Gloss comes off Brazilian exchange merger

The consummation of the marriage between Brazil’s stock market, Bovespa, and commodity and futures market, BM&F, to create BM&F Bovespa has brought into being a regional powerhouse. Long-term prospects for cost savings, new products, and capturing money from other Latin countries are exciting although plans will surely take longer to come to fruition than expected. The short- to mid-term is occluded by a rapid reversal in market sentiment which has led to a bear market, calling into question the sustainability of Brazil’s equity miracle. New rumblings over corporate governance are unlikely to help the market recover its glitter quickly.

The bear market has come on the back of a generalized withdrawal of foreign and local money as questions over valuations in Brazil’s commodity-heavy equity markets emerge with the strength of the long cycle coming into question. Trading volumes have been slumping, with predictably dire effects on the new exchange’s shares.

The retreat will likely set back the exchange’s ambitious plans to launch new products. If combined with further questions over corporate governance, it could more permanently damage Brazilian capital markets and bring into question the exchange’s business model.

Certainly, the exchange needs to keep a close eye on expenditures for now. Its first profit announcement revealed net profits of R$165.2 million in the second quarter but also highlighted how operational costs caused net income to fall 6.1% on a pro forma basis. That will need to be tightened in these tougher markets.

Trading History
Shares in the merged BM&F Bovespa had started auspiciously enough: on August 20, the first day of trading, they jumped 7.5% to R$11.84, following the sizzling pattern of the Brazilian IPO market of 2007. But that was more of a technical bounce and they came off the boil in the next couple of days. Moreover, the leap came after shares in the individually traded companies had provided dismal performance since their fêted IPOs late last year.

Indeed, shares in Bovespa Holding peaked at R$37 on November 9 and came steadily down to hit a low of R$14.25 on August 18, just before the shares were converted into new BM&F Bovespa shares. BM&F, which carried out its IPO only in December, peaked at R$25 on December 28 and also hit a low on August 18, in its case of R$9.91.

Until recently, the business numbers had seemed to stack up. The average daily trading volume on Bovespa more than doubled in each of the last three years, reaching as much as $3.7 billion this year, up from $198 million at the end of 2002. In that period, individual investors upped their presence on the exchange too and now account for 26% of trading compared with 22% in 2002.

And in the first quarter, volumes continued to rise: the average was close to R$6 billion per day compared to R$4.9 billion in the same period of 2007. The problem is that future predictions were extrapolated from the past. The more recent numbers are worrying: total volumes fell in July to R$125.2 billion compared to R$132.5 billion for June. Numbers for August are likely to be worse.

International investors have been pulling out, selling almost $10 billion of Brazilian stocks in June and July. That represents the fastest pace of withdrawals since 1994.

Many foreign investors feel burned by many of the glossy presentations and over-optimistic forecasts that supported the wave of IPOs in 2006-07. “There was a lack of responsibility from both corporate and their advisers in producing estimates,” says Bernardo Parnes, CEO of Banco Bradesco BBI, the investment arm of the private domestic bank.

Many companies that should have tapped a private equity (PE) investor instead prepared for a market launch, preferring to skip over a necessary transition, believes Antonio Félix, a partner at law firm Tozzini, Freire, Teixeira e Silva Advogados. That has left many investors resentful of pressure and suspicious of the Brazilian sell-side’s pushiness.

The exchange is responding by trying to shift its investor base. It is looking to sell itself more aggressively to local investors. Some 500,000 Brazilians own equities and the exchange expects that figure to grow as it promotes itself. It intends to target agriculture workers, which accounts for 5% of the nation’s $1.2 trillion economy. “We have this big project of taking the Bovespa to the farmers,” Chief Executive Officer Edemir Pinto has announced.

That is likely to happen slowly over time, but looks extremely difficult in current markets. The tightening of the interest rate cycle since April has already taken rates up to 13% and most economists are predicting further tightening to 14% or even 15% before rates start to come back down. With some of the highest real rates in the world and lame performance from the stock market, there has been a significant domestic move out of equity funds and into government bonds.

Some investment management houses, most of which had been moving into equities, have seen their assets under management drop by 50% or more as investors pile into bank certificates of deposit. That has been the case even with very well-known houses including Mauá Investimentos and Quest Investimentos, both in São Paulo.

Merger Excitement
It wasn’t supposed to be this way. Earlier this year, Brazil became the biggest single component of the MSCI Emerging Market index and last year accounted for an outstanding 10% of all global IPOs with foreigners representing 70% of the interest. The merger between the exchanges has created the second largest stock exchange in the Americas and third largest in the world.

The argument went that huge growth in foreign interest in Brazil’s economy and the rapid deepening of financial markets would continue to push demand for equities and the Brazilian real long-term. The exchange would be constantly able to increase volumes as markets deepened, launching new products together with partners and acting as the exchange of choice for other Latin companies, deterred from a US listing by the over-zealousness of Sarbanes Oxley.

But since June, the idea that Brazil could decouple from global market trends has proven hollow. The first leg down in the market came in the smaller company sector. Shares in this area, in housebuilders and property developers, small- and mid-sized banks and smaller clusters of listed companies in areas such as education and healthcare, were battered by the global rush to liquidity. Volumes of trading dropped as investors moved into large-cap, appreciating commodity stocks. The second leg came as commodity prices started to fall in the late spring, with stalwarts of the exchange such as Petrobras and Vale losing more than 20%.

Long-term story
The selling point for the combined exchange was that the huge increase in trading is a longer-term, secular trend and that volume is the driver for profitability. Then, there is the real possibility that Bovespa can turn itself into a regional centre for companies seeking to raise capital. That is predicated on the liquidity that is attracted to São Paulo, a feature lacking from all other regional exchanges, with the possible exception of Mexico City.

Until the recent market drought, the Bovespa exchange had accounted for as much as 80% of the listings in Latin America and Argentina’s Banco Patagonia listed a concurrent Argentine, Brazilian and international offering of shares through Brazilian Depository Receipts (BDRs), seeming to point the way to the emergence of São Paulo as the regional exchange of choice.

Since the Patagonia deal, although there have been a number of BDR issues, there have been no other real foreign listings. Instead, most BDR issues have come from companies that are Brazilian businesses, typically using an offshore primary listing to raise foreign capital and minimize tax. There is unlikely to be more interest from overseas companies, which can easily tap New York or London, unless liquidity returns to the exchange in force.

There is also the possibility of further consolidation as exchanges globally join together to enjoy cost reductions. The Brazilian exchange already has two partnerships, one with the CME Group, which had a 10% stake in the BM&F, and the other with NYSE, which bought a 1% stake in Bovespa. It has not ruled out further or deeper partnerships.

These relationships will help the Brazilian exchange upgrade its systems and gain more direct access to US investors. Pinto has said that the access to CME Group’s powerful Globex derivatives platform is going to boost its ability to offer new products substantially. Globex has more than 100,000 terminals worldwide, Pinto said, compared with the BM&F’s 750. That should help bring back liquidity.

The Bovespa-BM&F deal will position the new exchange in a number of new product lines. Brazil has been consolidating its position as one of the world’s powerhouses for agricultural products and management at the exchange are keenly aware that this could be a powerful driver of volumes.

The exchange has said it would like to rework its cotton futures to bring in worldwide investors. The future for other commodities contracts, from soy to ethanol, looks bright. Brazil is a worldwide leader in ethanol and the Brazilian government would like to see the fuel commoditised to encourage global take-up.

The question is whether São Paulo will be the exchange of choice. It has proved difficult to get commodities contracts off the ground in Brazil and stiff competition exists from efficient, deeply liquid commodities exchanges, such as Chicago and London. Unlike local equities, where Bovespa has a clear advantage, there is no obvious draw for global commodity traders to come to Brazil.

Corporate governance and management
The effect of the merger on corporate governance standards, a key area where Brazil has been showing leadership in the region, is not clear. It does seem likely that the merger will not great affect the management or oversight of markets, analysts believe. João Batista Fraga, listings and issuer relations executive officer at Bovespa, says he does not envisage changes to the structure of market monitoring and enforcement.

And there continues to be progress in the area. The CVM, the market regulator, has been working hard to keep abreast of a market that until recently was growing fast. It recently created an enforcement division to streamline laws and bring more sophistication and, in May, started to work closely with the Federal Attorney, exchanging information and collaborating on research. The cementing of that relationship comes after the two worked together in 2007 on case involving market-listed companies, Ipiranga and Suzano, when the CVM was able to go to court and obtain an order freezing the accounts of traders involved after just three days, a record time in Brazil, points out Alexandre Pinheiro dos Santos, a senior attorney attached to the CVM.

The CVM is also building on its track record in voluntary agreements, where a fine is paid but no admission of guilt is made. Such voluntary agreements will help remove cases that are clogging up the system, explains dos Santos.

Still, there are some red flags. While corporate governance standards have immeasurably improved, too many Brazilian 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 from which the firm is only just recovering.

Recently, UK fund manager F&C has been leading a fight against a controversial proposed take-over bid. The fund manager was joined by over a dozen leading UK, North American and European institutional investors in urging greater legal protections for minority shareholders. The action was triggered by the August bid by Votorantim Celulose e Papel (VCP) to control fellow pulp and paper producer Aracruz, in a deal which will hurt minority investors.

F&C says they raised concerns because of the possible damaging effect on their other Brazilian holdings and confidence in the market. “What is most important is that the CVM re-evaluate the existing regulatory framework so as to restore global investor confidence in the Brazilian capital markets,” said Karina Litvack, F&C’s Head of Governance & Sustainable Investment.

The start of trading of the new BM&F Bovespa has been a more muted affair than expected as the exchange deals with a sudden downdraft in interest in its product. Shocks are hardly new in Brazil, which is used to seeing foreigners come and go and has equity markets that have rarely relied strongly on local investors who have typically preferred the safety of fixed-income.

Interest and liquidity will return, fed by the growing economy of Brazil, but the downturn has focused minds on just how many Brazilian companies currently have the heft to generate substantial enough liquidity to interest large foreign investors and where the exchange really has value added over deeper markets in other countries.

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