May 1, 2012
Interviewed by: David Snow
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Doing Deals in Brazil

Brazil has one of the world’s largest economies, with a vast number of middle-market companies. Meet three general partners who have spent years transacting in this underpenetrated space.

In a conversation with Privcap CEO David Snow, Tim Formuziewich of Brookfield Brazil Capital Partners; Nicolas Wollack of Axxon Group Private Equity; and Cristiano Bocciar of Graycliff Partners Latin America describe what’s unique about doing deals in the Brazilian middle market in the first of three parts.

Topics include the need to proactively source deals and how succession and interpersonal issues often lead to opportunities.

Brazil has one of the world’s largest economies, with a vast number of middle-market companies. Meet three general partners who have spent years transacting in this underpenetrated space.

In a conversation with Privcap CEO David Snow, Tim Formuziewich of Brookfield Brazil Capital Partners; Nicolas Wollack of Axxon Group Private Equity; and Cristiano Bocciar of Graycliff Partners Latin America describe what’s unique about doing deals in the Brazilian middle market in the first of three parts.

Topics include the need to proactively source deals and how succession and interpersonal issues often lead to opportunities.

David Snow, Privcap: We are joined today by Tim Formuziewich of Brookfield Brazil Capital Partners, Nick Wollack of Axxon Group Private Equity, and Cristiano Boccia of Graycliff Partners, Latin America. Gentlemen, welcome to Privcap. Thank you for joining me today.

We’re talking about Brazil’s middle market. It’s a big topic. But specifically, I’d like to talk about doing deals. All you have done deals, and will do deals.  So I’m fascinated to get your insights about what it’s like compared possibly to other markets.

So, first of all, let’s start with a topic that your investors probably always ask you about first. M aybe we could start with Tim. Investors want to know about your deal flow. Where do you get it? What are the motivations of the sellers?

As someone who’s been investing in the middle market for a while now in Brazil, what does your deal flow look like today? Where is it coming from?

Tim Formuziewich, Brookfield Brazil Capital Partners: That’s a great question. First, I’d say that the deal flow in any organization is blood, sweat, and tears. You need to go out and you need proprietarily source transactions.

What we tend to do is we tend to utilize the platform that we have in Brazil today. We try and look at sourcing proprietary deal flow. Again, that means we have five offices in the country. We already have investments in 10 States, 7,000 employees.

So, we try and go out and utilize that platform as best we can to try and find unique deal flow in various regions. We also like to talk to our portfolio investments about the issues and challenges that they’re having, whether it’s on the supply side or it’s on the client side of their businesses, to find out what would be an exciting value proposition for them. How their supply chain could be improved. Which suppliers they have in their businesses that they think very highly of. Then, go out and speak with those businesses.

We also have a process where we create, effectively, investment theses. We go proactively meet and engage contacts and targets in those markets by picking up the phone, having a conversation.

We are, I would say, lucky in the sense that we can use the Brookfield banner in having that conversation. It’s a name that they’ll have known and recognized. We typically get the meetings that we want and narrow that target down from maybe a mapping of 20 companies to two partner targets of three to four and acquisition targets of a five or 10.

Snow: Nick, can you talk a bit about how your firm, Axxon, sources its deals?

Nick Wollack, Axxon Group Private Equity: Well, I was going to say that it sounds like Tim has a much more thoughtful process than we do in terms of origination. I think our approach is much more opportunistic, for better or for worse. What we find, again, in this segment of the market– and I don’t know if it’s 15,000 companies, 20,000 companies. But it’s just a very broad universe of companies spread all over the country.

It really is very difficult to have or to expect to have relationships with even a meaningful number of these companies. So we work mostly through a network of advisers that we’ve built over the past– we’ve been here in Brazil doing exactly this small and midcap investing, principally controlled situations and we’ve done that for almost 12 years now.

We’ve built over that period of time a network of advisers. Which is certainly not proprietary, but there’s about 150 of them across the country, which may be small boutique investment banks, some tax advisers, business consultants, accountants, lawyers, what have you. These are people that refer the opportunities that they become aware of. They refer them to us.

One of the reasons that we’ve always focused more on this opportunistic approach as opposed to the more thoughtful approach is that we’ve tended to find that in the end, we’re a small firm, so we prefer dedicating our resources when a real opportunity has come to us, and it’s already been sourced, in effect, by one of these advisers.

There’s something going on. They want to have a conversation. They’re bringing a possible opportunity to us, as opposed to convincing a potential sell that there’s something that could be done. Again, it’s not to say that there’s not a lot of merit to that. But for our modus operandi, we’ve just found this opportunistic approach more effective for us.

Snow: How about your firm, Cristiano? What is maybe different from the way that you source opportunities? Or similar?

Cristiano Boccia, Graycliff Capital Partners: Sure. It’s similar to Nick’s. I think the lower you go in the middle market, the more bottoms up you need to be. The more opportunistic you need to be. It’s just too vast. The deal finders, the advisers, are not the usual suspects.

It’s very spread out. It’s very regional. So the way that we do it is we have a network of operating partners or one man show investment banking boutiques that have a relationship in a specific industry or in a specific region that try to find the right partner for us.

We prefer to back a person than a company. So we tend to be a bottoms up finding the right partner, the right person, to be our back investor together with those in that company, and then take the company to the next level. We also have the benefit of leveraging on the HSBC network from being a spin-off from HSBC, which is a unique venue also to our deal sourcing.

Snow: Are you finding that intermediaries are becoming more involved in private equity deal flow? Are you seeing more than, not withstanding the one man shows that you might find in smaller deals, is there more institutional types of groups that are getting and referring deals to you?

Wollack: Oh, for sure. I mean, I think we are now seeing in at least at the major investment banks here in Brazil, some of them, I don’t know if all of them, actually have a financial sponsor group or another managing director who will be responsible for maintaining a relationship with the GPs in Brazil. So I think that’s pretty new. It’s only two or three years ago. I don’t think that–

Snow: Sure. Even a smaller group such as yours, or rather a group targeting smaller deals, is now being contacted by these bigger named investment banks?

Wollack: Sure. I mean, obviously, they know what we’re looking for. So they’re not going to bring to us a situation where it’s going to require a $500 million equity investment. That’s not going to be for us. But I think they understand what we’re looking for.

They also know that we might be interested in doing something with them at time of exit, when we’ve hopefully created value, built up a business to the point where it might be an IPO candidate or a more significant M&A mandate for them. So they’re interested in having a two way flow to develop a relationship with groups such as us, we think.

Formuziewich: And intermediaries can play a positive role at times.

In one situation, what we did is we, throughout our process of mapping and targeting and looking for partners, we created a transaction where we were able to acquire a business at quite a low value. But then, we presented it to the partner that we wanted to partner with. Obviously, that partner wasn’t going to accept selling his business at the value that we were acquiring the target at.

In that case, an intermediary came in to support the value that we thought his business was worth to give him the confidence that we were being fair.

Boccia: I think on the intermediary side, they tend to be more educational in helping the founder or the family understand how private equity works. And it’s helpful. It’s actually helpful for us. It makes the deal easier to get implemented. It helps us dealing with the founders.

It’s less on the process. So you shouldn’t expect when you go to the middle market or the low end of the middle market, that you’re going to have all the process organized, then the intermediary is going to give you a data room and everything is done. But they do help on making sure that the communication, understanding how private equity investors think, is on the table and it’s laid out clearly.

Snow: Nick, you mentioned something about how it’s more often that when a deal comes to you, there’s been a decision by the, whether it’s entrepreneur or the owner, that they should be having a conversation with private equity as opposed to you knocking on their door and saying, “Hi, would you like some private equity?” So, if that’s the case, what are some of the reasons why these middle market business owners are seeing the need for capital for a partnership?

Wollack: I think there are multiple reasons. First of all, you have to do the traditional succession issues. Many businesses are second, third generation. So you get the typical succession issues that you find everywhere in the world for these types of companies. So that’s one part of the situation.

Another situation, which we see quite commonly, is actually misunderstandings or even conflicts between family shareholders–

Snow: So you’re like a psychologist.

Wollack: My wife often tells me that my job has nothing to do with finance. It has everything to do with psychology and I now deeply regret having given so little attention to psychology when I was in college. But it is a very important part of this business, I think, in our segment of the market.

So these are sort of, let’s say, some variables. Other variables, more business-wise, you have companies that now find that the environment is changing, so they have other growth opportunities that they need to see how to capitalize on, where they see potential to create value in their business.

They need capital and/or management to do. I think many times, many of these family companies actually recognize that it’s not only capital that they need, but also management. So they have this understanding that private equity or some private equity groups can bring both this capital and management.

You have competitive pressures with multinational companies are becoming much more aggressive in Brazil now than they used to be 10 years ago. Ten years ago for a multinational to come into Brazil was an opportunistic buy. If you were in the right situation with the right clients, maybe you’ll do it.

Today, Brazil is a must-be country for the vast majority of the multinational. Local corporates who have now greater access to capital also have much greater flexibility to make acquisitions. So all this starts changing the dynamics of competition within certain sectors. I think all of these factors are bringing some of these families to consider private equity.

Boccia: There is one major challenge when we’re looking in the low end of the middle market, which is, most of those companies are still very dependent on the founder. The founder is still a very important person running the day to day of that business.

So I agree with both Tim and Nick. We have, though, a preference of doing a cash-in transaction and finding those partners that are saying, look, I’m not interested in cashing out now. I’m interested in growing my business and selling it in a couple years now with you. I need the help in making sure that I can capture the most value throughout the way with the appropriate help getting the company ready.

Part of that is working on succession. Making sure that the company can go to the next buy area, either strategic or private equity fund, and less dependent on that person. But it is a challenge of dealing with that dependency on the founder the smaller you go on the size of the company.

Snow: I’d like to talk about due diligence. Before you buy a company, you have to come to a mutual understanding about what the company looks like. Maybe you could imagine a US GP flying to Brazil and trying to do a deal, which probably is not recommended anyway.

But they come here. They try to do a deal. What do you think they would find rather surprising or interesting about the due diligence process in your end of the market? I don’t know. Maybe Nick, what would impress them.

Wollack: What would impress? I’m not sure I have the right frame of reference. Because I don’t know what exactly the scene looks like there in the US. But I think you still have in this segment the market books that, even though they’re in better shape than they were five or 10 years ago, as Cristiano was mentioning in an earlier answer, they’re still very often quite confusing.

So there’s, typically they say, the accounting reconciliation. But not just in an accounting standpoint, but in terms of understanding really what drives the economic value and the profitability of business. That typically requires quite a bit of work.

Secondly, you are going to run into all these legal and tax issues, which in Brazil are frankly very, very complex. I think that the ability to do deals in Brazil in this segment certainly in part has to do with an ability to make judgments on what is the true liabilities that you’re faced with. Obviously, at least on our side, we certainly never look to assume the risk of contingent liability.

We always try to get the right guarantees and escrows, et cetera. But your ability to provide to the right dimension to the problem can make or break a negotiation basically. So that’s always a tricky subject.

Snow: Thoughts on due diligence?

Boccia: It takes a long time. It’s not a formal organized process. It’s very inefficient. Which is what I like. It creates this barrier to entry in why the middle market has got better pricing, got better deals. It can take up to a year.

Companies are not ready. So you need to do the due diligence, like four hands. You help the company to put the information together. As Nick said, even putting the books together. You need to make sure that you understand accounting and get deep into it. You don’t expect to get all your work done.

In reality, our most scarce resource is time. So when you’re getting to this due diligence process, you need to be able to understand quickly what the deal breakers are. Most of it is actually done, is still based on trust. It’s amazing how much you find over dinner and over wine rather while they’re doing the due diligence process.

You need to ask the right questions. Make sure you get the right level of comfort with the founder that you understand what the key issues are right in the beginning of the process.

The second thing is, most of those companies don’t have enough horsepower. They don’t have a lot of people that you can put into a due diligence task force to prepare all the information that you want. So you need to be mindful that you need to help, and even careful not to disrupt the business that you’re going to end up owning together with that person. So it’s long. You need to be patient and tactful in how you do it.

Snow: It sounds like you’re recommending mixing wine with due diligence. Is that a good strategy?

Boccia: No, it’s a lot based on trust. I think you’re doing deals– and I think it’s everywhere in the world. It’s not only in Brazil. Particularly when we’re teaming up with someone. And that’s why pricing is also not the decisive factor.

You are doing a deal with someone wants to bring you as part of their family and their business. So it does take a certain level of trust building. It’s an important exercise. It’s hard to do it remotely.

Snow: Does the length of time required for due diligence also extend into just getting the deal done? So, once there’s an agreement, a letter of intent, yes, we’re going to be doing this deal, how hard is it to just seal the deal? Does that take time?

Formuziewich: Yeah. It takes a lot of time. It takes more time in Brazil than it does, say for example, in Canada or the United States for us. There’s a combination of factors of which a number of them that we just described.

But I think the biggest one is trust. It’s building that trust. Once you have built that trust, you have that shared alignment of interest, and your due diligence process is always painful, but manageable. You have your tax and labor issues that you have to deal with that are relatively unique in most cases here.

But the due diligence process as part of the transaction process overall is actually a great way to address some of the issues that Cristiano mentioned earlier in terms of a one man show or lack of a plan for moving people into more senior roles. You actually go into the company and potentially source human capital that maybe wasn’t recognized by the current leadership.

Wollack: Showing trust is, of course, an essential component of the equation. But I think in many ways, it goes beyond that insofar as when you look at these companies, many times, the owners or whoever’s running the company is not necessarily fully aware of the opportunity he has.

He’s doesn’t necessarily fully understand what his business is all about in terms of the top line, and even to cost, how to maximize the opportunity on the revenue front, and how to minimize the cost on the cost side.

So I think that understanding– when you have these situations where you have companies where the books are not necessarily sufficiently organized for you to be able to make quick judgments on that, you have maybe a second or third generation founder. Or even if it’s a first generation founder who may have been a great entrepreneur, but not as great a manager, understanding where the opportunity, where the value of the creation of opportunity is, is a process that takes time.

Snow: Very briefly. I’ve heard people talk about  the level of debt available for private equity deals in Brazil is simply not what it is in other more developed markets. How much of a role, or to what extent does debt play a role in the Brazilian middle market for doing deals?

Formuziewich: In our experience, historically in the United States or Canada, there may have been more of a focus on debt, because that’s where the bulk of the value was being created. But I don’t think that that’s the opportunity here in Brazil.

Our strategy– I’ll let my colleagues here speak to theirs– but our strategy is not debt focused. Having said that, we think that there’s a lot of opportunity to create value by either reducing financing costs in some of the businesses that are currently operating in the mid-market. Or conversely, by taking businesses that may be under-leveraged and getting them access to cheap financing that is available in the market.

The last time I read the statistic, it was 36% of all of the total debt in Brazil was actually subsidized. If you can access some of those financing lines, you’re actually doing really, really well from a return on equity prospective.

Wallack: It’s very appropriate. The other thing I add is that something to find the acquisition financing to fund an acquisition or an investment on our part, in our similar market, would be unusual. Even though, then when you move to slightly larger companies, I think that’s becoming more available in Brazil. And perhaps some time in the medium term, that will also become an option for us.

But what we have done at times, I wouldn’t say as a substitute, but as way to deal with those types of issues when they arose, was to use seller financing mechanisms with the sellers, or contingent payments that are not related, et cetera. So you have other ways of achieving that type of similar financial benefit that can provide in different ways and forms.

Boccia: Yeah. It’s the same experience that we had. I think in terms of leverage, the amount that we see in the low end of the middle market is like, two times, three times max. It’s usually your non-acquisition finances like working capital lines or some long-term financing for CAPEX.

But it’s very limited. So, it’s something that at least keeps price dynamics a little bit more reasonable. There’s no leverage available for acquisitions in our part of the world.

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