Giddy days for Brazilian private equity

Brazilian private equity is enjoying Lotus days and an unbridled sense of optimism. Established firms are raising big new slugs of money, creating giant funds that dwarf any currently in operation. Money is pouring in not just from the traditional investors in the developed world but increasingly domestic and Asian institutions. And the world’s very largest private equity firms are finally being enticed into the market.

Several factors explain the interest. Firstly, Brazil has the strongest macroeconomic environment for private equity ever seen, reckons Patrice Ledoux, head of the Brazil office of ACTIS, pointing to international reserves and falling interest rates as well as a trade and primary surplus. The country’s economic stability is finally generating longed-for economic growth, which topped 5% last year. All this should culminate in the awarding of investment grade status in the next 24 months.

A track record of success has been established by private equity houses in Brazil over the last three years as they exit positions successfully and profitably. That has fed investor demand. International investors have realised that they are under-exposed to Latin America after piling into Asia – which has enjoyed some $30 billion of inflows annually -- while the most sophisticated domestic Brazilian institutional funds have been gradually increasing their exposure to alternative asset classes as part of a broader attempt to diversify.

Risk Factors
Private equity firms were being helped to exit positions by Brazil’s public equity markets, whose performance had been nothing short of spectacular. Last year, Bovespa was the world’s second best performing market, providing a 74.1% return in US dollar terms, the fourth consecutive year of high performance. Even after the re-ratings of Brazilian companies, multiples remain lower than other big emerging markets compared to Asia. Patrice Etlin, the seasoned managing director of Advent International in São Paulo, says that his firm, which tends to sell to strategic investors, floated four companies on Bovespa in the last two years. That was a purely opportunistic approach to maximize returns, he notes.

The strength of Bovespa’s performance has been of course a double-edged sword: companies were starting to opt to avoid the straight jacket of inviting in meddlesome private equity investors and list shares instead, depriving private equity houses of investment opportunities. Furthermore, they were able to demand high multiples and bargain aggressively thanks to so many fund raising options. For private equity firms, the market had started to look perilously short of bargains

The big question mark is what the next couple of years hold for public equity markets and how that performance affects private equity firms. Until recently, Bovespa was offering giddy multiples for all-comers. But with just one tiny IPO in the first six weeks of this year, which priced below expectations, compared to six IPOs last year with a value of R$3.4 billion, market conditions clearly bear little resemblance to that dynamic.

The new reality of volatility on Bovespa removes companies’ listing option and strengthens the hand of private equity firms scouting for investments. “Private equity firms are counter-cyclical. Whenever the IPO market is very hot, the outlook for private equity is very hard,” says Denise Moura, managing director, head of investment banking at Banco Bradesco de Investimento. The flipside is of course that private equity firms that want to exit positions now have fewer options. The likely upshot is that there will be more sales to strategic investors and between private equity firms themselves.

Raising Funds
The Emerging Market Private Equity Association (EMPEA) shows just how much Latin America is on investors’ agendas. In its 2007 survey of limited partners, EMPEA revealed that just 31% of private equity investors have money in Latin America. But by 2012, a full 64% said they expect to have investments in the region, with the money evenly split between Brazil and the rest of the area. Indeed, the amount of private equity money entering Brazil more than trebled last year. An estimated $7 billion in new funds was raised compared to less than $2 billion in 2006.

Etlin says that firms like his, which passed through the ‘nuclear winter’ of 2001-03 when local equity markets were dead, are now reaping the rewards of their staying power. They have proven that they can survive tough market conditions, are successfully divesting stakes in investments, and are now reaping the rewards with a tsunami of investor interest. Advent’s latest bid to raise cash generated $2 billion of interest in the fund and the company capped its size at $1.3 billion, he says. In 1996, Advent raised $235 million for its first Latin fund.

Other firms with a long-standing presence in Brazil have been using this window of opportunity to raise funds. AIG Capital, for example, is preparing another $600 million portfolio for Brazil. The arm of the US insurer has been behind some of Brazil’s best-known deals, including investing in and helping bring public airline GOL and department store chain Lojas Americanas.

Perhaps the best known private equity firm in Brazil, GP Investimentos, is thinking big. It is said to be close to announcing a fund for $2-3 billion. The firm’s CEO Antonio Bonchristiano has been fund raising in the US for this, the firm’s fifth fund. GP successfully raised just over $1 billion for its fourth fund, GPCIV, just last year.

Things are looking so good for GP that it is also looking to speed its regional diversification by opening a Mexican office. The office will be headed by Marcio Trigueiro, one of its seven partners, who has been hiring to build out the Mexican team. The move consolidates the Brazilian firm’s international presence after it bought the Latin operations, spread across eight Latin countries, of Houston-based oil services business Pride International in August for $1 billion.

Other foreign firms are seeing money come in not only as allocation from broader funds, such as global emerging markets and BRIC funds, but from local fund raising. That, at least, is the case with Darby Overseas Investment which is finalising a 400 million reais Brazilian Mezzanine Infrastructure fund, with money raised purely from local investors, says Fernando Gentil, head of Brazilian operations.

The long-awaited arrival of the US giants is also in place. Carlyle too opened an office in Brazil last year and has been intensifying its capital raising efforts. The US firm picked up real estate veteran Eduardo Machado at the beginning of last year and has since announced two major agreements in the sector.

Blackstone, which has a relationship with local investment bank and private equity house Pátria, is cementing that. The US firm will provide $500 million to a $675 million fund that Pátria is raising. Stephen Schwarzman, CEO of Blackstone, has said that the firm has not been deterred by the global downturn and Pátria has said that the fund is nearly ready with the remainder of the money coming from local pension and institutional funds. KKR is said to be one of the other giants keen to enhance its presence. “These mega firms represent serious competition because they have the clout, relationships and track record with large investors to raise large amounts of money quickly,” admits Gentil.

Finally, Brazilian hedge funds are starting to set up or at least act more like private equity funds. Hedge fund Gávea, for one, has raised money for a private equity fund partly through Harvard Management Company (HMC), while Pactual and Tarpon have both branched out into the area.

Fund raising
Most of the money is still coming from traditional sources, institutional funds in the US and Europe, but interest from other quarters is steadily growing. Domestic pension funds are estimated to have R$7 billion invested in the asset class, according to data from São Paulo-based RiskOffice. Petros, the pension fund of state-owned oil giant Petrobras, was one of the first to invest in the asset class and in 2005-06 the firm approved further investments of some R$1.5 billion in it.

Investments are also coming from Asia. GP, which raked in over $1 billion last year, saw Singaporean wealth fund Temasek invest some $100 million and other Middle East and Asian funds chip in. Temasek is so keen to increase investments in the country that it has announced it will open an office in Brazil.

The strength of institutional investor interest from round the world should help make up for one area in which private equity firms are now facing more difficult times in raising cash, the yo-yoing public capital markets.

They will have an impact on GP, for one, which had been highly active in both equity and debt capital markets until recently. After its successful IPO in 2006, it issued US$150 million in perpetual notes last year and has used the exchange to divest stakes of investments. Fund raising plans must look bleak for FIR Capital, a venture capital specialist in small and mid-sized companies, which has lodged a request to distribute shares through Bovespa via UBS Pactual.

Firms that have increasingly depended on Bovespa as an exit for investments will also need to put on their thinking caps. Amid the gloom, there’s one new avenue of hope. Bovespa Mais, the new market segment directed at small and medium sized companies, saw its first ever listing in February. While fertilizer company Nutriplant raised less than anticipated at R$20.7 million, the very fact that it was able to raise money at all in current difficult market conditions where investors are paying a heavy premium for liquidity, shows the viability of the idea of the segment. The emergence of Bovespa Mais may give private equity firms, which tend to focus on this segment, wider opportunities to sell through public equity markets.

And private equity firms can increasingly count on local banks to finance acquisitions, says Moura, who has developed long-term relationships with a number of them. Bradesco’s lending varies according to whether the borrower is well established and a cash generator, for whom terms can be relatively flexible, or capital intensive firms, which face much stricter scrutiny.

Deals and sectors
All this new money being invested into large funds and the advent of the blue-chip players into Brazil’s private equity scene will lead to the emergence of bigger deals. Not only that, but the international trend to private equity firms clubbing together to form consortia to leverage that will have a multiplying effect on the trend, argues Ledoux. Brazilian banks also have a role to play in increasing deal size as they start to fund private equity firms, with leverage for some deals at fifty and even 60%.

These larger funds will enable private equity firms to benefit from the widely-anticipated shake-up in real estate. Shares in these firms have come to a shuddering halt after strong performance through mid-2007. Firms such as Darby and ACTIS believe some of the best opportunities may lie with suppliers rather than attempting to finance consolidation through M&A. Ledoux points out that Votorantim, the main concrete supplier, is working flat out and Gentil favours new sectors, such as middle and lower income homebuilders.

Infrastructure, too, remains popular. Darby’s Mezzanine Fund joins a crowded marketplace, admits Gentil, explaining that it will differentiate itself through investing in much-needed small hydro plants, which fail to appear on most investors’ radar screen as well as ethanol, where he reasons that consolidation in the fragmented industry is overdue and that many projects will get cancelled.

Still, Etlin for one prefers steering clear of these areas, seeing them as ‘hot’ sectors. He reasons that valuations are overvalued with too many companies having coming to market too quickly, sacrificing quality. The run-up in prices for ethanol firms and homebuilders which then helped lead the market down, shows up their volatility.

Finally, there is some space for non-traditional segments. Stratus has recently announced investments in Brazil Timber, which operates in the area of sustainable forests and has some $40 million in assets and 6,500 hectares of forests.

The outlook for private equity in Brazil has never looked better than over the last months, at least for newcomers and those raising money. That money should not upset the delicate balance of corporate financing too much as public equity markets are proving stingy, particularly for the small and medium sized companies in which private equity firms specialise. For now, credit is readily available for private equity houses as Brazilian banks continue to be willing to lend in the teeth of global conditions.

But the gathering clouds of the global recession have already taken their toll on the IPO market and small- and mid-sized debt deals. A recession would quickly eat into private equity firms’ ability to raise more money from overseas investors and domestic investors remain tiddly despite rapid growth rates. The next few months look rosy as private equity firms are flush with cash, but the mid-term has become a lot more challenging.

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