IPOs: More Haste, Less Speed

Brazilian equity markets have enjoyed another excellent first half, fuelling a record number of IPOs issued from an ever-wider range of companies. However some issuers are coming to market too quickly.

The prevailing mood in Brazilian markets this year has been one of untrammeled optimism. There has been a huge acceleration in the number of companies coming to market, with 46 IPOs listed by 31 July against just 14 in the corresponding period of 2006. The key Ibovespa index was up by some 22.7% in the year to July 30 in local terms and 39.5% in dollar terms.

That has helped the transformation of the Bovespa from an obscure commodity-based exchange to one of the world’s hottest markets. Executives, from large and small firms – not all of them Brazilian – are taking note.

At the beginning of the equity boom, Brazilian industrialists were not familiar with capital markets and going public was an unknown quantity, says Alexandre Barreto, a partner at São Paulo law firm Souza, Cescon Avedissian, Barrieu e Flesch. “Managers typically asked questions such as: ‘Does it mean that I have to share all my strategic decisions with the markets? Are there huge costs associated with going public? What happens in the event of succession?” He adds that the sight of other companies going public has reduced fears about listing.

Recently, corporate executives’ interest has risen to fever pitch and there has been an almost unseemly rush to take advantage of the buoyant market. Executives know from experience that Latin capital markets can close as fast as they open. Their desire to capitalize on global liquidity puts immense pressure on investment banks and lawyers to speed up their preparation.

Mauro Cuhna, the new head of equity at hedge fund Mauá Investimentos, points out that the quality of company prospectuses is rapidly deteriorating. He says there are elementary grammar mistakes and basic data errors in up to 60% of recent prospectuses. “These are legal documents and any error could be the grounds for a successful lawsuit,” he cautions.

Cuhna adds that he finds companies failing to do necessary balance sheet adjustments or overall structural improvements before listing.
From an investment banker’s perspective, it is hard to ignore client pressure to step on the gas. Juan Vogeler, managing director and head of LatAm equity capital markets for at Merrill Lynch, says that he has had occasion to caution companies not to rush. “My pitch is that the market is here to stay. There will be volatility, good times and bad times, but it’s a deep market and there’s a lot of confidence.” In LatAm, sometimes waiting a quarter or two may result in a better reception by the investor community, he notes. But he acknowledges that “sometimes that can be a really hard sell.”

This also complicates the job of market regulator Comissão de Valores Mobiliários (CVM). It has been in large part responsible for the burnishing of the reputation of Bovespa, but the sheer number of new issues and the continuance of some outdated practices leads some to question whether it can keep up. “The CVM is limited by delivery capability,” says Edvaldo Morata, head of asset management at Santander Asset Management. “It’s not like a production line where it’s easy to boost results.”
Some IPO rules will need to be amended, believes Barreto. He points to overly-diligent regulations on the silent period before an offering. They are too broad and create problems in ensuring investors have access to information ahead of a deal, he says. The CVM has an excessive fondness for paperwork and market participants want to see changes to the requirement to distribute 10% of the deal to Brazilian retail, as well as on restrictions on cutting a deal size. In the latter case, Brazil has much more onerous rules than in the US, requiring the prospectus to be re-circulated, for example. This is particularly important when volatility is on the rise and there is ever greater uncertainty about how much of a deal can be placed.

A and New Sectors
Another impulse bringing companies hastily to market is the desire to follow in a competitor’s footsteps. This has proved particularly strong in the real estate sector where the success of early homebuilders’ IPOs sparked a wave of deals from competitors and related companies, including shopping centers and office developers.
Although it is reasonable to assume that the real estate market will develop quickly in Brazil, not all of these deals will be successful, warns Ricardo Kobayashi, co-head of equities at UBS Pactual Asset Management in Rio de Janeiro, until recently director of research for UBS Pactual. That makes thoroughly researching each company an imperative, he says.

Part of the reason why IPOs from companies in a single sector bunch up lies in M&A. A flood of capital has boosted the number of M&A deals both domestically and internationally. The overall number of transactions in the first half of the year was 294, up 28% year-over-year with domestic transactions increasing by more than 50%, says Cláudio Ramos, a partner at KPMG in São Paulo. He reasons that more companies are listing on Bovespa to raise money to take over competitors. That has led others to carry out defensive IPOs to avoid becoming prey, he adds.

Investors have also been increasingly willing to accept new sectors, allowing niche companies to issue. The listing of two education firms, Anhanguera Educacional Participações and Kroton Educational, shows how far that trend has come. Merrill’s Vogeler says education is particularly interesting as it is not only new to Brazil, but also relatively under-represented worldwide. That makes finding a comparison to price against doubly difficult, he notes. Merrill, which helped price Anhanguera, went to a select band of international investors with deep experience of the few global companies in the sector to generate a realistic price.

The receptiveness of investors to these deals is encouraging entities with little more than a business plan to come to market. Cunha is cautious. “Some of these companies predict that they will see 100% earnings growth in just three years. These valuations just don’t hold water,” he warns.

Valuations Not Stretched
Still, overall the valuation of companies is not that expensive, reasons Kobayashi. Strong growth in profitability and cash flow generation has helped moderate increases in key multiples despite the strong performance of the market, he notes. At the beginning of the rally in mid-2003, the market ratio was 10 P/E on a trailing basis. That has only moved up to 12.5-13 times.

A good deal of the rally has come from an improvement in fundamentals, including de-leveraging and higher commodity prices, as well as the consumer and internal market, he notes.
Pedro Martins, LatAm investment strategist at Merrill Lynch, says the next leg up in the economy and markets will come from domestic consumption, mostly in the private sector. Access to credit, stable inflation and better economic activity are all contributing to this positive scenario, he says. Consumer power and access to credit is particularly playing out in the booming car industry, adds Martins. He recommends investors play this through steel, car sales and toll roads.

This consumer boom also helps explain the keenness of banks to tap markets. Daycoval earmarked proceeds from its IPO for expanding credit to consumers and small and medium-sized companies. The lending business calls for robust balance sheets and mid-sized banks have been finding it hard to keep pace with larger financial institutions. Mid-sized banks may also be issuing shares to give potential acquirers pricing transparency at a time when M&A activity in the sector is heating up, as evidenced by recent acquisitions by Bradesco and BNP-owned Cetelem.

Mauá’s Cunha agrees that the consumer sector is one to watch. He is broadly focused on retail and producers of durable and non-durable goods, institutions involved in credit, and vehicle sales. The last can be played again through credit companies and banks and steel companies like Usiminas.

The next wave of deals could be from capital-thirsty companies building infrastructure, Cunha reasons. The government’s sputtering attempts to improve infrastructure are already holding up growth in exports and private investment is needed to support the improvement of ports, railways and roads. This is particularly true of the boom in agricultural exports, which use a combination of transport modes, he predicts.

Volatility Resurfaces
With credit tightening worldwide, equity investors have to consider the implications of a resurgence of volatility. They got a reminder of just how quickly sentiment can change when a fresh squall wiped 7.86% off the Bovespa index in one week in mid-July, buffeting the IPO pipeline. Two deals priced at the bottom of the range and Aliansce Shopping Centres, part-owned by ex-Central Bank governor Armínio Fraga’s Gávea Investimentos, postponed its offering because of choppy conditions.

“Market performance has been based on high liquidity and we are not bullet proof,” acknowledges Santander’s Morata. Still, he predicts that the Brazilian economy will not suffer as badly as in the past, thanks to improved macroeconomic conditions and the fact that Brazil is now a net creditor.

Cunha is also relatively sanguine. He sees two factors as likely to mitigate volatility in Brazil. The first is the entrance of more local investors, particularly mutual funds and to some extent pension funds. They are starting to underpin the market. Equally, he believes that the supply of equity will be more responsive to demand, acting as a safety valve for the market. Ironically though, the resurgence of market turbulence may aggravate the trend of Brazilian company executives’ pushing for speed at all costs when coming to market.

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