Bovespa Holding: a super-charged IPO

The IPO of Bovespa Holding, the Brazilian stock exchange, was a blow-out and the largest deal on that market to date. It pressed just about all the buttons for champagne all round: the price range was raised, the deal heavily oversubscribed and the shares shot up by over 50% on the first day of trading. Not surprisingly after that stratospheric launch, the Brazilian Mercantile & Futures Exchange (BM&F) IPO was a shoe-in. The deals cement the position of the two as the undisputed leaders of Latin America and the spicy pricing show the strengths of a near-monopoly industry in a growing economy and investors’ love affair with the exchange story. The spectre of enhanced competition in the long-term and weaker global markets now could douse the feel-good factor.

The deals, a solid story

Shares in Bovespa Holding, which priced at R$23 reais apiece on October 26 blew through the original pricing range of R$15.5-18.5 and came at the very top of the revised pricing band of R$20-23. The offering raised a cool US$3.7 billion.

“Stock markets have an interesting model that is highly attractive to investors and can be summed up in two words, operational leverage. We are basically an entity with a fixed cost. The more business transacted over the exchange, the more profit we make,” says Gilberto Mifano, CEO of Bovespa. The proof of the pudding can be seen in its $1 billion cash hoard, which is “much more than we need,” he says, adding cash flow amply covers spending needs.

José Olympio, managing director and head of Brazilian investment banking at Credit Suisse in São Paulo, which led the Bovespa deal, says that during the initial book-building process, it became clear that there was little to no price sensitivity. That looks like an understatement. Shares went on to hit R$35 valuing the exchange at 50 times forward earnings.

Mifano is convinced that the consistent growth of the Brazilian market in the last years is sustainable and marks a secular change. “It’s not a bubble. The market has changed profoundly. For the first time, companies are using the exchange to raise capital to invest to grow their business,” he says. The numbers speak for themselves. He points out that by number of IPOs, Brazil ranked as the third market in the world last year, trumped by just China and Hong Kong, a trend likely to continue as economic growth in emerging markets further outstrips developed countries.

For foreigners, who bought 78% of the shares of the Bovespa IPO, there are several reasons that help explain the strength of the deal. Much of it is macro-related. “Brazil is one of the most dynamic regions in the world,” says an official from the NYSE, which bought a 1% stake in the Brazilian exchange.

Neal Brady, head of business development, at CME Group, points out too that the country risk premium for Brazilian debt has dramatically narrowed and the country is slated to achieve an investment grade rating. “It has become one of the hottest markets in the world”. CME Group is an entity that encompasses the Chicago Mercantile Exchange and the Chicago Board of Trade, which recently took a 10% stake in the BM&F.

The Bovespa and BM&F deals are also riding the crest of a wave of consolidation as globalization and electronic trading allow well-run exchanges to generate plenty of liquidity from foreign investors, feeding their trade-equals-profit business model. That consolidation trend means the $1 billion in cash is a potentially useful war-chest. Mifano says that the exchange is keeping an open mind on possible tie-ups and acquisitions. He admits that Bovespa Holding does not currently see interesting opportunities in the region, but ambitions are broader: “We could speak with much larger exchanges than us. We don’t have any barriers,” he says. Any deal would need to meet the two key criteria that the deal makes sense for shareholders and the business model.

Bovespa Peculiarities

There are some more individual reasons for Bovespa Holding IPO’s success, notes Credit Suisse’s Olympio. Broker fees paid to the exchange are passed on to investors. That atomizes the cost and as investors are a diversified and loose group, there has been no outcry to lower fees. Naturally, as brokers do not pay, they have little incentive to lobby the exchange to reduce it.

Then, there is the intriguing possibility that Bovespa will become a regional fund raising centre itself. This year, the exchange has accounted for some 80% of listings in Latin America and that liquidity is starting to interest non-Brazilian companies. Argentina’s Banco Patagonia listed a concurrent Argentine, Brazilian and international offering of shares, BDRs and ADSs in July. The bank sold 200 million shares through JPMorgan.

The Bovespa Holding deal has had a halo effect too, reckons Olympio. For many overseas investors, it was their first foray into Brazil. They are now coming back for more: “Bovespa’s IPO helped Bovespa’s business,” he says. The listing will continue to deepen the market both in its own right and through this attraction of new investors.

So far, so good. But it is less clear that other trends are favourable to the exchange. One of the key selling points for Bovespa Holding has been the lack of competition from other exchanges. With high barriers to entry and the rapid establishment of Bovespa as the premier exchange in the region, competition is locked out, the argument goes.

There’s much in that, but a change in the competitive landscape is the bear roaming in the woods. It could come from other physical exchanges or electronics ones. The New York Stock Exchange was for years the first choice for Brazilian companies and still represents the biggest single potential rival, according to Olympio. Larger companies of the ilk of Petrobras, CVRD and Gerdau have American Depository Receipts trading in New York; US investors are still the single biggest buyers of Brazilian stocks; and the US exchange clearly has a history of stability that Bovespa lacks.

For now, competition from the NYSE looks unlikely, Olympio believes. The combination of a better-run, more liquid home market in Bovespa and the Sarbanes-Oxley Act (SOX) and its associated costs for listing in the States means many Brazilian companies are happy to stay at home. If SOX provisions were to be watered down, as the NYSE dearly wishes, or global liquidity trends turn very averse, Brazilian companies might change their mind.
Mifano is sanguine about the threat from up north. He notes that since 2004, only four companies carried out a dual listing in New York and they had very specific reasons, such as wanting to give investors direct peer comparisons. He admits that SOX has helped Bovespa build up its business, but argues that it’s a prop that’s no longer needed: Bovespa is now firmly established and that even if SOX is diluted, the NYSE will be hard-pressed to win back business, he reasons. “70-80% of our IPOs are bought by foreigners. They are comfortable investing directly in Brazil,” he says.

One investor, who declined to be named, believes that the emergence of electronic trading platforms could chip away at Bovespa’s business. Mifano says that while that’s not impossible, Brazilian legislation has erected some tricky hurdles for that business model. They include identification of the final beneficiary of a trade and the imperative that transactions involving either an institutional investor or financial intermediary use a regulated market for transactions. That means a new competitor would need to create an organised market.
Other bankers see rivalry from the newly-demutualised and cash rich BM&F turning its attention to the cash market. In the short- to medium-term that makes no sense, reasons Mifano. “We both have to do lots in each of our respective markets. It’s not reasonable that they would de-focus on their market.”

Indeed, the tables might be turned according to one banker who suggested that the more likely scenario is for Bovespa to move onto the BM&F’s turf. Unlike Bovespa, the BM&F does not have its own depository, for example, he pointed out.

Irrational exuberance?

At one stage, Bovespa Holding’s share price valued the exchange at about half the value of the New York Stock Exchange, even though the combined value of companies trading on the New York exchange was $16,000 billion in September, compared with just $1,200 billion on the Bovespa. Bovespa Holding shares have also proved volatile trading by more than 7% in one day. They are trading at the very high end of international exchanges, between Shanghai and Hong Kong exchanges, the top two thanks to exposure to an economy with much brighter economic prospects than that of Brazil.

For respected economist Luiz Carlos Mendonça de Barros founder and partner of Quest Investments in São Paulo, while the long-term macroeconomic trend is positive and the exchange profitable, it’s also partly investors buying into a fad: “There’s a sort of mania surrounding stock exchange IPOs,” he believes. Furthermore, while Bovespa may well emerge as a regional hub he pours cold water on its significance, noting the paucity of listings from other markets. Argentina, the largest other market, is in a ‘populist trap’ and unlikely to offer rich pickings for now.

There are some red flags in the wider IPO market in Brazil too. Recently, a number of IPOs have traded down in the immediate aftermarket. And while corporate governance standards are good, some companies respect the letter rather than the spirit of the law. Giant ethanol producer Cosan, once a darling of the exchange, moved its listing to Bermuda to enable the owner to keep control of the company with a 10% stake. That contributed to a collapse in the share price.

Strategic Investment
In taking a 10% stake in the BM&F, CME Group is cementing a long relationship, says Brady. The cross-share swap also gives BM&F a 2% stake in the CME, he notes. CME took its stake in BMF alongside General Atlantic which also took 10% and has a seat on the board. Brady believes that they bring complementary strengths with CME providing technical know-how and General Atlantic strategic input.

The Brazilian exchange, which is the fourth largest such market in the world, has been a: “Shining success story in a market that’s been very volatile. It has earned a great reputation,” he says. Investors can see exactly what has happened to electronic privatized exchanges in the US and Europe and map that to a growth story and the asset base to run calculations.

The CME-BM&F deal also exploits new global trends. Clients increasingly wanted to trade in Brazilian assets and set up hedging strategies, which regulation makes relatively easy. Equally, there is demand from Brazil to trade offshore and get exposure to CME products. “This has come together in the last few years and particularly months [with the merger of CME and CBOT],” opening a far broader suite of products, says Brady. Other factors include the move from floor to screen-based trading allowing more complex execution arrangements – and some cross-over in the products offered on the Brazilian and overseas exchanges, including the overnight interest rate, FX and agricultural contracts.

Management of both institutions is world class, Brady believes. Indeed one of the main attractions of the BM&F was the strength of its management. That means that there won’t be need for any major change of course.

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