The Rise and Fall of Brazil Equity

The Bovespa has held steady, but issuers are in hiding until the global storm passes. Corporates are finding private alternatives and M&A is picking up slack for bankers.

In late February, amid a glacial IPO market, Brazilian bankers took a breather from all the gloom to crow over at least one piece of good news. Brazil had overtaken China in the MSCI Global Emerging Market Index capitalization rankings, with a free-float cap which was then $509.10 billion (14.95% of the index) against giant China which had tumbled to $481.80 billion (14.15%). In 2002, Brazil accounted for just 5.3% of the index. Not only that, but with trading multiples of about 12.5 times 2008 earnings, Brazil remained significantly cheaper than BRIC rivals China or India.

More cynical foreigners point out that the figures flatter Brazil as the Chinese market has been in a deep sell-off while Brazil’s commodity rich Bovespa has held up better, with giants Petrobras and Vale – representing 30% of the index – accounting for almost all the good performance. Furthermore, they point out that the MSCI measures only the free float of a company, distorting the figures in Brazil’s favor. And even in Brazil, the back-slapping was short lived as bankers went back to contemplate what is turning out to be a grisly year for primary markets.

The contrast between the first two months of 2007 and this year could hardly be starker. Nine companies issued in the first two months of 2007, raising 6.794 billion reais with the smallest transaction accounting for 448.5 million reais alone. The first two months of 2008 saw two deals raise just 387.5 million reais, less than 6% of the 2007 number. True, one jumbo secondary offering took place in March this year for 1.2 billion reais, but it still miserably failed to reach last March’s level. São Paulo-based equity bankers say they will be lucky to reach a third of the 2007 level this year.

Reading the Economic Runes
The resilience of the global and domestic economy is key to capital markets in Brazil. So far, the South American powerhouse has weathered the global economic downturn well, and while estimates for growth have been trimmed they are still relatively strong, with the IMF predicting GDP will rise 4.8% over the year, versus expansion of 5.4% in 2007. Yet much of that growth is contingent on there being no fast deterioration in the developed world, which would hammer commodities markets, on which Brazil still depends.

Even in the fast-growing, purely domestic component of the economy, there are increasing signs of stress. Consumption at home is contributing an ever-larger part of Brazilian economic growth. Yet the consumer boom, fed by higher wages and cheap credit, is starting to drive up inflation, which is already aggravated by global trends in food and commodity prices. Consumer price growth in the 12 months through March climbed to a two-year high of 4.73%, up from 4.61% in February, above the Central Bank’s 4.5% target.

It is widely believed that Brazil has finished its interest rate easing cycle and rates will start to rise over the next 12 months. Carlos Dayan, executive director of Daycoval, a mid-sized bank that has cashed in on the lending boom, is predicting that rates could rise to 12.5-13.0% by the end of the year. That would hurt lending and domestic investment, curbing economic growth. It would also drive the currency up further, exacerbating a rapidly deteriorating trade balance.

A strong currency hurts prospects for a wide range of Brazilian manufacturers, says Antonio Félix, partner at law firm Tozzini, Freire, Teixeira e Silva Advogados. The government is already trying to manage foreign investment and is considering slapping taxes back on investment in the government bond market at a rate of 2%-3%. It is even possible, though unlikely, that the government may take fright and try to deter foreign portfolio investment. This will depend on the evolution of the exchange rate, says Félix.

“If we reach a point where reserves start to decline that could be a red light and they will probably try to create some kind of limitation,” he predicts.

Equity Bust
The question on everyone’s lips is when the equity markets might re-open and whether the first quarter pause is just that or something more like a big time funk. Investment bankers agree that late last year many companies were simply rushed to market to take advantage of investors who were jumping on anything Brazilian.

“The Brazilian markets experienced irrational exuberance which can be seen in the quality of some of the stories that came to market. They have not delivered in terms of news flow and growth. They may be high quality companies, but they were not at the right stage [for a public market launch],” says Ricardo Lacerda, managing director and head of investment banking Brazil & co-head of investment banking Latin America at Citigroup.

Investors feel burned by many of the glossy presentations and over-optimistic forecasts, other investment bankers say. There has been a lack of responsibility from both corporate and their advisers in producing estimates, says Bernardo Parnes, CEO of Banco Bradesco BBI, the investment arm of the private domestic bank. That has left many investors resentful and companies frustrated by limited access to international markets, he says. Many companies that should have tapped a private equity (PE) investor and prepared for a market launch preferred to skip over that transition and go directly to an IPO last year, adds Félix.

The chickens have come firmly home to roost. The hyper-active real estate sector is a particularly severe lesson on the pitfalls of the me-too IPO. Of the 32 listed companies involved in the sector, almost all have experienced declines this year – Rodobens, Helbor and JHSF are exceptions while Cyrela Realty has been stable – with most tumbling 10% or more.

Still, despite tight liquidity and a new dose of skepticism towards Brazilian firms, it remains possible to get deals done, particularly when they have liquidity and a robust story to tell. José Olympio, managing director and head of Brazilian investment banking at Credit Suisse, sees investors as selective, but by no means refusing to consider new opportunities. “Any story that has the combination of a good sized free float, quality management and business plan and a track record will get done successfully,” he reasons.

Sonia Dula, head of LatAm investment banking at Merrill Lynch in New York, sees investors going back to basics. When you have very hot markets, investors are prepared to take more risk, but as markets start to trade off highs, they demand quality and growth, she says. Dula expects a pick-up in the second half but says investors will be asking: “‘Why are you issuing? Is my money funding growth? Is the management good quality?’”

Investors will demand solid, deep track records, proven cash flow generation and profitability, growth and the ability to deliver a consistent positive news flow, confirms Lacerda. He expects to see around 10-20 IPOs this year, most of which will be larger than the deals that squeaked through last year.

Regional Bellwether
LatAm, and Brazil in particular, could be a global bellwether for equity market activity in the second half of the year. If the global write-down and credit problems ease then markets in the region could be the first in the world to open up, thinks Val Carlotti, president of Goldman Sachs Bank in Brazil. “We believe there are still plenty of opportunities here despite the fact that the US and Brazil will never really fully decouple,” he says. In dollar terms, the Bovespa was up by mid-April which compares well to developed country markets, he notes.

Emphasis on quality and liquidity raises the question just how many more Brazilian companies can meet the specifications of ever fussier investors. The Brazilian market is in a period where funding is hard to come by. Even so, there are still investors willing to invest, says Lacerda.

Rodolfo Riechert, head of investment banking for Brazil at UBS, believes there is still cash out there for equity deals. Furthermore, while he accepts that some companies and advisers over-stated their attractiveness, he argues that the vast majority of 2007 issuers were solid. UBS and rival Credit Suisse were lead book runners in the vast majority of last year’s equity transactions.

“Many of the companies recently bought to market are making good sales and seeing positive return on equity that are beating expectations,” says Riechert. He points out that fundamentals for the banks that came to market, a significant sector last year, are underpinned by consumer and credit growth and most are surpassing ambitious targets.

Cruzerio do Sul, soundly beat earnings expectations and achieved a return on equity of close to 35%, for example. “None of these companies [that came to market] have gone bankrupt or faced significant financial difficulties,” Riechert concludes.

Alternative Funding Mechanisms
Whatever the timing of a IPO market re-opening, investment bankers are not resting on tarnished laurels. They are exploring a variety of alternative funding options with clients in need of cash. The problem with many of the alternatives is that they do not generate the same level of fees as public equity.

“Our mission is not to carry out IPOs but meet clients’ needs,” says Olympio. Alternatives for firms looking to raise cash include selling part or all of a business. He points to the example of Goiânia-based MB Engenharia, a real estate firm catering to lower and middle class buyers outside the hot markets of São Paulo and Rio. The firm had filed for an IPO but opted in March for a sale to Brascan.

For those issuers sensitive to valuations and without immediate needs, waiting for public equity markets to open is another solution. “It’s all about staying close to your clients and understanding what they need,” says Olympio.

In other cases, investment banks are raising PE-style money. Riechert notes that funds are available from a variety of sources, including clubs of between three and 15 investors, hedge funds, and traditional PE firms, which are cash rich after a wave of capital raising. The latter tend to have a shorter horizon for investment and can act as an intermediary before a public offering for more permanent capital.

US PE firms and hedge funds are increasingly scouting LatAm opportunities, and private placements especially for smaller deals have become much more viable, says Dula. That is filling a gap in public markets which have not been keen on smaller, secondary offerings, she notes.

In addition to private deals, Citi is also keeping a close eye on the debenture market, despite predicted increased rates. “It is a high interest rate environment, but local debenture investors are looking for private names and non-government risk and prefer local markets to avoid foreign exchange risk,” Lacerda notes. He admits that an upward shift in the yield curve may prove negative, but points out that large names trade at a small discount to the base rate.

M&A Still Flying
Amid all the gloom of equity, M&A continues to go great guns. The volume of Brazilian M&A activity was close to $27 billion in the first quarter of the year, a rise of 140% over the previous year, compared to a 24% fall worldwide, according to data from Thomson Financial. Admittedly, this is somewhat distorted by the huge union of the BM&F and Bovespa, but there are other jumbo deals in the works. These include the tie-up between Brasil Telecom and Oi, as well as the BNDES’ sale of energy company Brasiliana.

Still, bankers are starting to worry about the future. Financing is tougher to come by, even as targets start to look more attractive. But volatile markets make it difficult to reach agreement between buyer and seller. Although banks boast of a large number of deals in the pipeline, the ratio of possible deals to successfully executed ones looks likely to fall.

“The hit ratio is suffering already,” says Lacerda, whose firm is a leader in the market. He points to the attempt by Vale to buy Anglo-Swiss competitor Xstrata, a $90 billion deal that was nixed as the parties were unable to agree on price, as well as the aborted privatization of the São Paulo electricity firm CESP.

“It’s going to be a tricky year that could go either way. Firms are not abandoning plans and are looking very actively at opportunities, but the challenge is to complete the process,” says Lacerda.

Meanwhile, Dula sees key domestic and global trends underpinning continued high levels of M&A activity. The consolidation trend is both local, for example in real estate, and international – including metals and mining, and healthcare – she points out. Big global players really want to put down a footprint in high growth markets while internally, the new wave of capital raising is allowing firms to consolidate many fragmented industries, she notes.

Riechert sees the equity market pause allowing companies that have come to market to focus on growth, whether organic or through acquisitions. Those that have raised money through IPOs will benefit as they are flush with cash.

The outlook for domestic capital markets remains uncertain. Brazil has clearly emerged as the LatAm leader, a fact cemented by the tie-up between the cash and derivatives exchanges Bovespa and BM&F.

But signals from the global economy are just too mixed, the decoupling theory debunked and local markets still too dependent on fickle foreigners to be confident that 2007 was more than a one-off freak that will not be repeated for years. After last year’s froth, investment bankers are going to need to work hard to restore investor confidence and convince them that new issues are solid and being done for the right reasons. At best, they hope for consolidation of last year’s unprecedented leap forward. LF

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