The objective of this article is to present the most significant investment issues of the private equity industry, including investments in venture capital companies, referred to as venture capital, and to demonstrate the intense growth that these industries have experienced in the past years in Brazil.
In relation to venture capital investments, it is important to mention that they are a branch of private equity investments. This investment mode refers to venture capital investments, in which investment is made in start-up companies whose lines of business are usually related to the field of technology and involve innovative ideas, in order to make both an important business opportunity attractive for investment purposes.
Examples of venture capital targets are technology and information-technology companies that are still being organised, precisely for their innovative character and return perspectives they provide.
Private equity and venture capital investors carry out their investments in several economic sectors and in different types of companies, which can be both start-up companies and famous companies that already hold an important position either in the domestic or international market.
Therefore, it is important to determine the different stages and configurations through which private equity and venture capital investors act. It is possible to divide such investment modes in the following manner.
Private equity
(i) Later stage: in this stage, the company has already reached a relatively stable growth rate and already has a positive cash flow; (ii) Acquisition finance: capital contribution for a company to purchase another company. This category includes mezzanine finance, which uses a combination of debt and equity; (iii) Management buyout: funding so the management team of the company itself or even external managers can acquire shareholding control of a company; (iv) Bridge finance: capital carried out when the invested company plans its initial public offering within a year. It can also involve the restructuring of the shareholding stake of large shareholders; (v) Turnaround: financing for companies undergoing operating or financial difficulties; (vi) Mezzanine: investments in advanced stages of the company's development through subordinated debt; and (vii) Private investment in public equity (Pipe): a contribution in low-liquidity publicly-traded common shares.
| Vehicles: breakdown |
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| Source: Gazeta Investe AnoIV No5/December 2008 |
| Stage of companies in portfolios |
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| Source: Gazeta Investe AnoIV No5/December 2008 |
Venture capital
(i) Seed capital: small capital contribution which favours a business founder or entrepreneur, carried out during the pre-operational phase, for the development of an idea, project or even for market testing or patent application; (ii) Start-up: capital contribution for companies in development, in general for companies with less than one year, when they still have not commercially launched their products/services. During this phase, the company has already started hiring professionals and needs the investor's capital to carry out all the necessary studies so that the company's market and business plan can be put in practice; (iii) First stage – early development: the investment is carried out when the company already has a business plan and the company's prototype is healthy, market studies are favourable and the management of its businesses seems promising; and (iv) Second stage – expansion: capital contribution, generally for working capital, to expand the company that already sells its products/services commercially. The contribution can also be allocated to the expansion of the facilities, the distribution network or even to marketing and communications.
Private equity and venture capital investments have increased. In 2007, the industry achieved important investment figures and maintained its growth in 2008. This expansion, associated with the recent investment difficulties found in the securities market, render 2009 a promising year for the industry.
In view of the economic crisis that has contaminated the business world, all investments have been reduced. Thus, the resulting credit reduction provides private equity and venture capital managers with significant opportunities in Brazilian companies. Nevertheless, managers have increased their level of demand when carrying out their investments.
In one of its recent issues, Valor Financeiro informed the total resources and committed capital regarding private equity and venture capital investments, in relation to the current maturity stage of the Brazilian private equity and venture capital industry.
As can be seen in the graphs, there is still non-invested capital. So the private equity and venture capital market is still promising. As previously mentioned, because assets are available at lower prices, the trend is for investors to increase the number of demands when joining a company. Therefore, several alternative investments will be necessary, which are often pegged to certain asset-growth targets of the invested company.
For all of these reasons, the private equity and venture capital industry is growing fast, and large transactions have been carried out amidst the global crisis; for instance, the acquisitions of Quero-Quero network (construction material and electronics) by Advent, Imbra (dental implants) by GP Investments, and Frango Assado Restaurants by International Meal Company (part of Advent).
The private equity and venture capital industry is currently in an extremely important moment resulting from the growing volume of transactions of which it is a part to support Brazilian companies. Hence, the legal issues involving private equity and venture capital in Brazil will now be assessed. First, there will be a brief statement on how the Brazilian legislation regulates the most important investment vehicles, followed by the explanation of the basic concepts involving the main means through which investors can withdraw from the invested companies.
Legislation
All private equity and venture capital managers use vehicles to take part in an invested company which can vary according to the type equity of intended investment.
In relation to venture capital, there is a certain investment-fund mode largely used by investment managers in promising undertakings, based on the annual revenue of the invested company. This is the Fundo Mútuo de Investimento em Empresas Emergentes (FMIEE), regulated by the Comissão de Valores Mobiliários (CVM) Instruction 209 of the Brazilian Securities and Exchange Commission and amendments thereto.
These funds are closed-end partnerships, have a limited number of 35 investors and a 10-year term, which can be extended by means of approval of the general quotaholder's meeting.
FMIEEs can be under the management of an individual or a legal entity (authorised according to CVM Instruction 306) and are limited to investments in corporations, publicly or privately-held. Such companies cannot have an annual net revenue above R$150 million on the date on which the first investment is made, nor be part of an economic group whose consolidated net worth is above R$300 million.
The profile and targets of FMIEE investment portfolios are companies undergoing the seed capital, start-up or expansion investment stages.
FMIEEs are not often used in relation to more advanced investment stages – in other words, later stages, acquisition finance, management buyout or buy-in, bridge finance, turnaround, mezzanine and Pipes, especially because of the revenues of the companies to be invested in and of the necessary management level in these companies. Hence, the most attractive vehicle for these investments is the Fundo de Investimento em Participações (FIP) or private equity investment funds.
FIPs are regulated by CVM Instruction 391. They are characterised as closed-end investment funds with accepted resources whose investors can only be qualified investors, defined according to Article 109 of CVM Instruction 409/04 and amendments thereto.
Such funds are governed by specific legislation and are not subject to the Brazilian corporate law Lei das SA. Much like FMIEEs, they are restricted to investments in publicly or privately-held corporations. However, there are no limits to the revenues of the invested companies. Moreover, FIPs must participate in the decision-making process of the invested companies and only legal entities can manage these funds.
Both FIPs and FMIEEs are the most important tools of the private equity and venture capital industry in Brazil.
In relation to international structures, these include north American limited partnerships. Companies under this legal status are organised especially in the US state of Delaware and act as ghost companies or pass-through entities, for in most cases they are organised as companies that invest in Brazil (investments can be made in the different venture capital or private equity stages), and their controlling shareholders are funds or companies located in tax havens.
Through this structure, when the payment of dividends for its activities in Brazil is due, dividends will be distributed to the parent companies, which will automatically, or in a short period of time, redistribute such dividends to their parent companies located in tax havens.
Corporate legislation of Delaware has significant weight in the choice of organising this type of company, for it is extremely modern and dynamic.
Investment funds regulated by CVM Instruction 302 and 409 and holding companies organised as corporations or limited liability companies are also included among the private equity and venture capital vehicles. However, they are usually identified only in the form of institutional investors, which normally invest in companies undergoing the turnaround or Pipe investment stages, or even in the free-float of companies listed on the São Paulo stock exchange, Bovespa.
| Total funds and committed capital |
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| Source: KPMG research for Valor Econômico |
| Invested and non-invested resources |
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| Source: KPMG research for Valor Econômico |
| Amount of disinvestment |
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| Source: Gazeta Investe AnoIV No5/December 2008 |
Pull-outs from invested companies
All private equity and venture capital investment vehicles, once they take part in the invested companies, require certain guarantees for carrying out their investments in order to safeguard their interests. In most cases, the most effective guarantees these investors are able to obtain are some withdrawal mechanisms from invested companies.
An investor can join a company through equity or debt. When the investor joins the company directly through equity, the investor immediately becomes a shareholder of the company object of the investment and, therefore, he is also liable for the corporate transactions of the invested company.
Joining through debt is usually carried out through the purchase of convertible debentures into shares or any other form of securities or instrument of credit that may result in the investor's participation in the company. At the maturity date of the debt, the investor converts and joins the company as a shareholder, undoubtedly through the use of certain contractual instruments, such as shareholder agreements, investment agreements or the establishment of predetermined productivity goals.
In a previously mentioned recent study, WA Sahlman described some forms of this type of investment usually employed by investors, ">
"A successful corporate interest investment is far from the mere consummation of flowback. The withdrawal amount of the invested company is one of the foundations for the success of a private equity fund – for this reason it is planned from the initial participation in the company. Joining the company, taking part in its management and withdrawal are the basis of the fund's operation."
Therefore, in order for a private equity and venture capital manager to carry out an investment, there will necessarily be an agreement between the founding shareholders or with their controlling shareholder and the founders of the invested company. In the current economic scenario, the joining of this type of partner is extremely interesting because of the difficulty Brazilian companies are facing to obtain loans in reasonable amounts in order to carry out their transactions.
Through the meeting of ideals – on the one hand, an investor with money, searching for good deals, and on the other hand, an entrepreneur looking for partners who believe in his company – shareholder agreements are drafted in accordance with legal and financial issues, with several forms of withdrawal for the investor. Such withdrawals can be partial, take place during a certain period of time, or can even be full withdrawals, representing the effective implementation of the divestiture.
"Full withdrawal is the sale of the entire corporate interest held by funds managed by the private equity and venture capital organisation, as well as the total liquidation of the assets of the companies in the portfolio. In the event that the withdrawal has taken place through several partial withdrawals, the last operation was considered as a full withdrawal, and the previous ones as partial withdrawals."
Divestitures can be carried out through different ways. Currently, withdrawals through the sale of corporate interest in the stock market and secondary transactions prevail.
Because Bovespa underwent a large downturn due to the international economic crisis, other withdrawal mechanisms will probably be used to a greater extent. Below are the most commonly adopted withdrawal modes in agreements entered into by investors and entrepreneurs:
Tag-along right
The right the investor has to tag along when the other shareholders sell their shares to third parties. The investor's right is usually pegged to changes in the shareholding control of the company in a single transaction or in view of several successive deals that result in the accumulated sale of a certain percentage of the entrepreneur's interest (usually triggered at 30%).
Drag-along right
The right the investor has to demand the sale of all the company's shares/quotas; this right is usually pegged to certain multiples. Nowadays, the most commonly used multiple is earnings before interest, taxes, depreciation and amortisation (Ebitda).
Therefore, if the invested company does not achieve certain pre-established goals, the investor can demand that the other shareholders collectively sell the shares with him to a third party.
Buy-back
Mode through which the invested company or its entrepreneurs have to buy back the investment made by the investor, usually guaranteed through the unilateral purchase obligation, or call option, or through the unilateral sale obligation, or put option, which are unilateral options granted to the investor so that the investor can undo the investments in the company. Likewise, one on the most commonly used modes by private equity and venture capital investors is the put option of preferential shares in case the company does not achieve certain goals. The buy-back of shares is carried out by the invested company itself or by the entrepreneurs.
IPO
So far, this has been the most commonly used means for investors to carry out their divestitures. Based on the invested company's undertaking to carry out the public offering, investors withdraw from their shareholding interest when the invested company goes public through the second offering of the shares they hold.
The criteria for the second public offering are very similar to those required in the IPO. However, the company is already listed on the Bovespa, and the withdrawal will be carried out through a new issuance or roll-on.
Trade or strategic sale
Sale of the entire shareholding interest to a strategic buyer, which in general is an industrial group interested in integrating the company vertically or horizontally. In trade sales, the entrepreneur can require that the investor sell its shareholding interest through drag along in order to consolidate the company within an economic group. The strategic buyer aims at achieving commercial objectives through vertical or horizontal integration, thus acquiring the entire shareholding control.
Write-off
The final divestiture alternative, a write-off, means an unsuccessful investment in terms of flowback. It is a drastic and seldom-used alternative, given that there is always the possibility for the investor or entrepreneur to sell the company to a strategic investor.
The private equity and venture capital industry boosts the Brazilian economy with the input of significant resources for the development of the industry and the Brazilian labour market. It is important to mention that the legal instruments available to formalise private equity and venture capital investments and divestitures are complex and usually based on legal financial principles (goals, growth indices and interest adjustment formulae, among others).
The investment vehicles assessed herein grow exponentially, as do their resource volumes and capital commitments. Given the downturn in the Brazilian stock market because of the international crisis, the current complexity level at the time of the investment tends to increase with the weakening of public offerings in Brazil (main withdrawal form until 2008).
It is important to mention that the private equity and venture capital industry is undergoing large-scale development. An extremely organised movement is beginning in Brazil so that this industry can have a self-regulation code in order to establish the guidelines and principles to be followed by its players.
The year 2009 will be one to gain maturity, for renewals and for a greater development of the private equity and venture capital industry, which contributes and encourages international economic growth.
| Author biographies |
Fabio Campos Mello
Campos Mello, Pontes, Vinci & Schiller
MA in Commercial Law from New York University School of Law.
Marcus Vinicius Bitencourt
Campos Mello, Pontes, Vinci & Schiller
Post-graduate course in business law from Fundação Getulio Vargas – FGV/RIO.
Member of the Brazilian Association of Private Equity and Venture Capital. |