July 1, 2012
Interviewed by: David Snow
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Change and Exits in Brazil

Some 95% of Brazilian companies in the mid-market are family-owned, passed down from one generation to the next, leading to little world-class corporate governance.

“Change and Exits in Brazil: Innovation and Private Equity in Corporate Brazil” is Part 3 in Privcap’s discussion series featuring Marcos Marinho Lutz of Cosan, Christopher Meyn of Gavea Investimentos, and Carlos Asciutti of EY Terco in Brazil. The experts discuss the types of corporate governance most needed in the market. The video includes an expert Q&A with Asciutti.

Some 95% of Brazilian companies in the mid-market are family-owned, passed down from one generation to the next, leading to little world-class corporate governance.

“Change and Exits in Brazil: Innovation and Private Equity in Corporate Brazil” is Part 3 in Privcap’s discussion series featuring Marcos Marinho Lutz of Cosan, Christopher Meyn of Gavea Investimentos, and Carlos Asciutti of EY Terco in Brazil. The experts discuss the types of corporate governance most needed in the market. The video includes an expert Q&A with Asciutti.

David Snow, Privcap: We’re joined today by Carlos Asciutti, from EY, Marcos Lutz, from Cosan, and Christopher Meyn from Gavea Investimentos.

Gentlemen, welcome to Privcap today. We’re talking all about driving growth in Brazil. And specifically, I’m interested in your experiences about what works in productivity gained and transforming cultures and transforming business prospects within the companies that you’ve been involved in.

Carlos, since you see across the corporate landscape in Brazil, can you talk about the importance of corporate governance in driving change? What kinds of companies are in need of it? And going from the smallest companies to the largest corporations, where are there issues that need to be addressed most importantly?

Carlos Asciutti, EY: If you look at the screen you have probably the companies that are more close to the IPO and have corporate governance already and have audited financials and have all the reporting skills. On the other side, you have companies that are family-owned, never reported to anyone. They don’t even have accounting records. They have their management controls done on a cash basis and don’t even understand what accounting is or how to report. And there’s no advisory board in the company.  It’s just a family.

And 95% of the businesses in Brazil up to a level of $200 million are family-owned by one member or two members of the same family, which makes it very difficult for a company to grow or to think about growing and getting more permanent capital in the market without understanding what it is to be a corporate governance company. So there’s a lot of opportunities there for PEs looking forward to bring this corporate governance understanding and the culture to the company, even private company going to any public market to get any sort of capital.

So that is a major issue in Brazil, is this cultural change, because in these companies, these families have been owning the business for decades, sometimes centuries. So they don’t understand. Why do we need a partner? Why does the partner need all this information? They think it’s a matter of trust, rather than just being accountable for the market. So it’s a very difficult issue in the middle market in Brazil.

Snow: Chris, as someone who assesses and vets a lot of different opportunities, as you look across all of the both private and maybe even some public opportunities to invest, what kinds or what forms of corporate governance are most needed? Where do you see a biggest deficiency that your firm can help address?

Christopher Meyn, Gavea Investimentos: I think a lot of it’s been mentioned. I’ll maybe go a little more specific. First, there’s sort of a common considered correlation between poor governance and family-owned businesses. I don’t quite see it that way. I think there’s no issue with a business being family-owned.

In fact, in many cases, the passion and heart of most successful businesses have come from the founders and from the controlling shareholders in many ways. And where private equity really can be of help is how to manage that transition and not stay inward-looking, how to select the right and best management for a company rather than default to family if that’s not the most qualified manager. Now, that’s just simply core governance of separation of management, professional management, and shareholders. That doesn’t change in a public company or a private company. That’s where a lot of the work in base corporate governance is happening right now in Brazil, is to get companies to have that comfort, trust, and belief of separating professional management from the shareholding aspect.

And then the rest, I think, is there is a lot to learn. And that goes beyond governance. I think it goes almost to the core of finance, which is there are more and more accessible tools, let’s say, in the toolbox for financial chiefs and for owners to access. And there’s not a lot of experience with those tools.

This is a high interest rate, historically closed debt environment, that has been a killer of businesses in high inflation environments in volatile currency cycles, mismatching cash flows with the wrong currency of debt. There’s a hangover of these cultural issues that creates, I think, inefficient balance sheets. So how can a company start to feel comfortable utilizing new tools, having an improved capital structure, and that confidence to use capital to grow and attack new business opportunities?

In a lot of ways it sounds like holding hands or being a babysitter, but it’s not. It’s to give that partner, through private equity, that comfort, trust, and platform to make those new decisions and teach them a bit of why that’s a good idea. It’s baby steps, but it’s the most important part to accelerate productivity and innovation in the country right now.

Snow: I want to talk a bit about moving towards an IPO, but before we get there I’d like to talk about the need to become more international. Clearly, the Brazilian market, the domestic market is a huge one and it continues to grow as the Brazilian consumer continues to have more buying power. But a lot of Brazilian companies are at a stage where in order for them to make it to the next level, they need to become more internationally active.

So what are the challenges of that? And how can private equity firms help to globalize the operations of some of these firms? Maybe starting with Carlos?

Asciutti: This is a new venture. 20 years ago, you would not have any Brazilian multinational companies. Probably in the last 10 years, you’ve seen some companies in certain industries going first to the region, to Latin America. Very few going to Europe or the US. Now with the economic problems in the US and Europe, and some of the Brazilian companies with the decreasing interest rates in Brazil, having some more suitable capital in Brazil, it will probably start room for these companies to look at the US and Europe.

But it will still be certain industries. I think they’re going to go to Latin America first and have that understanding before they go to any of the more mature economies. There is some movement between emerging to emerging, like Brazil going to China, Brazil going to South Africa, Brazil going to India, probably more than you see Brazil going to more mature economies. And I’m sure all of this business, that the PE is playing a big role, saying, let’s look at Brazil. But let’s not take the rest of the world outside of the equation, because there might be room for us to go into these places.

Snow: Marcos, to what extent is there international complexity to your business? Are you just moving sugar to the docks and then your job is done, or are you increasingly finding yourself coordinating with overseas entities?

Marcos Marinho Lutz, Cosan: Cosan is today a big exporter, so we started a long time accessing international markets as an exporter. But we also have trading operations abroad. More recently, we expanded our finished lubricant operations and we bought an entity in the UK. So we are exporting to 43 countries out of the UK. We are finalizing this deal, still in the transition process.

So Cosan is becoming more and more international.  But I think there’s not a specific need for being international. This is a matter of opportunities. Sometimes you develop scale and skills in Brazil that can be applied profitably outside. So I think that’s more the driver.

And obviously the market. Sometimes, as I mentioned in sugar, sugar is 80% exported. And Brazil corresponds about 50% of the world exports of EHP, which is the bulk sugar raw material.

Snow: Chris, to what extent are that companies that you invest in looking to establish more international businesses. Is it really mostly just gearing up for a greater domestic opportunity?

Meyn: To the most part, yes. I mean, I think first, let’s be honest, you mentioned it’s a large country. We’re in a very positive long term cycle. The wealth creation that can be accomplished, the gains that can be accomplished by domestic business are significant and sustainable for an entire private equity industry and local capital markets.

Why would you go international? For the only reason that you should, which is to have either a product or a productivity advantage– which I think outside of commodities and certain industries that have had a long term history of, let’s say, productive or product leaders, steel, iron ore, this agricultural commodities, and certain brands, but very limited brands. So you start to look at what real need is there outside of some of these core export-related commodities to be international?

And I think that’s where some mistakes are in fact being made. Using cost and pricing as a belief of a good deal, it’s so cheap to buy something now in the US or Europe that it just makes sense to be international. It doesn’t really have core sense if there’s not a product or productivity advantage. So we don’t feel stressed at all in our portfolio to push companies either regionally or internationally if the product itself doesn’t makes sense.

Snow: Well, I mentioned IPOs earlier. A big part of productivity gains and corporate governance initiatives is getting a company ready to go public. Is it still seen as a prestigious or an important step for a growing Brazilian company to go public? And do they see private equity as being a partner to help them get there? Maybe starting with Carlos?

Asciutti: Very much so. Yes. Most of these companies at a certain level, if you’re an over $500 billion company, you’re going to look at an IPO. IPO in Brazil is still very expensive. So anything below 500 million is probably very difficult. So you’re looking at mostly larger corporations or larger Brazilian companies to go into IPO.

And IPO obviously as the way of the cost of the capital and being permanent source of capital, for certain businesses is very, very important. And only now in the last four or five years have they realized that the PE is probably a way of reducing the time that you need between going from family to IPO, whereas normally it would take in 15, 20 years. With some PEs, you can reduce that to 5, 7, 10 years.

So now some of these corporations are seeing the PE as a way of reducing the time and the cost of accessing more permanent public capital. So that’s pretty much the case that you have seen in Brazil. And having the positive and successful cases is what makes it even– obviously, you have the capital markets in the last two years not being very open for this. But if you look back in 2006, 2007, and 2008, 2006 and 2007, I would say about 120 IPOs in Brazil, one third of them backed by PE investors.

Meyn: 70%, 80% of the equity market is funded by foreign demand. And that should be the way it is for many, many years with the interest rate differentials we see on a global basis and the desire to have exposure to Brazil. There’s a lack of sector opportunity in Brazil for the foreign investor. So you need more companies in more sectors and more exposure to the actual Brazil story.

But when demand slows, due to a foreign crisis, due to currency volatility, due to any of the reasons that can make investor appetite slow down or even pause for a while, there’s no way to get companies public. So we’re a little bit hostage to foreign demand, which is a good thing, that Brazil is in demand and should be. But I think it’s less regulatory than it is simply the nature of where we are in our development and maturity phase for the public equity markets.

And I don’t know if companies see it as a charm or a premium. I think it’s all about affordable capital and public markets. When they’re right, they pay more, pay cheaper in private equity than debt markets than virtually anything.

Lutz: I think the public market attracts– in my perspective, there’s one big advantage on the public company versus private companies on attraction of management.

I think that this brings you a different let’s say league of management, which is quite important in Brazil at this point. And besides that, I don’t see valuation changing very much. We don’t see crazy multiples on the public side anymore.

So I would say, at this point, a good project will be probably better priced with a PE transaction then a public transaction. Because if you have a smart and able PE on the other side, you can really prove your thesis a lot easier than to the public world when the public world is skeptical about plans. So the single strong source, I would say, of good news on the public side will be how you attract your managers if you need them, if you need to grow the team or to hire people or retain people because you’re in a too hostile environment.

Snow: Chris, as you look maybe 5 to 10 years ahead at possible exit opportunities for your firm, how important is the public market? I mean, where do you see the demand for buying into the companies that you’ve invested in?

Meyn: I think it’s historically for us, and I think historically for the private equity market, it’s still a bit in favor of, say, trade sale or internally agreed formats for exiting. There’s still quite an active market here of controlling shareholders buying back stakes from private equity rather than go public or sell to a third party. That’s modifying and changing even in our own, say, last five year history at Gavea, we’ve been maybe more than half taking companies public it.

I think over 5 to 10 years it becomes a greater and greater proportion of your exit opportunity as more and more companies can access and are going to be willing to access and need to attract capital and need to attract good managers using options and the like. But I think it’s always been a very heavily and active trade sale market. So for us, we don’t look at public offerings being the only and primary source for us. But it’ll be an important source as we go forward.

Snow: Will IPOs places other than Brazil ever be an important exit avenue? Probably only for the largest–

Meyn: On a very, very limited basis there are some opportunities to take advantage of certain sectors, but not on the type of scale that Gavea tends to invest. If we were investing in smaller companies, we could look at other markets for either growth companies or mining and minerals in Canada. But really for very liquid larger businesses, we think the Brazilian capital markets are not only well structured and well regulated on an international scale, are deepening and will provide plenty of liquidity for the companies that we invest in. So we wouldn’t look to list outside of Brazil.

Snow: Carlos, what are your predictions for private equity exits over the next, let’s say, five years. We won’t hold you to them, but crystal ball, what are your predictions

Asciutti: There are many PEs right now with portfolio companies ready to go public, just waiting for the right timing to go. So I think looking forward, if we take the example of 2006 and 2007, of about a third of the IPOs being PE-backed, I would not be surprised if that would repeat again as the market reopens. Again, a lot of these companies are ready to go. It’s just a question of timing. And because they’re ready to go, imagine how the PEs are thirsty for having them gone.

Snow: Well, now that Brazil is the most popular economy in the world, with the foreign demand, and if that indeed drives the IPO market to a large extent then it sounds like there could be a wave of private-equity-backed IPOs coming up?

Asciutti: That’s what I would think. I don’t know if Marcos or Chris would say that.

Lutz: I think so. I would say when I started working, people would be finding ways to repatriate companies, really finding ways to bring companies that were Brazilian to have an excuse to not only list, but actually tell to the market that they were not Brazilian any more. I think today the opposite is happening. People are finding excuses to say the companies are Brazilian, and basically saying, this company is Brazilian because X% of the sales are here or X% of the management is here, because they have offices here.

So at this point, Brazilian commands almost a premium on the market versus other markets. And so this trend is now going. I would say Brazilian public markets are liquid, are well regulated. You have always the option of having a listing here and an ADR in New York, which gives you double enforcement on your regulatory side, because you have to comply with all the SEC rules and all the Brazilian Novo Mercado rules. So you have a big avenue here for those companies.

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