Private equity takes off, pushing valuations.

New private equity managers and money are pouring into Brazil with locals excited by the level of interest and forecasting greater inflows through next year. Many foreign firms have launched in the country this year thanks to economic growth and recent industry performance. The downside is that many of the newcomers are focused on investing in larger companies and the wall of money is driving asset values up fast just as the government is trying to slam the brakes on private equity to contain the real.

“I see a real possibility of a major flow in funds with as much as $10-20bn in 2010-11,” says Marcus Regueira, founder of Belo Horizonte-based FIR Capital and former president of the Brazilian Private Equity and Venture Capital Association (ABVCAP). The attitude and how institutional investors are talking about Brazil has changed: many are close to writing commitments, he says.

Others agree that the industry is on the cusp. Most believe $5-7bn is a reasonable estimate for this year with Patrice Etlin, managing partner of the giant Brazilian operations of Advent International, predicting $6bn.

That is driving EBIDTA valuations sometimes into double digits creating a high hurdle for private equity investments. Perennials such as Lojas Renner and Pão de Açucar are at record valuations. Average valuations in private equity are running to six times annual EBITDA, managers say. “There are not cheap assets in Brazil any more,” says one.

Fund flows
Foreign investors have been turning to Brazil to offset weak economic growth at home. A large number of foreign pension funds, family offices, endowments and direct investments are looking at the market, says Mr Regueira. Foreign firms have struck up joint ventures with existing Brazilian funds to hit the ground running.

Blackstone bought a 40 per cent stake in Pátria, one of the most respected funds in the country for an undisclosed sum in September. The firm plans to invest $1-2bn in Brazil over two years, Steve Schwarzman, Blackstone’s chief executive announced. The Brazilian firm is spread across sectors including consumer, retail, real estate and infrastructure.

Earlier this year, Buenos Aires-headquartered Southern Cross raised $1.7bn and is looking for buy-out opportunities via its Brazilian office. Warburg Pincus has teamed up with Tarpon Investimentos to invest R$350m in a renewable energy fund Omega. The investment represents the US company’s return to the Brazilian market after a near 10 year absence.

Even highly specialist funds are taking their first steps. Silver Lake of Menlo Park, California made its first Latin investment in Brazilian Internet specialist Locaweb Serviços de Internet. San Francisco-based specialist Burrill is raising $100m to invest in biotechnology companies throughout Brazil.

At the other end of the spectrum are the giant Brazilian banks which have the resources to invest and an unmatched depth of contacts. Itaú-Unibanco has an 80% share in start-up private equity specialist Kinea Investimentos with partners owning the remainder.

Itaú provided seed capital of R$250m and the high street bank’s name has helped it recruit investors and open the door to companies, says Cristiano Lauretti, managing partner at Kinea in São Paulo. Itaú has 40 per cent of the high net worth market, defined as those with R$100m or more to invest, making it an ideal partner for Kinea in raising funds, he notes. Kinea has already raised some R$200m in capital for its planned first transaction.

“Itaú’s private banking group helped us reach family offices, many of whom had not invested in private equity before,” says Mr Lauretti. “It also gives us a compelling story at a time when even getting into see management of target companies can be difficult,” he claims.

The expansion of the industry is far from over and there are more competitors waiting in the wings. “We see a lot of interest. I get visits every week from investors wanting to understand the market,” says Mr Etlin.

That has made hiring and retention a very real challenge for the industry. “Training and retention has been a major topic in the industry over the last five years,” says Mr Etlin. Advent started a trainee programme in 2003 to bring in talent through a selection process in which successful candidates receive support to take an MBA in the US. “You have to create a pool of talent that’s closer to you,” he says.

Strategies and Sectors
The large number of new, very large private equity managers in Brazil is causing concerns about valuations and some managers privately question whether big players are concentrating firepower on a small segment of the market. Most large investors, including GP Investimentos, Pátria, Carlyle, APAX and Southern Cross, tend to be concentrated on investments in large companies and buy-outs as opposed to minority investments, says one manager.

Advent operates in this end of the market and has stepped on the brakes in Brazil. “We are more cautious on Brazil. Our pace of investment this year in Brazil has slowed down compared to 2009, as we are keeping our discipline in entry valuations. We have the benefit of being a Latam fund and are also very active in other countries in the region,” says Mr Etlin.

The very large transactions end of the market is a very crowded niche, says Luiz Eugenio Figueiredo, vice president at ABVCAP. At the same time, owners of companies are getting more sophisticated and calling in financial advisers to help them get the best valuation driving up prices, he notes. Foreign investors also need to take into account the high level of currency, he says.

Themes in the private equity industry are similar to those in public equity, with attention focused on consumer-related stocks and infrastructure plays. With share prices rocketing for the most popular sectors on Bovespa, private equity is emerging as a powerful way of tapping these markets. That is especially the case as these sectors are under-represented on Bovespa.

That listed consumer stocks have done very well may not be obvious at first glance as Petrobras has dragged down key Bovespa indexes. However, smaller cap stocks and particularly consumer-oriented ones in retail, financial and IT are at record levels, according to Mr Etlin.

Given high valuations for large companies that have the option of turning to the stock market, there is more space for investment in small- and medium-sized business, thinks Mr Figueiredo. The area is more fiddly and difficult to research and requires a local presence. Angel and seed capital and private equity for small companies is growing fast but are not showing up in statistics in Brazil, he reckons. That’s because the transactions are neither heavily publicized by the parties involved nor do they make headlines. “The feeling is that not much is happening, but it is,” he says. Firms specializing in smaller investments include Antera (Rio de Janeiro), CRP (Porto Alegre), FIR Capital and Stratus (São Paulo).

Private equity managers need to specialize and be nimble and look at areas well off the radar screen of the big players and at regions, says Mr Silvestri. Rio Bravo is launching its North-East Two Fund, looking at companies with between $50-100m in revenues in the region, he notes.

The focus is on capturing the increase in consumption through food processing, special retail and industries related to construction such as equipment and materials. The fund is also analyzing opportunities in health and education although no deal has been signed so far. FIR Capital concentrates on smaller companies where Brazil has a global competitive advantage in areas such as mining, IT and tourism.

Rio Bravo has made two recent R$25m investments in the North-east. One is Multdia, a processor and distributor of foods, specializing in baby foods, in Natal, Rio Grande do Norte. “This is a dynamic company and the distribution business allows us to go deep into the interior where infrastructure is very weak,” says Mr Silvestri.

Giant Advent is looking to spread its wings geographically and already has investments in the south of Brazil and Minas Gerais state. However, Mr Etlin points to some of the pitfalls. “We found that when you go out of the main cities it becomes difficult to attract top tier management teams: Brazilian CEOs and CFOs don’t like to live in smaller cities. This is very different to the US. The big challenge in moving out of the São Paulo-Rio axis is finding human talent,” he says.

In the future, Advent is interested in infrastructure plays as well as continuing a strategy to look at regions. Mr Etlin is studying opportunities in ports and airports. The firm has an edge in this sector as Advent has significant experience in Mexico and the Caribbean and can bring that expertise to Brazil, he says. His team is analyzing airport regulations and he is confident that new models will emerge. That optimism comes in spite of a lack of coherence and progress and the state-run airport infrastructure group Infraero’s allergy to the idea.

“The new government will have to deal with airports even though President-elect Dilma Rousseff is more wary of privatizations and concessions,” says Mr Etlin. He points to the concession model at Natal’s airport and calls this a test scheme, which could serve for other airports if successful. The proposed airport concession is for 28 years with estimated investments of R$650m.

Still, even these niche areas are being clustered bombed by investment banks and private equity firms looking to buy stakes. One private equity leader recounts a story that is common to the industry. On visiting a small pharmaceutical company in southern Brazil, the owner, without prompting, announced he would only sell his business as 12 times EBITDA or more. “Business owners are really focused on the price that you’ll pay and because they have been pitched so much, they are knowledgeable,” says the banker. “We could be running headfirst into a brick wall,” says another.

At the same time, ABVCAP has been fighting a rearguard action to secure an exemption on the industry from a financial transaction tax, the IOF, which was increased a second time to 6 per cent on October 18. Industry leaders recognize that the tax may be necessary to slow short-term portfolio investment but argue private equity, which invests for the long-term, should be exempt.

“Our industry is very surprised to be caught by this. There’s no reason to tax the real economy. It will affect the flow of capital and generation of jobs,” says Mr Figueiredo. “Private equity has been caught in the crossfire as an innocent bystander,” agrees Paulo Silvestri, head of private equity at Rio Bravo in São Paulo.

Brazilian managers disagree vehemently on the likelihood that the finance ministry will grant an exemption for their industry. That uncertainty is causing anxiety among foreign investors. “We have received a lot of calls and people are very worried about their commitments,” says Mr Figueiredo. Private equity is particularly hit because of the long nature of investments and the time between fund raising and disbursement, he notes.

Further moves to tamp down the real are a major concern. “It recalls the not distant past when investment rules were changed on a regular basis in Brazil and creates great uncertainty about the future. What’s coming next? Could the IOF tax be raised to 10 or 12 per cent? ” wonders Mr Silvestri. The longer-term situation is also unclear as economic policies under president elect Dilma Rousseff are not clearly defined.
The extra tax makes Brazil even more pricy, thinks Mr Etlin. “A sudden shock, another Greece moment, might cause investors to pull money out of the country and that could have a snowball effect,” he says.
All this has to be set against a lack of reliable data in the country and little consensus on just how much money the industry has attracted in recent years. Different data suggest between $17-30bn of capital had been committed by the end of last year with much depending on whether real estate funds are included in the figure. One manager points out that unreliable data are not confined to Brazil: “I don’t believe in the Chinese and Indian numbers at all,” he adds.
BOX: Mining private equity opportunities
Belo Horizonte-based Devex is the kind of start-up you associate with US entrepreneurs: a bunch of bright college graduates get together and developed new hardware and software. In this case, the three graduates developed a way to run mines more efficiently. The package gave managers a snapshot of which machines are where and how they are operating across operations across the face-to-plant process and was branded Smartmines. Guilherme Bastos, the chief executive, and his colleagues started the company in 1997 and were in time for the mining boom that kicked off in 2001. Back then, the firm 20 people employed and with revenues of R$500,000 to 1m. After years of growth, the company was looking for international expansion opportunities and had identified a UK company of the same size. It needed money. Mr Bastos says he was skeptical about inviting in a private equity firm: “They often change executives and being very frank I feared for my job.” But he finally overcame his qualms and FIR invested between $5-15 million for a meaningful stake. Devex is now reaping the benefits. Governance, planning, structures, marketing and sales are more sophisticated and revenues have increased to R$25m per year. The board is composed of two members of FIR capital, two of the founders and a professional from the market and a former head of BHP Billiton in Brazil.
Mr Bastos reckons that the best exit for FIR Capital is likely to prove an IPO. Bovespa does not yet accommodate smaller companies and if that segment has not developed by the time of the exit, Devex may look at the possibility of listing in Australia or Canada. What’s missing? Thanks to the mining boom, the company has not yet managed to seal a foreign acquisition. It has, however, opened a number of offices abroad.

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