May 1, 2012
Interviewed by: David Snow
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Navigating Middle Brazil

How big, competitive and expensive is Brazil’s middle market? The second of a three-part series about Brazil’s middle market presents a macro perspective on this highly important private equity market.

In this segment, Tim Formuziewich of Brookfield Brazil Capital Partners; Nicolas Wollack of Axxon Group Private Equity; and Cristiano Boccia of Graycliff Partners Latin America share their perspectives as long-time participants in the middle market.

Topics include why so few middle-market companies have been taken public and why Brazil is similar to the U.S. in 1975.

How big, competitive and expensive is Brazil’s middle market? The second of a three-part series about Brazil’s middle market presents a macro perspective on this highly important private equity market.

In this segment, Tim Formuziewich of Brookfield Brazil Capital Partners; Nicolas Wollack of Axxon Group Private Equity; and Cristiano Boccia of Graycliff Partners Latin America share their perspectives as long-time participants in the middle market.

Topics include why so few middle-market companies have been taken public and why Brazil is similar to the U.S. in 1975.

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

We’re talking about a big topic. It’s the Brazilian middle market for private equity. It’s a vast and variegated opportunity. All of you are involved in different aspects of the middle market, so I’m going to be very interested to hear your perspectives on this opportunity, as will the international investors who want to learn more about it.

But why don’t we just start at a very high level. The first question can be for Nic. Why are so many of Brazil’s companies still private? Why is there such a big middle market and why aren’t more of them on the stock exchange?

Nicolas Wollack, Axxon Group Private Equity: I think there’s a number of reasons for that. First of all, the way we define the middle market and that’s the first part of your question. We’re talking about companies that to us have revenues of anywhere let’s say between $25 and $250 million in revenues. So these companies, even in the current market conditions, probably don’t have the right size and the critical mass to access the capital markets and to be publicly listed companies.

Notwithstanding that fact, if you go back five years and before that, there was no capital market, no public market to speak of, certainly for these types of companies, even for larger companies. Consequently, you find that most of these companies are still family-owned businesses. They may be at times subsidiaries or divisions of either domestic or multinational companies. But they’re by and large family-owned companies. We think there are about 20,000 of them. So that’s a pretty vast universe of companies. That’s our best estimate.

Snow: Is that your guess, Cristiano?

Boccia: Yes. I heard different numbers. It’s a large number no matter how you cut it. I think one interesting thing to add is it’s not only family-owned business. A bunch of businesses have been founded in the last 10 years that developed over the last growth that Brazil has had as a phase.

So we’re dealing with first-time generations. It’s a founder who is interested in teaming up with a private equity to be backed. So it’s a large group of those players.

Snow: Tim, how would you define middle market as you pursue your strategy?

Formuziewich: Well, if you looked at the definition of middle market in the United States, it would be something like between a $50 million and a $1 billion market cap. For us, we don’t look at it that way. We look at it and say, well, are these companies– similar to Nic– are these companies actually big enough to go out and access the public markets. And the answer is no. From our perspective, those are the companies that we look at, the larger middle market companies, not necessarily $5 million of EBITDA, up but a company that would be maybe $200 million worth of value.

When we ask the question, why are there so many companies that are private in Brazil, similar to what Nic had just described, the capital markets are sort of a new development for the most part here in Brazil. What has happened historically is that family companies have used their company as a way to invest, because there weren’t all that many investable alternatives. With the development of the capital markets here, now there’s investable alternatives for people to consider in selling their businesses and investing in other options, which is why you’re starting to see a number of these middle market companies consider selling whether it’s a portion of their business of their entire business.

Boccia: I think we can add one comment. I think the definition of middle market, when you ask private equity investors, is that it’s a commonplace. Most funds say, look, we play in the middle market. You need to look a little bit deeper to find where are you in that part of the middle market. As Tim mentioned, the definition’s actually very broad. And you need to look and say, OK, which part of it are you in?

I think in our case, we’re definitely on the low end of the middle market, which is the further you go into this side, the more family-owned businesses, the less sophisticated they are. We define it as, from a private equity context, on the size of the deal that we would do. So it would be doing an equity or a ticket size anywhere between $10 to $50 million reais.

So that’s on the low end of the market. And there are other funds also playing in the middle market, but on the high end. And the strategies and the way that you approach it is actually very different.

Snow: Well, if you compare Brazil’s middle market to the most mature market in the world in the United States, in the US, you commonly hear, oh, there’s too much capital chasing too few deals. I’m wondering if you believe that as more capital has come into the Brazilian market and as more GPs have been created to pursue what they defined as middle market deals, if it’s becoming much more competitive or is there still room to grow? Why don’t we start with maybe Nick?

Wollack: The trend is clearly for increasing competition in the market. There’s no escaping from that. But I think that’s a healthy trend that’s a sign of an evolving and growing and maturing market. So there’s not an issue there.

But again, if we look at this segment of the market– and as Cristiano was saying, the best number we have is 20,000. I don’t know if it’s 15,000 or 25,000. But it’s lots of companies. The number of groups, of private equity groups, of GPs that are active in this segment of the market, this small mid cap end of the market, is still a very limited number of companies.

I remember going on a road show in the US and talking to potential investors and talking about the landscape there in the US. And they were saying, in the middle market in the US, I think they talked about 50,000 companies. I can’t remember. But the number was just significantly larger here than in Brazil, for sure. But they were saying there are probably thousands of groups, GPs, looking to do deals in this so-called mid cap market in the US.

If you look here in Brazil, I don’t know exactly how many it is, but it’s still a very, very limited number of players. Then when you start segmenting by what exactly they’re looking to do– are they looking more for the $10 to $50 million reais, or is it more the $50 to $100 million reais? Are they looking more for minority? Are they looking for majority? Control, no control growth, et cetera.

You put all these different sectors, you put all these factors in the equation, I think in our experience we’re still finding that competition on the deals that we have looked at, as we speak now, remains very restricted. It’s a rare case when there’s more than a couple of groups such as ours looking at a situation. We’re normally able to move very quickly towards exclusivity when there’s a situation that attracts us and that we want to focus on. That’s been the dynamics we’ve seen. I’m not sure it’s going to change that quickly.

Snow: Cristiano, I saw you nodding. Is that what you’ve observed?

Boccia: Yes, it is. I think we’re in a good part of the market. You actually need to look into the stats here. You look at how much money was raised in Brazil last year, it’s a meaningful number. We’re talking about $7 billion raised last year in private equity.

So people raise the question, is Brazil over-heated? Is Brazil too much money chasing too few deals? There is an international appetite coming from larger funds coming into Brazil. But when you’re looking behind the data, the $7 billion is concentrated on a few players.

So what happened is a trend of these smaller funds raising billion-plus dollar funds and moving up in terms of size of deals, which created sort of a void, which is what Nic’s describing. So when we look at transactions, it’s actually rare that we bump into those larger names or the international names, which creates a very interesting dynamic. It’s a more inefficient market and therefore creates a barrier in entering and tapping into the middle market, at least on the lower end. So it’s a much better place. We still see multiples being more reasonable and transactions on a proprietary basis.

Snow: Tim, is that what you’ve observed by way of competition?

Formuziewich: Yes. I tend to agree. The market today has maybe 8 or 10 funds now that have over a billion dollars of capital and prior to this time had never raised more than $500 to $600 million of capital.  So these groups now have to go and try and deploy capital in $100, $150, $200 million deals, which is something not only they’ve never done before, but they’ve all created competition amongst themselves, which has in turn left the middle market relatively available.

Nick’s number is 20,000 companies. I read an article this week that said that there were 14,000 companies with a market value of probably $200 million or less. Or $200 million reais, I should say. There’s a great opportunity here.

What we have done historically, because we have a national platform, we have investments in 10 different states and 5 different cities, we’ve been able to very comfortably go out and do a middle market transaction of, say, $30 million, and build that into a national champion by doing a number of follow-on acquisitions or greenfield investments, create a national champion, and then look to exit.

Snow: Well, let’s talk about pricing a bit, since it sounds like at the very top of the market there are some very well capitalized players who are now looking for a finite number of appropriate companies to buy. And then there is kind of the rest, which is an area where you three are active. What is pricing like? What should an international LP without much of a knowledge of the Brazilian market understand about how pricing compares for some of these companies to some other place, like the US? Maybe Cristiano?

Boccia: Sure. It’s hard to generalize. I think the pricing in the middle market is moving up also. I think it’s driven by a natural– like, for a headline inflation, you see larger deals getting better multiples, owners and families, are saying, look, my company should be worth more. There is a natural trend here.

But it’s moving. And it is still in an area that is not the double digits that the large transactions are getting. It’s still anywhere between six, seven times. And those are the type of multiples that we see.

Again, it’s hard depending on the industry, depending on the growth prospects of those companies. But the idea is always being under the radar screen of the larger deals you get better pricing. And we also try to source proprietary transactions to avoid the auctions. And therefore you get a better multiple.

Snow: Does that sound roughly like what you see?

Wollack: I think that’s pretty much it. If I look back a few years, we used to see this in the larger end of the market, as people defined it. And just to be a little bit cynical, because of these trends that Cristiano was talking about, I think everybody– even the larger players are trying to define themselves as middle market players, because they think that that’s going to sound better for all the investors who think that the high end of the market is too expensive.

Anyway, so the larger end of the market let’s say five years ago was maybe priced– five or six years ago, whatever– was maybe priced six to eight times, EBITDA. That’s now commonly moved into double digit EBITDA. So there’s been a significant expansion of the multiples there, and I think quite rightly, in our opinion. But I would say that’s our opinion.

Some investors or LPs are concerned about that. If we look at the small and mid cap end of the market, the type of transactions that five or six years ago were commonly between four and five times EBITDA, now we’re seeing a lot of them, for us at least, between five and six, maybe creeping up to seven. But still, the multiple expansion that we’re seeing, which is happening because Brazil is looking better or is more attractive, the opportunities are more concrete and so on, it’s natural that the assets become more valuable. But the multiple expansions that we see is, I think, nowhere near what’s happening in the high end of the market.

That’s what’s generating investor interest in that segment of the market. That’s why we think this is a great segment of the market to be in. And at least Axxon’s view is that this is not a 2012 opportunity. We think this is a 10-year opportunity to play itself out, because of the number of companies or level of competition, the trends, et cetera.

Formuziewich: Pricing’s obviously a very difficult conversation to have when you’re looking to source opportunities. These are family businesses that sometimes hold fairly meaningful sentimental value to the businesses that they’ve built, and rightfully so. What we try and do is we try and articulate the value that we think we bring to a transaction, bring to a deal, to try and bring that entry value down.

In that conversation, that discussion, in that process what we’ll do is we’ll put people into two different groups. Either they’re a partner who we’d like to partner with over the long term, or they’re target. We’ll be willing to put a bit of a premium on the partner relative to the target if we think that there’s a significant opportunity to create value throughout the investment process.

But at the end of the day, it ends up being sort of a book building process for us. As you add value, the seller’s willing to sell more of their company. We don’t want them to be interested in selling 90 to 100% of their business. We want them to be interested in selling 50 to 60% of their business to us and then grow into a much larger position over time.

Snow: Well, I’m glad you mentioned the sellers and the fact that these are people who actually take a view on the businesses they’ve built. I’m wondering if each of you can comment on the awareness in the middle market, and even on the lowest end of the middle market, the awareness of private equity as an opportunity to partner, as an opportunity to go to the next step. I would imagine that 10 years ago your average family business owner would have said, what is private equity and why do I need it? Whereas today, probably a little bit more awareness, but I’m wondering how much more. What are you seeing, Cristiano?

Boccia: 10 years ago, when we were doing this in the first wave of private equity, there was a lot of explaining what it is, so you had to approach the company, explain what private equity is. I think in the last few years– and this is a phenomenon in which success breeds success, and there have been very successful private equity transactions, companies going public. The market, and the middle market actually, is very aware of private equity as a financing alternative.

The conversation still exists, and there’s a lot of explaining how it works. So you go to those family businesses and you take an enormous amount of time explaining how we work with them, how we add value, how the whole structure works, exit. So there’s just still a lot of work to get done, but the concept as a viable alternative changed dramatically.

And there’s a second step to all of this, which is that companies are now getting a little bit more prepared for this. They changed the mentality. 10 years ago you wouldn’t have your book so much in order.

Now you are a middle market company, you are interested in private equity, there is a clear benefit of someone putting a multiple on your earnings. So keep your earnings in order and we’re starting to see that more and more.

Snow: How about you, you’re a longtime participant in the middle market. Is there greater awareness now?

Wollack: I think I can only repeat literally word for word what Cristiano just said. I think it’s gone from the process of almost missionary work 10 to 15 years ago to now something that people have common awareness and knowledge of. But it still requires all these explanations that Cristiano was mentioning. But I think it’s a much easier process than it used to be.

Snow: One more quick question. I don’t know to what extent macroeconomic trends really affect your day-to-day operations or the way that you’re pursuing your strategy, but what are some really important macro trends, whether it’s demographic or whether it’s macroeconomic, that are affecting the middle market investment opportunity?

Wollack: We’ve been investing in Latin American private equity firms for over 20 years. We’ve seen how these macro trends, at the really macro level or even at the sectoral level, how abruptly they can change up or down, and how dramatically that can happen. So we tend to try to identify and think about opportunities not in terms of macro drivers, but in terms of what is the opportunity at the micro level, independently of the macro. Because we think the macro is too, frankly, uncertain to deal with.

Formuziewich: I echo the same comments. I think that just from a contextual perspective, when we look at Brazil today versus, say, the United States, today Brazil’s 200 million people have interest rates that are just slightly less than 10%. The average age is 29 years old.

And those statistics are exactly the same as what the United States was in 1975. And so we think that the runway for growth over the course of the next 10 or 15 years in Brazil is very similar to what happened in the US between, say, 1975 and 1990. We look to invest in growth sectors where there’s lots of opportunity for growth, where there’s creating alpha, if you want to say creating alpha.

But we also tend to focus on opportunities where we think we can bring value. And that value is typically in improving the cost structure of the company in some way, shape, or form. If we don’t see how we can’t create whether it’s 1,000 basis points or 1,500 basis points of value on the cost structure, we typically don’t do that deal.

Boccia: I think one thing, only to add that the trends that Nic and Tim mentioned about the growing of the economy, it has one meaningful impact on how we source deals. What happened was there’s a lot of companies now throughout Brazil. So we have an investment all the way in the south.

So the whole Sao Paolo, Rio, usual area of growth is actually now becoming more regional and more spread out. It’s driven by the trends that Nic was saying. So I think the numbers are not only large in the middle market, but it’s becoming a little bit more spread out. And you need to actually go out and source those deals more regionally, and look at trends also from a macro level on the regional plays that you see. It’s a large and vast country to take advantage at that level.

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