Thiago Sandim is a partner at Demarest’s M&A and PE practice. He is also a visiting professor at INSPER and a member of the board of directors of leading Brazilian companies in the retail, real estate and financial industries. Thiago led the Demarest team in several recent relevant transactions, such as the advisory of GIC in the circa US$2 billion acquisition of the stake in Rede D’or, the circa €1.5 billion acquisition by Vinci Highways of LAMSAC (an asset held in Peru by Invepar) and EIG in the US$1.7 acquisition of BSI from Banco BTG Pactual.
GTDT: What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?
Thiago Sandim: The level of private equity (PE) activity in Brazil in general has been a little below historical averages when one takes into account the past four years.
If one breaks down PE investors by type, however, some particulars appear. Pure market-based PE investments (which in general get their upstream funding from the private market) slowed down, both because of the uncertainty over the presidential elections and the general macroeconomic situation and the continued pricing gap between sellers (high) and buyers (low). The pricing gap works in favour of strategic buyers, as they have more capacity than pure financial investors to absorb increases. Some sovereign wealth funds and foreign pension plans, on the other hand, made use of the opportunities created by the crisis and the urgent financing needs of some of the sellers to go on a buying spree that pretty much concentrated on large-scale projects. The Canadian pension plans are a good example of funds that made use of opportunities to increase their Brazilian portfolio.
In this last quarter (Q3/18) we are going through what we believe may be a temporary resurgence of classic PE in Brazil, due to the devaluation of the Brazilian currency vis-à-vis foreign currencies. The devaluation has made Brazilian assets cheaper and hence more attractive to foreign buyers. This trend, however, greatly depends on the foreign exchange rates and high levels of activity going forward will therefore depend on how stable the economic policies of the next government are. Add-on acquisitions by companies that received PE investments in the educational and health sectors continue to be strong, but the amounts involved in these types of transactions are most of the time significantly smaller than mainstream PE.
GTDT: Looking at types of investments and transactions, are private equity firms primarily pursuing straight buyouts, or are other opportunities, such as minority-stake investments, partnerships or add-on acquisitions, also being explored?
TS: Add-on acquisitions were more frequent in the country in the past 12 months for a series of reasons. First, the PEs had already invested in portfolio targets of certain industries (here I would quote education and health services) and add-ons were necessary to make the business models adopted at the time of the acquisitions feasible and realistic. In other words, the acquired companies need scale, and scale demands add-ons. Second, of course, add-ons are less risky than new portfolio acquisitions, since PEs already know the market and have expertise. Straight buyouts are the general rule in this type of transaction, but some deals incorporate earn-out provisions, which, of course, require the continued participation of selling shareholders as minority shareholders.
GTDT: What were the recent keynote deals? And what made them stand out?
TS: The keynote deal for the past couple of years in terms of value, structure and momentum, was the acquisition of a 25 per cent (roughly) participation by the sovereign wealth fund of Singapore (governmental investments of Singapore – GIC) and Carlyle in Rede D’or São Luis SA (which is the leading private hospital service provider in Brazil). The value was very high by Brazilian standards (circa US$2 billion on aggregate) and involved both the subscription of new shares and acquisition of shares held by former shareholders, which made the contractual structure very sophisticated. It is also worth noting that a highly relevant piece of the transaction was implemented during a period of distress of a financial institution that was a shareholder of the company, raising regulatory, banking and insolvency issues that were new to the Brazilian legal and business community until that date. Also worthy of praise are the acquisitions made by Brookfield last year – the most visible of which was the acquisition of Odebrecht Ambiental SA and its transformation into BRK Ambiental, under the Brookfield brand.
GTDT: Does private equity M&A tend to be cross-border? What are some of the typical challenges legal advisers in your jurisdiction face in a multi-jurisdictional deal? How are those challenges evolving?
TS: PE is not necessarily cross-border. There are both local and international players in the small and medium-cap companies. It is fair to say, however, that the majority of the big-ticket PE M&A is indeed cross-border. Because of the size of these deals, they usually involve the formation of a consortium of investors. The biggest challenge is always to make the objectives of the members of the consortium compatible with their rights within both the context of the transaction and their respective rights as consortium members. The regulation of the rights and obligations of consortium members is indeed evolving in Brazil. The landmark deal in terms of formation of consortia in Brazil was the 2010 BTG PPM, which involved the sovereign wealth funds of Singapore, China and Abu-Dhabi, very relevant PE funds, such as JC Flowers and some of the most famous family businesses, such as Santo Domingo’s and Agnelli (Exor). Another challenge is how to measure returns for guaranteed internal return rates (IRRs) (when applicable) and how to deliver them through equity in case IRRs are not achieved. We have seen a number of deals where the IRR is delivered through primary issuances, but this is pretty complex in the local environment, especially when it involves listed companies. The structures during the past few years, however, have evolved more towards protection mechanisms against indirect losses (loss or profit, loss of value) related to corruption issues, rather than pure contractual upside or downside protections. It is a reflection of the situation of the country.
“The regulation of the rights and obligations of consortium members is evolving in Brazil.”
GTDT: What are some of the current trends in financing for private equity transactions? Have there been any notable developments in the availability or the terms of debt financing for buyers over the past year or so?
TS: No. The structures for the financing of PE transactions remained the same for the past couple of years. The country went through a huge crisis, which is still ongoing. In competitive terms, investment in PE for individuals and legal entities is less attractive than other market possibilities for a number of reasons. For example, such investments had to compete with very high fixed returns paid by the government (similar to the US T-Bills) (interest rates went down after the start of Michel Temer’s government, but are still high). The prospects for the next four years, however, are going to be defined in October 2018, at the time of the general elections. The level of uncertainty is currently high, but some of the leading candidates have a liberal agenda, which tends to work in favour of free markets in the country for the first time in decades. It could be the start of a positive cycle both for upstream and downstream PE.
GTDT: How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
TS: There is a higher degree of legal uncertainty related to PE tax issues. Some of the most traditional investment mechanisms in the country (private equity funds, FIPs) are under scrutiny by the Brazilian Federal Revenue Office, which is putting the market in the spotlight. Premium-creating structures (in a nutshell, the premium paid for a Brazilian asset can be offset against operating profits) are also under scrutiny by the Brazilian tax authorities, as this structure too was used beyond reasonable standards by some of the players. However, on the other hand, I understand that the authorities go too far when they involve individuals in tax assessments – it is almost a terrorist tactic. PE players will no longer make use of legitimate tax-saving structures because some branches of the Brazilian government will go against the managers and the company, and not just the company. That obviously creates huge imbalances, as individuals have much more to lose than entities.
GTDT: What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?
TS: Policymakers and the public do not pay particular attention to private equity. There is no resistance whatsoever to private equity buyouts by target boards or shareholders in the past. Shareholder activism is increasing. It is noticeable, for example, that minority shareholders are shifting some of the focus (and firepower) to members of the management who can in some instances be held personally liable in Brazil, as a means to create a certain level of uncertainty in the individuals and hence create leverage. We find this strategy of creation of leverage through multiple layered litigation involving individuals – which is a typical US approach – to be curious but risky in Brazil. There are provisions in Brazilian law that establish that shareholders must not act contrary to the interests of the company and should not target their own interests when they are in conflict with the interests of the company – this may be considered an abuse of rights and expose such shareholders to damages. In other words, multiple layered litigation as a clear strategy may backfire. We are looking forward to seeing how the Brazilian courts react to this strategy. In a nutshell, in terms of business environment Brazil is pretty favourable to PE investments and the sophistication of investors (including active shareholders) is increasing. This is a recent trend, so we have yet to see the practical effects.
GTDT: What levels of exit activity have you been seeing? Which exit route is the most common? Which exits have caught your eye recently, and why?
TS: A number of stop-loss investments in businesses that were performing poorly from an operational perspective occurred. This was a trend particularly for greenfield-type investments – those that target assets required development rather than a simple increase in EBITDA. Timing of environmental and regulatory licensing, poorer than expected market conditions, etc, were some of the drivers of the stop-loss sales. However, on the whole exits did not occur, as market conditions were not favourable. The Brazilian currency lost significant value versus the EU and US currencies, which caused the rates of return, when calculated in foreign currency, to go down. PEs are likely to be expecting an increase in the economic conditions before they sell.
GTDT: Looking at funds and fundraising, does the market currently favour investors or sponsors? What are fundraising levels like now relative to the past few years?
TS: The situation has not changed much from last year. Levels for funding in the Brazilian markets continue to be low in comparison with a couple of years ago and from our perspective the market continues to favour investors, which are scarcer and therefore have a competitive edge. From a broader perspective, everyone knows that jurisdictions and industries compete for financial investments (which migrate very fast). The global funds destined for Brazil are frequently driven by jurisdiction rather than industry (with certain noticeable exceptions, such as agricultural investments). It is hence natural that with high fixed-income rates paid by the government, a relevant part of the investment migrated from riskier investments (such as PE and VC) to fixed income. This may change soon, if the perception of the market in the country shifts for the better and the government continues with lower interest rates. The future depends on a significant extent on the outcome of the general elections. A market-friendly government has the potential to multiply wealth very quickly in the country, and recent history shows that PE investors can play a good part in this.
GTDT: Talk us through a typical fundraising. What are the timelines, structures and the key contractual points? What are the most significant legal issues specific to your jurisdiction?
TS: Upstream PE funds are frequently raised abroad for investment in Brazil. PE funds raised locally are driven more by tax efficiency (in light of some applicable tax exemptions) than by their efficiency. Having said that, the level of participation of investors at the funds, its corporate governance and the rules applicable to conflicts of interest are among those more intensely debated when local funds are raised.
GTDT: How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?
TS: Regulation is more driven to the type of fund than to sponsors in Brazil. The main regulation is Instruction No. 391 of the Securities and Exchange Commission (CVM). This regulation needs to be interpreted jointly with tax rules that, combined, allow for advantages (mainly tax on capital gains). The supervision of FIPs is performed by the CVM and is intense. However, the scrutiny focuses more on ‘box ticking’. This is, however, changing and evolving quickly, as the Brazilian Securities Commission invests more and more of its time and resources in the scrutiny of the players of the Brazilian capital markets and the enforcement or regulations. We can safely say that there were two different moments in the recent history of the Brazilian capital markets. In the first moment – which was the first decade of this century – the CVM issued new and clearer regulation. It is now investing in the scrutiny of the compliance of such regulation by the market players.
GTDT: What effect has the AIFMD had on fundraising in your jurisdiction?
TS: The truth is that upstream PE, or fundraising activities, have been very limited if not non-existent in the Brazilian markets over the past couple of years owing to the intense economic and political crisis. There is therefore no practical effect for the time being, but, of course, local PE funds are looking at the AIFMD regulations and are willing to adapt their business, organisational structures, remuneration policies, etc, to AIFMD. This move essentially derives from the fact that the Brazilian business environment usually follows European and US standards shortly after they are adopted in an effort to keep the Brazilian market standards in line with the best US and European systems, and hence attract investors. The adoption of widely used standards – such as the AIFMD – makes the Brazilian environment easier to understand for foreign investors, who make up the bulk of the local markets.
GTDT: What are the major tax issues that private equity faces in your jurisdiction? How is carried interest taxed? Do you see the current treatment potentially changing in the near future?
TS: The most important tax issues affecting PE investments in Brazil are those deriving from the form of foreign capital registration that the PE takes in Brazil. In brief, there is a difference in the treatment of foreign direct investments made under Law 4131 (which is the oldest Brazilian regime – the direct investments) and foreign investments made under regulation 4373 of the Brazilian Central Bank (which is a more modern type of registration – the portfolio investments). Portfolio investments may enjoy a favourable income tax on capital gains. The problem is that, in general, such beneficial treatment only applies if the equity is acquired and sold on the capital markets. It is possible to migrate a direct investment into a portfolio investment through several corporate acts and capital markets registrations and de-registrations. The mechanics around this migration are, however, very complicated and may themselves lead to tax implications. There is no sign that this specific treatment will change. Another issue of importance is buyers’ ability to amortise the goodwill arising from acquisitions. This particular tax feature, however, unlike the benefits arising from a portfolio investment, is under intense scrutiny by the Brazilian government, and changes were introduced in late 2013. The calculation of the size of goodwill, for example, was changed to make it more along IFRS lines, which in essence reduced the size of the goodwill. There is also intense scrutiny by the Brazilian tax authorities of the economic substance of goodwill when it starts to be amortised by Brazilian companies. It is thus very important, when tax planning, to ensure that the entities used to generate the goodwill have more substance and purpose than merely the creation of goodwill. The fact that some branches of the Brazilian government are going against individuals (management) is also worthy of note. This has significantly reduced the willingness of some portfolio managers to implement tax-saving structures, as their personal assets may be affected by assessments.
GTDT: Looking ahead, what can we expect? What might be the main themes in the next 12 months for both private equity deal activity and fundraising?
TS: The general elections in October 2018 will set the tone for the next four years. There is no single more important element when one examines the market – the size of the Brazilian government versus the economy in general is the reason. A win by a market-friendly candidate who reduces state spending could steer the PE market (both upstream and downstream) forward very quickly.
The Inside Track
What factors make private equity practice in your jurisdiction unique?
Tax issues and exit mechanisms. On exit mechanics, the Brazilian capital market is not as developed as the US or UK, so exits may prove difficult not only for contractual/legal issues (listing rights are common, but rarely tested) but also because of the huge volatility of the market (which drains liquidity and hence the ability to realise investment for long periods). It is therefore very important to build an alternative exit scenario and the instruments to implement it. I have seen, for example, put options against the original sellers or sindicalising rights (which are usually exercised right after an acquisition). Block trades following IPOs are also used more frequently than in other jurisdictions because of the tax advantages.
An issue of specific importance to PIPEs is the widespread and disorganised existence of poison pills in the by-laws of Brazilian companies, which aim to make a takeover or even the acquisition of relevant minority stakes much more expensive. Most of the time the mere reading of these clauses is misleading as the Brazilian Securities Commission has already disregarded a large part of such provisions, so one must be very careful when analysing the effects of a transaction in its early stages. The explanation for the expansion of these clauses is the IPO boom around 2007, which was very erratic – leading some companies to build excessively complicated corporate governance structures and unrealistic poison pills. It is an amazing example of the widespread use of solutions to build mature markets in a still growing capital market, which rapidly creates liquidity problems for many players. We examined several potential PIPE deals recently and most of them stumble over poison pills, creating a gap between the price expectations of sellers (which usually expect to capture the premium of control) and buyers.
What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?
Your counsel must have a strong tax-planning capacity and a very good understanding of the Brazilian regulatory environment, especially with regard to the central bank system of registration and its interaction with tax law, as this may make a big difference to the economic results of a transaction. I would also add experience and a track record to this list. Exit structures and scenarios are particularly challenging as a result of corporate governance (as mentioned above, mostly created during an excessive liquidity of the capital markets and hence unrealistic) and complex laws or regulations.
What interesting or unusual issues have you come across in recent matters?
We have lately been through very interesting and value-creating earn-out and contingent payment structures involving PEs. Due to specificities of Brazilian law and regulations it can be very difficult to implement these types of structures, but in the past 12 months we have had the opportunity to successfully negotiate and implement a number of them – which was very important to bridge the pricing gap and make some of transactions feasible from a negotiation perspective.