Brazil Special Report: Consolidation Wave Not Broken

Brazilian M&A bankers are unflappably optimistic in spite of a crisis in global markets. With consolidation penetrating ever more sectors, M&A appears on track.

M&A bankers claim their Brazil pipeline is as strong as it was in 2007. Ricardo Lacerda, head of investment banking at Citi in São Paulo, believes economic growth and rising consumer power means 2008 could even be better than last year. That would extend a trend. There was $60 billion in deals in 2007, a 40% increase over 2006 once the giant $17.2 billion Vale-Inco deal is excluded, he points out.

Brazilian companies are set to continue to lead again in initiating transactions this year, accounting for some 60%-70% of acquisitions, says Raul Beer, partner and head of corporate finance at PricewaterhouseCoopers in São Paulo. Multinationals are responsible for the remaining 30%-40%, he adds.

Brazilian firms will continue to be active overseas too, although there will be concentration in a small number of large deals, he says. They still have access to affordable financing, making them truly competitive with foreign rivals. Vale’s possible acquisition of Anglo-Swiss mining concern Xstrata for some $90 billion would trounce all of last year’s M&A activity put together. Vale has conditional financing lined up despite dire global conditions, but the initial $76 billion bid was reportedly rejected by the target in February.

Optimism may seem surprising given the onset of a global economic slowdown, with most economists having already trimmed forecasts for GDP growth in Brazil to some 4.0%-4.5%. Credit markets are frozen and there is a distinct possibility that commodities, a mainstay of the Brazilian economy, will come off the boil. Brazilian bankers do not fear major fallout locally for two reasons, one macro economic and the other capital markets related.

On the macro side, Brazil is strong in hot areas like agribusiness and commodities. Fragmented industries have started and will continue consolidating. And the domestic consumer is just beginning to flex his muscles. Admittedly the latter is based on rapidly-growing credit, but this is piffling in international terms. Credit represents just 35% of GDP in Brazil, according to the National Association of Institutions of Credit, Financing and Investment. Last year’s US household personal credit was 96%, according to the Woodstock Institute.

Brazilian corporates have not relied heavily on equity markets to fund M&A, says Lacerda. He points out that Brazil’s M&A activity is still puny compared to developed markets. He compares M&A volume to total market capitalization and GDP. In the UK, M&A represents 21% and 36%, respectively, while in Brazil this is a much more manageable 6% and 3%, respectively.

In addition, Brazilian companies remain under-leveraged compared to international norms, says Beer. His firm has been advising a wide range of clients and none has withdrawn from a proposed deal. And for those companies that are cash-rich from a recent trip to the IPO market, the uncertain environment presents an opportunity to pick up targets cheap. Still, if conditions do not improve, as the year wears on transactions will be trickier to finance, leading to creative tie-ups between commercial banks, hedge funds and private equity sponsors to keep the market well oiled.

Small Deals Repelled
For SMEs that do need to raise cash to acquire, conditions are hostile. Daniel Goldberg, managing director and head of M&A for Brazil at Morgan Stanley, sees both more expensive financing and much greater due diligence, with clients insisting financing packages are water-tight. “Let’s not fool ourselves, current market conditions are extremely challenging,” agrees Lacerda.

Equity funding for all SMEs, regardless of reputation and track record, has been choked, though it remains conditionally open for blue chips. “The equity market is not accepting small deals right now. The deal size has to be large and from a large company,” says Denise Moura, head of investment banking at Bradesco, which deals with a large spread of companies, including SMEs. A $300 million offering from a company with total equity of $600 million runs into a brick wall. The same sized issue from a $1.5 billion company can be pushed through, she adds.

As SMEs are no longer able to tap equity, they will look to grow organically and through small acquisitions to accumulate the muscle to come to markets when they re-open, Moura predicts. That is, as long as they do not fall to larger predators.

Even bullish Beer sees a reduction in equity activity, with some knock-on effect on M&A. Still, he believes the stock market pause is not all bad. The market was looking frothy and starting to encourage companies to rush to market, inflating valuations to unrealistic levels and encouraging unlisted rivals to harbour illusions about the multiples they could generate. The effect of the downturn will be an adjustment in valuations and willingness to sell to strategic investors.

War Chests Build
There are plenty of Brazilian companies able to buy, particularly those listed over the last couple of years that are flush with cash. “Even those IPOs from companies that have disappointed investors raised significant amounts of private capital,” says Lacerda. These firms will lead consolidation through M&A to boost results, he predicts.

The other development is interest in domestic, semi-private deals, says Nicolas Aguzin, head of LatAm investment banking at JPMorgan. He adds that for public markets, volume in the first half is likely to be down some 30% year-on-year.
Debt markets too are also doing the splits. Giant mining company Vale’s ability to obtain $50 billion in debt funding promises for the possible purchase of Xstrata after its jumbo purchase of Inco shows market appetite remains solid for the crème de la crème. Vale managed to line up a strong syndicate dominated by international banks including Santander, HSBC, BNP Paribas, Credit Suisse, RBS (via ABN AMRO), Citi, Calyon and Lehman.

That may seem surprising as banks like Citi have been severely battered by the US credit crisis. Lacerda insists that the Brazilian operation remains unaffected, and its commitment proves that there is still a lot of money out there for the right Brazilian names. Still, with US banks becoming incredibly selective in how they spend capital, prospects for big acquisitions with bank financing must be damaged, reasons Aguzin.

Financial institutions are starting to re-price risk, insist on stricter covenants, and retain the right to change terms, says Goldberg. He adds that corporate ability to leverage will fall as banks grapple with more restricted lending policies and putting together syndicates becomes more uncertain. Bridge financing, in particular, will become harder.

Banks are indeed already insisting on stricter covenants, particularly on credit ratings. Heightened sensitivities from banks and agencies’ need to show that they are not patsies after the subprime crisis mean blue chips need to work extra hard to keep their grade during transactions. That is particularly the case for Vale (Baa3/BBB) and other Brazilian blue chips, which are held back by sovereign weakness and hover perilously close to junk.

Bond investors also prefer solid stories in these markets. That is in evidence at the smaller end of the market where companies are already suffering the credit drought. Bicbanco postponed a deal in the region of $100 million run by UBS because of market conditions at the end of January. That suggests it will be difficult for SMEs to use debt markets to fund acquisitions, particularly in the banking sector. Even Petrobras had to pull a mid-February attempt at a bond reopening that was launched too tight for the buyside.

Foreign Bidders Jump In
It is not only Brazilian companies that are acquiring, but foreigners, says Roderick Greenlees, head of M&A for Brazil at UBS Pactual. Anglo American’s $5.5 billion offer to purchase majority ownership in miner MMX shows that foreign interest is alive and kicking. Anglo wanted to grow in iron ore and was happy with earlier investments. Greenlees believes that despite weaker market conditions, foreign companies will continue to enter. He adds that hostile transactions are unlikely because most Brazilian companies are still privately owned or have a control group. “We will continue to see negotiated “friendly” transactions,” adds Greenlees.

Finally, private equity firms, hedge funds and commercial banks are all combining in new ways to facilitate deals. Financial sponsors are able to compete in Brazil as the cost of funds has trended lower. They are starting to use leverage plus expertise in reorganizing companies. “We will see more creative types of financing,” says Goldberg. These include hybrid debt-equity deals and convertibles, for example.
Moura confirms that banks like hers are lending to private equity firms. It is an area that has become attractive quickly. “You find a niche but then everyone does it and very competitively,” she says. Here again, though, there are stringent conditions on providing financing which favor cash generative, established businesses. “We are flexible for strong cash generators but strict for capital intensive businesses,” she says. Leverage for the former can reach a 40:60 debt-to-equity ratio.

Opportunity in Diverse Sectors
M&A bankers predict continued activity across many sectors. Moura says she has never seen such an eclectic range of companies eyeing transactions. Bradesco is working on M&A in services, logistics, ethanol, retail, petrochemicals, food, textiles, financial, industrials and mining. Brazil used to be focused on just four or five industries.

Broadly, the sectors most favored are related to consumer growth stories and include services, manufacturing and financial institutions, says Greenlees. Insurance and healthcare will also be strong, driven by new regulations to strengthen minimum capital requirements in what is a highly-fragmented industry, adds Goldberg.

Many firms will not be strong enough to survive.
Two key sectors stand out as ripe for consolidation: ethanol and real estate. There have been 21 homebuilder IPOs, points out Ricardo Behar, managing director at Morgan Stanley. A number of them came to market with high earnings predictions and some are likely to flunk the test. Behar sees two tiers emerging, including a top tier of well-capitalized firms, which will now want to expand into virgin territory, outside fiercely competitive São Paulo and in niche areas. They will look to acquire smaller, private, regional players to do so, he predicts. The lower tier will struggle to meet earnings expectations.

Ethanol is also in a state of flux. After posting some of the worst performance on the Bovespa in 2007, with leader Cosan down 50%, shares were sharply up by the end of January on stronger sugar prices and hedge fund buying in soft commodities. Goldberg sees this as a genuine change of investor mindset. With a number of projects stalled, there will be M&A to bail-out smaller, less successful companies, he reasons.

These two sectors may be a sideshow to the more important mining and hard commodities sector, where an uncertain global outlook and sterling share performance last year means that some retrenchment of commodity markets and related shares looks likely. Both mining and the agro industrial and meat-exporting sector are very export dependent and have been some of the most active sectors, says Beer. The emergence of JBS Friboi as a meat-packing powerhouse through acquisitions and Vale’s ability to buy, in part because of the appreciation of its stock, may be reduced.

“They enjoyed these benefits because of growth in world demand and stand to be more hit by reversal,” says Beer, reasoning that slower economic growth will hit the cyclical commodities business. Lacerda agrees that commodity-related sectors are likely to decelerate after very robust performance.

That surely implies many dangers lurking for Brazil. Caught between a commodities downturn and an international credit crisis – which will dent banks’ ability to continue supporting the credit boom – the country is also dogged by slowing GDP growth. If markets continue comatose and the economic outlook remains glum, more and more deals will be postponed, shelved or abandoned.

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