In the bad old days, Brazils financial markets were riddled with pitfalls for the unwary, the most egregious being the shareholder structure. Companies typically issued two types of share: controller-owned ordinary shares that granted voting rights and preference shares that did not. Laws governing the ratio of ordinary to preference shares could give control to shareholders that had slightly less than 17% of total equity and enabled this elite group, often a small family clique, to treat minority shareholders as they saw fit. In the 90s, it was clear that there was something very wrong with the Brazilian market. Shares did not represent proportional parts of a company, notes Mauro Cunha, portfolio manager at Franklin Templeton Brasil in São Paulo. In a study that Templeton carried out, the average discrepancy in the price of different share classes during the wave of M&A deals of the 1990s was eight times, reflecting the enormous powers that majority shareholders wielded.
The problem stemmed from the governments push to facilitate issuance in the 1960s with non-voting shares and tax incentives that distorted motivations for companies to issue and investors to buy, explains Cunha. It was an artificial market. Companies and investors took advantage of the tax breaks without paying much attention to the underlying shares. Investors bought preference shares without bothering much about to voting rights because they constituted the bulk of traded equity and were thus more liquid.
As the market grew, controlling shareholders exploited their ability to dictate terms to preference shareholders. This made it impossible to calculate the value of preference shares as controllers could enforce massive dilution among other nasties. If you dont know how much youre going to get when the controlling shareholder sells, it makes pricing your shares impossible. And uncertaintys the one thing that shareholders really hate, says Mike Lubrano, Manager of the Investor & Corporate Practice of the IFC in Washington DC, a part of the Corporate Governance and Capital Markets Department. Increasingly, liquid preference shares, which come before ordinary shares in the queue for company assets in the event of bankruptcy, were mistrusted and began to lose the price premium they had enjoyed over ordinary shares.
Tightening of Standards
It was an outrageous deal by AmBev (now InBev) that crystallised the issues, becoming a rallying cry for investors. The 2004 transaction saw the Brazilian brewer issue 9.5 billion in ordinary shares and 13.8 billion in preference shares in its merger with Belgian Interbrew. Holders of the ordinary shares (primarily, the company and its exectuvies) were entitled to swap them on a one-for-one basis. Investors with non-voting preference shares (minority shareholders) were not. They faced massive dilution and huge losses, with preference shares plunging 30% almost immediately after the announcement of the terms of the deal.
For the first time, domestic institutions fought back, particularly Banco do Brasils pension fund Previ, which held three billion preference shares and calculated it would lose R$3 billion. The firm complained vociferously to the Comissão de Valores Mobiliários (CVM), the market regulator, and to the exchange, Bovespa. Retail shareholders joined battle and the deal became a cause célèbre. AmBev found itself slammed in local and international media. Company executives were taken aback by the strength of the reaction and agreed to buy back around R$500 million of preferred shares. It wasnt enough. Even now, the terms of the deal rankle. One London-based investor who got hurt in the deal remembers: Investors sometimes dont have a long-term memory, but we all remember the AmBev deal.
Although the AmBev deal and others like it galvanised regulators and investors, the overhaul in laws had had in fact started a couple of years earlier. Under the energetic leadership of José Luis Osorio at the CVM, the building blocks for change were already in place. Osorio made great strides in empowering and professionalising the CVM, pushing through important legal changes and emphasising shareholder rights, according to Lubrano.
During the market freeze of 2001 when just three companies carried out an IPO and 21 companies sought to de-list from Bovespa, the CVM succeeded in getting a barrage of new legislation through the national Congress to make the market more investor-friendly. The government updated legislation that gave minority shareholders better protection, tightened regulations against money laundering and enhanced the role of the CVM. Crucially, the CVM gained financial independence through using listing fees, fines and other market-based revenue as funding.
The CVM was also making better use of its discretionary power, says Lubrano. The regulator started earning a strong reputation on its use of the right to suspend shareholder meetings and on responding to shareholder requests. It did so by really taking the time to understand if minority shareholders had a legitimate complaint against the controlling shareholders or whether they were sabre rattling merely as a bargaining chip to extract a better deal.
Meanwhile, the exchange was putting together a market segment with a voluntary code of corporate governance, the Novo Mercado. Advised by the IFC which was instrumental in bringing together companies, investors and other parties to thrash out terms for the market, the new market was launched in December 2000. The essence of it was quite simple. Firms would sign up to stricter regulations on transparency and, of vital importance, a one share, one vote approach. The quid pro quo was that investors would feel more secure in investing and shares would be priced accordingly.
The launch of the Novo Mercado tapped into a global trend that was just arriving in the country. Many Brazilian companies were astute enough to realise that they could use corporate governance as a selling point for international investors, who typically purchase some two thirds of the equity issued through the Bovespa. Companies were already starting to offer tag-along and other rights to all classes of investors. Giant steelmaker Gerdau offered tag-along rights in 2002, for example. Investors were increasingly willing to pay up for higher levels of corporate governance, says João Batista Fraga, Listings and Issuer Relations Executive Officer at Bovespa. Research suggested that investors would pay up to a 25% premium for strong corporate governance, he notes. Brazilian newspaper Gazeta Mercantil published a report that showed that in the year to December 12 an index of company shares that provided tag-along rights was up 39.05% compared to 29.42% for leading index Ibovespa.
Ironically, at first the new market was shunned. It was not until the storming success of cosmetics company Natura, the first to list on the new market segment, that bankers woke up to the possibilities. Natura raised R$768 million in May 2004 in a deal that was ten times oversubscribed. It caught the attention of media worldwide. There was no looking back and as the Brazilian capital markets opened up, almost all companies that listed followed Natura onto the Novo Mercado, with 41 listings by early December. Companies that dont list [on the Novo Mercado] need to have a good excuse, says Fraga. One example is airlines which under Brazilian law need to keep majority control. And even they have not been left behind with many migrating to Level Two of the main board, which imposes more onerous corporate governance rules, covering transparency and reporting, Fraga notes.
Despite the very real progress, the regulator and exchange have a number of thorny challenges left. Ironically, the Novo Mercados sweeping conquest of the listings market may be responsible for strangling another of Bovespas cherished projects: the launch of a market for small and medium sized enterprises, Bovespa Mais. The market, which has the same high levels of corporate governance as the Novo Mercado, but does not have that markets 25% equity float requirement, was launched in late 2005 but has yet to attract a listing.
The experience of Bematch, a Curitiba, Paraná based technology provider, may help explain why. The company was set to be the first Bovespa Mais listing. It certainly has all the right ingredients as a fast-growing IT company with a growing international presence. The firm announced its listing plans in 2005, but changed its mind last year and is now planning to list on the Novo Mercado later this year. Marcel Malczewski, the charismatic co-founder, says Bovespa executives did everything they could to woo management. They came down to Curitiba two or three times to talk with us about Bovespa Mais and explain why it would be a good choice for us. They really wanted us to be the first. The original plan was to raise $20-30 million through Mais and list on the Novo Mercado later. We saw Mais as an incubator, explains Malczewski. Even at the beginning, he admits that he had misgivings: I was nervous to be the first one on the exchange. I only wanted to go ahead if I were really sure that the market was going to be a success.
Investment bankers from giants that included Credit Suisse, UBS, Pactual and HSBC fuelled those feelings of insecurity. They suggested the firm wait a while, build some size and go straight to the Novo Mercado. You know what bankers are like. Theyre deeply conservative. They dont want to be the first ones on bring a company to an exchange, Malczewski says. Executives decided to beef up the company through acquisitions, and to offer more equity in order to bump up the capital raising from $20-30 million to the current planned level of $150-200 million. When we had our change of heart, Bovespa were really disappointed, he acknowledges.
Templetons Cunha notes that the lower liquidity and the difficulty in getting consistent research coverage are deterrents for companies considering listing on Bovespa Mais. But he also notes that financial intermediaries have an incentive to promote bigger deals to capture the higher fee income associated with larger deals and that means they drive clients to list on the Novo Mercado. Lubrano agrees: Not too many investment bankers want to work on small deals. If youre looking for a promotion or for your next job, you want to be associated with the big ones. Bovespa will have a tough job to sell Bovespa Mais to investment banks, Cunha thinks. Theres no magic wand: They need to talk to the banks and understand the dynamics of their business. Its not going to be easy.
Deep global liquidity and the sterling performance of the Brazilian market means companies have seen that they could raise more cash and have gone straight to the Novo Mercado, admits Fraga. Bovespa is working to address the other concerns of investors and bankers. To ensure coverage, Bovespa has contracted two research companies to follow any company listing on the new market segment for three years. Trading will be encouraged with a more flexible structure than on the Novo Mercado and Bovespa is sounding out qualified overseas buyers, such as family offices, that are likely to take an interest in the kind of companies. The exchange is talking to a number of companies that have lower annual revenues and Fraga believes it is only a question of time before one lists on Mais. Still, until one of them takes the plunge, Brazil is going to have to do without the dynamism of a small company market.
Other significant issues include insider dealing and the system of fines that the CVM uses to regulate the market. Although the CVM issues fines, final enforcement takes place through the Brazilian legal system. The slow and cumbersome judicial system allows companies to evade payment and reduces the effectiveness of the CVMs principal enforcement weapons, says Lubrano.
If problems remain, the overall prognosis for Brazil is good. Brazils infrastructure is now way above that of the average emerging market in everything from counterparty risk to settlement to reporting, says Cunha. Brazil has been active in nearly every sphere, agrees Lubrano Its a veritable Petri dish for corporate governance. The route the Brazilians have taken is quite distinctive. It combines features from many of the different points of the spectrum, from government and market regulation through to the structure of the market and the extensive use of the private sector, he says. This sets it apart from neighbours who have tended to follow principally just one of these routes, he notes. Chile has long had a legalist/enforcement approach to ensuring the smooth running of the market but little in the way of private initiatives. Decentralised Colombia has pursued the opposite route, with plenty of private sector efforts and active efforts by the Confederation of Chambers of Commerce to take the initiative on corporate governance but relatively national legislation. Brazils pursuit of strong corporate governance through multiple avenues gives it unique strengths and a very solid base.