Brazil: A basket of benefits

Author: | Published: 1 Oct 2008
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Nicholas Pettifer
Staff writer

“There is no delinking from the global economy and there will be volatility here like everywhere else”

At the International Bar Association conference in Buenos Aires this week, there is a discussion on Latin American private equity and hedge funds. Christopher Meyn is a partner at Brazilian firm Gávea Investimentos and is he speaking at the session. Here, he previews what he is likely to add to the debate and reveals reasons why he feels Brazil is the best country in Latin America for private equity houses to invest into.

Have you had some pre-discussions about what you are going to talk about in your session?

I'm going to talk generally about the private equity environment in Brazil. There are two of us coming over from Brazil and that is a pretty traditional speech topic. It's a country that (right, wrong or indifferent) is perceived as a bit buffeted and delinked from a lot of what we are seeing right now globally. It's not true. It is a very attractive market, and there are fundamental reasons why it has become more attractive for private equity. But, like anywhere else, it is not magic: there is no silver bullet, there is no delinking from the global economy and there will be volatility here like anywhere else.

So I'm going to talk about Brazil – what the environment is like, what we see happening right now and what we think the outlook will be for the next two or three years. We have our own impression and people usually like to hear it, but whether it's correct or not is up to the audience.

You mentioned existing legislation that makes Brazil attractive.

There are certain market friendly, investor friendly changes that have been implemented over the last few years. You've got to take them as a basket of positive regime changes – any one by itself is really not enough, but as a group the results are interesting. Tax incentives for foreign direct investment, including vehicles domestically and abroad that can be used to reduce or eliminate taxes for foreign investors, including private equity. The streamlining of capital flows back and forth between countries has been important. Prior to the early 2000s, foreign exchange flows were processed with quite a lot of bureaucracy – arcane registration processes to get your money flows approved. That led to some less than perfect mechanisms for capital flows here – it stimulated parallel markets (as do the very high tax burdens in Brazil). But that has all been simplified and it is now fluid. It is no different having our money abroad and bringing it in than it is in any other developed economy.

What rules in particular have helped?

Law 2689 allows for capital gains and financial transaction tax exemptions on stock market investing for foreign investors.

More importantly, for direct investing in companies such as under private equity, you can use newly created and regulated investment vehicles. For example, the FIP (Fundo de Investimento em Participações – a fund of investments structured like a limited partnership or a corporation) is a vehicle that investors can make investments in private entities through on a capital gains tax-exempt basis, including allowing for washing of gains and losses among investments in the same fund.

These structures and vehicles are gaining popularity and the lawyers involved do a good job. Tax haven domiciles change a lot here and if you're not careful you can end up paying more tax than the basic rate. If you find yourself in a locally classified tax haven, capital gains are not exempt and in fact increased from 15% to a 20% rate. You have to be in tune with what is happening while you are structuring both the fund and the investments. Some things are just irreversible, so you want to avoid making mistakes by keeping your eye on the ball. We certainly spend a lot of time on tax planning and investment structure internally.

Have there been any developments in the capital markets that have increased attractiveness of companies to investors?

I would certainly point to the creation of the Novo Mercado, which is the special listing designation within the Brazilian Stock Market (Bovespa). It was created in 2000 and now there are more than 100 companies listed. This designation is reserved for companies with the highest level of corporate governance and transparency within the stock market. So you can file to become a Novo Mercado company, and you must meet an advanced level of both shareholder friendly and market friendly characteristics. Such as a minimum float of 25%, one class of shares with tag along rights for all minorities, etc. So you align interests of all shareholders, no longer having the game of isolating minority shareholders or creating a control group, an "us versus them" mentality inside the company.

And this is attractive to investors.

Yes, there has been a great premium for the companies that have adhered to this set of requirements and you can actually start tracking that. The companies that comply have performed very well relative to the broader market. There has been, as I recall up to a 30% average premium in valuation for Novo Mercado companies. Whether that is statistically or purely linked to the Novo Mercado, who knows. But it is the right kind of movement for an investor – it's a private equity mentality.

The transparency helps too. That has helped stimulate a confidence that (and this goes hand-in-hand with a better macro economic environment for the long term) a sense that the equity markets are real. It's not just a capital game for the controlling shareholders to play with and jam the little guy at the end of the day. It has helped drive a lot of foreign investment into the stock market here.

Have there been any new legislative changes that have helped?

The relatively new bankruptcy law in Brazil has been quite beneficial. It sounds crazy to say, as it does nothing more than implement a European or American style bankruptcy system where none existed before. But it does now provides a chance to have a controlled recovery process versus an arbitrary judge-ruled bankruptcy/ liquidation proceeding.

Before, you would be bankrupt and some guy without any link to the business in some far away city would decide the life of the company for debtors and creditors. And it wouldn't always be rational. Today, creditor groups are formed, the recovery plans are submitted and negotiated, and there is a waterfall of seniority in claims. This gives you a clear and better judicial system for resolving problems. There has always been a good judicial system in Brazil, albeit a little bit slow; but this has helped create certainty for investors.

And all of these things together add up to a better environment for private equity investment?

Taken together as a whole, these legislative and structural changes have created a much better investment environment over the last five to seven years. None of these can match the most important thing though – simply a better economic environment. Brazil has turned itself around and positioned itself to be very, very stable for the long term, which hasn't really happened since the seventies.

Why Brazil? It's a much bigger country, it's very western thinking and consumption habits are very much American. That can be good or bad. Good if you're selling Big Macs! Seriously though, there is more of a habit of adopting credit and therefore being a consumer in the truest sense. You will spend your earnings, you will take on credit and you will increase your consumption as your spending power increases. This is something we are used to seeing in the western world, but we don't really see it happening in the same model elsewhere in emerging markets. Here, it is happening. So you can play themes that work in other markets, you just need to time them right.

It's really hard to strip out one thing that has increased Brazil's attractiveness, but high interest rates create opportunity. They also create a challenge for private equity in terms of more expensive capital, but it keeps valuations down. So I view that as an opportunity if you are comfortable with risk. Leverage is not a significant option with high rates and because of that you are doing a lot of things on a pure equity basis. Leveraged buyouts are tough to execute here and will continue to be so until debt is more creative and cheaper.

Are there any structural differences to deals in Brazil that make them stand out from other Latin American countries?

I'm very Brazil-centric, but anecdotally I understand the judicial system here is clear and direct. It works. It may not work in the same time frame you were hoping it would, but it works and there is clarity to the law.

There is political stability too. Historically, Brazil tried all the tricks in the book to get itself out of problems. Price controls, tax regime change, nationalisation of assets – none of it really works and the average Brazilian won't accept any new gimmicks. So prudent politics, steady economic policy and a very free media are certainly important contributing factors.

Do you know of any future legal developments that will help promote investment in Brazil?

I don't think we will see any significant legislative changes in the near future. There is an election in a year and a half and there is never a great urge to shake the tree. The economy is humming along and so far any real softness in the economy seems to be lagging the global crisis enough.

So, what you worry about here is a change in the micro-environment in terms of capital markets and liquidity. That's going to happen. I hate to tell everyone that, but it is going to be rough for some folks out here in Brazil.

But you are confident of your long-term investments?

We have always had confidence in Brazil. A little patience, a little cold blood and trying not to get emotional is the key.

On January 1 2009 some changes to the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz, AWG) will come into effect that are likely to have a significant impact on foreign investors wishing to invest in German target companies. Under the new regime, any such acquisition by foreign investors may trigger the right of the German Federal Ministry of Economics to investigate and even prohibit the transaction.

The reform

Who is affected?

Under the Foreign Trade and Payments Act, investors from non-EC countries that do not belong to the European Free Trade Association (EC plus Switzerland, Norway, Iceland and Liechtenstein) and that acquire shares representing 25% or more of the voting stock of a German company may have their acquisition investigated by the Federal Ministry of Economics. Shares held by companies controlled by the acquirer (by holding at least 25% of the voting stock) are treated as if they were held by the acquirer itself. Shares that are subject to voting agreements are also assigned to the acquirer.

If the Ministry comes to the conclusion that Germany's public order or national security are threatened by a transaction, it may prohibit the acquisition. Unfortunately, the Act does not contain any definition of public order or national security, so the Act brings a certain degree of uncertainty about which transactions fall within its scope. If the Ministry decides that a transaction falls within the scope of the Act, it may order that the acquisition (which may already be consummated) be reversed. The Ministry may also choose only to prohibit the exertion of voting rights of shares held by the foreign investor, thus restricting the investor's influence on the German target.

How long does it take to reach a decision?

Foreign investors are under no obligation to file their transaction with the Federal Ministry of Economics. However, they may do so after signing and will, in that case, receive a final decision on whether the transaction will be prohibited within one month. If the transaction is not filed with the Ministry, it may start an investigation on its own account within three months after the consummation of the transaction, with the effect that the transaction is put under the condition precedent of the Ministry's approval. The Ministry will immediately inform the investor of its decision to investigate the acquisition, which triggers the acquirer's obligation to provide the Ministry with data. The acquirer will be informed about the specific data required by the Ministry through an announcement in the Federal Gazette (Bundesanzeiger). The investigation must be completed within two months of receipt of the transaction data.

Aims and criticism

The reform seeks to protect sensitive branches of German industry such as the energy, telecom and military sectors. Potential threats are perceived to come from state-controlled funds (in particular from China, the Emirates and Russia) that may be used to influence German politics via investments in German key enterprises. State-controlled foreign corporations have also been classified as potentially dangerous.

The reforms have attracted much criticism. For example, the new powers granted to the Ministry of Economics are suspected of infringing the freedom of capital movement as guaranteed by Article 56 of the EC Treaty. The European Commission is planning to examine the Act for its reconcilability with Article 56 and the freedom of establishment (Article 49). Also, the scope of the Act is considered to be unreasonable because it not only restricts investment from foreign countries, state-owned funds or state-controlled corporations but foreign investors in general. Any private equity investor wishing to invest in Germany may find his transaction being investigated by the Federal Ministry of Economics.

The problem for foreign investors

The main problem is the legal uncertainty for foreign investors. If an investor has successfully completed a transaction, it may still be subject to investigation for a period of three months after the closing date. A further two months may pass until the Ministry has completed its investigation. The result may be that the transaction is prohibited and the acquisition must be reversed. This uncertainty is unacceptable for the seller, buyer, target, financing banks and employees of the target company.

Recommended course of action

Foreign investors wishing to acquire 25% or more of the voting stock of a German company should therefore adhere to the following guidelines.

Informal enquiry before signing

A foreign investor can contact the Federal Ministry of Economics before he signs a share purchase agreement on a confidential and informal basis in order to find out if the Ministry will investigate the transaction. A similar approach is generally taken if a bidder wishes to know the position of the German Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) on a takeover process. There are no guidelines on how such an informal approach should be made, though any informal contact bears the risk that information may be leaked. A seller is therefore unlikely to agree to such contact.

Filing for investigation after signing

Therefore, a foreign investor should voluntarily file the transaction with the Federal Ministry of Economics immediately after signing a share purchase agreement. He should refrain from filing only if he and the seller are in no doubt that the transaction does not qualify for an investigation by the Ministry. If the investor intends to file the transaction, the share purchase agreement should contain a clause that makes the clearance of the acquisition by the Ministry a condition precedent for the obligation of the parties to consummate the transaction. After the Ministry has received all relevant data, it has one month to decide whether it will prohibit the consummation. In order to speed up the process, the investor should agree with the Ministry on which information it needs in order to come to a decision as quickly as possible. It appears likely that an investor will, in most cases, be able to get a decision before the German Federal Cartel Authority (Bundeskartellamt) has cleared the transaction. Therefore, the filing of the acquisition should not lead to delay in most cases.

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