By Camila Aguirre, Oscar Lauz del Rosario, Ryan Meehan and Rodrigo Patiño
According to data provided by the Emerging Markets Private Equity Association (EMPEA), Brazil's PE industry in 2011 raised a record US$7.1 billion, or 18% of the new capital committed to emerging markets. Of this total, it invested US$2.5 billion across 47 companies. More than half the deals were in the energy, infrastructure and consumer sectors. This comes as no surprise, as Brazil has the largest consumer market in Latin America, worth US$1.5 trillion in 2011. The country is more open to PE than ever before, with success stories covered in the local press, stronger capital markets and an increasingly institutionalized investor base.
Brazil's Economic Takeoff
Over the past decade Brazil has exceeded expectations, becoming a success story among emerging market economies. Per capita GDP rose from US$2,812 in 2002 to US$12,594 in 2011, growing 18% a year on average. In September 2012, Brazil's unemployment rate was at a near record low of 5.4%, compared to 7.8% in the US.
The Brazilian economy's success has translated into increased consumer spending in a variety of areas, ranging from basic goods to furniture and automobile sales. In addition, the government continues to invest money in offshore oil exploration. The country is currently home to the second largest infrastructure project in the world — the development of its offshore oil deposits in the pré-sal, which will bring in US$270 billion in investments over the next 10 years and a huge demand for ancillary products and services. This project is expected to generate 2 million new jobs in an industry that currently has only 500,000 employees. Along the way, Brazil has attracted significant foreign capital, as investors seek to capitalize on the country's growing consumer segment and infrastructure needs.
Despite Brazil's relatively slow growth in the economy over the last 2 years, the consumer sector continues to see double-digit growth in the lower middle class. Given the country's tumultuous history of government intervention, corruption and a bout of hyperinflation in the not-too-distant past, one must consider how the different administrations were involved with the marketplace and to what extent they have been responsible for Brazil's current status.
Most people agree that the foundations for the consumer sector's success were established during President Fernando Henrique Cardoso's administration. The economic stability resulting from the Plano real of 1994, which consisted of a series of contractionary fiscal and monetary policies and the creation of a new currency, dramatically reduced the levels of inflation inherited from the post-military dictatorship, allowing consumers to save and purchase on credit. Inflation is corrosive to society and severely affects the purchasing power of the lower class, which is heavily affected by increases in staple goods and which possesses limited assets. Once inflation was controlled, it became possible to invest in the growth of the emerging Brazilian consumer.
The administration of President Luis Inácio Lula da Silva, from 2003 to 2010, although initially feared by the marketplace for its radical rhetoric, was able to gain the trust of the private sector by maintaining market-friendly policies. Over the same period, Brazil managed to increase its middle class from 26 million to more than 59 million, aided by social programs such as Bolsa Familia, which provided financial support to millions of underprivileged families throughout the country. New consumption patterns also developed, making Brazil one of the most coveted emerging markets.
Under the leadership of President Dilma Rousseff, investors are eager to see what new policies will be enacted. Although one should not expect major changes, due to the affinity between Lula and Rousseff, the current administration is under pressure to continue its predecessors' consumer growth. During the last 12 months, the SELIC target rate has shown a substantial decrease from 11.0% to 7.25%. Analysts expect that Rousseff will offer cheaper lines of credit to the lower-middle class, often referred to as "class C," a group that has long depended on credit provided by retailers. Euromonitor International research indicates that Brazil's annual lending rate averages 43.9%, compared to 14.1% in Argentina, 12.4% in Indonesia, 10.4% in India and 6.6% in China.
Government support for consumer financing can be seen in the recent interest rate cuts at Banco do Brasil and Caixa, the 2 largest state-owned banks in Brazil, and the extension of credit to less affluent individuals. Despite substantial government pressure on banks to reduce their lending rates, there is anecdotal evidence that some private banks are pushing back. Recent media reports estimate loan growth of 10% in 2012, down from the previous estimate of 14% to 17%. This may be a signal from the banks that management is trying to reduce future exposure to bad loans by avoiding higher-risk loans, or that the demand for loans remains lackluster. As of February 2012, 44% of the total credit in the financial system came from the public financial system, compared to only 34% in February 2008. Such trends are being observed keenly by investors interested in the region, as they plan their next moves in the consumer retail sector.
Private Equity, Brazilian Style
Over the past decade, the Brazilian PE sector has grown significantly, deploying over US$22 billion of capital. Brazilian PE funds have played an important role in the economy, helping to professionalize family-owned businesses, improve corporate governance and provide needed growth capital. According to a 2011 Knowledge@Wharton report on the Brazilian PE market, nearly one-third of the companies listed on BOVESPA between 2004 and 2008 were PE-backed, helping to promote the development of the country's capital markets.
In 2011, Brazilian-focused funds raised a record US$7.1 billion, significantly above the 2008 peak of US$3.6 billion. Fundraising is concentrated, with the majority of capital invested with 4 firms: Gávea Investimentos, BTG Pactual, Vinci Capital and Patría Investimentos. As of September 2012, fundraising activity had slowed down, with only US$1.7 billion raised for the year so far. Recent fundraising shows an increased focus on the infrastructure and energy sectors, with US$1.4 billion raised for specialized funds from BTG Pactual, Mantiq Investimentos and Valora, among others.
Investment activity has accelerated, with US$3.4 billion invested in the first 3 quarters of 2012 compared to US$2.5 billion the previous year. In an interview with EMPEA, Piero Minardi, a partner at Gávea Investimentos, recently noted that they had "already deployed almost half of the $1.9 billion fund" they raised in 2011. Anecdotally, although funds are aware of increased competition, several managers feel the sector is still underpenetrated, with 2011 deal flow representing less than 0.1% of GDP compared to 1.0% in the US and 0.3% in India.
PE strategies have evolved significantly in Brazil. With a history of high inflation, dollar-denominated funds, prohibitive hedging costs and limited exit opportunities, the 1990s and early 2000s saw investments in companies with an export-oriented business model, where revenues would be in foreign currencies. In light of limited exit opportunities, investors had to think about "exit first," ensuring that the asset had multiple natural buyers. Minardi pointed out that, following the 1999 currency devaluation, "weak capital markets remained a big concern. ... It was tough to go in front of an investment committee and say you felt secure in having an exit."
Interviews with local PE managers and consultants revealed 3 areas of focus for investment today: infrastructure, retail and health care. Chris Meyn, a partner at Gávea Investimentos, noted that "inadequate infrastructure and education are the main constraints to Brazil's growth today. The country has high electricity and logistics costs. Only 10% of roads are paved, and the country faces increased infrastructure needs from industry and growing sectors, such as offshore oil." While some investors are attracted to the stable cash-flow base, a GP Investimentos representative commented that infrastructure and commodity deals often face lower target returns; they prefer "deals that give us exposure to the domestic Brazil" and are less dependent on what happens in China.
The other areas of focus — retail and health care — are targeted largely due to the attractive growth of the Brazilian consumer base. Retail sales are expected to grow from US$289 billion in 2007 to US$550 billion in 2012 (13.7% CAGR), and the health care segment is struggling to meet demand, with a tenfold increase in public health care expenditures since the government established the United Healthcare System in 1988. A Credit Suisse report highlighted that working-age adults (18-65) represent nearly two-thirds of the population, and the country's demographic dividend is not expected to peak until between 2020 and 2025. Low unemployment, wage growth and expansion of credit will continue to drive the development of the middle class.
Patría Investimentos' investment in Alliar, a medical imaging company, and Carlyle's acquisition of Tok Stok, a furniture retailer, illustrate the continued interest in the rise of Brazil's middle class. According to data compiled by Bloomberg, 34 of 80 PE deals announced in 2011 were consumer-related. Fernando Borges, head of Carlyle's South American Buyout team, explained that their "focus will keep being companies related to consumption, rising income and the growing middle class."
Most of the Brazilian stock market remains tied to extractive industries. But there is still a large unmet demand from international investors to gain access to companies in the consumer sector that are better tied to Brazil's macroeconomic fundamentals. Consequently, PE funds continue to see consumer deals as a priority area for them in Brazil. These deals will allow investors to build companies that will have a natural and attractive exit potential through an IPO.
The positive environment for the consumer sector has brought significant additional competition in the form of new local PE firms, foreign investment groups and strategic acquirers who have greater confidence in the Brazil risk (Brazil has been investment-grade since 2008 and is now considered "BBB" by the major rating agencies). A GP Investimentos representative recognized that the fund had actively looked at a number of deals in the consumer space but decided not to move forward due to valuation expectations. Funds have to rely increasingly on their proprietary networks to source their transactions.
A fund manager, who asked to remain anonymous, commented that one of the most significant problems with Brazil today is not leverage per se, but rather the high interest rates and low durations of consumer loans. An increase in duration and a decrease in interest rates could easily see a doubling of the consumption power of the middle class. Bloomberg noted that in 2012, Rousseff had already taken multiple steps favoring consumption growth, such as cutting taxes on durable goods and pressuring banks to cut interest rates on credit cards.
The technology and e-commerce sectors have seen more interest from VC funds such as Redpoint e.Venture and Monashees, which have invested in online retailers such as baby.com.br and Sophia & Juliette. Industry experts predict Internet penetration will increase dramatically in the nation, and they forecast e-commerce growth of more than 30% per year. Most recently, there has been a flood of "tropicalization," the business of replicating online startups that have already succeeded in other markets. Examples include Peixe Urbano, a Groupon clone, and baby.com.br. Given the success of such ventures, it is likely that e-commerce will continue to attract significant investment from PE and VC backers.
In discussing the future of PE in the region, fund managers were lukewarm about Brazil's potential to serve as a platform for pan-Latin American investments. Gávea Investimentos' representative stated that it was important to stick to the fund's strengths; there are still too many opportunities at home. Minardi noted that "many of us are still very busy looking at the south region of Brazil, which is perhaps another indicator that Brazil is not yet overheated. People do not have enough time to go to other regions and look around because there is so much to be done locally." The GP Investimentos representative commented that acquiring or partnering with a foreign company could be attractive, but "it is difficult because the differences in culture are quite large." Family owners in Latin America are quite risk-averse and remember the deals where "a local investor from their country got burned investing in Brazil."
Is Brazil Too Hot?
There are many challenges associated with the recent influx of foreign capital into the Brazilian market. As competition has increased among funds, the prices that companies are willing to pay have surged. The GP Investimentos representative stated that foreign players are now more willing to pay very high prices for such assets. In August 2012, General Mills closed the acquisition of Yoki Alimentos for approximately 20 times the last 12 months' EBITDA. According to the GP Investimentos representative, investments from foreign markets allow local companies to take on debt and grow at much greater rates than they could on domestic credit lines alone. Such was the case with the 2012 sale of Fogo do Chão, a Brazilian steakhouse restaurant chain purchased by Boston-based Thomas H. Lee Partners.
The lack of infrastructure remains a primary concern among investors looking to develop businesses in the region, and could pose a potential risk to long-term projects that will require complex logistical operations. This has made infrastructure investment interesting to many PE funds. As mentioned by a PE specialist at Bain Consulting, there is great interest in the steady returns that can be made from energy projects, such as power plants and green energy. Some PE firms, such as Gávea Investimentos, have tackled these obstacles by investing in and building their own infrastructure for portfolio companies.
In 2010, Cosan SA Industria sold a US$226 million stake to PE investors Gávea Investimentos and TPG Capital. The partnership gave birth to a collaboration among business and private investors looking to solve the company's distribution problems. Together, they invested in a new rail system, replacing thousands of delivery trucks. In what could be an increasingly popular partnering, a company and its investors were able to tackle infrastructure challenges in an innovative and expedient way by circumventing government inefficiency. Yet, privately partnered infrastructure deals notwithstanding, investors will continue to ask themselves whether the government will be able to effectively meet the larger and more inhibitive infrastructure needs of the growing markets.
With the recent attention Brazil has received from foreign investment, many potential investors wonder if the economy is overheating due to increased competition and heightened attention on the upcoming World Cup and Olympic Games. Some are concerned about the country's ability to develop independently without a direct link to Chinese demand; others are worried about the potential "Dutch Disease" of a strengthening currency due to commodity exports and a rise in cost of domestic manufactured goods. With the recent slowdown of Chinese growth, the demand for soy and iron ore is on the decline, warranting worry.
Still others remain cautious about the government's ability to control inflation, estimated at 5.4% in 2012, above the government's goal of 4.5%. High inflation, combined with high interest rates, have many concerned about Brazil's consumer credit situation. This could prove to be a problem for consumer retailers and create unease for PE firms seeking to invest. Default rates on consumer loans reached 7.9% in August and were as high as 28% for credit card accounts at least 90 days overdue. While nearly 40 million Brazilians have entered the consumer middle class over the past 5 years, some investors, such as BlackRock's Will Landers, do not believe this is sustainable and feel that a more realistic outlook over the next 5 years is closer to 25 million — still a healthy growth rate, but not nearly as large a boost to the economy as in the recent past.
The positive news is that the Brazilian government has shown its resolve to lessen the burden on heavily indebted consumers by lowering interest rates, lengthening terms of payment and extending consumer-related tax breaks. The key factors for investors to weigh will continue to be government intervention and global demand. For now, the government seems committed to lowering the costs of doing business and increasing logistical capacity.
In August 2012, Brazil's government announced a US$66 billion stimulus blueprint to provide subsidized loans for improvements of road and rail systems. Plans to improve port and airport infrastructure are the country's next priority, although some state-run projects have already been planned, such as a nearly US$3.2 billion project at the port of Itaqui in the state of Maranhão. But investments will take time, money, proper management and oversight by government officials. Over the long term, as Brazil continues to grow steadily, the consumer retail sector will remain an attractive investment, but the path to high returns will depend ultimately on the Brazilian government's ability to manage resources, invest prudently and control consumer debt levels as domestic demand continues to grow.
This article was written by Camila Aguirre, Oscar Lauz del Rosario, Ryan Meehan and Rodrigo Patiño, members of the Lauder Class of 2014 and republished with permission from Knowledge@Wharton the online research and business analysis journal of the Wharton School of the University of Pennsylvania.
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