Brazil has experienced big structural changes in its economy, politics and law over the past 20 years. Looking at the timeline beginning in the trade liberalization and political transformation process of the late 1980s until the early 21st century, an unmistakable pattern arises – obstacles to solid economic growth are surmounted and replaced by the challenge of meeting new standards in terms of economic expansion and deal making. All of this has implications for the ever-changing landscape of Brazilian business, and so for mergers and acquisitions.

Politics

The 1980s and 1990s marked the beginning of a political process that, starting with a much demanded return to democratic standards, included the impeachment of former President Collor, a democratic re-election after a military regime with former President Fernando Henrique Cardoso, and the harmonious handover of power to a left-wing government, with the recently re-elected President Lula da Silva. This political renovation has formed a solid economic foundation that has given local and foreign investors reassurance that economic issues are no longer attached to political orientation in Brazil.

Economics

Economic bliss might not yet have been achieved, but the past 10 years have shown many positive signs, including the taming of Brazil's persistently high inflation, one of the country's most enduring problems. The Brazilian currency has also consistently grown stronger and appreciated dollar-wise. This had worried certain export-oriented segments, but has two positive aspects: an opportunity to restructure public debt and an increase in the potential margin for dollar appreciation in the future (making foreign investments more attractive). International liquid reserves are at a record high, amounting in January this year to almost $88 billion, boosted in part by favourable trade balances. In addition, Brazil has experienced an increase in its consumer population basis due to a slightly better income distribution.

These positive times in Brazil can be credited in part to the performance of the global economy, and many challenges still need to be overcome, such as high interest rates, core infrastructure problems (especially in energy – the market expects energy rationing to threaten Brazil in 2009 unless changes are made), and an overall mediocre growth of the gross domestic product. But local consumers and foreign investors are optimistic, a fact reflected in Brazil's Emerging Markets Bond Index Plus (Embi+) record low rating (around 190 points at the time of writing). Many expect an economic boost if the right mechanisms are set, particularly regulatory and legal mechanisms.

Legal and regulatory

Brazil has witnessed a myriad of legal and regulatory reforms in the last seven years. Some of the most important reforms were the Civil Code of 2002, which reformed a large part of domestic business law, a new bankruptcy law in 2005, which replaced an inadequate and archaic body of laws, and the creation of public-private partnerships, a promising alternative to a public infrastructure tending process flawed by inefficient expenditures and slow-paced project developments. The Brazilian public-private partnership (PPP) is narrower in concept than its US or British cousins. It is one of many options for joint infrastructure investment by public and private entities, only suitable in specific cases (the projects must have a term between five years and 35 years, and be worth more than R$20 million ($9.4 million)), and is more attractive to private partners than other forms of partnerships because it presents flexible guaranties that are easier to execute (the result of yet more legal reform).

The government and regulatory agencies now have a more substantial part to play, and firm regulatory grounds have been put into place. Examples of this modernization are the changes made to the Brazilian Securities and Exchange Commission (CVM), the watchdog of the capital markets, with swifter rulings and modern, efficient regulatory provisions, and the Brazilian central bank, which (despite the fact that Brazil has a socially oriented government) meets international standards in terms of monetary policy and has had a role in the deregulation of foreign exchange and foreign investment, increasing the inflow of foreign capital.

There are two forms of international investment in Brazil: one for investments directed at capital markets through a structure called 2.689 and the other for direct equity investments in legal entities, through a 4.131 structure. Both of these mechanisms have been made simple and highly practical by the central bank's introduction and continuous development of electronic registry mechanisms (RDE), forming a consistent and solid structure for investment that, together with tax privileges extended towards the foreign investor, have paved the way for a seamless inflow/outflow channel.

Market review

Along with (and as a consequence of) all these structural changes, it is also possible to detect shifts in the Brazilian market's profile. More companies are migrating from the predominant traditional and familiar control structure to complex, professional and disperse participation schemes (of which Eternit was pioneer, followed by Perdigão, Lojas Renner and Embraer). But this model, particularly its dispersion aspect, has received criticism for its risks, such as the so-called balance-sheet dictatorship (where there is a stronger emphasis on the company's statements, resulting in short-term strategies offering short-term returns in spite of a business's long-term outlook).

The São Paulo Stock Exchange (Bovespa), Brazil's most important stock exchange, has grown stronger and has been responsible for innovations in the capital markets such as Bovespa Mais, a welcome intermediary step for smaller companies intending to go public. Another innovation carrying the Bovespa brand is the Differentiated Corporate Governance Practices Stock Listing (divided by levels: Níveis I, II and Novo Mercado), comprising corporations that adhere to new standards of corporate governance. Launched in 2001 and fully consolidated in 2004, it has been so well received by the market that today almost all new publicly traded companies adhere to these new standards, and seek this differentiated segment.

This shift has been accompanied by substantial growth in the capital markets, with an increase in the number of public offerings. Last year saw 42 public offerings of over R$30 billion, IPOs alone representing half of those offerings. Twenty-six new companies joined Bovespa, distributing R$15.2 billion in stock, compared to 2004, which saw seven new companies offering R$4.5 billion in stock, with a grand total of R$8.8 billion for the year. Additionally, the market capitalization value of the 350 listed companies reached R$1.54 trillion in 2006, a 36.9% increase over the preceding year.

The volume of M&A transactions during 2006 involving Brazilian companies was the highest since 2000 (when total M&A equalled $42.2 billion, driven by the internet bubble and including a solid $10 billion from privatization), topping out at $33.2 billion, more than triple the volume for the preceding year.

However, Brazilian participation in M&A transactions worldwide is still tentative. Last year the grand total of internationally announced M&A totalled $3.8 trillion ($2.9 trillion of them concluded), and deals involving Brazilian companies represented a mere 2% of that amount.

But this is balanced by a positive development in 2006: Brazilian companies on the raiding side of international M&A, which is a natural consequence of the open economy and increased stability, forming a two-way road that encourages foreign investment as well as outbound Brazilian investment. Price stability, economies of scale, geographical diversification and other factors that force companies to seek competitiveness through M&A also apply to Brazilian entities, and so they have been shopping abroad. Last year Cia Vale do Rio Doce acquired Inco, a Canadian company, through a complex financing structure worth $19.4 billion. And Companhia Siderúrgica Nacional (CSN) is competing with its Indian counterpart, Tata Steel, for Anglo-Dutch steelmaker Corus, in a deal worth over $9.5 billion, which would make either Tata or CSN the fifth largest steelmaker in the world.

Trends and perspectives

The IPOs carried out last year have increased companies' financing capabilities, adding an important ingredient to the M&A recipe: available funds. Looking at Bovespa companies in 2006, financial institutions were the most prominent, with 21.6% of the total market capitalization value, followed by oil and gas (15.3%), telecommunications (10%), mining (9.8%) and electric energy (9.5%). Almost one-third (31.1%) of all announced M&A last year involved financial institutions and electric energy companies, so if this trend is maintained, Brazil could play a larger role in international deals, at least in these segments. Competition has been intense in the financial sector, meaning a narrower spread in interest rates. Also, the sector is still heavily regulated, and changes in strategy could easily affect acquisitions abroad.

Other variables taken into consideration in corporate strategy include ability to innovate and consumer-relations capabilities, which are all taken into account in the search for target companies with solid intangible assets. Such was the case with Grupo Nova América Agroenergia, whose acquisition of União da Coopersucar in 2005 was motivated by the need for a solid image and reputation. If this pattern persists, the Brazilian market is well positioned, with firm market support for transparency and stakeholder-friendly companies since Bovespa prepared incentives and exposure mechanisms for companies that consider corporate governance a priority. (The corporate governance index (IGC) comprises the stock of such companies. It showed an annual return of 41.29%, as opposed to 32.93% of Ibovespa, Bovespa's main index.)

A brief overview of the recent performance of certain sectors of the local economy makes some activities stand out as promising areas for M&A. Realty businesses, including land acquisition for new developments and shopping centres administration, grew impressively in Brazil, with the IPOs of Lopes, Gafisa and Brascan and the arrival of international players such as Developers Diversified, a US real estate company that plans to invest up to $300 million until 2009, and Equity International, which partnered with GP Investments to acquire participation in the Ecisa Group, one of Brazil's largest shopping centre owners and developers. The same applies to the electric energy sector, where there is a need for investment in energy generation, and where the presence of multinational energy groups will probably mean that Brazil will follow the international trend for consolidation in this market, illustrated by the dispute over Spanish power company Endesa between Spanish Gas Natural and German E. ON, and by the takeover of Light, by Rio Minas Energia (itself controlled by Pactual bank, CEMIG power company, Andrade Gutierrez contractors and Luce fund). The telecoms sector also shows potential for consolidation activity, arising from regulatory change in the sector and the Telecom Italia imbroglio. Lastly, the recent consolidation in the buoyant financial services sector seems to be a solid pattern. A highlight in the series of mergers and acquisitions involving Brazilian companies was the acquisition by UBS of Banco Pactual, one of the last independent investment banks in Brazil, in a deal worth $2.6 billion. Also notable is Credit Suisse's acquisition of a majority interest in Hedging Griffo for $294 million, as part of Credit Suisse's integrated bank strategy, which includes giving greater weight to its onshore asset management and private banking business.

Lastly, due to the sheer expansion of Brazilian capital markets, with an increase in the number of participants (which has more than tripled since 2000), an evolution in market capitalization value and a greater diversity of companies and corporate structures, a predictable trend is that litigation involving corporate law matters will gain in importance and frequency. Also, a larger number of players allows for a greater number of combinations of M&A activities and strategies, and will naturally lead to the appearance of a previously rare mechanism: hostile takeovers. Hostile takeovers will become more common and sophisticated, bringing with them a raft of developments such as new defence mechanisms for minority shareholders and tactics deployed to make a company targeted for acquisition less appealing to its raider, otherwise known as poison pills.

A piece of the action

All of the above has helped to shape Brazilian M&A. Price stability and international liquidity generate strategies to increase in a company's competitiveness, with an increasing emphasis on economies of scale in certain cases and flexible specialization strategies in others. Taking these conditions together, a positive outlook for 2007 results is expected, and variables such as a good Embi+ rating and a robust economy qualify Brazil as a strong runner in claiming a larger portion of the international M&A pie.

Author biographies

Francisco Antunes Maciel Müssnich Barbosa Müssnich & Aragão Francisco Antunes Maciel Müssnich is a senior partner at Barbosa Müssnich & Aragão. His practice areas include corporate finance, mergers, acquisitions and divestitures, joint ventures and associations, privatization, securitization, international business transactions, tax planning, public companies and securities laws, corporate and international tax, corporate litigation and arbitration. He holds a master's degree (LLM) from Harvard Law School and a law degree (JD) from the Universidade Católica do Rio de Janeiro. Müssnich is former president of the Legal Commission of the American Chamber of Commerce and executive director of the Brazilian Association of Financial Law (an affiliate of the International Fiscal Association). He is also a professor of corporate law at the Catholic University and at Ibmec (both in Rio de Janeiro) and at Fundação Getulio Vargas. He is on the board of directors of the Brazilian Symphony Orchestra and WWF (Brazil). Müssnich speaks Portuguese, English, German and French. He is a member of the Brazilian Bar Association. Mauro Teixeira Sampaio Barbosa Müssnich & Aragão Mauro Teixeira Sampaio is a partner at Barbosa Müssnich & Aragão. His practice focuses on corporate law, mergers, acquisitions and divestitures, corporate taxation and corporate finance. He holds a JD from the State University of Rio de Janeiro Law School. Before joining BMA, Sampaio worked in the tax department at Arthur Andersen, the tax-planning department at Boris Lerner Frazão Garcia Malvar & Consultores Associados and in the New York M&A team at Skadden Arps Slate Meagher & Flom. Sampaio speaks Portuguese and English. He is a member of the Brazilian Bar Association.