PE Shows Signs of Restraint

Brazilian private equity has been enjoying a fundraising heyday. But optimism will be severely tested by a choppy Bovespa and hostile debt markets.

The biggest international players are arriving, the drip of money from wealth funds is slowly accelerating, local institutional funds are starting to invest and domestic private equity (PE) IPOs have met with success. But the euphoria in Brazilian PE may well be short lived.

The amount of PE cash entering Brazil more than trebled last year. An estimated $7 billion in new funds was raised, compared to less than $2 billion in 2006, according to Patrice Etlin, managing director of Advent in São Paulo. That investor interest should be piqued is hardly surprising after four years of sizzling stock market performance, culminating in 2007 with the globe’s second best return, at 74.1% in dollar terms.

Brazil has the strongest macroeconomic environment for private equity ever seen, reckons Patrice Ledoux, head of the Brazil office of London-headquartered PE shop ACTIS, with $450 million under management in Brazil. He points to support from international reserves, falling interest rates, as well as a trade and primary surplus. Multiples remain lower than other big emerging markets, and PE inflows are low compared to Asia, which has enjoyed some $30 billion annually, he says.

Data from the Emerging Market Private Equity Association supports the view that LatAm is the next hot thing. Its 2007 survey of limited partners found that 64% expect to be investing in Latin America in five years’ time. That is more than double the 31% already investing. The money will be evenly split between Brazil and the rest of the continent.

A KPMG poll of 140 private-equity stakeholders released in February shows 42% of participants plan to invest in Brazil over the next two years, compared with 34% in Mexico and 12% in Colombia, the next highest. Some 84% say that Brazil is either favorable (49%) or very favorable (35%) to inbound PE investment. However, only 39% say they expect overall 2008 LatAm fund raising to exceed last year’s level.

In the next two to three years, infrastructure deals in communications and distribution channels such as ports, airports, pipelines, water treatment plants and roads comprise the most attractive investment opportunity for private equity, according to 69% of respondents, while 66% of the fund managers polled said energy and natural resources held the most opportunity. Consumer markets was cited by 55% of respondents, financial services was named by 50%, and 35% said they saw the most opportunity in health care in 2008-2010.

New Cash Pouring In
Much of the new money is already in evidence. In 1996, Advent International raised $235 million for its first Latin fund, says Etlin. Last year, it was able to get $1.3 billion for its fourth fund, illustrating the huge interest from institutional investors in the region. The private equity arm of JPMorgan has more than $1 billion in its war chest for Latin America as do Merrill Lynch, UBS Pactual, GP Investments and Gávea with a similar amount each, says Ledoux.

Foreign firms are seeing money come in not only as allocation from broader pools, such as global EM and BRIC funds, but also from local fundraising. Darby Overseas Investment, for example, is finalizing a 400 million reais Brazilian Mezzanine Infrastructure fund, with cash raised purely from domestic investors, says Fernando Gentil, head of the firm’s Brazil operations.

While foreigners hunt in Brazil, purely local PE firms locally are getting cosy with overseas wealth funds. GP Investments, which raised over $1 billion last year, saw Singaporean wealth fund Temasek invest $100 million, and other Middle East and Asian funds chip in. Temasek is keen to raise investment in the country and plans to open an office in Brazil.

Finally, the US giants who have tiptoed around Brazil are arriving in force. Carlyle hired real estate veteran Eduardo Machado at the beginning of 2007 and has since announced two major agreements in the sector. Blackstone, long rumoured to be scouting for opportunity, finally sealed a deal in December, entering a strategic partnership with Pátria bank. KKR is also said to want 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,” says Gentil.

Still, one avenue of promising fund raising looks blocked for now. Last year, GP blazed a trail by raising capital through equity markets. And FIR Capital, a venture capital specialist in small and mid-sized companies, submitted a request to sell shares through the Bovespa in January through UBS Pactual. But it remains to be seen just how long that deal will take to place.

Equity uncertainty also affects exits. Advent, which typically sells to strategic investors, has floated four companies on Bovespa in the last two years. It uses a dual-track process whereby both an IPO and sale are considered and the decision is made at the time of sale depending on market conditions, says Etlin. Other firms that have depended more heavily on public markets will be undermined by market conditions.

Deals Getting Bigger
The wave of new money is almost certain to mean that deals grow when firms club together, as they have done in the US, to gain more financial clout for takeovers, reckons Ledoux. Brazilian banks also have a role to play in increasing transaction size, as they start to fund PE firms, with leverage for some deals at 50% and even 60%, according to one seasoned private equity professional.

Access to size should mean that PE firms are well positioned to benefit from a widely-anticipated shake-up in ethanol and real estate, both of which have come to a shuddering halt after strong performance through mid-2007. Infrastructure also remains popular.

Firms such as Darby and ACTIS believe some of the best opportunities may lie with suppliers to homebuilders, such as firms making concrete and machinery, 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 low income homebuilders.

Still, Etlin prefers steering clear of hot sectors. He reasons that valuations are vastly overdone in some areas, with too many companies coming to market too quickly, sacrificing quality for a quick buck. He points to the disastrous performance of ethanol as an example of the dangers of investing in trendy sectors. Share prices in ethanol were down across the board, with giant Cosan losing some 50% of its market value.

Whoever is right on the best sectors, it is clear that PE investors are going to need to focus a lot harder on the bottom line. Those who poured into ethanol and alternative fuel found out to their cost just how much their investments can affect asset prices in a small, inefficient, fragmented industry. And with a looming global crisis, many firms are likely to sit on the sidelines and wait things out rather than committing too much to a PE sector that remains to be tested.

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