January 1, 2012
Interviewed by: David Snow
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Convergence in Brazil

Alvaro Goncalves, Founding Partner and CEO of São Paulo-based Stratus Group, gives a commanding overview of the Brazilian private equity market and its key opportunities and challenges going forward.

We discuss why lack of information about Brazilian private equity remains a core challenge; why the “capital-market lens” is not the best way to understand the Brazilian private equity opportunity; why it’s “very good news” that big international firms and new GPs are joining the competitive fray; why there’s “an ocean of companies…untouched” by private equity in Brazil; why sustainable energy is Brazil’s “convergence of the century”; and why a shortage of talent keeps Goncalves up at night.

Alvaro Goncalves, Founding Partner and CEO of São Paulo-based Stratus Group, gives a commanding overview of the Brazilian private equity market and its key opportunities and challenges going forward.

We discuss why lack of information about Brazilian private equity remains a core challenge; why the “capital-market lens” is not the best way to understand the Brazilian private equity opportunity; why it’s “very good news” that big international firms and new GPs are joining the competitive fray; why there’s “an ocean of companies…untouched” by private equity in Brazil; why sustainable energy is Brazil’s “convergence of the century”; and why a shortage of talent keeps Goncalves up at night.

David Snow, Privcap: Clearly, private equity in Brazil has gone from not very popular as recently as five years ago, to all the major firms are opening offices there; international investors are creating allocations for Brazil. That’s good news, but what are some high-class problems that Brazil and your private equity market in Brazil have faced as a result of this surge in popularity?

Alvaro Goncalves, Stratus Group: Well, I think the first thing that came up when this wave of interest in Brazil peaked over the last three years or so is the lack of information.  So at the end of the day, at this particular moment, what’s going on there is really a match of information.  People are getting to know [Brazil]. Everyone is interested in the Brazil story, but people are still mapping the market. So, I think that’s the big gap that we identify as we deal more with international investors and global investors coming up.

On the Brazil side, to organize information in a better way and also disclose information in a more structured way, and from the international investors to get closer and to actually go to the fundamentals, not only to the headlines, to really understand what’s going on and who is making it and who is not making it. So, there is still a lot of misperceptions about the way it goes and the way it doesn’t go. There’s still the average thinking, so people think of Brazil as an index, people think Brazil is an average.  Brazil is a complex, dynamic economy.  t’s very diverse, it’s very large, and if you go for averages you may miss the point.

Snow: As recently as five years ago, ten years, five years ago, international investors went from not wanting any information about Brazil to, as you say, now they want more information. But what specific kinds of information do they really want? What are they asking you for?

Goncalves: I would say in general – because most people looked at Brazil through the capital markets lens, and the capital markets in Brazil is not approximate to Brazilian economy, so we don’t have many lists of companies in Brazil.  We have a huge volume because we have strong companies listed there, like Petrobras and Vale.  Brazil is a very concentrated market with not many companies listed, so if you take the index lens and you take only the information that is around those companies that are listed, you clearly don’t understand some segments that Brazil is powerful; some companies that are completely unknown by the capital markets.

So, I think that’s the major fact that investors rely perhaps too much on the investment banking type research through the lens of capital markets and now they realize that Brazil is much broader than that.  Both of the capital markets’ catching up, but also the investors need to do something with other lens. I think private equity has a role in that, but not only private equity, I would say even the corporate, the whole business wave that is going through Brazil these days. We see that very basic information on demographics on the state dynamics because Brazil is 26 states, so you go from one to another you may find very specific drivers in each one, and depending on the business you are in that may effect what your expectations should be.

I think understanding the dynamics, the regions, the competitive advantages, the competitive disadvantage is something that no one in the global perspective has ever come through a greater degree of details or one degree down in terms of being closer to the action except for capital markets.  Now it’s that process as it goes on.

Snow: Your firm Stratus Investimentos has been investing in Brazil for quite a long time.  Now there’s, as you know, many international firms coming in, there’s been the creation of new local firms.  What has this increase in supply of capital meant for your business?  How are you continuing to stay competitive as an investor in Brazil?

Goncalves: Well, I think it’s very good news that not only the international players, international general partners, the fund managers are coming, but also international investors are coming to also pick local managers.  So, I think we have very good conditions for both to interact in a very positive way for providing returns to investors because the investment environment is very positive these days.  Also, for us to have the best of an improved market with this influence of continual players that are coming, so I think it’s all positive, but still there is an ocean of companies that are completely untouched.  So, there’s still very long or big room for players to come and join us as most of Brazil’s sectors, private equities, also creating its own bottlenecks.

So clearly, the wave of people coming up until now, or money coming up until now is still retained in the top, so only the big transactions, the big buy out plays are actually collecting 90 percent of the capital, so I would say the movement of capital towards Brazil up until now is not so organized. It creates voids and bottlenecks, so mid-market, for instance, is basically underserved. It has a completely different dynamic in terms of flow and competition compared to what is going on in the large buyout game. So, I think that will be leveled off at some point in time, but I would say it’s still in a process that is not organized, so a lot of opportunities, you have to be very selective, and very fundamental because this is a long-term play.

You can’t make decisions based on yesterday’s trend or something like that.

Snow: Well, as you mentioned, Brazil has a huge population of medium sized and small private companies. How has the perception of private equity changed among those business owners over the years, and what has that meant for your ability to do deals?

Goncalves: Well, it has improved significantly. The big challenge wasn’t the fact that they had a negative perception, but they had no perception. They had no information about it. So, we still have to be explaining to them what it takes. So, our relationship with a company that invests, on average, starts a year, a year and a half before. It’s not just an informal relationship. We establish some aspects that we tell them are not ready yet for private equity investment, but if they do this, this, and that, eventually you’re going to consider for investing. And because the market is also competitive, they actually take that advice, they come and give us updates once in a while, and we actually invest at a certain point.

So, it has happened this way three or four times for us and I see that even the newcomer and international player is also taking that approach to mid-market as well. So, I would say it’s a relationship market in the mid-market, so these companies in the mid-market are not typically advised by an investment bank so it’s not an auction type most of the time. It’s a different thing. It’s the owner talking to its possible potential financial partner, so it requires dating before marrying, it requires letting him know what it takes, and usually the advice he goes and gets is more the auditing advice, it’s more making sure that his kitchen is ready. That’s the process that goes on.

The consequence of that for private equity players, at first, takes longer for you to have a flow.  So, you don’t start there and start investing tomorrow for a mid-market. If we’re in a large buyout, you might have five deals on our table in one day there, right, but they are going to be competitive, they’re all going to be auction type, they’re all going to be investment banking advice type of game. So, it’s a completely different dynamic, and I think that’s also good about what’s going on there because I think both sides are positive and the evolution of that, I can’t think of anything that is not positive.

Snow: Brazil has a very substantial renewable energy sector, and at the same time investors around the world are increasingly interested in sustainable strategies and sustainable energy companies.  Is that an overlap that is benefiting your firm?

Goncalves: I think this is, to me, the convergence of the century for Brazil.  That’s the greatest opportunity not only for the clean economy oriented businesses, but for any business in general, I think the awareness of sustainability, the environmental aspects, the social and governance issues is starting from a very, I would say, a comparatively higher degree than I would expect in other places.  So I think a typical business player in Brazil, even if it’s not a company from the renewal side or so, they come with an awareness and a level of attitude towards sustainability that’s comparatively much better than 20 years ago. So, I think that convergence is probably going to be the number one thing that makes the different in Brazil in ten years’ time.

Snow: Will your firm benefit because you’ll be investing in companies that provide sustainable technologies that engage in sustainable activities?

Goncalves: Well, we do have a working tech platform that does that as a main strategy, so we pick and choose and invest in companies that are on the edge of their own segments related to those technologies. But on the other hand, I think even a typical business sense, for example, we’re just about to announce a new deal that is actually an service related to logistics in general, but the management team, when they presented it to us the first time, among the few ideas that they had they had ideas of how to make their fleet more sustainable, how to make the use of the fleet more environmentally friendly.  We didn’t ask anything, so it came from them.

So naturally, it’s coming from the companies that are not in the typical energy sector, ideas of improving their own business in a way that they cause a better impact. So, I think that’s coming, kind of mushrooming in Brazil. It’s a silent evolution, but it is a good convergence between the whole hype of Brazil and the economy, the growth, the fundamentals, et cetera, together with a sustainable attitude.

Snow: As people look at the Brazilian economy today, most people are struck that it has made it through the financial crisis relatively unscathed, or at least it’s had some natural advantages that has allowed it to not be as directly affected, but what do you see as some key challenges going forward that will make your job a lot harder?

Goncalves: Well, I think that there are a few elements that, at times, keep us awake at night. The thing is, some investors are concerned about challenges of the past. The challenges of the past, most of them are solved. Most of them are economic fundamentals, inflation aspects. Although inflation is always a challenge to be managed, it’s not a critical management thing these days in Brazil. But, I do recognize that because of the growth, because of the whole dynamic and demographic of the society, and also some failures in the past, some problems in the past, we have not invested in education on time to get this wave now.

So, shortage of talent is, to me, the biggest issue of Brazil going forward, so we need to play catch-up in education severely, and also it’s a place where people – there’s no way to continue to do Brazil without importing talent, so I think Brazil is going to get, and is already getting, more internationalized. Every firm is getting internationalized. Every team in every level is getting people from the neighborhood, Latin Americans, and from many other places in the world.  So, it’s nice to see that happening, but I think that there’s more to happen to actually circumvent that bottleneck. That is the number one.

Then, infrastructure is a big issue that actually undermines the ability of businesses to go further in many occasions. The combination of infrastructure and high interest rates, if we need to invest in infrastructure in a high interest rate scenario, it’s very difficult to get it done. So, I think we need interest rates to go down to allow infrastructure to improve. In that order. And I think those are the two things that I think are the things to consider when you see a business plan, when you have a plan to Brazil.  Consider that finding talent may be more difficult than you would think, and infrastructure may be an extra cost in your line of business that you perhaps wouldn’t consider in other places, or at least wouldn’t consider in that level. So, those challenges, I think, are worth considering.  In the whole positive environment around, we do have bottlenecks.

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