When Brazils TAM Linhas Aéreas airline went public in March, comparisons were made with the 2004 IPO of its arch-rival, discounter Gol Linhas Aéreas Inteligentes. Both Brazilian, both airlines, both listing on Bovespa. These two IPOs had one other thing in common. Both were successful and lucrative exits for private equity funds.
Gols listing netted AIG a cool seven times its initial $1.2 million investment, a sum put in just 18 months before. TAM raised close to $700 million, with most of the monies split between five investment funds. Private equity in the domestic airline industry doesnt stop there. VarigLog, buyer of Varig, the nations other major airline which filed for bankruptcy in June 2005, is funded by north American private equity firm Matlin Patterson.
That private equity listings have become such a big deal is a story of the tail-wagging-the-dog. Marcus Regueira, president of the Association for Brazilian Venture Capital and Private Equity, emphasises the point. Thirteen out of the 20 IPOs in the Brazilian market since early 2005 have been in the portfolios of venture capital or private equity firms at some stage. These are not minnows either with substantial deals including the likes of Lupatech and Submarino.
Its a big turn-around. Until recently, Brazilian private equity had been in the doldrums. The 1999 devaluation started the process of decline. Reverses in global markets with the resultant lack of liquidity and doubts over regional political instability, especially with the election of President Luiz Inácio Lula da Silva in 2002, hastened it. There were more interesting opportunities in Asia. Those Latin private equity firms that depended on capital markets to exit positions found they were locked in as market fell and fell silent.
In 2003, the pendulum of global liquidity began to swing back in favour of Latin markets, pushed by macroeconomic stability and a return of global liquidity. That is enabling private equity firms to sell investments through equity markets and post positive results generating more interest in the asset class and opening the door for more fund raising. Alex Burgess, managing editor of Venture Capital Latin America, points out just how rapid the process has been. In 2004, there were $600 million in distributed private equity exits in the region. In 2005, that number rose to $1.5 billion. So far in 2006, there have been $2 billion. In Brazil, the largest market by far with $1.25 billion of the $2 billion, IPO exits this year have already outstripped the levels seen in 2005.
In Mexico, things have improved too. Although capital markets are thinner, there have already been two significant offerings in the year to date, says Burgess. Homebuilder Homex raised $246 million and Mexican furniture and household goods retailer Grupo Famsa $230 million in its home market and the US.
Fund raising opens
The improved picture on the exit front has started to feed through to more interest in fund raising, albeit with a time lag. One of the largest private equity firms is sitting up and taking notice. Ernest Lambers of AlpInvest Partners, the Dutch giant with 30 billion in private equity investments, is focusing more on Latin America after being broadly absent. We are more optimistic on the region now and expect to become more active in the near future. We clearly see positive signs, both in terms of the economies as well as the environment. And Ernest Bachrach, Chief Executive of Advent Internationals Latin American deal group, which has led $1.5 billion of investments in the region over the last 10 years, says that track records are now sufficient to attract institutional investors. Still, he sounds a note of caution. Although the $1.3 billion in private equity raised for Latin America last year is up considerably from the low of 2002-03, it is still well below the peak reached in 1998 and is miniscule compared to the amount raised in Asia: This is not a boom, but it is a pick-up in activity.
For many firms, which take minority shareholdings and seek an exit through capital markets, proving a track record has been hard. The lack of such is a roadblock for drumming up more business. And track records for private equity can be poor in the short- to medium-term. Antonio Gledson de Carvalho, professor of finance at EAESP in São Paulo, explains why. In the early years of the life of a private equity fund, the only investments these firms divest are those that have gone sour and need to be written down. We have a saying. Lemons mature faster than pearls, he says. Funds successful investments remain in the portfolio for a more orderly exit once the business has been properly prepared for sale, usually several years into the life of the fund.
Advent, whose funds concentrate on majority shareholdings and typically sell to strategic investors, largely escaped the capital markets downturn and has a strong track record in the region, according to Bachrach, who says that the firm has made compound annual returns of 35-40%. That would be more than enough to woo more investors. Local pension fund PETROS, the pension fund of Petrobras, expects a real return of some 13.5% net of fees from its infrastructure investments, 16% for other private equity investments and 22.5% for venture capital investments, says Ricardo Malavazi, director.
As sentiment improves, funds are getting larger. Giant Conduit Capital Partners raised $400 million in July for a power fund and Advent International closed a $375 million fund in autumn last year. Still, this is small beer compared to the size of funds in the buoyant late 90s which produced funds of more than $1 billion.
One of the keys for more sustainable growth is the participation of stable, local institutional funds and thats starting to happen. Moreover, its likely to prove a growing force as the pension fund industry in Brazil is in its infancy but likely to grow fast. We are seeing the first investments in private equity by Brazilian pension funds. Two years ago, they would not have looked at such investments; now they are making dedicated allocations, says de Carvalho.
For now, Brazilian funds are circumspect. Malavazi explains that PETROS started to invest in privatisations at the end of the 1990s, in line with many other Brazilian funds. The fund found itself locked in to these private equity investments between 1999-2002 and only in 2003 did the situation start to improve. Since then, PETROS has committed some R$850 million ($396 million) in private equity of which R$70 million is in venture capital, he says. The fund was attracted to the asset class because of the likelihood of falling interest rates in Brazil, a low exposure to floating rate investments and the rich seam of opportunities, especially in infrastructure.
Regueira sees this local money as key. Pension funds such as Previ (from the Banco do Brasil), Funcef (Caixa Econômica Federal), and funds run by BNDES are scrutinising or entering the market, he says. The re-entrance of institutional funds is very promising as these were the kind of funds that were responsible for the growth of the private equity industry in the US in the late 1980s. Bachrach agrees. Private equity in the region is going to remain a volatile source of funds until local investors are a more significant presence, he says. Still, the amounts local institutions are investing needs to be put into perspective. Foreigners continue to dominate, buying 68% of the total value of IPOs on Bovespa since 2001.
There are other reasons to be more optimistic about the longer-term prospects for the industry in the region. Theres a strong consensus that the teams that are working on private equity in the region are stronger and more professional. The famine in the early years of this decade winnowed out weaker and less dedicated firms and teams. Burgess believes that: There is a commitment to building strong, high quality private equity teams in the region, which are able to work very closely with the managements of the companies in which they take a stake. This is now seen as key to the success of private equity investments and represents a new generation of talent in the region. Lambers adds a nuance. His funds investments are focused on growth capital and buyouts because he does not yet see many quality managers focused on venture capital.
The quality of teams is especially important this time round, thinks de Carvalho. The late 90s saw private equity firms focus on the low hanging fruit: mature companies needed help restructuring as the Brazilian economy was opened up, he says. Investors focused on these late-stage opportunities, cases in which the firm already had a viable, established business model. Although these opportunities still exist, many of the more obvious such investments have been made. That means more private equity funds are going to earlier stage firms. These require much more nurturing and specialised skills as they typically need help in developing everything from a business model to staff hiring and product development.
The predicted wave of investments, if indeed it comes, arrives at a time when there is keen interest in several micro-sectors of the Brazilian economy. The most obvious is renewable energy sources, where Brazil is a world leader with its long experience of biomass energy, or energy derived from plants. In clean energy and biomass, Brazil is competing with the best of the world, says Bachrach.
Regueira notes that roughly one third of the planned private equity investment is likely to be in the sector. Renewable energy is a buzzword right now and foreign investors are flocking to the country to learn more about the technologies with Japan and the US likely to be very significant importers of ethanol. Owners of sugarcane, distilleries and hydro energy plants are attracting most interest. Bachrach argues that the punitive tariff that the US imposes could be dropped too. The Americans and Brazilians are working hard to get a reduction in tariffs. Its a win-win situation. Its labour intensive and job-producing for Brazil, and reduces American oil dependence on countries such as Venezuela and Iran. There is a major initiative to look at this seriously. The biggest downside risk for alternative investments is a fall in oil prices. At $70 a barrel, there is a short-term incentive to turn to biomass fuels. With recent price decreases, that logic is looking less secure. If prices were to sink back to $50, investments in alternative fuels such as ethanol would be a lot less interesting, reckons Bachrach.
Infrastructure is popular too with firms raising funds to invest in sanitation, roads and logistics. This is a nexus of investment for PETROS. Malavazi explains that a sound rule-based structure for investment encouraged the fund to look there and the portfolio is concentrated in electricity, including transmission lines, civil construction, transport and ports. One of the other most talked about areas is utilities. These offer high yields (attractive to long-term funds) and are relatively well regulated and have become attractive now that inflation and sovereign risk are not unbearable. Biotechnology, agribusiness, with development of pest- and weather-resistant crops and tourism, especially in the North east and north, are likely to benefit too.
Malavazi is very positive on prospects for private equity in Brazil. He sees the return of international investors after years of absence, the consolidation of macroeconomic gains and improvements in regulations, especially within capital markets as Bovespa and the market regulator refine listing requirements, as key. The drop in interest rates too will propel more money towards private equity. Frankly, institutional investors are bound to find Latin America more compelling as the other alternative regions become saturated and start to produce more marginal returns, adds Bachrach. Its hard to believe that all those funds will produce satisfactory returns.
For now, though, the markets are in recovery phase and a little money goes a long way. A few billion dollars of new funds into Latin America would have a significant impact in the local capital markets, whilst still representing a tiny fraction of what is invested in more established markets, says Bachrach. Fears that the easiest pickings have already been had against a background of economic stagnation could have a long-term toll on investor interest in the region. That might not matter if local investors were more of a force, but for now, Latin and Brazilian private equity is still too dependent on foreign flows of funds and liquidity. It remains to be seen if Latin private equity will produce lemons or pearls in the long term.