Brazil is steadily solidifying itself as South America’s preeminent private equity hub. An achievement that has come with it increased scrutiny by investors of how funds are tackling the country’s macroeconomic challenges, says Debevoise & Plimpton private equity lawyer Erica Berthou and her tax-focused colleague Peter Furci.
Consequentially managers are tweaking standard terms and conditions to develop custom-made funds designed to address such investor concerns, say the two partners. In the end, Brazil-focused funds may signal what factors any emerging market vehicle will need to consider.
What macroeconomic trends specifically are resulting in investors demanding tailored fund terms and conditions for Brazil-focused funds?
Furci: Appreciation of the real (Brazil’s currency) is without a doubt one of the most important trends on LPs’ minds. Think about it, you have a fund for international investors who commit in dollars, but all investments are real denominated. If you then convert the disposition proceeds back to dollars to calculate the carried interest, the GP in effect took a long-position on the currency. If the real continues to appreciate, this goes in the GPs favour.
Berthou: And limited partners are questioning if that’s really fair. Some believe a manager’s carry should be more of an apples to apples comparison which would involve measuring their total performance in reais. So we have seen some LPs and funds say they would calculate the waterfall and the carried interest by effectively converting the dollars to reais at the time of the original investment and on distribution, so you’re not looking at the currency movements but the real denominated gain on the investment.
Makes sense, but what if the currency ended up moving against the GP?
Furci: Investors are also concerned if the real goes the other way. They worry there is a risk a manager will lose incentive to maximise a portfolio’s value if their carry will take a hit by a bad price movement in the currency markets.
Berthou: Really the bottom line is LPs are saying they want to minimise any distortion on incentives that may be created by uncertainties in the currency movement. Imagine if a drop in the real resulted in a GP no longer hitting their carry in the fund – that might change their approach in how they manage the portfolio.
Speaking of economic conditions, Brazil is known for high inflation relative to developed markets, does this raise any issues in private equity?
Furci: Absolutely. Because you’ve got on average a roughly six percent inflation rate over the past few years in Brazil, investors are questioning if an eight percent return hurdle rate is the right measure for earning carried interest.
The concern relates to whether sponsors are being rewarded for investment performance as opposed to benefiting from inflationary value increases. We’ve seen a number of variations to address this concern. A fund might use a higher fixed rate, or a fixed rate increased by a variable amount tied to the rate of inflation in Brazil (usually, above a target level) measured over the fund’s term.
Berthou: We’ve seen some pushback from LPs on this issue –typically LPs sophisticated in investing in Brazil and that are making large fund commitments. What’s interesting is we haven’t seen this issue crop up in other emerging markets, which goes to show just how much attention and capital is going into Brazil at the moment.
Interesting, why aren’t other emerging market fund tackling similar issues?
Furci: It’s hard to say, but perhaps because most emerging market funds invest in multiple jurisdictions, there isn’t as obvious a choice for a default currency other than dollars to calculate carry.
Berthou: It’s also worth noting private equity investors are starting to focus on this issue now and so it is possible this will become an issue in other emerging market funds dedicated to one country.