon in the Brazilian financial industry, NSG Capital's Luiz Eduardo Franco de Abreau said: “We are now seeing a sustainable decrease in interest rates, and that will permit long-term investments. Many local LPs that previously invested in government bonds need to go to the stock market or private equity investments.”

While local GPs expect more investment capital from local LPs and from abroad, they are equally confident that they can put this capital to work in a powerful fashion. “There are several investment gaps in Brazil – infrastructure gaps, industry segment gaps, consolidation gaps,” said Alvaro Goncalves, co-founder of Stratus Group. “We are possibly the most under-served in terms of long-term capital among the top 20 economies. That means a lot of opportunities. That means deal flow for many of the players in this market. This will certainly drive some great fund vintages for many years in a row, which will possibly be ahead of any other market in the world.”

Speaking as one whose job is to spur business, capital markets and infrastructure development, BNDES' Eduardo Sa noted two upcoming major events that have placed an exclamation point on the need for Brazil to form investment capital. “The upcoming World Cup and Olympic games here will require many investments,” he said. “This is a big challenge for us. Business services, telecommunications, real estate, airports, oil and gas services – we are trying to focus private equity towards these things. We have only a few years to accomplish this.”

The many investment challenges of Brazil are made surmountable by something that, according to The Carlyle Group's Fernando Borges, has not historically been associated with Brazil's economy: stability. “It took us a while to get here,” said Borges. “But in the end we got here. I think the market is very attractive; it is growing, stable. There are many sectors that need money and we're going to see good deal flow. The level of activity we'll see over the next five years will be totally different than what we saw over the past five years.”

A keen understanding of the Brazilian private equity opportunity requires a keen understanding of the dynamics on the BOVESPA, the country's largest stock market. Two years ago, BOVESPA was on fire, and while this spelled exit opportunities for private equity sponsors, the public market fervour also worked against private equity in that many entrepreneurs were lured into a listing over a private equity deal.

Today the public market is again revving up. Witness the world's largest IPO in 2009 – the $8 billion listing of Banco Santander's Brazilian division on the BOVESPA. But this time around, the roundtablers agreed, private equity is more widely seen as an important step toward a listing.

“In the middle market, we're not really competing with the public market” for deals, said Stratus' Goncalves. “In addition to capital, middle-market companies here need a good layer of governance and want to be tested with a financial partner first. Most of them don't feel prepared for an IPO, but they have that vision.”

We are now seeing a sustainable decrease in interest rates, and that will permit longterm investments

Luiz Eduardo Franco de Abreu

De Abreu agreed. “The middle market needs governance, management and financial skills, which are not usually in place at those companies,” he said. “They look to private equity firms for this.”

Carlyle's Borges noted that many entrepreneurs who went public during the boom period of 2007 have lived to regret it. “Some companies that went public shouldn't have,” he said. Many business owners “saw their peers that went public, and now are trading at half of where they were trading a year ago, and they say, ‘Oh thank God I didn't go public, and now I have the opportunity to be more prepared’.”

“The investment banks in Brazil encouraged IPOs too early,” explained de Abreu. “I think that more than half of the companies [that went public in 2007] weren't prepared. And not because of size, but because of management. Perhaps if those companies hadn't gone public and they had instead had an investment from a private equity firm, you would have seen a better outcome.”

“This is a big opportunity for private equity,” continued de Abreu. “Stock investors are now more carefully picking companies. They are going to focus more on governance and management and that will help private equity because that's what private equity does. We force corporate governance and other important aspects.”

One thing is for certain – the number of Brazilian companies that are not on the stock market – or anywhere near it – is staggering. Goncalves estimated that while there are less than 500 listed Brazilian companies, there are some 15,000 private companies throughout Brazil, most of them in the middle market, and most of them controlled by families. But deal opportunities are now coming from a number of different types of motivated sellers, said our roundtablers.

Many private companies are seeking the assistance of private equity as they seek a public listing. But even companies that are already listed are seeking out private equity, said Borges. “One thing you see today is a lot of succession dislocations,” he said. “I would guess that more than 50 percent of publicly traded companies are still family controlled. It is very normal to run into succession situations. Sometimes they need to have a cash-out and it's a way to step into the company.”

The upcoming World Cup and Olympic games here will require many investments. This is a big challenge for us

Eduardo Sa

Another source of deal flow, said Goncalves, is coming from the large, multinational corporations active in Brazil. “Some of these multinationals have been hit by the international crisis and they need to cash something out, and they sell sound, cash-generative local divisions,” he said. “You also have huge consumer goods companies that in the 1990s were acquired when the multinationals were buying everything that moved in Latin America. Now some of these brands have been sidelined because they don't fall into the global strategy, and they could be sold.”

One very encouraging sign in the current deal market is the high incidence of sellers who, in fact, want to stay with the company after the private equity investment and participate in the growth. Stressing that this is a general observation only, Goncalves said he believes as many as three-quarters of the deals he sees involve a management team that wants to use the fresh equity only for growth and consolidation plays, as opposed to cashing out. De Abreu agreed: “Yes, most deals are growth instead of cash-outs,” he said. “Several years ago, you had more cash-outs than now.”

“This is an attitude that I really like,” said Goncalves. “Although you may find a tired shareholder in certain deals, and you may have to cash him out, there's always somebody that comes in with a big plan. Maybe it's a succession and one side of the family wants to stay and grow the company bigger. They want the right partner to grow and go public later.”

BNDES' Sa placed the desire for growth over cashing out into a broader context of Brazil's entrepreneurial culture, and a shift within that culture that now values a partnership approach to building a business. “A few years ago I still remember entrepreneurs complaining about the approach of some private equity managers,” Sa said. “It was new for them, I think. They were used to getting bank credit, and the credit providers didn't ask for rights.”

“That's right,” said Borges. “At the time they didn't have anyone asking for rights and wanting to read their business plans.”

“Private equity has brought a big shift,” continued Sa. “It's on the board assigning strategy with the entrepreneur. Some of these people thought they were getting free credits. But over time, as private equity became more well known, many companies came to see this as a good way to get capital.”

Brazil is a vast country, stressed Sa, and while private equity is well known to many business owners in the southeastern cities of Sao Paulo and Rio de Janeiro, it has a long way to go elsewhere. “If you go a little further outside of the southeast region, they don't understand too much about private equity,” he said. “They say, ‘This is my business, I run it my way.’ But this will disappear over time. They see the good results of private equity firms increasing the value of some companies.”

The deal flow in Brazil could well serve 40, 50 GPs with subsequent vintage funds but very few players here have a fund two

Alvaro Goncalves

Indeed, the brief history of private equity in Brazil has nevertheless yielded many high-profile success stories (as well as a notable disaster, discussed below), and these stories are being shared with skeptical business owners. In some cases, the stories have created in business owners a fear of missing an opportunity that is more powerful than the desire to seize an opportunity, explained Goncalves. “We all know of cases from the 90s where we tried to convince family owned companies to take our investments, but the families were quite shy,” he said. “They said, ‘Well, I don't want to give so many rights to a financial investor, and I don't know exactly what their agenda is.’ But then a competitor took private equity capital and grew quite aggressively by acquiring a number of companies in a row. These were clearly perceived as winners. And three years later, the shy family is still there, smaller than a competitor that was once the smaller company. Today we have many compelling examples of this type and the so-called private equity agenda is well understood by business owners.”

One of Sa's missions is to encourage the further development of Brazil's already sophisticated capital markets. This means that companies that receive direct funding from BNDES are asked to pledge that they will seek financing from the capital markets within a few years.

This clearly has had a stimulative effect on the public markets in Brazil, but perhaps more important has been the move – only in its early stages now – of local institutional capital into public equities. The Brazilian fund management industry controls some R$1.3 trillion ($750 billion) but, of that, an outsized R$1 trillion is in fixed income assets. This will gradually move into equities as pensions in particular need to meet actuarial assumptions, and it will in turn create a demand for listed companies.

The continued growth especially of BOVESPA has provided an obvious benefit for private equity firms – a potential exit route. It is one of several liquidity routes that have opened up in recent years in a market that once could only exit through cross-border trade sales. “We look for companies that have size and a growth story and may seem nice for a strategic buyer,” says Borges. “But this also means they'd be a good fit for the stock market.”

Goncalves offered a brief history lesson of exits in Brazil. “In the 1990s, if you invested in a company, you had only one exit strategy, which was to sell to a multinational,” he said. “We didn't have any IPOs from 1998 to 2002. More recently we started talking about cross-border trade sales and IPOs for larger companies. Now there are two additional exits – IPOs in the middle market and local trade sales.”

Borges jumped in with a fifth exit route: “Also IPOs outside of Brazil.”

“Yes,” said Goncalves. “Our companies have been approached by representatives of the AIM market in London, the Nasdaq, American Depository Receipts on the NYSE. These are possibilities for exits that didn't exist only 10 years ago.”

All of the GPs at the table had been in close contact with LPs in North America and Europe, either for active fundraisings or as part of ongoing investor relations efforts. An uptick in LP interest towards Brazil has been noticeable and welcome, they said, noting however that fundraising is easy for no one in the world today.

I would guess that more than 50 percent of publicly traded companies are still family controlled. It is very normal to run into succession situations

Fernando Borges

The subject of raising capital from Brazilian LPs is somewhat more complicated. While major Brazilian institutions look to both public and private equity to bolster their performance, they insist on playing a more active role in the private equity funds they back than is the norm internationally. For example, a GP asking for a commitment from a Brazilian LP, such as BNDES, should expect to have a representative from that LP sit on the fund's investment committee. Not every local GP is a fan of this, and as a result there are two kinds of GPs in the Brazilian market – those that take local capital and those that don't.

Our roundtablers, including funds from both sides of this divide, all agreed that the future would bring a gradual easing of this demand from local LPs, but none were prepared to predict when Brazilian LPs would embrace standard international governance terms.

Although its name was not mentioned, the spectre of the CVC/Opportunity fund debacle is widely believed to be the main factor behind the desire by local LPs for greater fund oversight. That fund, originally managed by Daniel Dantas, received the backing of many major Brazilian institutions and ended up in the mid-2000s a corporate governance and investment fiasco. It fundamentally changed the way local LPs chose to interact with GPs.

“The local LPs here demand to be near the decision process of the investments and divestments,” said Sa, who sits on the investment committee of Stratus Investimentos. “But I believe that in the mid-term we will converge to a form that, while it does not look like the US, will be one in which every decision will not have to be taken on board by the LPs. I think in the future LPs will not sit on an investment committee but on an advisory board. It will be a body that will question and understand the businesses receiving investments.”

“This is a very young industry and local investors tend to be interested in getting closer to the action,” said Goncalves. “They want to understand more about the way that deals get done. This is a positive and an evolutionary process. If that somehow becomes a practice for the long term, then it's not a good practice. But at this moment in time it's not a major issue.”

Goncalves also expanded on an important point made by Sa – Brazil's regulated private equity industry does not include a governance body for LPs other than the investment committee. It is a structural gap that the local private equity association is seeking to address by implementing advisory boards in the local PE funds.

In the meantime: “The speed of this process will depend on the results of the private equity industry,” said Sa. “If I say to the board of BNDES, ‘Look, we are going to invest in a fund and we won't be on the investment committee,’ they will say, ‘Why the change?’ I would have to show the track record for the last fund. And if we have a good track record, we can speed this process.”

Local investors, at the very least, are sold on Brazil, and they are gradually feeling confident in private equity. Overseas investors are sold on private equity, but still have questions about Brazil, said the roundtablers. “Brazil is recovering better and faster than other countries, so that's good and the investors ask questions about it,” noted de Abreu. “But when it comes to looking at our GPs, it's interesting. LPs know that the industry is new, so how can they expect a track record of two or three funds in a row if they know that such a track record doesn't exist in the entire industry?”

Borges commented at this point: “It's a natural complaint that they might have.”

Goncalves noted that more and more international LPs are becoming educated about Brazil generally, with a key revelation being that the economy is not dependent on commodity exports. Those that do embrace Brazil as the allocation of the future are “disappointed in the number of managers there are to back”, said Goncalves. “The deal flow in Brazil could well serve 40, 50 GPs with subsequent vintage funds but very few players here have a fund two. I've heard this many times as I think the market will find a way to expand its current platform.”

At the table, Carlyle is the most recent arrival to the Brazilian market, although Borges himself has been active as a GP for years here. However he confirmed the difficulty of building a team in a market where private equity talent is hard to find, let alone hire. “Management here is not a commodity,” he said. “We experienced the difficulty of building a team. You need to build your own track record. It requires a lot of investment. You can't just say, ‘I need seven people’ and go out and hire them'.”

The Brazilian firms that already have teams in place, including our roundtablers, have never been busier deploying them on new deals. And they are bracing themselves for a coming wave of big international firms who will no doubt be looking to poach deals and employees as they seek a foothold in this exciting market. This would be a high-class problem in a market that for too long has had endless patience and not much capital or competition.

Head of funds development, entrepreneurship area BNDES

Rio de Janeiro-based BNDES is the main state-owned bank in charge of channeling long-term capital to Brazilian companies. BNDES began committing capital to local private equity and venture capital funds in the mid-1990s. The funds development division, led by Sa, now has investments with 27 funds. BNDES also makes direct minority investments in companies. Its budget for this year is around $60 billion for investments and loans. Sa has worked at BNDES since 1985.

Founding partner

Stratus Group

Founded in 1999, the Stratus Group is an independent firm focused on private equity and financial advisory, based in Sao Paulo. The group is composed of 20 investment professionals. It has broad coverage of the Brazilian mid-market segment, combining investment strategies based on buyouts and growth capital. Before Stratus, Gonçalves was at Pactual Electra Capital Partners, a fund jointly sponsored by Electra (UK) and Banco Pactual (Brasil). Formerly he held executive positions (CEO and CFO) at important Brazilian companies and served on the boards of local and multinational entities. Gonçalves has also served as chairman of the Brazilian Private Equity Association (ABVCAP) from 2004 to 2006. He has directly participated in many initiatives to improve the institutional investment market in Brazil, such as a number of local working groups for regulatory improvements, and the listing committee of BOVESPA (Brazil's stock exchange).


NSG Capital

NSG Capital manages private equity funds as well as other forms of private investment funds. Organised in 2006, the Rio de Janeirobased firm is currently focused on greenfield energy projects in which costs and revenues can be established prior to launch of operations. De Abreu, one of the founders, has acted as a member of the board to institutions such as Itaúsa, Aliança do Brasil, Telemar, Companhia Brasileira de Securitização and CBLC (BOVESPA). De Abreu previously worked as CFO of Banco do Brasil and CEO of BB Investimentos, Banco do Brasil's investment bank, and before that was chairman of the board and CEO of BRB Banco de Brasília. De Abreu also serves as a professor of finance at Fundação de Getúlio Vargas.

Fernando Borges
Managing director

The Carlyle Group

Borges is a managing director and Carlyle South America advisory team head focused on private equity investment opportunities in South America. He is based in Sao Paulo. Prior to joining Carlyle, Borges was a managing director at AIG Capital Partners and CEO of AIG Capital Investments do Brasil, having participated in 12 investments in the region with nearly $320 million invested. From 1994 to 1999, he was a director at Bozano-Simonsen Private Equity, where he was responsible for managing a private equity fund sponsored by Bozano-Simonsen and Advent International. The Carlyle Group is a global private equity firm with $84.5 billion of assets under management committed to 64 funds.