ukti_brazilian_private_equity_report-final

Private Equity and Venture Capital in Brazil

I am delighted to present you with a copy of Peter Thorpe’s report on Brazilian Private Equity and Venture Capital opportunities for UK businesses.

This report has been researched and written on behalf of UK Trade & Investment (UKTI). The report is also supported by Lord Mayor of London and the Brazilian Chamber of Commerce.

Brazil has undergone a rapid transformation over the last few years that has seen substantial rises in GDP levels and increasing demand for goods and services to meet the expanding needs of consumers.

With a population of nearly 200 million, geographically the size of Western Europe and rich in natural resources, we believe that this market offers tremendous opportunities for UK businesses.

I am sure that you will find Peter’s study informative and that it will provide you with a better insight into this market.

Sir Andrew CahnChief Executive UK Trade & Investment

UK Trade & Investment

UK Trade & Investment is the government department that helps UK-based companies succeed in the global economy. It also helps overseas companies to bring their high-quality investment to the UK’s economy – acknowledged as Europe’s best place from which to succeed in global business.

UK Trade & Investment – Private Equity and Venture Capital in Brazil

Peter Thorpe

Peter is an associate director in the assurance and business services department of top 10 accountancy firm Smith & Williamson. At Smith & Williamson, his client base is focused primarily on small and mid cap Main Market and AIM listed companies, as well as owner-managed and private equity backed businesses.

Commenting on his recent secondment to UKTI in Sao Paulo, Peter explained that “being provided with the opportunity to spend 5 months in Brazil at such a positive time in its development was very exciting. Very early on in the secondment, through speaking with an number of people within the financial services and business communities, I realised that there is real potential for private equity in Brazil and UKTI could play a major role in trying to bring together the UK investor community and private equity opportunities there”.

Smith & Williamson

As a business, Smith & Williamson has been working in Brazil and servicing Brazil focused clients for several years, both on the accounting and tax advisory side, as well as in our role as Nominated Adviser for AIM Listed businesses. We are part of two global alliance organisations – Nexia International (on the accounting side) and M&A International (on the corporate finance and M&A side). Both organisations have a strong presence in Brazil.

Speaking recently about the secondment opportunity to UKTI in Brazil, Stephen Drew, head of London assurance and business services, explained that, “as a firm, we see real value in terms of developing and nurturing a long term relationship with UKTI. The Brazil secondment was one important aspect of this, but we see ongoing mutual benefits in terms of being able to build deeper and broader relationships with the financial services and business community in Brazil”.

UK Trade & Investment – Private Equity and Venture Capital in Brazil i

ii� UK Trade & Investment – Private Equity and Venture Capital in Brazil

CONTENTS

1. Executive summary 2

2. Why Brazil? The opportunity 6

3. The Brazilian Private Equity industry in 2010 14

4. The Brazilian model and how it might develop 18

5. Venture Capital and innovation 24

6. Sector focus 26

7. UK investors interested in Brazil 42

8. The focus of international investors 44

9. London’s capabilities 48

10. The London Stock Exchange and the Alternative Investment Market 52

11. The challenges ahead 64

12. The next steps 70

13. Appendices 72 1: Example tax efficient structures 73 2: Definitions 77 3: Useful contact organisations 77 4: Bibliography 78 5: Acknowledgments 78

UK Trade & Investment – Private Equity and Venture Capital in Brazil 1

SECTION 1

EXECUTIVE SUMMARY

2� UK Trade & Investment – Private Equity and Venture Capital in Brazil

A country of superlativesBrazil has undergone an economic transformation over the past decade. A volatile history of seriously high inflation and interest rates has now given way to economic and political stability.

Furthermore, the country received investment grade status in April 2008 and avoided the worst of the international financial crisis (GDP growth was flat in 2009 and has recently been upgraded to 6-7 per cent for 2010). Depending on which forecast you read, Brazil is expected to become the fifth largest economy in the world in the next 10-15 years.

This is perhaps not surprising when you consider that the country is geographically the size of Western Europe, has a population of close to 200 million, plays host to 20 per cent of the world’s productive agricultural land and given the abundance of its minerals and natural resources. If recent major oil discoveries off the coast of Brazil are proven to be commercially viable, then exploitation of these could take Brazil from being the thirteenth largest oil producer in the world to the sixth largest producer.

But it is not just these natural factors that are propelling Brazil forward.

Over the last few years, there has been a dramatic rise in people moving out of poverty and up into the lower middle, and middle, income class brackets. It is estimated that between 2000 and 2008, 23.5 million Brazilians moved up from bands D/E to band C and that 11.4 million people moved up to bands A/B. In addition, GDP per capita is rising – from US$2,638 in 2002 to US$8,626 in 2008.

The combined effect of the expanding middle classes and a relatively young population is to feed demand for consumer goods and credit – people aspire to the quality of life that they see enjoyed in more developed countries. This translates to rapidly increasing car ownership, a surge in new shopping malls and retail centres, regularly eating out, increased travel and tourism and generally better provision for themselves and their families.

While harnessing the country’s agricultural and natural resources potential, together with satisfying and anticipating the growth in consumer demand, offer huge opportunities for businesses and investors, the Government has realised that Brazil suffers from serious deficiencies in infrastructure that will inhibit growth potential unless they are tackled urgently. With this in mind, in 2007, the Government introduced a four year Accelerated Growth Plan (PAC) which aimed to provide in the region of US$250 billion of public and private sector investment in energy, social and urban and logistics infrastructure developments. While much of this investment comes from the Government and the Brazilian development bank, BNDES, significant private sector investment is required − not only within the infrastructure projects themselves, but also in respect of the supply chain and the application of new technologies, many of which have been, or will be, sourced from overseas.

THE time for Private Equity in BrazilThese economic developments provide serious opportunities for the further development of Private Equity in Brazil. While by December 2009, committed capital to Private Equity in Brazil had increased to US$34 billion, the country has remained a relatively underpenetrated market. As at 30 June 2008, capital committed to the Brazilian Private Equity industry represented just 1.7 per cent of GDP, compared to a world average of 3.7 per cent and a UK figure of 4.7 per cent. This is primarily because the industry is still relatively young in Brazil (ABVCAP, the Brazilian Private Equity association recently celebrated its tenth anniversary), but also arises as a consequence of the business environment in Brazil. There are a large number of privately (often family) owned, mid market companies with around 250–1,000 employees and annual sales of US$20–200 million that are perhaps difficult to access and remain largely untapped by the Private Equity industry. Many of these businesses operate in fragmented sectors and/or have succession issues which are preventing them from achieving their growth potential.


At the sector level, there is massive scope for consolidation of fragmented industries − for example, within retail, leisure and entertainment, the dairy and agribusiness industries, logistics and distribution as well as ethanol. The opportunities for infrastructure funds and investments have been highlighted above. A number of these opportunities offer relatively high return and low risk characteristics, especially those arising within the telecommunications and electrical energy sectors. There is also widespread interest in renewable energy sources – not just biofuels, but hydroelectric power too. It is a staggering statistic that 45 per cent of Brazil’s energy comes from renewable sources. The link between venture capital and the development and application of innovative technologies, often working with universities and science parks, is also becoming crucially important in Brazil. For more information on opportunities in these sectors, as well as others, please refer to Section 6.

It was mentioned earlier that the Brazilian Private Equity industry is relatively young. Despite this, as at 31 December 2009, the industry comprised 180 Private Equity managing organisations, with 236 investment vehicles and 554 portfolio companies. During the period from 2005-2009, there have been 489 new or follow on investments and 37 Private Equity backed IPOs. The average Private Equity investment over the period 2005-2008 was US$45 million. There are indications, however, that the average deal size since the onset of the financial crisis has risen to closer to US$100 million.

In terms of personnel, industry in Brazil is increasingly being driven by highly qualified, experienced professionals. In 2009, 1,700 professionals and staff were employed by industry and according to a 2008 survey, at least 74 per cent Private Equity managers and managing partners hold a postgraduate degree. In addition to a high quality academic background, the vast majority of managers also have relevant practical experience, either as finance sector professionals or experience more closely related to the formation and execution of business strategies. Section 2 provides some interesting findings regarding the track record of Brazilian Private Equity funds and managers.

The Brazilian Private Equity model is committed to operational value creation, with a strong emphasis on improving management and providing strategic direction to companies – all of which are of critical importance to many of those mid market, family orientated businesses referred to above. The model lacks leverage. This is due to a limited history of medium to longer term bank lending to business in Brazil, partly as a consequence of historically high rates of interest and inflation, but also due to a cultural environment where banks and businesses were reluctant to commit to long term funding due to risk aversion and the unpredictability of rules and economic scenarios.

Crucially, the regulatory and structural environment within the Private Equity industry is continuously strengthening. The LAVCA (Latin American Venture Capital Association) 2010 Scorecard rates the business environment for Private Equity in Brazil as being virtually on a par with that of Chile and Spain. In their commentary on Brazil, LAVCA highlighted favourable laws on fund formation and operation, together with permissive regulations on institutional investors as strengths of the regulatory environment in Brazil.

In 2003, the CVM (the Securities and Exchange Commission of Brazil) issued Rule 391, which governs the typical Private Equity fund vehicle in Brazil (the “FIP”). The principle objectives of this regulation were to define participants’ rules, drive higher levels of corporate governance and enhance investment and transparency standards within the industry. The result of this is that the Brazilian Private Equity industry is now widely acknowledged to be the most transparent and regulated of all of the BRIC nations (Brazil, Russia, India and China) and, some commentators argue, is more transparent than the industry in some more developed countries such as the USA.

In addition to the CVM regulation, ANBIMA (Brazilian Association of Financial and Capital Market Entities) together with ABVCAP (Brazilian Association for Private Equity and Venture Capital), are currently developing a self regulation code for the industry with the aim of ensuring enhanced transparency for the funds and for the work carried out by the General Partners. This code also intends to establish criteria that are more rigid for the registration of Private Equity funds in Brazil and that consider the relationship between General Partners and Limited Partners.


The United Kingdom and Private Equity in BrazilThe UK has much to offer Brazil and the Brazilian Private Equity industry. This is partly because the UK and the City of London have long been respected as pioneering and dynamic financial hubs, but additionally due to geography and the time zone advantage of being located between the Americas and Western Europe, the Middle East and Asia. This gives the UK a natural comparative advantage compared to other financial centres.

The breadth and depth of London as a financial centre means that it is home to a large number of institutions and organisations that are excited about, and are actively pursuing, opportunities for investing in Private Equity in Brazil. UK based investment managers with emerging market allocations, family offices, private equity funds of funds and other institutions are seeking to increase the proportion of their funds that they allocate to high growth markets and to Brazil in particular. The EMPEA (Emerging Markets Private Equity Association) 2010 Survey found that of all emerging markets in the survey, Brazil should see the largest increase in new investors over the next two years – according to EMPEA, 19 per cent of emerging markets Private Equity investors expect to begin investing in Brazil over that period.

In respect of UK Private Equity houses themselves, a number of the largest firms have either made significant portfolio company acquisitions in Brazil or have/are seeking to establish a place of business there.

The London Stock Exchange and the AIM market (the exchange for small and mid cap businesses), with their high levels of liquidity and deep pools of capital, provide an often cost-effective route to IPO (for a detailed comparison of the relative strengths of London compared to the New York exchanges, please refer to Section 10).

In short, the timing for Brazil and the UK financial community to work together in order to fulfil the potential for Private Equity in Brazil has never been better. With this is in mind, UK Trade & Investment (UKTI) is arranging to take a delegation of interested UK investors and Private Equity Houses to Brazil in the autumn of 2010. While in Brazil, the participants will meet up with Brazilian funds and businesses interested in Private Equity investment for a series of one to one meetings, as well as meet advisers to the Private Equity community in Brazil. The event will be held in conjunction with ABVCAP, the Brazilian Private Equity association. If you require further information about this event, please contact Paula Abreu at [email protected].


SECTION 2

WHY BRAZIL? THE OPPORTUNITY


There are three principal reasons why international investors are focusing attention on Brazil and Brazilian Private Equity in particular:

— Economic context

— Business environment

— Private Equity specific factors

Economic contextThe long term macroeconomic outlook for Brazil is strong. The country received investment grade status in April 2008 and avoided the worst of the international financial crisis. GDP was essentially flat in 2009 and real GDP growth in 2010 has recently been upgraded to 6 or even 7 per cent. It is projected that the GDP growth rate will continue to be higher over the next few years than the expected growth rate of the major developed economies.

In addition to strong growth, rising domestic investment supported by the 2014 World Cup and 2016 Olympics, major new oil discoveries, enhanced integration with international trade, high currency reserves and relatively low levels of corporate and consumer debt (although consumer debt is rising rapidly) all converge to enhance stability and international confidence in Brazil.

The other compelling economic factor for Brazil is the rising middle classes over the last few years. It is estimated that between 2000 and 2008, 23.5 million Brazilians moved up from bands D/E to band C and that 11.4 million people moved up to bands A/B. In addition, as well as absolute real GDP growth, GDP per capita is rising – from US$2,638 in 2002 to US$8,626 in 2008 (source: IMF, World Economic Outlook). The combined effect of the expanding middle classes and a relatively young population is to feed demand for consumer goods and credit, providing the stimulus to business growth rates that is often lacking in more advanced economies.

Chart 1: GDP per capitaUS$

BrazilChinaRussiaIndiaChile

ColombiaMexicoSouth AfricaSpainUK

Key

10,0000 20,000 30,000 40,000

Source: IMF, World Economic Outlook


Business environmentBrazil hosts a huge pool of privately owned companies. Only circa 500 of the country’s estimated 12 million companies are listed. Many of these private companies are middle market companies of around 250–1,000 employees and annual sales of US$20–200 million. Although a large proportion of such businesses are located in the south and south east of Brazil, a large number are benefiting from rising consumer demand in the north east of the country and others are agribusiness companies situated in the central west (Mato Grosso and Mato Grosso Do Sul). These are companies that are well positioned to benefit from the ongoing boom in middle class consumption and are the candidates for mid cap IPOs. Some operate in very fragmented sectors and could therefore serve as platforms for high value added consolidation plays. Others are family owned companies undergoing succession processes and experiencing difficulties in sustaining high growth without a professional management team and adequate funding. Currently, the vast majority of available Private Equity is directed towards a small group of companies and this potential market of mid size companies remains relatively untapped. It is clear that further research and analysis is required of the many thousands of growing mid market companies that have not yet been targeted by the Private Equity industry.

Chart 2 highlights the very low levels of productivity for Brazilian businesses – even compared to regional peers. One of the reasons for this is that a relatively low level of corporate investment in employees and training, together with historically low government spending in this area, has resulted in a poorly qualified and low paid workforce that is not motivated to become more productive. Additionally, the cost for firms of complying with Brazil’s onerous labour and tax laws also affects productivity levels. By targeting businesses in high growth sectors, which are currently underproductive and therefore are in need of additional managerial focus, this provides significant opportunities for operationally focused Private Equity firms to create value.

Chart 2: Labour productivity(GDP in US$/hours worked)

UKSpainMexico

ColombiaChileBrazil

Key

0 10 20 30 40 50

Source: The Confederation Board Total Economy Database


Private Equity specific factorsThe Emerging Market Private Equity Association (EMPEA) 2010 survey in association with Coller Capital produced some interesting findings:

— Emerging markets share of Limited Partners Private Equity investment will continue to grow, with total commitments to emerging market Private Equity funds expected to rise from 6-10 per cent to 11-15 per cent in two years time.

— Seventy-seven per cent of Limited Partners expect annual net returns greater than 16 per cent from their emerging market Private Equity portfolio, compared with 29 per cent of Limited Partners who expect similar returns from their global Private Equity portfolio.

— Seventy per cent of Limited Partners are either satisfied or very satisfied with the performance of their emerging market Private Equity portfolio relative to that of their listed emerging market equities.

— Sixty-one per cent of Limited Partners view the alignment of their emerging market Private Equity managers as just as strong as that of their developed market General Partners, and an additional 23 per cent of Limited Partners see a greater alignment with their emerging market General Partners.

— Of all emerging markets included in the survey, Brazil should see the largest increase in new investors in the next two years – 19 per cent of emerging markets Private Equity investors expect to begin investing in Brazil, while only 3 per cent of current investors plan to reduce or stop investment in the country.

Furthermore, the 2009 EMPEA and Coller Capital survey showed Brazil moving up to second place (from fourth) – behind China – in terms of emerging market attractiveness over the subsequent 12 months.

Table 1: Emerging market attractiveness

2009 survey 2008 survey Change

China 1 1 –

Brazil 2 4 +2

India 3 2 -1

Central & Eastern Europe 4 3 -1

Latin America (excluding Brazil) 5 7 +2

Africa (excluding South Africa) 6 5 -1

South Africa 7 9 +2

Middle East 8 8 –

Russia/CIS 9 6 -3

Source: EMPEA/Coller Capital Emerging Markets Private Equity Survey, 2009

On an annual basis, the Latin American Venture Capital Association (LAVCA), in conjunction with the Economist Intelligence Unit, produces a “Scorecard” which ranks the business environments for private equity/venture capital activity on a scale of 1-100, with 100 being the most friendly. Twelve Latin American and Caribbean countries are included in the benchmark, together with four countries from outside of the region.


The table below is an extract from the 2010 Scorecard:

Table 2: Business environment for Private Equity

Argentina Brazil Chile Colombia Mexico Peru Israel Spain Taiwan UK

Overall score 43 75 76 60 63 51 81 76 61 93

Laws on VC/PE formation and operation

1 4 4 3 2 2 4 3 4 4

Tax treatment of VC/PE funds and investments

1 3 3 2 3 1 3 4 3 4

Protection of minority shareholder rights

2 3 3 3 3 1 4 3 1 4

Restrictions on institutional investors investing in VC/PE

0 4 3 3 3 3 3 3 2 4

Protection of IP rights 2 2 3 2 2 2 2 3 3 4

Bankruptcy procedures/creditors’ rights/partner liability

2 3 3 2 2 2 2 3 3 3

Capital markets development and feasibility of exits

2 3 3 2 2 2 3 3 3 4

Registration/reserve requirements on inward investments

2 3 3 3 3 3 3 3 2 3

Corporate governance requirements

2 3 3 3 3 3 4 3 2 3

Strength of the judicial system

2 2 3 2 2 1 3 2 3 4

Perceived corruption 1 1 3 1 1 1 3 3 2 3

Quality of local accounting/use of international standards

4 4 3 2 3 4 4 4 2 4

Entrepreneurship 3 3 3 2 2 2 3 2 3 4

Source: LAVCA 2010 Scorecard


An interesting observation here is that Brazil’s score of 75 is only one behind that of Spain and is almost on a par with the best performer in the region − Chile, with a score of 76. While Brazil’s score remained constant from 2009 to 2010, in its commentary, LAVCA highlighted favourable laws on fund formation and operation, permissive regulations of institutional investors and quality of accounting standards as among the country’s major strengths.

In their June 2010 Private Equity Update – “Rising Star: Brazilian private equity after the crisis”, Ocroma Alternative Investments explain that while the Brazilian Private Equity industry has been very active since the crisis, it has only been since the end of 2009 that the raising of new funds with foreign investors has been able to take place. They provide the example of the closing of Advent’s LAPEF V fund at US$1.65 billion in April 2010 – which was the biggest fund ever raised for the region. Ocroma continue by commenting that “while the level of activity is high... and more investments are made from funds coming from abroad, one can hardly feel the same level of competition for deals usually seen in Asia and especially China”.

In considering the attractiveness of Brazil as a destination for Private Equity investment, there are three further factors that are worthy of discussion here:

Domestic investor risk appetiteDue to historically high interest rates, many domestic investors have come to expect fixed income investment returns of +10 per cent as normal in return for assuming very little risk. More recently, the relative success of the Brazilian stock exchange, BM&FBOVESPA, has offered investors a market return with the added benefits of high liquidity and transparency. This gives rise to an environment where local investors determine a high hurdle rate when analysing private investment in higher risk and less liquid assets. This creates an opportunity for overseas investors who might be more patient, more experienced and therefore more willing to fund investments that local investors are reluctant to finance.

It is worth mentioning here, however, that wealthy Brazilian families that have historically invested their money via the banking system and other more traditional means (including government debt, which has historically been a profitable and liquid market), are now beginning to consider Private Equity for investment opportunities.

The role of Brazilian pension fundsSimilarly, Brazilian pension funds have historically invested in high interest fixed income securities. More recently, however, and due to generally lower interest rates, these funds have had to look to the equity market in order to maintain actuarial return. The Government has facilitated this by increasing to 40 per cent the proportion of their investments that these funds can allocate to equity securities. Most funds are well below this limit. In order to invest in equity securities and to analyse opportunities effectively, they need to develop equity expertise, which has been lacking in-house. Instead, they are looking at more experienced equity managers to provide the skills that they require.

They are also seeking to allocate part of their funds to Private Equity investment managers. In September 2009, a resolution of the National Monetary Council (CVM – a Brazilian Government institution responsible for promoting the improvement of institutions and financial instruments) established Private Equity as a separate class for investments by closed pension funds. They now may invest up to 20 per cent of their reserves in Private Equity funds. On average, Brazilian pension funds currently allocate 2 per cent of their capital to Private Equity. This compares to the international average of 8-10 per cent. In the UK, the largest investors in Private Equity are pension funds. There is therefore huge potential in Brazil for pension funds to increase their investment in Private Equity.

This situation creates a number of possible opportunities for UK investors and pension fund advisers.

The first opportunity is that there is potential for experienced investment advisory specialists to assist Brazilian pension funds in analysing the equity investment opportunities available.


The second is that Brazilian pension funds might provide a source of funding for global investors who are interested in establishing a presence in Brazil. The same resolution referred to above also established a limit of 10 per cent for pension fund commitments to funds registered abroad. One potential problem that would need to be resolved here, however, is that traditionally, Brazilian pension funds have tended to take a relatively active involvement in their investments (by board representation etc). This is a problem for international investors who may struggle to see the benefits of such representation and who will be nervous about potential conflict of interest scenarios (there are, however, some tentative signs that some pension funds are starting to reconsider this). The other point here is that, in practise, there are regulatory and political issues that would need to be overcome in order to facilitate such investment.

It is the lack of domestic investor appetite for Private Equity and the potential issues surrounding pension funds’ demands for active investment involvement that have led to a number of domestic Brazilian Private Equity organisations looking to international investors as a key source of funding.

A growing talent pool According to a GVcepe (Centre for Private Equity and Venture Capital Research at FGV-EAESP) 2008 survey, at least 74 per cent of Private Equity managers and managing partners hold a postgraduate degree.

In addition to a high quality academic background, the vast majority of managers also have relevant practical experience, either as financial sector professionals (for example, investment bankers) or experience more closely related to the formation and execution of business strategies (for example, CEOs, entrepreneurs, consultants or angel investors).

Research by Ocroma Alternative Investments produced the following findings in relation to track record in the industry in 2008:

Table 3: Industry track record

Depth of previous private equity fund experience

Number of funds

Proportion of total number of funds in

sample (%)Commitments (US$ million)

Commitments as a proportion of total

commitments across sample (%)

Firm wide 10 41.67 3,964.29 52.85

Team 5 20.83 2,700.00 36.00

Individual professionals 6 25.00 495.95 6.61

None 3 12.50 340.48 4.54

Total 24 100.00 7,500.71 100.00

Source: Ocroma Alternative Investments – Private Equity Update, Fundraising Report – Brazil, Leonardo L. Ribeiro, 12/2008, based on a sample of 24 Private Equity funds that were still in fundraising or pre-fundraising phases


These findings show that at the time of the survey, 63 per cent of funds with 89 per cent of commitments are either being raised by firms with prior track record or by new firms with experienced teams (for example, spin-offs of existing Private Equity groups). This indicates that management talent within the industry is growing rapidly and compares well with other BRIC countries.

It is clear from this analysis that excitement among international investors for business opportunities in Brazil is coupled with real enhancements to the business environment over the last few years that have sought to make Private Equity investment a very attractive prospect in Brazil. The attraction seems to arise primarily due to an expectation that emerging market funds will outperform developed market ones, at least in the short and medium term, and because in Brazil in particular, strong underlying growth rates matter more than leverage in terms of driving returns.


SECTION 3

THE BRAZILIAN PRIVATE EQUITY INDUSTRY IN 2010


The Private Equity industry in Brazil is relatively young, establishing in the early 1990s, but due in part to foreign exchange cycle issues, only really developing and evolving since 2004, when the Brazilian economy stabilised and the IPO market took off.

It is interesting to note that it was during this period that one of the most recognised brands in Brazil – Gol – Latin America’s leading low cost airline, listed on the New York and São Paulo stock exchanges. More interesting still is that Private Equity investment had enabled Gol to consolidate its strategy and expand its operations. The IPO netted AIG a return of seven times its initial US$1.2 million investment, a sum advanced just 18 months prior to the listing.

Before providing an overview of the Brazilian Private Equity industry in 2010, it’s worth mentioning that while there have been a number of very useful studies conducted into the industry, there is always scope for further detailed analysis. This is particularly as a consequence of the recent rapid evolution and development of the industry and the renewed international interest in Brazilian Private Equity in the last couple of years or so.

Private Equity fundraising in Brazil in 1999 totalled US$3.7 billion, but by December 2009, committed capital had increased to US$34 billion (source: GVcepe). Despite this impressive increase, Brazil’s Private Equity market remains underpenetrated. As at 30 June 2008, capital committed to the Brazilian Private Equity industry represented just 1.7 per cent of GDP, compared to a world average of 3.7 per cent and a UK figure of 4.7 per cent (source: GVcepe).

In December 2009, the industry consisted of 180 Private Equity managing organisations (General Partners), with 236 investment vehicles and 554 portfolio companies. During the period 2005-2009, there had been 489 new or follow on investments and 37 Private Equity backed IPOs. Within the industry 1,700 professionals and staff were employed. This compares to around 7,700 in the UK and 38,500 in the USA (source: GVcepe).

The average private equity investment over the period 2005-08 was US$45 million, while the average venture capital investment was US$4 million, mezzanine investment (see Section 4 for explanation) was US$11 million and PIPE (see Section 4 for explanation) investment was US$4 million (source: GVcepe). This compares to an average UK private-equity based buy-out in excess of £100 million – a figure which has remained relatively constant over the last decade – once the exceptional impact of the £11 billion Alliance-Boots transaction in 2007 is stripped out. There are signs, however, that over the period 2007-09, the average deal size in Brazil has started to increase from the small to mid market transactions that have historically dominated the market. Indeed, according to Ocroma Alternative Investments research analysis included within their June 2010 paper, the average deal size in Brazil since the financial crisis was US$75 million, with deals in the range of US$50 million to US$200 million being the most common, representing more than half the aggregate capital invested and almost 40 per cent of the number of deals.

In terms of the investor base, in 2009, 41 per cent of committed capital to Private Equity came from outside of Brazil. Twenty six per cent came from the USA and less than 2 per cent came from the UK (source: GVcepe). The proportion of committed capital originating from overseas was less in 2009 than in 2008. This isn’t unexpected, given that the USA and Western Europe were more affected by the financial crisis than Brazil. It is anticipated, however, that the proportion originating from overseas will rise in the next few years, as investors from developed countries increase their interest in Brazil.

Global private equity firms with offices in Brazil include Actis from the UK and Advent, Carlyle Group, Darby Overseas and One Equity Partners (working with JP Morgan) from the USA. This list is not exhaustive, but seeks to highlight that most interest to date has been from the USA, rather than the UK and Western Europe. This imbalance of overseas investor interest in Private Equity in Brazil has been a common theme, mentioned by a number of companies and funds that were interviewed as part of the information gathering process for this report. It is something that the UK should actively be seeking to rectify, as explained in the Executive Summary of this report.


In terms of the class of investor involved in Brazilian Private Equity, this is well diversified and consists of the most stable sources of financing over the long term. One particular point of interest here is that as at 30 June 2008, pension funds provided 27 per cent of the total committed capital to Brazilian Private Equity. This proportion is higher in other more developed economies and is anticipated to increase further in Brazil, as the authorities raise the proportion of the total funds that pension funds can invest in equity instruments and Private Equity.

Chart 3: Industry analysis by category of investor

Pension funds 27%Government 4%Parent organisation 13%Insurance companies 1%Investment funds 8%Trusts & endowments 8%Banks 7%

Multilateral organisations 1%Family offices 6%Funds of funds 5%Private companies 4%Others 12%PE/VC Organisation Partners 4%

Key

Source: GVcepe December 2008 research report: Overview of the Brazilian Private Equity and Venture Capital industry

Of the 127 Private Equity organisations (General Partners) in Brazil as at 30 June 2008, 79 per cent were independent (including seven publicly traded companies), 12 per cent had ties to financial institutions, 2 per cent were public sector, 2 per cent industrial groups and 2 per cent corporate ventures.

As at 30 June 2008 the distribution of portfolio companies was as follows:

Chart 4: Distribution of portfolio companies by category of investor

Venture capital start up 12%Venture capital seed 5%Venture capital early stage 17%Private equity expansion 43%Private equity later stage 8%Public traded 15%

Key



Co-investment in portfolio companies by more than one Private Equity organisation is infrequent in Brazil. According to GVcepe, as at 30 June 2008, less than 10 per cent of portfolio companies had investment from more than one Private Equity organisation. This is an area of activity that could therefore expand in the future and one where the UK’s experience in syndication could add value. It is considered further in Section 9.

In terms of whether Private Equity firms in Brazil seek control of the companies within which they invest, according to GVcepe, around 10 per cent of investment vehicles with a focus on earlier stage venture capital require control of their investment, while 30 per cent of vehicles working with private equity sought control.

Given that a large number of portfolio company investments were made before 2005 and considering that the lifespan of investments in Private Equity in Brazil is on average three-five years, we can expect a number of investment exits in the near future.


SECTION 4

THE BRAZILIAN MODEL AND HOW IT MIGHT DEVELOP


This section seeks to highlight some of the principle characteristics of the Brazilian Private Equity model and also discusses some of the main differences to the model adopted in the UK and the USA.

The rationale for Private Equity in Brazil and leverageThe Brazilian Private Equity model is committed to operational value creation, with a strong emphasis on improving management and providing strategic direction to companies. Furthermore, it is focused on creating value in high growth markets and harnessing demand from the rising middle classes. As a consequence, Brazilian Private Equity deals tend to centre around the provision of growth capital and mid-market buyout transactions. Consolidation of fragmented markets is fundamental in this respect.

This is different to the way that the model has developed in the USA and Western Europe, where, due perhaps to more limited growth opportunities and market maturity, cost cutting to create value, together with leverage and financial engineering, have become the dominant part of generating returns.

In Brazil, leverage is limited and this is due to a limited history of medium to longer term bank lending to business in Brazil. This is partly as a consequence of historically high rates of interest and inflation, but also due to a cultural environment where banks and businesses were reluctant to commit to long term funding due to risk aversion and the unpredictability of rules and economic scenarios.

There are signs, however, that commercial banks are starting to offer longer term debt products to business (relatively lower interest rates and deeper financial markets help here). Nevertheless, this is still a relatively undeveloped area and the products on offer are, in comparison to the USA and Western Europe standards, relatively unsophisticated and expensive.

The breadth of investmentAll the main aspects of the traditional investment chain are active in Brazil, including: venture capital (encompassing seed, start up and early stage), private equity (covering expansion, later stage and buy out), Mezzanine and PIPE investment. Venture capital in Brazil is considered in more detail in Section 5.

Mezzanine investment is a hybrid instrument combining the characteristics of equity and fixed income investment. It is comparable to an investment in capital, in that the expected return depends on how well the investment performs and generally sits between senior debt and equity in terms of both risk and reward. It is usually applied to later stage companies with the characteristic of steady cash flow and the capability of servicing both senior and mezzanine debt.

PIPE refers to Private Investment in a Public Entity. This is where the investing organisation takes an equity stake in a listed company, and often arises due to a belief that the company is either fundamentally undervalued by the market or, more commonly, because the optimal strategy of the business is inconsistent with the requirements of the public markets. By aligning the shareholders and managers more closely, due to the fund manager becoming actively involved in the strategic management of that company, it is argued that a turnaround or repositioning of the business can be more effectively achieved. Ocroma Alternative Investments research signalled that PIPE transactions in Brazil had risen significantly during the financial crisis, perhaps not surprising given the attractive valuations of listed assets.

While both Mezzanine and PIPE still represent a relatively small proportion of the total number of Private Equity vehicles in operation in Brazil, both are likely to expand their roles in the future. As the Brazilian stock market expands and matures, and in particular as the market for small and mid cap businesses becomes more established, then public to private transactions could become more prevalent. For Mezzanine, the sophistication of the more established London market should have something to offer here (see Section 5).


Vehicle structureAccording to research carried out by GVcepe, the distribution of total committed capital by legal structure of vehicle as at 30 June 2008, was as follows:

Chart 5: Committed capital by vehicle structureProportion of total (%)

CVM modelLimited partnershipDirect investment

Holding companyCorporate ventureOther

Key

0 10 20 30 40


The GVcepe report revealed that while the limited partnership structure still represents a significant proportion of all committed capital in the industry, this proportion has fallen from 62 per cent in 2004 to 34 per cent in 2008. In contrast, the proportion of committed capital held under the CVM (the Securities and Exchange Commission of Brazil) model has risen from 23 per cent in 2004 to 39 per cent in 2008. This helps to illustrate the widely held belief that the institutional model created by the CVM in 2003 (and explained in more detail below) has been successful.

Although holding companies constituted 24 per cent of the total of all investment vehicles in the industry as at 30 June 2008, they only represented 2 per cent of committed capital. This is essentially because they are vehicles that are used to invest smaller amounts of money in venture capital operations.

The CVM vehicleFunds focused specifically on investing in equity participations were initially regulated by the CVM through the introduction of FMIEE’s (Mutual Funds for Investment in Emerging Companies). CVM Rule 209, which created the FMIEE, however, addressed only investments in emerging companies, with limited characteristics and purposes. This rule, therefore, did not benefit those investors that intended to use a fund structure to invest in companies with other characteristics. These investors continued to use more complex corporate structures for Private Equity investments, which allowed greater flexibility when choosing the investment’s targeted assets.

In response to this situation, in 2003, the CVM issued Rule 391, which governs the Fundo de Investimento em Participacao ‘FIP’, the now typical Private Equity fund vehicle in Brazil. The FIP is a close ended investment fund of defined duration whose purpose is to raise funds in the capital markets in accordance with the rules and investment policy set out in the charter of the FIP. This structure allows funds to invest their assets in the acquisition of shares, debentures, warrants or other securities convertible into shares issued by public or private companies, with no restrictions as to company size or characteristics.


The principle objectives of Rule 391 were to protect the FIP’s investors, define participants rules, drive higher levels of corporate governance and enhance investment and transparency standards within the industry. The result of this is that the Brazilian Private Equity industry is now widely acknowledged to be the most transparent and regulated of all the BRIC countries and, some commentators argue, is more transparent than the industry in certain more developed economies, such as the USA.

It is a requirement of the rules that FIP’s are active in the decision making process of the companies in which they invest, thereby exerting real influence on strategic policy and management (for example, through the appointment of members to the company’s board of directors).

FIPs must be registered with the CVM and administered by a legal entity which is also registered and authorised by the CVM to perform professional portfolio management services (in addition, this administrator usually retains a manager provided that it is also registered and authorised by the CVM). The administrator is equivalent to the General Partner in the UK. Investors in the FIP (Limited Partners) can be individuals or legal entities. The FIP is subject to disclosure requirements, including the need to prepare and submit to the CVM annual and semi-annual financial statements prepared in accordance with specific rules. This information is also made available on the CVM website. Additionally, the annual financial statements of the FIP must be audited by an independent auditor registered with the CVM.

The cost associated with structuring a FIP is generally lower than that for a FMIEE, as registration is automatically granted by the CVM upon presentation of the required documents, as long as the regulation’s demands are met. From a taxation perspective, both are treated in the same way.

Foreign investors will generally invest in the FIP through a mechanism provided by the Central Bank of Brazil. This mechanism enables the remittance of funds to Brazil for investment in the Brazilian capital markets. Investments made in accordance with this mechanism may afford the investor beneficial tax treatment with respect to Brazilian withholding income tax, provided that the investor is not domiciled in a low tax jurisdiction and that certain other requirements are met.

A note of caution here is that some commentators believe that whilst the development of the FIP and associated regulation has been a significant step forward for the industry in Brazil, the structure is still not as robust in terms of insulating Limited Partners from the liabilities of the fund as the more traditional Anglo Saxon Limited Partnership structure.

As mentioned above, a growing number of funds in Brazil are now being established under CVM regulation. There is, however, still a tendency for funds that raise capital from international investors to establish their funds offshore, either as Limited Partnerships (LP’s) of Limited Liability Companies (LLC’s) in places such as the Cayman Islands or Delaware. This is because international investors are more familiar with such offshore jurisdictions and try to keep away from funds established locally, that might have investors sharing control of investment and exit decisions through their exit committees.

The regulatory and legal environmentIn addition to the CVM regulation discussed above, at the present time, ANBID (National Association of Investment Banks) together with ABVCAP (Brazilian Association for Private Equity and Venture Capital), are developing a self regulation code for the industry with the aim of ensuring enhanced transparency for the funds and for the work carried out by the General Partners. This code also intends to establish criteria that are more rigid for the registration of Private Equity funds in Brazil and that consider the relationship between General Partners and Limited Partners. The expectation is that this regulation will cover all funds in which the managers are part of ABVCAP or ANBIMA (ie virtually all of those not managed by an overseas Limited Partnership) and will be monitored by the associations themselves. From an international investor’s viewpoint, the hope is that this regulation will be aligned to western standards.

LAVCA, in their 2010 Scorecard commentary on Brazil, highlighted favourable laws on fund formation and operation and permissive regulations on institutional investors as strengths of the industry regulatory environment in Brazil. Additionally, it gave above average scores to protection of minority rights, bankruptcy procedures and corporate governance. On the downside, it highlighted the enforcement of, and procedures associated with, intellectual property.


In terms of minority rights, the perception is that Brazil is relatively strong in this area and the recent development of arbitration as an effective form of dispute resolution should enhance funds’ ability to hold minority interests, as they can be more confident that they will be able to resolve a dispute quickly, rather than getting bogged down in the legal system.

It should be noted, however, that while there have been certain significant steps forward in terms of the legal environment over the last few years, Private Equity investment structures and obligations have yet to be the subject of analysis in Brazilian courts. Likewise, there is no case law regarding the industry in Brazil.

In respect of the ability to borrow externally to invest in Brazil, while there are foreign exchange controls, in practice it is possible to get money into and out of the country and the effect of such controls on the Private Equity industry is unlikely to be significant.

RemunerationIn terms of the reward structure for Private Equity managers, this is converging towards the international standard structure. Typically, the management fee is 2-3 per cent of the committed capital or equity of the fund. Higher management fees are usually only charged by smaller funds in the venture/seed capital arena, while those funds charging less than 2 per cent are mostly first time funds attempting to differentiate their offer, and not, as one might expect, the larger funds sharing some of their economies of scale with investors. The performance fee/carried interest is variable and based on a pre-established percentage, usually 20 per cent. The hurdle rate can vary widely, but is common at around 8 per cent.

TaxationBrazil has a complex and multi-layered tax system, primarily due to taxes being levied at federal, state and municipal levels. The complexity of tax is a serious impediment to doing business in Brazil, an issue that is considered in more detail in Section 11.

In 2009, a 2 per cent tax on capital inflows was imposed. This will impact overseas investors investing in local funds, but will not impact offshore funds. The aim of this legislation was to put off flows of hot money and the effect on the Private Equity industry should be small, as the 2 per cent is effectively diluted over time.

The key driver of tax in the Private Equity industry in Brazil, like elsewhere, is the choice of vehicle. A company is considered a legal entity for Brazilian tax purposes, whereas, in most cases, a Brazilian investment fund – such as the FIP – is generally not considered to be a legal entity for tax purposes. Taxes levied on gains by funds that are regulated by the CVM are usually lower than those that are applied to other structures, such as equity holding partnerships or investment holding companies.

Currently, as an entity, a FIP is not subject to tax on the acquisition and disposal of investments in Brazil and the income received by this entity from such investments is not normally taxed at the entity level (it should be noted, however, that the 2 per cent tax on financing transactions is now applicable to FIPs). Conversely, the companies in which the FIP holds equity participation are normally subject to all Brazilian taxes applicable to a standard legal entity.

Foreign investment in regulated Private Equity funds is exempt from income and capital gains taxes provided that it does not come from entities registered in tax haven countries. Therefore, deals can usually be structured so as to manage the tax burden from the investee company to the ultimate fund investors and to avoid double taxation by overseas investors, even in the absence of a double taxation treaty (there are ongoing discussions regarding such a treaty between the UK and Brazil, but nothing has yet been finalised).

Please refer to the charts on pages 73, 74 and 75 for example structures that can be utilised to help ensure that future distributions are received in a tax efficient manner.


Fair value and transparency for investorsThere is ongoing worldwide discussion at present of the need for investors to keep track of the performance of the assets in which they invest. This discussion is also taking place in Brazil.

Regularity and quality of financial information is obviously crucial, but there is much debate about the underlying valuation techniques utilised. While historical cost, transaction adjusted historical cost, equity equivalent/consolidation and fair value are all used to value investments, there is a trend in Brazil towards fair value (the amount paid by an unconnected third party) and towards transparency, ie attempting to ensure that all funds are valued in the same way across all time periods. Part of the rationale for this is to ensure that fund management and performance fees are charged accurately and consistently.

The secondary market It is widely recognised that a strong secondary market provides liquidity for the buy out market when alternative exit routes might be difficult. It enables Limited Partners to rebalance their portfolio and to re-focus resources.

The results of the Coller Capital Global Private Equity Barometer – Winter 2009-10, showed that 29 per cent of Limited Partners surveyed have no exposure to the secondary market, but 34 per cent of private equity investors surveyed have increased their exposure to secondary funds over the past two years. The Barometer comments that “investors’ views of the secondaries market have changed significantly over the last couple of years. Limited Partners now see secondaries as an important tool for changing the overall composition and liquidity profile of their portfolios”.

Secondary market activity is beginning to emerge in Brazil, but is still rare. The market is not yet developed well enough to see exit routes other than by IPO, trade sale or buyback. However, as the Private Equity industry in Brazil evolves and given the renewed interest in this market by Limited Partners, it seems likely that we will see a growth in secondaries in Brazil over the coming years.

This is an area where London’s expertise can come in useful. Indeed, there is an example of this very recently with the UK’s Apax Partners entering into an agreement to acquire a controlling interest of TIVIT, a leading integrated IT and Business Process Outsourcing service provider in Latin America, headquartered in Brazil. One of the existing shareholders of TIVIT that has agreed to sell to Apax is Patria Investimentos, a leading Brazilian Private Equity business. TIVIT believes that the transaction with Apax will provide it with enhanced flexibility to execute its long term strategy. Commenting on the firms’ website, Martin Halusa, Chief Executive of Apax Partners, explained that “Our first investment in Brazil advances our global strategy of investing in large companies that have strong, established market positions and the potential to expand. We are excited by Brazil and have been actively sourcing opportunities in the country for some years”.

Club dealsA club deal refers to a Private Equity buyout or the assumption of a controlling interest in a company that involves several different Private Equity firms making the acquisition collectively. The practice has historically allowed Private Equity firms to purchase much more expensive companies together than they could alone. Also, with each Private Equity firm taking a smaller position, risk can be reduced. While club deals have grown in popularity in the more developed Private Equity economies in recent years, there are many issues that can arise related to regulatory practices, conflicts of interest and market-cornering. Given the stage of development of the Brazilian market, it may be that club deals remain relatively infrequent there for some time to come.


SECTION 5

VENTURE CAPITAL AND INNOVATION


According to GVcepe’s 2010 census of the Private Equity industry, 23 per cent of Private Equity investment vehicles in Brazil operate purely in the venture capital arena (seed, early and later stage). Despite this, the early stage part of the Private Equity industry is not nearly as developed as the growth capital and later stage parts of the industry.

Seed capital in particular, however, has been gaining importance over the past few years, primarily due to public policies and government support aimed at sustaining industry development over the long term. The Brazilian Innovation Agency (FINEP – Financiadora de Estudos e Projetos), which is linked to the Ministry of Science and Technology, is a key player in the Brazilian venture capital industry, acting both as an investor in venture capital funds and as a coach for new innovative companies seeking capital and managerial support to grow. This proactive role played by public bodies distinguishes venture capital in Brazil from other emerging countries.

There is also a developing role for universities and similar organisations in producing and nurturing start up businesses that become venture capital candidate firms. Although this symbiotic relationship is less developed than, for example, in the UK, clusters of technology companies are establishing around the best universities in São Paulo, Rio de Janeiro, Belo Horizonte, Santa Catarina and Pernambuco. Indeed, recent studies have shown that there might be as many as 400 incubators and up to 4,000 incubated companies in Brazil, operating in a wide range of sectors including industrial and commercial automation, communications, biometrics, renewable energy and nanotechnology applied to various industries including agriculture and medicine. It is the development and expansion of this type of relationship that will have a significant impact on Brazil’s ability to produce world-class companies with breakthrough technologies. Such technology development is high risk, but would produce serious opportunities for venture capital investment.

Alongside the development of the venture capital industry in Brazil, an angel network of investors is also becoming established. Many of these angel investors are former businessmen and work with incubators and universities in order to help determine where best to invest and to provide hands-on experience to new businesses. Their aim is to provide an accelerator so that businesses can grow quickly and a principle exit strategy is through the merger of several incubated companies.

The most innovative firms tend to leverage Brazil’s strength in agriculture and there are numerous examples of such firms in the biotechnology and ethanol technology sectors. Furthermore, Brazils’ position as a leading technology player fosters a favourable environment to cutting edge IT and communications innovation. Further analysis of the opportunities for private equity and venture capital in these sectors is provided in the following sector specific commentaries.


SECTION 6

SECTORFOCUS



It is clear that the development of consumer demand over the last decade or so has created huge opportunities to develop and grow the consumer goods and services space in Brazil.

The aim of this section of the report is not to consider every sector of the economy in which Private Equity might have an interest. Rather, it is to highlight some of the key sectors that are particularly receptive to Private Equity style investment and which are currently undergoing significant growth and development in Brazil.

The sectors covered are:

— Infrastructure, logistics and distribution

— Agribusiness

— Life sciences and biotechnology

— Renewable energy

— Information, communications and technology (ICT)

— Construction and real estate

— Financial services

OverviewResearch by Ocroma Alternative Investments indicates that “most investments made since the (financial) crisis were directed to sectors with a strong link to domestic consumption and the growing and unleveraged Brazilian middle class. Sectors such as retail, education, healthcare, media and financial services represented half of the invested capital. Also, infrastructure investments, mainly energy and logistics, amounted to 30 per cent of aggregated capital invested”.

Chart 6: Sectoral investment analysis post financial crisis

Retail 17%Healthcare 9%Financial services 11%Energy 18%

Education 5%Media 10%Logistics 12%Others 18%

Key

Source: Ocroma Alternative Investments – Private Equity Update, Rising Star: Brazilian Private Equity after the crisis, Ricardo Kanitz and Leonardo L.Ribeiro, 6/2010

Interestingly, however, according to GVcepe research, almost half of the Private Equity investment vehicles that were active in Brazil as at 30 June 2008 did not possess a defined sector focus. Chart 7 provides an analysis of sector focus for those Private Equity vehicles that, as at that date, did possess a focus. Of the vehicles with a focus in one or more sectors, the principle industries were IT and electronics, agribusiness, telecommunications and energy. The chart also provides a sector analysis by number of portfolio companies as at 30 June 2008.


Chart 7: Investment sector focus

By investment vehicle (%)By portfolio company (%)

IT & electronics

Agribusiness

Telecoms

Energy

Industrial products & services

Construction & real estate

Logistics & distribution

Food & beverage

Communications & media

Financial services

Education

Other

Key

50 10 15 20 25

Source: GVcepe Research Report December 2008 – Overview of the Brazilian Private Equity and Venture Capital industry


Chart 8 provides a sector analysis by value of investment made by Private Equity players during the period 2005 to 2008.

Chart 8: Sector focus by value of investment

Food & beverage 24%Industrial prod/serv 20%Constr/real estate 17%Retail 8%Agribusiness 5%

Energy 4%IT & electronics 3%Communications & media 1%Biotechnology 1%Other 17%

Key


This seems to tell us is that while the number of deals in certain industries such as food and beverages, industrial products and services, and construction is less than in other industries, the size of individual deals in these sectors is large. Furthermore, and unsurprisingly, vehicles that work in venture capital, where deal size is smaller, possess a greater focus in certain technological sectors (for example, IT and electronics, telecoms and biotechnology).

Infrastructure, logistics and distributionBrazil suffers from serious deficiencies in infrastructure that will require major new investment to resolve. With this in mind, in 2007, the Government introduced a four year Accelerated Growth Plan (PAC) which aimed to provide public and private sector investment in infrastructure as follows:

Table 4: Original PAC projected infrastructure investment

Sector Focus Value (US$)

Energy infrastructure

Oil and gas 138 billion

Renewables

Social and urban infrastructure

Housing 85 billion

Metro and urban trains

Electrification

Water resources

Logistics infrastructure

Roads 29 billion

Ports

Airports

Waterways

The merchant fleet

Expanding on the original PAC, in 2010, PAC 2 has been confirmed which forecasts the following infrastructure expenditure in the period 2010-2014:

Table 5: PAC 2 forecast infrastructure investment

Programme/Sector

Expenditure (2010-2014)

(US$)

Urban infrastructure (“Cidade Melhor”) 32.4 billion

Social infrastructure (“Comunidade Cidadã”)

13 billion

Housing plan (“Minha Casa, Minha Vida”)

158 billion

Electrification and Water Resources (“Agua e Luz para Todos”)

17.4 billion

Transportation 59.4 billion

Energy 264.5 billion

Opportunities therefore abound for investment in a wide range of infrastructure, including highways, ports, airports, dams, railroads and stadia − hosting the World Cup in 2014 alone is forecast to require investment of some US$50 billion.

Existing Private Equity infrastructure funds in Brazil tend to focus on providing medium to long term financing for new or expanding mid sized infrastructure projects and assets. The focus is usually on the supply and operational side of the sector. A number of the opportunities seen offer relatively high return and low risk characteristics, especially those arising in the telecommunications and electrical energy sectors.

In some funds, a mezzanine component is structured so as to match the project or company’s cash flows. This type of security is particularly well suited to infrastructure type projects. The mezzanine securities are comparable to investment in capital given that much of the expected return depends on how well the company or project performs. Investors in such securities are protected from downside risk through the existence of collateral and financial covenants on the fixed income component. However, they participate in the upside potential, thereby reducing the volatility of the expected return.

In 2007, Brazil’s securities regulator, the CVM, issued regulations governing the specialist Private Equity funds that invest in infrastructure. These funds are known as Fundos de Investimento em Participacoes em Infra-Estructura (FIP-IEs). Under the regulations that were issued, the FIP-IEs are restricted to investing in the energy, transportation, irrigation and sanitation sectors. The rules require that each fund should have a minimum of ten shareholders and that no individual limited partner should invest more than 20 per cent of a fund’s total capital. Tax incentives are provided in order to attract local institutional investors into the infrastructure sector.

In addition to traditional core infrastructure development, the country is also seeing rapidly increasing demand for professional logistics services from multinational and expanding domestic players. This is another area that should provide serious opportunities for Private Equity type investment.


AgribusinessWhile in a number of ways Brazilian agriculture is considered to be a world leader (for meat production, soya, sugar, orange juice, for example), in many segments it is fragmented, dominated by poor management and held back by inadequate infrastructure.

Partly as a consequence of this position, many commentators believe that agricultural land in Brazil offers one of the most compelling farmland opportunities in the world today. Inexpensive land compared to other agricultural countries, high productivity as a consequence of ideal sub-tropical climatic conditions, consistent rainfall and water supply and low population density are all factors which fuel Brazilian agribusiness excitement among investors.

The Deloitte January 2010 LATAM Confidence Survey suggested that “Over the course of the next five years, we expect to see a meaningful number of agribusiness companies going public in Brazil. Agribusiness accounts for 27 per cent of Brazil’s GDP and there is a huge gap between the limited number of publicly-traded vehicles in agribusiness in comparison to agricultural GDP”. This further illustrates investor appetite for Brazilian agribusiness.

On the production and processing side, consolidation is well underway and some very large internationally focussed processors, such as JBS-Friboi have emerged. It is therefore perhaps on the more fragmented farming side of the industry that opportunities abound. For Private Equity the dairy industry, in particular, might be attractive. Typically low margins due to limited added value mean that this sector is ripe for consolidation and efficiency gains.

With the world’s consumption for wood continuing to grow and the use of paper in all of its forms remaining low in most of the world (apart from Western Europe and North America), together with buoyant construction and industrial pulp industries in Brazil, there are serious opportunities for sustainable reforestation. Ideal climatic conditions, huge amounts of space and relatively low interest rates all work together to make this alternative asset class an attractive and potentially profitable proposition to potential investors. The disorganised nature of the industry also lends itself to Private Equity and fund style investment.

Life sciences and biotechnologyIn 2008, the Brazilian life sciences and biotechnology industry generated an estimated US$400 million in revenues and US$55 million in profits. Despite this, the industry in Brazil remains relatively young.

Many Brazilian biotech SMEs (small- and medium-sized entities) focus on agricultural or plant and animal biotechnology applications, primarily because Brazil is one of the few emerging countries of the world with a strong infrastructure in agricultural research. For example, it is widely respected for the provision of technological developments that enable the successful industrial scale production of renewable fuels (see renewable energy section on pages 34-37).

In health biotechnology, innovative businesses are involved in the development and provision of health products for human consumption. In a country of nearly 200 million people, many of who live in poverty, the Government has taken legislative and other steps to build upon the country’s innovative capacity in health and to address the demand for local health needs, and more broadly, neglected diseases. The industry in Brazil is therefore now transitioning from one based on generics to one capable of producing innovative products. The country is also one of the leading producers of gene sequencing data in the world and has also acquired a strong reputation in a number of crucial areas such as stem cell research and vaccines.

Pele Nova Biotecnologia is a Brazilian company that has developed a patented product now referred to as BIOCURE. This product is being used for wound healing applications, including diabetic ulcers, vascular insufficiency ulcers, pressure sores, vasculogenic ulcers, surgical and traumatic wounds. The active ingredient in the material, derived from Brazilian rubber trees, has been identified to help promote angiogenesis. Seed capital for this company was raised from an angel investor and three private equity firms.

The South East of Brazil, encompassing São Paulo and Rio de Janeiro states, Minas Gerais and Espirito Santo, is home to 72 per cent of all life science companies, which are clustered in and around universities and science parks. Technology incubators provide services that facilitate the formation and growth of new biotech companies.


Brazil has undertaken several strategies to enhance its innovation base, including the adoption of a National Innovation Law in 2004, which foresees the establishment of Technology Transfer Offices across the network of universities. In addition, in 2007, President Lula signed a National Policy for Biotechnology. The policy called for investments of up to US$5 billion over the next decade and encourages biotechnological applications in human and animal health, food security, industrial products and environmental quality.

In terms of financing, for a large number of firms, government agencies and development banks such as BNDES and FINEP are a major source of funding for their development and innovation activities. This is partly because traditionally high interest rates mean that debt financing is too expensive as a source of funding.

While there are a number of domestic early stage private equity and venture capital players in the sector, there remains a belief that there is a lack of private capital availability to fund innovative biotech companies. This is due to:

— The risk averse nature of most Brazilian venture capital investors. The consequence of the historical investment environment, in particular, traditionally high interest rates and the return that could therefore be achieved by investing in fixed income assets, means that the hurdle rate for many investors to commit funds to venture capital is high.

— A lack of knowledge about the sector among the investor community.

— The protracted nature of the development period.

— Potential legal implications for angel investors who in some cases can be held liable for the actions of firms that they invest in.

— The lack of available exit strategies to venture capital and angel investors, such as the demand for IPOs in the biotech sector or an established history of company acquisitions.

Could this therefore result in opportunities for the UK?

The leadership of UK innovation, especially in the life sciences and biotechnology arena, and the excellence of Brazilian science in this area, mean that concerted action aimed at attracting UK biotech companies to Brazil could have a substantial impact. The UK represents an enviable innovation model as Brazil seeks to cement its own innovation system. Exposure to UK practices through the establishment of joint ventures, investment and joint research and development (R&D) activities would have tangible and immediate positive effects on the Brazilian innovation system and on UK stakeholders wishing to access Brazilian science expertise.

With this in mind, in March 2010, UKTI and the Science and Innovation team facilitated a trade mission to the UK by a group of Brazilian venture capital participants, together with other interested parties. The objectives of this mission were:

— To provide Brazilian venture capital firms direct access to the UK innovation community in order to:

1) Generate Brazilian investment in UK companies that are particularly suited to the Brazilian market (for example, those operational in agro-biotechnology, biodiversity-based drug discovery, and bio-energy).

2) Establish joint ventures or technology transfer agreements between the UK and Brazilian start-ups that have already received investment.

— To forge partnerships between the UK and Brazilian funds with a view to establishing joint financing, exchange of best practice, joint technology evaluation and exchange of information on investment opportunities.

— To introduce Brazilian stakeholders to The UK Innovation Fund.


The mission programme included:

— Meeting with The Knowledge Transfer Network (KTN) and receiving presentations from a number of KTN members in the biosciences arena.

— Visiting Imperial College London and NESTA (National Endowment for Science, Technology and the Arts), meeting with Technology Transfer Offices (TTOs) and spin out companies.

— Meetings with UK venture capital and private equity funds.

— The signing of a friendship agreement between the British Venture Capital Association (BVCA) and ABVCAP (Asociaçäo Brasileira de Private Equity and Venture Capital), their Brazilian counterpart.

As a result of the mission, investment funds from both countries are in the process of developing strategic alliances, either through joint investment or joint-ventures with investor companies. The next step will be to replicate the mission to Brazil, having investment funds from the UK visiting the Brazilian market, spin-out companies, and key Brazilian stakeholders.

EnergyBrazil’s energy mix is among the cleanest in the world. Forty-five per cent of all energy comes from renewable sources. A recent United Nations Environment Programme (UNEP) has identified that more than 90 per cent of new investment in Latin America in renewable energy is targeted to the Brazilian market.

Chart 9 compares Brazil’s energy mix to that of the OECD.

Chart 9: Brazil’s energy mix (%)

BrazilOECD

Hydropower

Biomass

Natural gas

Oil & derivatives

Nuclear

Coal

Key

0 10 20 30 40

Source: Brazilian Energy Balance 2007: Brazil vs World – EPE/MME (for Brazil data). Key World Energy Statistics 2008 – IEA (for OECD data)


Biofuels

EthanolEthanol is the nation’s second most important energy source overall, after petroleum. The use of biofuels – both ethanol and biodiesel – is central to the Government’s commitment to improving the country’s carbon footprint.

There are two ethanol programmes in Brazil. One is the compulsory blend with gasoline (maintaining the blend between 20 and 25 per cent). The other is the hydrated alcohol programme at the pump.

In Brazil, flex-fuel vehicles, which are optimised to run on any mix of petrol and up to 100 per cent anhydrous ethanol currently account for around 92 per cent of new light vehicle sales. The Government uses changes in the petrol blend at the forecourt as an instrument to regulate the market according to the supply of ethanol.

Good climatic conditions, land and water availability, relatively low land costs and established infrastructure supporting the sector combine to result in the lowest production costs for ethanol in the world – US$0.75 per gallon, according to UNICA, the Brazilian Sugarcane Industry Association.

In terms of productivity, gains in sugarcane ethanol productivity in Brazil have been significant over recent years. Between 1975 and 2000, the sugarcane yield per hectare increased by 33 per cent and the ethanol yield from sugar rose by 14 per cent. This was primarily due to the implementation of more modern production techniques and better crop selection, driven by EMBRAPA, the Brazilian Agricultural Research Institute.

Table 6 compares ethanol productivity from sugarcane to that from corn, the dominant source of ethanol in the USA.

Table 6: Ethanol productivity.

Raw material

Production/hectare (kg)

Quantity of product (litre of ethanol)

Quantity of ethanol/hectare

Sugar cane

85,000 12kg 7.08 litres

Corn 10,000 2.8kg 3.57 litresSource: Brazilian Ministry of Agriculture

Additionally, it is widely believed that Brazilian sugarcane uses significantly less energy per set output (up to four or fives times less) than corn.

Brazilian sugarcane-based ethanol is a more sustainable fuel than ethanol produced from corn – it performs well in meeting sustainability criteria such as reducing CO2 emissions, mechanised harvesting and labour conditions. Furthermore, and crucially, land utilised for sugarcane plantations are long distances away from the Amazon rainforest (in contrast to soy farming).

It is true that the global ethanol commodity market does not yet really exist (as there is no worldwide technical specification for trading ethanol, there is no futures market [so hedging isn’t possible] and because infrastructure is still poor). However, the Brazilian Government and UNICA are seeking to position the country as a world leader in the global ethanol commodity market, when it emerges. UNICA predicts exports of 15.8 billion litres by 2020, compared to 5.1 billion litres in 2008. Furthermore, many industry commentators envisage that the European Biofuels directive is likely to result in an expansion of the European market, which should provide further opportunities for Brazilian exports.

Significant investment is still required in infrastructure support for the growing export market as currently most ethanol is transported by road (up to 90 per cent) or rail from refinery to port. In 2010 especially, congestion in centre south ports has resulted in a long line of ships waiting to load sugar and exports being inadequate to meet world demand.


As a consequence, sugar stockpiles in warehouses have expanded resulting in higher logistics and storage costs and it is the centre south’s ability to export, not produce, sugar that is now becoming the limiting factor for the global sugar market. However, the anticipated construction of pipelines is set to have a significant impact towards reducing the cost of exporting.

Within the Brazilian ethanol industry, where are the main opportunities for Private Equity investment?

While the main industry players have been the consolidators, international Private Equity investors have been investors in Brazilian ethanol. Companhia Nacional de Açúcar e Álcool (CNAA) was created in 2007 as a joint venture between Santa Elisa and Global Foods, with funding from the Carlyle/Riverstone Renewable Energy Infrastructure Fund.

The market remains fragmented and family-run (although it is undoubtedly consolidating). Many of the mills are small, with less than 1.5 million tonnes of crushing capacity per harvest, and utilise inefficient and antiquated equipment. Cosan, the largest player, has a 15 per cent share. Partly as a consequence of recent over-expansion in the industry, there is still much scope for further efficiency gains through consolidation.

Private Equity investment could be in the sugar mill as a stand alone business – seeking to make improvements via the introduction and application of new and innovative technologies (to increase efficiencies, enhance processes, storage capabilities, etc).

It could also be in other aspects of the industry. For example, via land ownership. Here, the possible benefit could be in making a return from price and volume improvements (perhaps by the introduction of new technologies), from improvements in storage (being able to better take advantage of higher inter-harvest prices) and from enhanced distribution (benefiting from infrastructure improvements). With land ownership, the aim would be to partner with local producers to build facilities close by and to therefore supply sugarcane to these mills.

Clearly, with any commodity, price fluctuations are a problem. The answer is to try to stabilise a commodity based business by trying to complement the business with more

service orientated add ons. For example, Cosan has recently joined up with Royal Dutch Shell in a joint venture where it will benefit from Shell’s global logistics distribution infrastructure. Additionally, Cosan has acquired Exxon’s retail gas operations in Brazil. Some businesses in the sector are also focusing on electricity cogeneration as a means of spreading risk. This enhances stability, as cash flows are inflation indexed and because energy could, for example, be sold during the dry season when hydroelectric energy is trading at a higher price (a note of caution here, however, in that it is not always possible to benefit from fluctuations in the spot price).

On the venture capital side, it’s worth noting that second-generation cellulosic and new seed technologies remain seriously underfunded in Brazil. In addition, there is a demand for new drought-resistant sugarcane crop varieties as well as genetically modified super-hybrids that produce higher amounts of sucrose. Such developments will require funding.

A good example of new technology harnessing Brazil’s strength in the biofuels sector is the development, in 2005, of the world’s first commercially produced award winning aircraft running solely on biofuels – Embraer’s EMB 202 Ipanema. This is a crop duster aircraft with an engine powered by alcohol. The objective of Embraer when launching the aircraft was to give a boost to agricultural aviation and the crop duster market. As well as being environmentally friendly, studies indicate that the use of alcohol can extend the engine maintenance cycle and result in a potential cost benefit advantage in terms of operational cost, potency and consumption.

Wind energyLatin America’s wind power industry is expected to reach capacity of 46GW by 2025 and Brazil will lead the region with 31.6GW capacity by this date, according to IHS Emerging Energy Research. Industry experts believe that Brazil’s market scale and proactive renewable energy policies are moving Latin America towards a key tipping point, from sporadic wind project activity to more sustained market growth. In December 2009, Brazil’s energy research corporation, EPE, approved the auction of wind farm licences with a potential installed capacity of over 10GW. A second auction is planned for later this year.


Government incentives and local content requirements are encouraging equipment manufacturers to invest primarily in manufacturing turbines of 1.5MW and larger. For potential investors, it is envisaged that one of the largest opportunities will arise through the wind turbine unit supply chain, given that annual demand for more than 300 turbine units is expected from 2011 onwards.

Hydroelectric powerConsistent rainfall and abundant river water systems means that almost 15 per cent of Brazil’s energy mix comes from hydroelectricity. An even more surprising statistic is that more than 80 per cent of electricity demand is met by the country’s hydroelectricity generation capacity. In Brazil, small hydroelectric plants (SHPs) receive favourable treatment because they have perceived social benefits combined with minimal environmental impact. While large hydropower plants build dams and reservoirs, SHPs operate mainly through the rivers natural flow that allows for a large number of eligible sites with lower construction costs. SHPs are defined by the Brazilian electricity regulator as hydroelectric power plants with installed capacity between 1 and 30MW and reservoir area of up to 3 sq kilometres.

Companies seeking to construct a portfolio of SHPs and utilise process technological improvements provide an attractive investment opportunity for Private Equity style investment.

Information, communications, technology (ICT)Brazil is a global strategic player in the IT and Business Process Outsourcing (BPO) industry. To assist this, the new brand image of the industry – BrasilIT+ – aims to stress the competencies of the software and IT services industry in Brazil, centralising the promotion of IT exports and the international expansion of organisations in the sector.

Supplying information technology and solutions to the financial sector is perhaps the key area where the industry in Brazil has seen cutting edge development and innovation. The necessity initially arose as a consequence of hyperinflation and the constant rule changes of the 1970s and 1980s that led to the provision of technological solutions that are worldwide benchmarks in banking automation, internet banking and funds transfer processes.

The most recent high profile and far-reaching project involving banking operations was launched in 2009 – the authorized direct debit (DDA). This is a system that will allow all payments to be received electronically by the banks that serve individuals and corporations. The impact of this change is massive – firstly in terms of saving paper and postage − monthly school bills, purchases, mortgages and car loans, among others, leave a paper trail of around two billion printed banking slips per year. Additionally, DDA will lead to increased transaction speed and improved security. The implementation of the system once again confirms Brazil`s position as a pioneer and a global reference point in business-related technology solutions for the financial services sector.

In addition to the strong reputation enjoyed by Brazilian IT in banking and financial services, the industry is also at the forefront of telecommunications developments and new opportunities abound for Brazil as a consequence of innovation in mobile banking, a niche in which India does not have the same international standing.

Brazil is also undoubtedly growing in importance as an offshore IT destination. Many commentators believe that time zone advantages (particularly with the USA) mean that Brazil could be an important alternative to India, with the intensification of globalisation leading to risk diversification.


As explained in Section 5, science parks, in close association with federal universities, are providing incubator facilities for the development of new technology and software and much of this effort is focused on the IT, BPO and telecommunications sectors. In addition, tax incentives are on offer to businesses choosing to set up in Brazil, so long as a proportion of turnover is reinvested into R&D activities. Many large international firms have taken advantage of this and it helps to make Brazil relatively more attractive when compared with some of its competitors. (Google, for example, has a research centre in Brazil.)

While the IT and electronics industry continues to provide a large proportion of companies in Private Equity portfolios in Brazil, it has decreased in terms of its relative participation in the last few years. This is primarily due to the considerable number of divestitures in this sector from 2005 to 2008.

In respect of Private Equity, investment opportunities for businesses interested in this sector arise as a result of:

— At the venture capital level, nurturing innovative IT and telecommunication businesses through the development and commercialisation of their product.

— Taking advantage of consolidation potential within the industry.

— Understanding the international growth prospects of businesses with cutting edge products and services that realise the potential value of these products and services to overseas markets.

The recent deal by Apax Partners with TIVIT, the integrated IT and BPO business, as referred to in Section 4, is a clear example of a UK Private Equity firm understanding the potential domestic and international growth prospects of a leading Brazilian player in this sector. Another success story in this sector is the acquisition by Google, in 2005, of Akwan Information Technologies from Fir Capital. Akwan was an internet search solution provider. The sale of Akwan generated an annual return of 72.1 per cent, achieving a multiple of 16 times the invested capital for the period of 2001 through 2005.

Construction and real estateAccording to research carried out by GVcepe, real estate has become one of the prominent sectors for Private Equity investment in Brazil in the last few years. Its relative participation in portfolio companies has risen from 3 per cent in 2004 to 12 per cent in 2008. The main drivers of this expansion have been relatively lower interest rates, more easily available government credit, the growing economy and the burgeoning middle classes.

Favourable economic conditions have driven a change in the attitude towards real estate as an asset class in Brazil. The investor model is therefore evolving from direct ownership of property to more sophisticated structures, including tailor made real estate portfolios, residential (particularly focusing on lower and middle class housing) and retail funds and Private Equity. One aim of these structures is often to diversify risk and to transfer risk and responsibilities to a management company.

Leverage is generally low in the sector. As can be seen from chart 10, real estate debt currently accounts for just 2 per cent of Brazilian GDP. This compares to an average of 64 per cent for developed markets and a 12 per cent average figure for the “best emerging economies”. Furthermore, there is no second mortgage culture and a lack of mortgage backed securities. Low real estate debt and the lack of sophistication of mortgage securities therefore points to huge growth potential in the sector for the future.


Chart 10: Mortgage loansas a percentage of GDP

BrazilTurkeyMexicoChileSouth AfricaJapan

IrelandSpainUSAAustraliaUK

Key

10 20 30 40 50 60 70 80 900

Source: Brazilian Central Bank

While the housing market still remains highly fragmented in Brazil, the residential real estate sector has exhibited a considerable increase in activity in the last few years. This expansion is partly due to government incentives to increase the availability of real estate funding, as affordable housing has traditionally been the least supported in Brazil. It is also due to unmet demand for home ownership arising from the growing middle classes, together with increased access to mortgage financing.

Many real estate companies went public in the 2006/2007 boom times and used the proceeds from IPOs to grab development land at inflated prices. Then the financial crisis hit and share prices dropped substantially. Consolidation within the sector is now widely expected as the larger, more profitable and efficient players acquire smaller and less efficient businesses. The Private Equity model is predicted to be successful here and also with those companies that didn’t go public, as they are seeking alternative funding for their activities.

It is also widely believed that the retail sector will experience substantial growth in the coming years as the middle class expands and has greater access to credit. The sector is also underpenetrated and fragmented, creating an opportunity for well capitalised players to expand through acquisition.

On the commercial property side, traditionally, Brazilian companies have owned their property, production plant or distribution centre. Recently, there has been an increase in companies selling this property to real estate investors, who then provide the company with some form of guarantee of operation, for example, via a lease or establishment of surface rights. Consequently, there are opportunities here for real estate investment funds.


A growth rate higher than the average for the country, together with government funded initiatives to support the industry (including investment in infrastructure and transport projects), have raised investor interest in the tourism industry in the North East of Brazil. It is widely believed that the quality hotel market in the region is under-served and has a lower barrier to entry than Rio de Janeiro or São Paulo, where competition is fierce. Traditionally, Brazilian hotels have been developed through a condominium type structure, whereby investors acquire a unit or a floor pre-development and on completion, the entire project is operated by a management company. Clearly, many international investors will be hesitant about investing in such a structure, due to the minimal control that they would have over the management of the hotel. It could well be, however, that increasing overseas investor interest going forward will act to alter this model to something which is more acceptable to such investors.

Financial servicesThe recent surge in consumer demand in Brazil is interwoven with the development of the country’s financial services industry. Many people have recently opened a bank account for the first time, into which salary and wage payments are made. They might have bought a car and, in doing so, have borrowed for the first time. They may also have taken out private health insurance for themselves and their families. The whole consumer finance and credit industry therefore gives rise to serious opportunities for Private Equity businesses.

In the mid market of the Brazilian banking sector, there are a number of banks each with a market capitalisation of up to US$500 million. Many of these have gone public recently and others have improved corporate governance in order to be in a position to IPO themselves. However, all of these banks are not large enough to compete with the largest Brazilian banks. A number of them are niche players servicing the mid market between corporate and retail banking. Returns here can be good. There is always demand for credit even in the recent financial crisis.

The difficulty for these banks is on the deposit side. This depends on institutional and corporate funding (not retail) and is therefore more volatile and uncertain. A further consideration with a number of these organisations is that there are control issues. They are dominated by a principle shareholder or family who are still active and don’t want to relinquish control by forming a joint venture with another Brazilian player. This therefore acts as a constraint to growth.

As a consequence, a number of these banks could be receptive to overseas investors taking a stake and Private Equity type investment. The lack of a reliable funding base could, however, be a problem here for Private Equity investors and the fact that this is a much regulated industry (by the central bank), makes a potential exit more complex than in other sectors.


SECTION 7

UK INVESTORS INTERESTED IN BRAZIL


Many internationally focused investors and Limited Partners are reviewing their medium to long term investment strategies. This is partly as a consequence of the recent financial crisis, when a number had their fingers burnt, but is also in part due to the differing projected economic fortunes of North America/Western Europe and key emerging economies over the next five to ten years.

Investors are therefore deliberating between continuing to pour most of their investment into mature economies where competition is fierce and many markets are saturated, or increasing allocations to high growth economies, where there is real market potential due to rapidly rising GDP per head, an expanding middle class and a still relatively young demographic.

Brazil is one of these high growth economies that is witnessing such an increase in international attention at present. However, as explained in Section 3, historically a very low proportion of committed capital to Private Equity in Brazil has come from the UK – most international interest has been from the USA, continental Europe and other regions. Having said that, the last 18 months or so has undoubtedly seen a significant increase in interest from the UK financial community:

— At the investor level, UK based investment managers with an emerging market allocation, family offices, Private Equity funds of funds and institutions are all looking to increase the proportion of their funds that they allocate to high growth markets and Brazil in particular. For many of these investors, this will equate to a doubling of current funding to such markets. A number of these organisations, while being UK based, also have significant operations and offices in other territories. There is therefore real scope for them to pool funds emanating from these places into further investments that they make in Brazil.

— A number of the large UK Private Equity houses are establishing a place of business in Brazil and acquiring businesses or stakes in businesses.

— There are a number of UK Private Equity houses that are specialist in the secondary market and, due to the lack of development of this market in Brazil, are scrutinising carefully opportunities that could form attractive investments for their business.

— Some funds are seeking to include Brazil within pan regional funds, with the aim of attempting to reduce exposure to any one particular country.


SECTION 8

THE FOCUS OF INTERNATIONAL INVESTORS


While the much improved and attractive economic fundamentals have been the catalyst to raising investor interest in the country, what are investors and Limited Partners particularly focusing on when they talk with the Brazilian fund community? This section should be read in conjunction with Section 11 “the challenges ahead”.

PipelineProbably the most important factor is deal flow and pipeline. Investors want to be able to see that General Partners are well connected and have access to strongly managed entrepreneurial businesses in high growth sectors. Furthermore, the ability of managers to take such businesses, accelerate their development and originate and structure innovative investment deals is crucial in being able to provide differentiation against a fund’s peers.

Business appraisal skillsAn overview of fund management experience in Brazil was provided in Section 2, and what is clear is that investors view fund management credentials as key. In respect of Brazil, there is a view that the country performs favourably on this when compared to other BRIC and emerging economies. As well as academic background and practical hands on fund management experience, investors are particularly keen to evaluate the analytical skills of any team with which they might work.

Strong analytical skills enable a fund management team to conduct appropriate due diligence on a target firm before any investment is made, but are also fundamental in ensuring that investors receive appropriate and accurate financial information about the performance of the business during the course of the investment. Good judgment is required by both the fund management and the individual reviewers − they need to fundamentally understand the potential investment. In terms of the business plan and financial modelling behind the investment opportunity advanced, the reviewers need to test this rigorously. This is achieved by challenging underlying assumptions, reviewing and verifying

source information, checking the sensitivity of the model, test checking the integrity of the financial modelling (for formula errors, etc) and giving appropriate consideration to comparable companies and market transactions.

While the prevalence of such skill sets is undoubtedly increasing in Brazil, the refinement of analytical skills is one area where some commentators believe there is still progress to be made. Furthermore, as the industry develops in Brazil, the development of skills and sector specific knowledge and experience is likely to rise, in order for firms to gain a comparative advantage over generalist investors.

While track record is an important part of evaluating a fund’s management credentials, some observers have questioned relying too heavily on track record, especially in rapidly developing markets, as past achievements are not necessarily a good indicator of future successes.


TransparencyAs part of the fund management and underlying business investment appraisal, investors are demanding ever increasing levels of transparency. They want greater access to financial management information concerning the business and they want to receive updates on an increasingly regular basis. They are demanding independent audits of the investments.

Investors and Limited Partners are also working with much stricter due diligence than in the past. They like to visit the companies in which their funds are to be invested and to talk with the key management of the business.

There is a varied view among the investor community as to whether investing in opportunities in a high growth country such as Brazil requires more intensive due diligence procedures – perhaps this is an issue that needs to be considered on a case by case basis. However, as mentioned in Section 11, there are specific concerns in Brazil, regarding tax and legal that does require close consideration.

Corporate governanceAs part of their due diligence process, investors are seeking to ensure that the ultimate investment target companies understand the importance of strong and developed internal controls and corporate governance procedures. They want to ensure that the key management and director team of such businesses is receptive to new ideas and to learning from established best practice procedures that have been adopted elsewhere.

Alignment of interestsAlignment of interests between the General Partner and Limited Partners/investors is another area of focus. Generally, Limited Partners would like to see General Partners contributing more to each fund and also see management fees and carried interest structures focus the wealth creation opportunities for the General Partner more firmly on the carried interest element. There is a widespread belief that the manager should not earn on the management fee – this shouldn’t be part of the profit centre.

The co-investment by Brazilian Limited Partners in the same funds as international investors is also welcomed. This increases confidence levels as it is believed that such co-investment raises transparency and increases the accountability of the General Partner.


SECTION 9

LONDON’S CAPABILITIES


The UK and the City of London have long been respected as pioneering and dynamic financial hubs. In addition, geography and the time zone benefit of being between the Americas and Western Europe/the Middle East and Asia gives the UK a natural comparative advantage compared with other centres.

The 2010 Global Financial Centres Index ranks London on a par with New York and ahead of the rest of the world when ranking financial centres on a number of criteria including regulation, market access, infrastructure, business environment and talent pool available.

Chart 11: Global financial centres rankingScore

LondonNew YorkHong KongSingaporeTokyoChicago

ZurichTorontoShanghaiFrankfurtSao Paulo

Key

100 200 300 400 500 600 700 8000

Source: The Global Financial Centres Index March 2010


In terms of Private Equity, along with the United States of America, the UK has one of the oldest, largest and most developed industries in the world. The industry in the UK accounts for almost 60 per cent of the entire European market.

With this in mind, this section seeks to set out some of the areas where the UK has expertise that could assist the development of the Brazilian Private Equity industry.

The BVCA and the Brazilian industryThe British Private Equity and Venture Capital Association (BVCA) mission statement explains that for more than 25 years, “the BVCA has acted as the industry body and public policy advocate for private equity and venture capital in the UK, speaking for, and negotiating on behalf of, the UK industry to a wide range of key stakeholders, including government, the European Commission and Parliament, media and statutory bodies at home, across Europe and globally”. The organisation therefore has a potentially invaluable role in sharing with its Brazilian counterpart, ABVCAP (the Brazilian Private Equity and Venture Capital Association), the development experiences that it has encountered, and where appropriate, industry and organisational best practices.

A specific area where the BVCA could seek to assist ABVCAP and the development of the Brazilian venture capital industry is in enhancing the links between universities and business, particularly with respect to commercialising technological innovations and promoting the university incubator model.

It might also be useful for ABVCAP and the Brazilian industry to liaise with BVCA regarding the voluntary code of best practice that is currently being developed within Brazil. In 2007 the BVCA worked with Sir David Walker to produce “Guidelines for Disclosure and Transparency in Private Equity”. The BVCA has also produced reporting guidelines in the past, and a responsible investment guide more recently, that apply to both private equity and venture capital. Furthermore, it could also be mutually useful for the two organisations to discuss and compare the programmes of professional development that are currently offered to their respective memberships.

Capital structuresThe comparative histories of the capital markets in Brazil and the UK inevitably mean that there is a greater range and sophistication of financial instruments in the UK than in Brazil.

In a more developed industry, a Private Equity investment is often made using a combination of financial instruments that together generate the required blended return. The objective is to minimise the cost of capital used to fund the business subject to its risk profile. The term financial engineering is often used to describe this process of creating an optimal capital structure for a company. Financial engineers blend together a series of rights and obligations to create the desired mix of risk, reward and control. The ultimate structure will need to be flexible enough and have sufficient headroom to accommodate commercial volatilities, and also be efficient, thereby minimising unnecessary taxation, as well as currency and interest rate risk.

While the traditional Brazilian industry model has been one with relatively low levels of leverage, an increasingly international profile is having an impact here, as there are obviously times when the introduction of debt and other forms of financing can make sense, depending on the objectives of the parties involved.

In Brazil, some commercial banks are now beginning to offer more medium and longer term debt products to businesses. However, these still remain relatively expensive, due to interest rates that are high by international standards. More sophisticated debt products on offer in the UK could therefore be of interest to Brazilian Private Equity businesses when structuring a deal, but the applicable interest rate would need to be sufficiently low so as to offset the additional exchange risk on overseas denominated debt.

Furthermore, while there are examples of alternative and hybrid instruments, such as mezzanine finance (see comments under infrastructure, logistics and distribution above) being used in deal structures in Brazil, the UK’s experience in utilising such instruments in structuring larger transactions should also offer further potential for working with, and providing advisory services to, Brazilian Private Equity players.


SyndicationWhen the amount of funding required is particularly large, or when the investment is considered to be relatively high risk, the Private Equity firm might consider syndicating the deal, bringing in other Private Equity firms as co-investors.

The principle advantage of syndication to the Private Equity firm is the spreading of risk, but the process can also confer advantages to the candidate business as it:

— Avoids any one investor having a major equity share and significant unilateral control over the business.

— Makes available the combined business experience of all of the Private Equity partners to the benefit of the company.

— Permits a relatively greater amount of financing than with a single investor.

— Can offer more sources of additional future funding.

The depth of UK experience in dealing with such structures, including overcoming the many practical issues faced, should provide opportunities for UK Private Equity firms and their advisers to work with Brazilian Private Equity businesses.

Buyout and secondary fundsThe UK is widely respected in having particular strengths in buyout (mid market) and secondary funds. Please refer to Section 4 for further discussion of this issue.

Tax incentivesIn the UK, a number of tax incentives have been introduced with the aim of trying to encourage investment in smaller unlisted and AIM quoted businesses.

Examples of such incentive schemes include:

Enterprise Investment Scheme (EIS) The EIS was set up by the UK Government to try to encourage business angels to invest in certain types of smaller unquoted UK companies. If a company meets the EIS criteria, it may be more attractive to business angels, as tax incentives are available on their investments. Under the EIS, individuals not previously connected with a qualifying unlisted trading company (including shares trading on AIM – the Alternative Investment Market), can make investments of up to £500,000 in a single tax year and receive tax relief at 20 per cent on new ordinary share subscriptions. These investments qualify for relief from Capital Gains Tax on disposal, provided the investment is held for three years.

Venture Capital Trusts (VCTs)VCTs are investment vehicles which are used to encourage investment in smaller unquoted or AIM quoted UK companies. Again, tax incentives are offered on such investments. Investors receive 30 per cent income tax relief on a VCT maximum investment of £200,000 in each tax year, provided that the investment is held for five years. Shares in VCTs acquired within the annual limit are also exempt from capital gains tax on disposal at any time.


SECTION 10

THE LONDON STOCK EXCHANGE AND THE ALTERNATIVE INVESTMENT MARKET


Initial public offerings as an exit in BrazilAccording to information collated by GVcepe (see charts 12 and 13), in Brazil, during the period June 2005 to June 2008, Initial Public Offerings (IPOs) and secondary sales between funds accounted for 54 per cent of investment exits by number and 89 per cent by value.

The ability to exit a Private Equity investment via IPO is therefore as crucial in Brazil as it is elsewhere.

The domestic exchange, BM&F-BOVESPA, in 2009 was within the top ten stock exchanges in the world, when classified by domestic market capitalisation. However, while the domestic and international profile of the exchange has grown appreciably over the last few years, there also remains significant interest among the business community in overseas and dual listings. This is particularly relevant for smaller and mid cap companies, the market for which BM&F-BOVESPA is least developed. This should provide serious opportunities for London and for AIM, which has a history of attracting companies with previous Private Equity backing.

Chart 12: Analysis of Private Equity Investment exits 2005-2008 by number

IPOs and secondary public salesBuy-backWrite-off/write downTrade sale

Key



Chart 13: Analysis of Private Equity Investment exits 2005-2008 by value

IPOs and secondary public salesBuy-backTrade sale

Key


The London Stock Exchange (LSE) – an introductionAccording to the exchange itself, “the LSE is at the heart of the global financial market and is home to some of the largest, most successful and dynamic companies in the world. It continues to be the exchange of choice for international issuers, hosting the most international companies among the world’s major exchanges” (LSE: June 2010).

An exchange publication, “A guide to capital markets – your route to the heart of global finance” continues by explaining that “The Exchange’s thriving markets have helped to make London the focus of the international financial community and the ideal place for companies to raise capital and enhance their corporate profile. Our central location spanning global time zones, combined with world-class standards or corporate governance and deep pools of capital, are just some of the strengths that attract the world’s foremost investors and companies to our markets”.

The following information is for 2006 and 2007, the last “normal” years before the global financial crisis, and highlights the importance of London to the global financial community.

2006

— 367 new companies joined the LSE

— In the same year, the New York Stock Exchange (NYSE), Nasdaq and Hong Kong Stock Exchange combined had 332 IPOs

— US$104 billion was raised on the LSE, US$40 billion on NYSE and US$29 billion on NASDAQ

2007

— 252 new companies joined the LSE

— 142 new companies joined Nasdaq and 67 new companies joined NYSE

— US$52 billion was raised on the LSE

Source: London Stock Exchange and other websites – December 2009


The benefits of the LSEGiven this profile, what are the key attributes that draw internationally focused businesses to one of the markets of the LSE?

Deep pools of capital and a diverse range of investors − companies on the London market are exposed to one of the world’s deepest and varied capital pools, which provide an established, experienced and reliable potential source of funding. This funding can enable a business to realise its strategic ambitions – for example, expanding into new markets or investing in growth opportunities ranging from acquisitions to research and development.

Liquidity – London has the most liquid equity market in Europe. While the level of liquidity is ultimately dependent upon a company’s individual circumstances including the level of free float and concentration of investors, a listing in London will increase liquidity. This is because investors participate both actively (through investing in specific opportunities) and passively (by tracking or benchmarking indices). The inclusion of a company in such an index is an important driver for liquidity as most indices have characteristics that enable investment funds to be built around them, thereby increasing exposure of a company’s share capital to a larger number of UK institutional investors, who will often provide products that benchmark an index.

Increased liquidity will provide enhanced strategic flexibility for a business, as a liquid market in a company’s shares provides a basis for valuing the business and benchmarking its performance against the competition.

Enhanced profile− being admitted to one of the LSE’s markets will significantly boost a business’s profile and commercial position with key stakeholders, including shareholders, customers, suppliers, employees and business partners. Such an enhanced profile can act as a springboard for future development of the business.

Low cost of capital − previous studies have concluded that the overall cost of raising funds in London is considerably lower than in the USA. This is partly due to more efficient price discounting at IPO, but also due to generally lower underwriting and professional fees.

(A useful study in this area is “The Cost of Capital – an international comparison”. Oxera. June 2006)

Intelligent corporate governance − the City’s world renowned reputation for integrity, together with a principles and risk-based approach to regulation, underpin the success of London in attracting internationally focussed businesses, together with institutional investors, to its markets. This approach to regulation contrasts with the more prescriptive and rules based approach adopted in the USA, which is widely considered to be more onerous and more costly, while being no more effective nor efficient, than the UK approach.

A London listing compared to New YorkFor a number of reasons including geography, time zones and historical ties, there has been a tendency for Brazilian companies to look north to New York when they seek to raise capital internationally. As a consequence, there is a lack of awareness among some parts of the Brazilian business and financial community as to the potential benefits of raising capital in London, when compared to New York.


The comparison below provides an overview of these benefits:

Table 7: Comparison of London and New York for an IPO

London New York

Lower cost of raising funds, due to more efficient price discounting at IPO and generally lower underwriting (3-4 per cent) and professional fees.

Higher cost than the UK due to the Sarbanes Oxley Act requirements. Underwriting fees tend to be in the region of 6.5-7 per cent.

Faster to market. Rapid turnaround by regulators (where required) and time limits for regulatory approval of offer documents. Typically a London listing on the Main Market takes around six months. A listing on AIM usually takes three-four months.

Slower to market due to SEC (Securitieis and Exchange Commission) regulatory approvals required. No certainty on turnaround time. Typically a NY listing takes around 12 months.

Principles and risk based “comply or explain” intelligent regulation. Ranked first in corporate governance standards by GMI, Deminor and Davis Global Advisors.

Rules based and prescriptive regulation (Sarbanes Oxley). Exacerbated by need to protect against opportunistic securities litigation. No evidence that Sarbanes Oxley delivers better and more effective regulation than the UK regime.

Perceived lower costs of complying with corporate governance requirements deemed to be one of the main factors influencing the choice between a UK and US listing.

Perceived higher costs associated with complying with corporate governance standards.

Lower risk. Although a large proportion of AIM companies are early stage businesses and/or operating in high risk sectors, the failure rate on AIM is low, running at less than 3 per cent in recent years.

Higher risk.

Half yearly financial reporting required. Quarterly reporting is a general requirement for listed companies in the USA.

Controlling for the relative size of the economy, the UK and US markets are reasonably comparable in terms of depth of the pool of equity capital.

However, in the UK, fund management activities are focused in one place – London, rather than geographically spread over different centres (as in the USA). Results in cost savings (saving time and cost of travelling to multiple centres during beauty parades).

Although larger volume of equity assets managed in the USA than the UK, spread over a number of financial centres.


Table 8: Comparison of admission requirements for Premium and Standard listing

Admission requirements Premium listing Standard listing

Minimum market capitalisation £700,000 £700,000

Financial accounts Three years of audited accounts Three years of audited accounts (1)

Accounting standards IFRS and equivalent GAAP IFRS and equivalent GAAP

Requirement for three year revenue earning record

Yes (covering 75 per cent of business)

No

Free float 25 per cent (2) 25 per cent (2)

Requirement for control over majority of assets for the prior three year period

Yes No

Sponsor Yes No

Working capital statement Yes (unqualified) Yes

Admission and disclosure standards

Yes Yes

(1) or such shorter period that the company has been in operation (2) FSA will consider lower free float if it is satisfied that there will be sufficient liquidity in the market

Source: London Stock Exchange

Table 9: Comparison of continuing obligations for Premium and Standard listings

Continuing obligations Premium listing Standard listing

UK Code on corporate governance Yes No (1)

Model Code Yes No (2)

Pre-emption rights Yes Yes

Half yearly report Two months after period end Two months after period end

Interim Management Statement Yes Yes

Major Shareholder Notification Yes Yes

Annual Report Four months after financial year end Four months after financial year end

Inside Information Price sensitive information to be disclosed immediately

Price sensitive information to be disclosed immediately

(1) Required to include a corporate governance statement in annual report for financial years beginning after 31 December 2009 (2) Company Law

Source: London Stock Exchange


Market options at the LSEThe LSE is unique in the choice of markets that it offers:

Main Market − a listing of a company’s shares on the Main Market gives that company access to the deepest pool of potential investors. It also offers investors the highest level of corporate governance, and therefore protection.

On 6 April 2010, the UK Listing Authority’s (UKLA) changes to the listing regime came into effect, involving a restructuring of the two tier regime. There now exist two segments – Standard and Premium. While Standard Listings must meet European Union minimum standards, Premium Listings must meet “super-equivalent standards” (which are the UK’s highest level of regulatory standards). A comparison of the two segments, in terms of admission requirements and continuing obligations is provided in Tables 8 and 9.

The majority of the changes compared to the previous Primary and Secondary regime affect the Standard Listing route. The potential attractions of the Standard Listing route, in terms of the prestige of being on the Main Market and lighter touch regulation than the Premium Listing, may appeal to companies that otherwise would have listed on AIM.

Alternative Investment Market (AIM) – offers a solution to smaller and mid cap growth companies (typically, but not exclusively, with a market cap of up to US$500 million). AIM is particularly attractive to businesses wishing to raise capital at an earlier stage of their development. For further information on AIM, see below.

Specialist Fund Market (SFM) – the SFM is the LSE’s regulated market for specialist investment funds, targeting institutional, professional and highly knowledgeable investors. It provides investment managers and their advisers with a global market capable of accepting a variety of corporate structures within a flexible regulatory environment.


Key attributes of the market include:

— Regulated by the UK’s Financial Services AuthorityApplicants to the SFM will be required to comply with European harmonised standards both at admission, and on an ongoing basis, in terms of standards of disclosure and transparency.

— Acceptance of sophisticated legal structuresThe SFM can accept a variety of sophisticated legal structures including limited partnership interests and non-voting share structures allowing the flexibility to create structures that can comply with home country tax or securities laws while also allowing access to permanent capital.

— Global profileThe SFM is open to UK and non-UK domiciled investment funds wishing to use London as a centre from which to access permanent global capital.

— Efficient secondary marketLiquidity in SFM securities will be facilitated by the world class trading platform, TradElect.

Professional Securities Market (PSM) – specifically designed for companies seeking to issue specialist securities, such as debt and depositary receipts, from professional or institutional investors. This is a highly specialised market that is particularly suited to the needs of overseas companies, especially those from emerging markets. Companies are attracted to the PSM because of its proportionate regulation and since they are able to continue to use domestic accounting standards.

Listing depositary receipts (DR’s) on the Main Market or PSM enables overseas companies to access a pool of capital and liquidity that might not be available locally.

AIM – a market for smaller and mid cap businesses

Setting the scene – some key statistics:

— 1,253 companies on AIM, including 239 non UK incorporated

— 36 admissions to AIM in 2009 (25 admissions up to April in 2010)

— Total capital raised on AIM in 2009 – US$9 billion

— Total capital raised since 1995− US$108 billion

— Average market cap as at 30 June 2010 − £48.2 million

Source: London Stock Exchange market statistics – April 2010


Chart 14: Distribution of companies on AIM by equity market value (£m)

0 to 22 to 55 to 1010 to 2525 to 50

50 to 100100 to 250250 to 500500 to 1,000Over 1,000

Key

50 100 150 200 250 3000


Chart 15: AIM – Number of companies and market capitalisation by sector

Basic materialsOil & gasIndustrials

Number of companies

Consumer goodsHealthcareConsumer services

KeyMarket value (£bn)

0

0 50 100 150 200 250

2 4 6 8 10 12 14


It is also worth mentioning here that as many venture capital firms now focus on larger and later stage transactions, AIM has become important as a source of funding for early-stage high-technology companies.


The attraction of AIM to Brazilian Private Equity businessesThe specific characteristics of AIM that would potentially appeal to a growth business that is seeking to raise further funding, or that has investors that are seeking an exit, can best be illustrated by comparing the requirements of AIM and the Main Market:

Table 10: Comparison of Main Market and AIM

Main Market AIM

Regulated by the Financial Services Authority (FSA). Regulated by the LSE (ie by the exchange itself).

Admission documents are pre-vetted by the FSA. Simplified admission requirements. Admission documents are not pre-vetted by the LSA or FSA (unless classed as a Prospectus under EU legislation).

Normally, a three year trading history required. No trading history requirement (minimum of three years if available).

Minimum of 25 per cent of shares in public hands (but see table 8 on page 58).

No minimum number of shares in public hands.

Minimum market capitalisation of £700,000. No minimum market capitalisation and no size restrictions.

A sponsor (for Premium Listing) is required for new applicants and certain transactions.

A Nominated Adviser (NOMAD) and a broker are required at all times. The initial role of the NOMAD is to ensure that the company is appropriate to be quoted on AIM and that the AIM rules are complied with at flotation. Subsequent to the float, the NOMAD must advise and guide the directors and ensure that the company complies with the AIM Rules on an ongoing basis.

Compliance with the LSE’s Admission and Disclosure Standards.

Compliance with the AIM Rules. The regulatory and corporate governance framework is specifically designed to suit growing and innovative companies, for who AIM is their first experience of operating on a public market.

Compliance with Combined Code for UK primary listed companies or explain why not. Adherence is voluntary for international primary and secondary listed companies (see Table 8 on page 58).

Adherence to the Combined Code is on a voluntary basis.


This comparison seeks to highlight that AIM combines the benefits of an IPO with simplified admission requirements. It provides a very attractive platform for innovative companies with a shorter track record to access capital and raise their profile within a regulatory regime that has been specifically designed to suit such growth businesses.

For most businesses, listing on AIM will represent their first experience on a public exchange, but crucially, the regime enables such companies to migrate across to the Main Market as their business continues to develop. During the period from 2003 to 2008, a total of 34 companies have moved from AIM to the Main Market. The average market capitalisation of a company transferring to the Main Market since 2003 is £339 million (source: London Stock Exchange Trade Statistics – December 2009).

AIM as a host exchange for resources companiesBoth AIM and the Main Market have become an important host exchange for resources companies. Of the 1,253 companies listed on AIM as at April 2010, 133 were in the mining sector, with a total market capitalisation of £10.5 billion, making the sector one of the three dominant sectors on AIM (along with oil and gas and financial services companies). The LSE therefore attracts a deep pool of specialist investors who have particular interest in this sector.

Special mention is worthy of AIM’s mining capabilities and experience in part due to the scale of the mining and related services sector in Brazil, but also due to the relative level of awareness of the attractiveness of AIM compared to the Toronto Stock Exchange (TSX).

The TSX has been established for longer than AIM and has been heavily promoted throughout the Americas. Due to this promotional activity and also because of geography and history, Brazilian businesses have a heightened awareness about the TSX, compared to AIM.

While the TSX has a focus on energy sector companies, in particular mining businesses, it is arguably not a direct competitor to AIM – it serves a different market. This market is primarily the US$5-15 million retail fundraising market, whereas AIM principally serves the US$50-200 million professional and specialist institutional investor market.

Additionally, if you are a business that has business aspirations outside of the Americas, then London arguably has much more international focus than Canada.

Given these advantages of AIM, together with the substantial resources based bias to the economy of Brazil and Brazil’s projected growth trajectory over the next decade, now is arguably the time when UK brokers, NOMAD’s and other professional advisers should actively be seeking to promote London’s and AIM’s capabilities in terms of serving growth Brazilian companies operating in this sector.


SECTION 11

THE CHALLENGES AHEAD


Now is clearly an exciting time for Brazil with the stabilisation of the economy, projected growth over the next ten years or more and the country’s rise in prominence on the world stage. Likewise, the domestic Private Equity industry is building momentum and has the potential to contribute significantly to future economic growth.

There are, however, a number of issues that, while not insurmountable, require significant political will to drive through changes. If changes aren’t made, many of these difficulties will continue to have a serious drag effect on the pace of growth. Some commentators also believe that there is a risk of a bubble forming – not just in respect of Brazil – but because attention is now on high growth economies and emerging markets, due to a relative lack of opportunities in the “developed world”.

Economy wide constraintsThe World Bank produces an annual “Ease of Doing Business Index”, which for 2010, ranked 183 countries overall and also on specific criteria, such as the ease of employing workers and paying taxes. Table 11 compares Brazil’s position with a number of other emerging economies and also with the UK.

Clearly, the results are disappointing both in terms of Brazil’s overall position (129 out of 183) and also its position in respect of ease of employing workers (138 out of 183) and paying taxes (150 out of 183).

Table 11: World Bank Ease of doing business

Ease of doing business rank

Employing workers

Paying taxes

Brazil 129 138 150

United Kingdom

5 35 61

Colombia 37 63 115

Mexico 51 136 106

Chile 49 72 45

China 89 140 125

India 133 104 169

Russia 120 109 103

South Africa 34 102 23

Source: World Bank “Ease of Doing Business” 2010


Labour lawsLabour laws in Brazil are based on a rigid labour code (the Consolidated Labour Laws or CLT) that was purposefully weighted in the employees favour.

Two principle problems arise with this structure. The first is that the cost of employing a worker is very high for the employer. Companies are required to pay taxes and compulsory contributions for each employee (over and above salary cost) that can double the cost of employing a worker.

Secondly, the complexity of the legislation means that it is easy for an employer to fail to comply with one of the myriad of requirements that are included in the CLT. Labour courts operate on a no win, no fee basis, meaning that labour cases are usually taken to court and the courts almost always rule in favour of the employee. Furthermore, taking a case to court is also very costly for the employer.

This situation gives rise to an informal sector and its associated problems − for example, reduced tax revenues and lack of pension provision. Consequently, while not a complete barrier, the cost and complexity of hiring staff in Brazil acts as a disincentive for investors. Due to the political sensitivity of this issue, tackling the problem is unlikely to be high on the agenda of the incoming President, following the elections in October 2010.

The tax systemBrazil’s tax system is complex, burdensome and regressive.

The complexity arises due to there being 85 different taxes, fees and social contributions that are applied at three different levels of government (federal, state and municipal). The World Bank “Ease of Doing Business” report for 2010 estimates that a medium-sized company in Brazil spends a staggering 108 days (2,600 hours) per year fulfilling its tax obligations.

In terms of burden, taxation now accounts for 35 per cent of GDP in Brazil, compared to 23 per cent for Argentina, 17 per cent for Chile, 10 per cent for Mexico, 18 per cent for India and 17 per cent for China. Furthermore, the quality of public services doesn’t reflect this level of taxation.

The system acts regressively too. It is estimated that 43 per cent of the price of food is indirect taxation, which means that the poor are proportionately harder hit. Additionally, there are too many taxes on production, which makes certain goods (those which go through a number of production stages) disproportionately expensive.

It is widely believed that as with the complex labour laws, the complexity, burden and regressivity of the tax system acts as a disincentive for business and results in an increase in the informal economy.

Tax reform, especially an overhaul of indirect taxes, is likely to be high on the agenda of the new President in 2011.

A double taxation agreement between the UK and Brazil is a long terms goal for the UK. Official talks have been held between the UK and Brazilian Governments on this issue. However, there is much further work to be done on this and an agreement is unlikely to be achieved in the near future. While British business wants it, and Brazilian business increasingly wants an agreement, until there is more weight from Brazilian business behind the necessity of an agreement, the position is unlikely to progress quickly.

InfrastructureBrazil suffers from weak infrastructure. Roads are poorly maintained and traffic accidents are common, the rail network is limited and airports and ports are congested and in many cases, antiquated, meaning that delays are frequent. Underinvestment in the electricity sector is to blame for widespread blackouts.

In 2007, the Government introduced a four year Accelerated Growth Plan (PAC) which aimed to increase public and private sector investment in infrastructure. However, with only a short time remaining for this programme, much of the US$378 billion (£242 billion) allocated to it has yet to be spent and significant problems remain. However, phase 2 of the PAC has recently been announced and this is expected to build on the (limited) success of phase 1.


It is widely believed that current investment in infrastructure development is insufficient to sustain projected GDP growth of circa 5 per cent. However, options for increasing the pace of infrastructure improvements are somewhat constrained by budget rigidity (the vast majority of Brazil’s current budget expenditure can’t easily be reduced), capacity constraints and the business environment (burdensome tax system, rigid labour legislation and other red tape – including legal and environmental obstacles).

If Brazil is to achieve sustained growth of 5 per cent, attract significant foreign private sector investment and service the pre-salt oil finds, 2014 World Cup and 2016 Olympics, then it will need to significantly increase investment in infrastructure improvements.

The legal system and intellectual property rightsWhile the Brazilian legal system is regarded as being independent and impartial in respect of disputes between domestic and overseas companies and investors and is a system that respects property rights, it is still slow and inefficient. Furthermore, lack of uncertainty regarding law enforcement is seen to be an issue. New reforms are therefore required to improve the current situation.

The LAVCA Scorecard for Brazil explains that “the enforcement and procedures associated with Intellectual Property (IP) remain a challenge for the country”. While “IP rights protection is deemed as fairly good”, software patents “can be difficult to obtain if not embedded in hardware that is being patented”. Furthermore, “the process of registering and enforcing patents and other IP remains slow and cumbersome”.

Availability of domestic corporate creditWhile the relative strength of Brazilian capital markets offers options not readily available in other capital markets in the region and there are signs that domestic banks are starting to increase medium and longer term corporate lending, corporate credit remains very expensive, as the cost of market-based credit remains high.

Overseas firms in Brazil that have easy access to foreign credit tend, therefore, to prefer to finance their operations abroad. Hence, the problem is particularly one for domestic based businesses. As mentioned in Section 11, this situation means that the more sophisticated debt products on offer in the UK could be of interest to Brazilian Private Equity businesses when structuring a deal.

Private Equity specific challengesIn addition to economy wide issues that require attention, there are also a number of Private Equity specific challenges that need to be overcome.

A cultural barrier to Private Equity in Brazil Private Equity is still a relatively young industry in Brazil and, as previously mentioned, its share of GDP is well below the developed world average. Part of the reason for this seems to be that there exists a cultural barrier to Private Equity in Brazil – due to the high risk perception of the industry.

In the UK and the USA (and elsewhere) Private Equity started with domestic savings. In Brazil, foreign investment was key to establishing the industry. China and India are aggressively adding domestic savings to the mix and although Brazil is trying (through growing participation of institutional investors and pension funds) it could arguably be doing more. Changing the perception of Private Equity and attracting domestic savers to the industry is therefore an important challenge to the country.

Connecting international Limited Partners with Brazilian Private Equity businessesPerhaps one of the key challenges, which in no way is unique to Brazil, is to continue to develop ways of connecting international Limited Partners with domestic emerging market Private Equity firms. A key aspect of this is in ensuring alignment of interests between both parties.

Transparency and manager profileThe transparency challenge, providing accurate and timely asset valuation, enabling investors to track the performance of their investments, is also crucial. Indeed, a number of international investors active in Brazil see this as the main difficulty to be overcome.


In Brazil, there is certainly a trend towards fair value, based on the amount that would be paid for the asset by an unconnected third party and where the investment is reassessed at least on an annual basis. The concerns arise at the fund and investment review level and with the sophistication of the analytical procedures that are applied in order to understand the performance of the investment. How do fund management assess the business with which they are working? Is there reference to comparable companies and market transactions? Accurate performance assessments rely on good judgments by the reviewer and management. Model integrity needs to be reviewed and assumptions need to be challenged and rigorously sensitised. There needs to be consistency in valuation procedures between investments and from one period to the next.

In order for the Brazilian industry to develop and fulfil its potential, there needs to be a continual supply of qualified and experienced professionals entering the industry that exhibit such skills. While the creativity and flexibility of Brazilian executives is well respected abroad, now is perhaps a good time to work more with overseas professionals and import, rather than export talent. Bringing in expertise from elsewhere, to work alongside domestic professionals, will undoubtedly strengthen the industry, adding invaluable and much needed analytical, investment evaluation and monitoring skills.

This is also important at the target company level. To have overseas managers in companies is still very rare in Brazil.

Corporate governanceThe family owned nature of many target companies, especially medium-sized companies, often means that internal controls and an awareness of corporate governance is somewhat lacking. Board culture is not strong and those boards that do exist regularly lack empowerment. Clearly, for international investors to invest into such businesses, there needs to be both an appreciation of the importance of these issues and defined plans for the implementation of appropriate internal controls and corporate governance procedures.

Stimulating the early stages of the Private Equity value chainBrazilian public organisations have been very important in promoting and developing the Private Equity industry in Brazil.

Specific initiatives have included:

— The creation of ABDI (the Brazilian Agency of Industrial Development) in 2004, which has been fundamental to the structured planning and sustained development of the Brazilian Private Equity industry.

— The creation of FINEP (the Brazilian Innovation Agency) that has assisted small- and medium-sized innovative, technology based companies raise finance.

— BNDES (the Brazilian Development Bank) has recently launched a programme to support seed capital and chose a Private Equity organisation – CRIATEC – to strengthen the seed capital stage of the industry’s value chain.

Given the successes to date of these initiatives, there is undoubtedly scope to further stimulate the start of the value chain of the Private Equity industry in Brazil, through the expansion of angel investor networks and seed/venture capital early stage investment vehicles.

Differentiation between firmsAs the domestic industry develops and as international investor interest increases, it will become critical for domestic Private Equity firms to differentiate the opportunity that they offer the investor. As mentioned earlier, the ability of fund managers to take growth businesses, accelerate their development and to originate and structure innovative investment deals will be crucial in being able to provide differentiation against industry peers. Intensified sector specific knowledge and experience will also enhance a firm’s profile.


SECTION 12

THE NEXT STEPS


The Lord Mayor of London and a delegation from the UK will visit Brazil on 18 and 19 October of this year. The principle objective of this visit is to promote the strengths and capabilities of the UK financial services community in Brazil.

With this visit in mind:

— This report will be formally launched at an event at Mansion House in the City of London on 7 September. The Lord Mayor will introduce the event and it will be held in conjunction with the Brazilian Chamber of Commerce in London.

— Additionally, later in the autumn of this year, it is proposed that a delegation of UK investors that are interested in investing in Brazilian Private Equity will travel to Brazil. The delegation may also include UK Private Equity houses that are interested in forming joint ventures or strategic partnerships with Brazilian funds. While in Brazil, the participants will meet up with Brazilian funds for a series of one to one meetings, as well as meet advisers to the Private Equity community in Brazil. The event will be held in conjunction with ABVCAP.


SECTION 13

APPENDICES


1: EXAMPLE TAX EFFICIENT STRUCTURES

Structure 1: Typical structure for dividend distributions

Investors

Fund

Offshore holding company

Brazil investment Brazil investment Brazil investment Brazil investment


Structure 2: Typical structure for capital gains planning

Investors

Fund


Offshore intermediate company

Brazil company

Disposal of the shares in the intermediate holding company should eliminate the 15 per cent capital gains tax that would have arisen had the shares in the Brazil Company been sold.


Structure 3: Structure for tax planning using FIPs

Offshore fund


FIPS

Brazil Holdco

Target company

Assumes that current regime for relief of goodwill on acquisition will continue.


2: DEFINITIONS

Private Equity In its narrowest sense, Private Equity refers to equity investment in private companies. Where the term is used in this report, it refers to private equity, venture capital, mezzanine and PIPE, unless specified otherwise.

PIPE Private Investment in Public Entity. This is where the investing organisation takes an equity stake in a listed company, where it foresees that it can actively participate in the strategic management of that company.

Mezzanine Mezzanine investment is a hybrid instrument combining the characteristics of equity and fixed income investment. It is comparable to an investment in capital, in that the expected return depends on how well the investment performs. It generally sits between senior debt and equity in terms of both risk and reward. It is usually applied to later stage companies with the potential for high steady cash flow.

Syndication Where several Private Equity firms participate in a deal, each putting in part of the total equity package for proportionate amounts of equity, usually with one firm acting as lead investor. While syndication is of benefit to the Private Equity firm in limiting risk in the venture, it can also have advantages for the entrepreneur as syndication:

— Avoids any one investor having a major equity share and significant unilateral control over the business.

— Makes available the combined business experience of all of the Private Equity partners to the benefit of the company.

— Permits a relatively greater amount of financing than with a single investor.

— Can offer more sources of additional future funding.

3: USEFUL CONTACT ORGANISATIONS

ABVCAP Brazilian Private Equity and Venture Capital Association

BVCA British Venture Capital Association

BRASSCOM Brazilian Association of Information Technology and Communications companies

SOFTEX Brazilian Association for Promoting Software Exports

UNICA Brazilian Sugarcane Industry Association

CVM Comissao de Valores Mobiliarios – the securities and exchange commission of Brazil

GVcepe Centre for Private Equity and Venture Capital Research at FGV-EAESP


4: BIBLIOGRAPHY

1. ICAEW Corporate Finance Faculty – Private Equity Demystified. An explanatory guide. Second edition.

2. BVCA – A Guide to Private Equity.

3. Cleantech magazine. Volume 4. Edition 2. Article. An ethanol economy. Brazil: a biofuel success story.

4. EMPEA/Coller Capital Emerging Markets Private Equity Survey – 2010.

5. Coller Capital Global Private Equity Barometer Winter 2009-10.

6. FGV GVcepe Overview of The Brazilian Private Equity and Venture Capital Industry research report. December 2008.

7. LAVCA 2010 Scorecard.

8. Chazen Society Fellow Interest Paper – Equity International’s Real Estate Investments in Brazil.

9. Highlights of Brazil – An overview of Brazil’s performance during the 2008/2009 international financial crisis.

10. ABVCAP Monitor Group – Private Equity and Venture Capital Analysis of Brazilian Industry.

11. Deloitte. Latin American Private Equity Confidence Survey. Full Steam Ahead! (January 2010).

12. Baker & McKenzie – Private Equity in Brazil – November 2008 paper.

13. Life science industry in Brazil – Fundacao Biominas.

14. Ocroma Alternative Investments – Private Equity Update, Fundraising Report – Brazil, Leonardo L. Ribeiro, 12/2008.

15. The Challenges and Opportunities for Financial Services in Brazil. City of London in association with Trusted Sources Research and Networks.

16. London Stock Exchange – a guide to capital markets – your route to the heart of global finance.

17. Ocroma Alternative Investments – Private Equity Update, Rising Star: Brazilian Private Equity after the crisis, Ricardo Kanitz and Leonardo L.Ribeiro, 6/2010.

5: ACKNOWLEDGMENTS

UKTI would like to thank the following organisations for their help and assistance in respect of this report:

— British Venture Capital Association

— CFS Capital Partners

— Ocroma Alternative Investments

— Stratus Group

— Tozzini Freire


UK Trade & Investment – Private Equity and Venture Capital in Brazil

A range of UK Government support is available from a portfolio of initiatives called Solutions for Business. The “solutions” are available to qualifying businesses, and cover everything from investment and grants through to specialist advice, collaborations and partnerships.

UK Trade & Investment is the government department that helps UK-based companies succeed in the global economy, and is responsible for the delivery of the two SfB products “Developing Your International Trade Potential” and “Accessing International Markets”.

We also help overseas companies bring their high-quality investment to the UK’s economy – acknowledged as Europe’s best place from which to succeed in global business.

UK Trade & Investment offers expertise and contacts through its extensive network of specialists in the UK, and in British embassies and other diplomatic offices around the world. We provide companies with the tools they require to be competitive on the world stage.

For further information please visit www.ukti.gov.uk or telephone +44 (0)20 7215 8000.

Whereas every effort has been made to ensure that the information given in this document is accurate, neither UK Trade & Investment nor its parent Departments (the Department for Business, Innovation and Skills, and the Foreign and Commonwealth Office) accept liability for any errors, omissions or misleading statements, and no warranty is given or responsibility accepted as to the standing of any individual, firm, company or other organisation mentioned.

The paper in this document is made from 50 per cent recycled waste pulp with 50 per cent pulp from well-managed forests. This is a combination of Totally Chlorine Free and Elemental Chlorine Free. The inks are vegetable oil-based and contain resins from plants/trees.

Published September 2010 by UK Trade & Investment © Crown Copyright

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