Brazil Private Equity: Relative Value Play

Private equity is the last man standing in the capital supply game. But fund raising prospects have sharply deteriorated and caution reigns.

Until mid-2008, Brazilian private equity (PE) firms faced brutal competition for investment from buoyant public equity and debt capital markets, credit from banks and even hedge funds taking pre-IPO stakes. These opponents have now vanished, generating a sense of opportunity.

“Between 2006 and 2008, we were competing against the IPO market, valuations were stratospheric and the real was very expensive,” says Patrick Ledoux, head of the São Paulo-based office of ACTIS, who is cautiously optimistic long-term. ACTIS specializes in EM funds and is a spin-off of the UK government’s CDC. It has raised $7.6 billion since its 2004 inception.

For global managers, Brazil is attractively valued on a range of fundamentals compared to China, and is closer to values seen in South Africa, Ledoux says. LatAm is a region that many global managers would like to increase their exposure to, having been heavily exposed to Asian markets in the boom years, Ledoux adds.

But, for now, many PE firms are struggling to close deals. The number of M&A transactions in Brazil was heavily dragged down in 2008 by a 40% year-over-year drop in the last quarter, according to Alexandre Pierantoni, corporate finance director at PricewaterhouseCoopers. In the last quarter of 2008, there were 121 deals compared to 200 in the same quarter of 2007. For the whole of 2008, there were 639 transactions, a decrease of 11% over 2007’s 721.

Transactions are proving difficult to close thanks to a wide valuation gap between the public and PE markets, as well as buyer and seller expectations. “We are seeing trouble concluding investments as it takes time for owners of private companies to adjust to the new market reality,” says Luiz Eugenio Figueiredo, president of Abvcap, the Brazilian PE and venture capital association in São Paulo and a manager of Rio Bravo, which has $250 million reais in PE/VC funds. That said, 2008 was surprisingly strong, with committed capital rising to $26.6 billion from $17.7 billion in 2007. Figueiredo sees a slowdown, but predicts growth of 10% in committed capital this year.

Nimbleness Wins
Patrice Etlin, managing partner at Advent International’s São Paulo office, agrees fund raising is today’s key issue. In 1996, Advent raised $235 million for its first Latin fund and was able to get $1.3 billion for its fourth in 2007.

Companies in public markets are trading at attractive valuations of some 3-4 times 2009 estimated Ebitda for 2009, says Etlin. But managers are holding out for valuations that would put them at 7-8 times 2009 Ebitda, and are not even prepared to talk about selling, he adds. A further difficulty lies in making realistic assumptions for 2009 results.

The new order provides an advantage for funds with more flexible mandates that allow them to make listed as well as non-listed investments and thus arbitrage. Eduardo Mufarej, partner at Tarpon Investimentos in São Paulo, says his firm – which has around 2.5 billion reais under management – has been taking minority stakes through public markets, gaining access to low multiples. Privately-owned companies not badly in need of cash will simply wait to sell, he reasons. “As a price sensitive company, it was difficult to do things in a bull market where we were uncomfortable with valuations,” Mufarej notes.

Others say PE managers pay up to take a more active role in underlying companies than investors in public equity markets, but they are confident the valuation gap will shrink. PE has played a growing role in stock market transactions, with 20% of last year’s public market deals having some PE participation, Pierantoni points out.

When valuations get more attractive, PE’s firepower should be turned to realize long-expected consolidations of key sectors, predicts Pierantoni. Education will continue to consolidate, with health and food stuffs joining the fray, he adds. Last year, education dominated: Anhanguera Educacional, which is majority owned by Banco Pátria, closed 14 deals in the sector. Estácio de Sá, another educational firm, in which GP Investimentos has joint control, completed 13.

Real estate, while slower off the block, could see more deals done, adds Etlin. Financial investors have been active in Gafisa and Tenda and there have been rumors concerning smaller players that face funding difficulties, such as Inpar, say PE market participants. Real estate firm Brasil Brokers closed 10 deals in 2008, notes Pierantoni.

Return to Safety
In this new environment, PE funds are re-thinking strategy. Many are getting more conservative, prioritizing investment in companies that have predictable returns, market leaders, or operating in sectors best able to withstand recession.

The industry wants companies with a mature business, proven cashflow and management, adds Hamilton Agle, partner at São Paulo-based AG Angra, which runs a $700 million infrastructure fund. Investors will also favor firms dealing in basic consumer goods, such as food retailers, and those not relying on credit, says Ledoux.

At a time when owners remain stubbornly unwilling to negotiate, PE money will also hunt companies in need. Some must push ahead with new investment or need to reduce leverage at a time of tight credit, says Agle. In an era of lower earnings, leverage ratios naturally increase, he notes.

Several firms face re-financing risk in 2009 and PE is one of the few options open to them. Advent is seeing bigger companies knock on its doors with refinancing and working capital needs. It is working on a consumer and a financial services deal that Etlin expects to close soon.

And several privately-held companies – particularly exporters –are grappling with unwinding forwards contracts on the dollar that turned sour. The near 50% devaluation of the real at the end of last year wrong footed many exporters with currency hedges, says Burkhard Ziegenhorn, head of global transaction banking at Deutsche Bank in Brazil.

Sadia and Aracruz are just the tip of the iceberg and many smaller companies were hedging out 12-months at rates of 1.7-1.8 reais/dollar, against recent levels of 2.3 and may require financing, he adds.

Funding Funk
If more transactions really do get off the ground, eyes are going to shift from spending to funding. Fow now, Brazilian PE firms are relatively well capitalized with 11 billion reais raised and unspent, notes Pierantoni. But funding was already becoming harder last year and is now very restricted.

In 2008, PE firms raised some $6 billion for Brazil, of which $4 billion came from foreigners, says Pierantoni. That compares to $9 billion in 2007, he notes.

Even industry leader GP Investments is affected. The firm is said to have been stalled for over a year in attempts to raise funds from the market, say competitors. GP declines to comment, citing a quiet period.

Mufarej, who recently went to London on a fund-raising trip, says the environment is much more challenging than a year ago and reasons that the number of managers qualified to raise assets will be much reduced. Due diligence is increasing substantially and requirements to allocate capital within specified timeframes will be much stricter, he adds.

For local funds, long-term institutional investors, such as the BNDES and pension funds, are increasingly key. Pension funds already account for some 24% of committed capital by Brazilian PE firms, or $6.4 billion. “There is still space in their portfolios for investments in PE and VC,” reckons Figueiredo.

Even so, the push by Brazilian pension funds into the sector is a slow and protracted process and there may be a retraction thanks to the global crisis, reckons Etlin. He adds that as overall portfolios shrink because of falling asset values in equity and bonds, funds will see allocations to alternatives diminish, even if they do maintain a dedicated percentage to PE.

Previ, Banco do Brasil’s pension fund, already dedicates some 4.5 billion reais to the sector through two VC and seven PE funds, says Emilio Sampaio, CIO. It is wrapping up evaluation of three more funds to add to its portfolio, focused on sustainability, including carbon credit, agribusiness and technology.

Sampaio says he aims to expand his portfolio in line with growth in the industry and notes that in an earlier wave of investment, the fund made returns of more than 20% per year. Still, the overall allocation is small at less than 2% of the fund’s total assets, versus more than 60% in public equity.

Exit Strategies
If cash raising is hard, mature funds will at least be able to sell assets to raise money for new investments. Tarpon’s pipeline for new deals has increased two or threefold, Mufarej says. “Now we may face tough decisions such as whether to sell an investment cheap to buy something even cheaper,” Mufarej says.

For the most part, exit strategies are likely to be delayed, particularly as public channels remain closed. From 2004-2008, 66% of the total volume of exits was through the Bovespa, points out Pierantoni, and PE was behind one third of all transactions. In a reversion to the patterns pre-2005, trade sales to foreign multinationals or local conglomerates will prove the rule once again, says Etlin.

Despite the blurred outlook, most PE managers are quietly optimistic, at least for the long-term. They see opportunities opening up as the year goes on, valuations fall and the impact of the downturn becomes clearer on cash flow and profit.

For now, however, valuation gaps between the private and public markets, the need to preserve cash for only the best opportunities, and uncertainty on how to gauge the worth of a company call for caution and extra analysis. That creates breathing space for managers to tighten up management of existing portfolios. Managing investment will be much more time consuming and trying than it was two years ago as companies face the downturn, says Agle.

PE firms will also be focusing on staffing up. Amid a dismal bonus season at investment banks, they aim to pick off some of the top talent that walks.

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