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AmericasApril 6 2008

Battered but still buoyant

Despite the subprime crisis affecting many areas of Brazil’s capital markets, commodity prices continue to boom, foreign investment remains strong and an investment grade rating is imminent, says Brian Caplen.
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Brazil’s economy may be heading towards investment grade but its capital markets have not decoupled from the US and European markets and are feeling the backwash from the subprime crisis.

The initial public offerings (IPO) market – one of the hottest in the world last year – has been moribund this year as foreign investors, who were accounting for 75% of the demand for new issues, have retreated. The same is true of the Eurobond market and a Petrobras deal was pulled earlier this year in response to the bad conditions.

Even the local credit markets, where the demand is largely from Brazilian investors unhurt by the subprime situation, are more challenging and some investment banks, though not all, report difficulties in getting deals away.

Ricardo Corradi Leoni, head of credit markets at Santander, says: “Even though people are saying that Brazil has decoupled [from the international markets], and that investors here are willing to put their cash into bonds, that is not what we are seeing. We have done two deals so far this year and both of them [an asset-backed deal for petrochemical company Braskem and debentures for Companhia Providencia] were difficult deals to place.”

Santander growth

Santander’s presence in the Brazilian market will grow significantly when its assets are merged with those of ABN AMRO in the Brazilian leg of the Santander/Royal Bank of Scotland/ Fortis carve-up of ABN. Fabio Barbosa, chairman of Banco Real (the Brazilian bank that ABN originally bought), has been appointed the head of all Santander activities in Brazil.

Demosthenes M de Pinho Neto, executive vice-president of Unibanco, says: “Since the subprime crisis, we have seen very little activity in the equity capital markets. There are a lot of mandates on hold.

“Between 70% and 75% of Brazilian IPOs were being placed abroad and that demand has dried up. We are also seeing some problems in the fixed-income markets and issues are more difficult to place, even domestically. Issuers have to pay higher premiums to investors and foreign buyers are very selective in what they will absorb these days.”

He adds: “Equity and debt investors talk to each other [international ones with Brazilian ones]. The international investors have investments that cannot be priced – they are being priced to model not to the market – and they communicate [that negative sentiment] to the domestic market. I don’t buy the decoupling idea.”

The good news

The paradox is that Brazil is booming; commodity prices are at record highs, the country has become a net creditor and an investment grade rating has become a question of when, not if. The pipeline of foreign direct investment is so strong that whatever happens in the markets, a growth rate of 4% to 5% is assured in 2008.

At company level, balance sheets are healthy and a temporary halt in capital market funding is unlikely to deter entrepreneurs from going ahead with investment plans. Where funds are needed, the alternative avenues of private equity and bank loans are being explored. Analysts also expect the hectic pace of consolidation in key sectors such as real estate to continue.

All of this means that any impact on the macro economy is unlikely to be felt before 2009 and optimists are predicting that markets will recover before then. Investment banking profits may be down from the highs of 2007 but inventiveness in finding new sources of revenue may break the fall.

“There may be less IPOs but there is more activity in merger and acquisitions, project finance and other areas,” says Ricardo Espirito Santo, the head of BES Investimento do Brasil. “The economy is in evolution and there are a lot of business proposals to evaluate.”

The investment bank is 80% owned by Banco Espirito Santo of Portugal and 20% by top Brazilian universal bank Bradesco. “We do a lot of transactions in partnership with Bradesco,” says Mr Espirito Santo.

“If we originate a transaction that is too large or needs lending capacity, we call up Bradesco and see if we can work on it together. They bring proposals to us as well.”

Mr Espirito Santo is bullish about 2008. BES has set up a private equity operation that instead of establishing a fund, works on a reverse-inquiry basis. It is also focusing on areas such as mezzanine finance and debt with an equity kicker – convertibles are not widespread in Brazil – and a wealth management business aimed at high-net-worth individuals – often entrepreneurs who have cashed out their business and have funds to invest.

Mr Espirito Santo adds: “We have a set up a private equity operation. We feel that there is a market for medium-sized companies which need money to grow but cannot access the IPO market. When we have a transaction, we will call up investors to gauge their interest in funding it.”

Alternatives options

Antonio Quintella, managing director of Credit Suisse in Brazil, feels that one of the key features about the current situation is that companies have alternatives in capital raising whereas in the past they faced a perverse combination of scarce and expensive sources of capital. The Brazilian companies took advantage of market conditions in recent years and are well capitalised, so they don’t need to rush into IPOs if market conditions are not attractive.

Mr Quintella says: “The markets are demanding a significant discount to fair value and as Brazilian companies are not highly geared so they are not under pressure to do just anything. In Brazil we have moved from an environment where capital was both expensive and scarce. Nowadays there is plenty of capital available for most parts of the capital structure and entrepreneurs have choices. With the IPO window currently more difficult, the ground is fertile for private equity and private placements.”

Brazil has a thriving private equity sector with national firms such as GP Investimentos and Gávea competing with international firms such as Carlyle. “One of the markets which remains very hot is private equity whose players are cash rich and face a challenge to invest all their funds,” says Vital Menezes, head of equity capital markets with ABN in Brazil.

“With investors demanding huge premiums to buy IPOs, we are seeing private equity firms paying better prices [than the IPOs]. They are serious and are looking at the long-term future of the assets. If companies need cash to develop, the capital markets may not be the best option at this point in time.”

Loan improvement

Another option is bank loans, and Brazilian banks report that loan spreads are improving as companies finding the credit markets more difficult go back to their banks for funds. How much this trend accelerates depends on how turbulent local credit markets really are as bankers differ in their views of the gravity of the situation. In any case it may be hard to measure the impact as tax-savvy Brazilian companies are circumventing new tax rules by issuing debentures and pushing the banks to underwrite and buy entire deals.

This is because when Brazil’s contentious financial transactions tax, the CPMF, was dumped, it was replaced by a 0.38% increase in the IOF tax on loans, which is now at 1.88%. As capital market transactions do not pay IOF, if a company issues a debenture that is bought entirely by a bank, the tax is avoided. A spike in debenture issuance, therefore, may not indicate a burgeoning debt market but an increase in bank lending under another name.

“Other parts of the market [apart from IPOs] remain active,” says Credit Suisse´s Mr Quintella. “In the credit market foreign capital is almost irrelevant and there is still great activity in debentures, loans and private placements. Tenors continue to extend, terms are attractive and rates are likely to resume their downward trend.”

Debt focus

Fabio N Solferini, president of Standard Bank, which is highly focused on the debt market and trade finance opportunities in the Brazilian market, says: “Since August, the Eurobond market for Brazilian names has shut down but the domestic bond market, where the buyers are local pension funds, hedge funds and banks, is still very liquid and only slightly less so than in 2007. We are still doing deals. Historically, people always said that Brazilian debt markets could only develop in the future when interest rates came down but now they have already come down to levels that allow the corporate bond market to grow.”

Mr Solferini does feel that the current situation will lead to some repricing. “When the international market calms down, first we will see issuers tapping the debt [Eurobond] market and then equity but at totally different prices and more attractive multiples. Debt will be more expensive,” he says. Last month Standard sold an 11.11% stake in the bank to the Industrial and Commercial Bank of China and while this will provide funds for growth everywhere, Mr Solferini does not see any immediate impact on the Brazilian operation.

Loan spread increase

Mr Pinho Neto, who is in charge of both investment banking and corporate lending at Unibanco, says that companies not wishing to pay the premiums being demanded in the debt market are seeking bank loans instead and, as a result, loan spreads have increased. This is having a knock-on effect as banks need to raise more funds with, in his view, limited alternatives. “The price of money is increasing,” he says. “You will see the impact of more expensive credit in the future.”

In the debate about how much and how significantly the country has changed there is a real conundrum over whether the glass is full or half empty. This is the first time that an international crisis has not provoked a flight to quality from Brazil and investment- grade status is on the cards.

A Fitch report in December stated that: “…sustained macroeconomic stability and greater evidence of the resilience of the country’s policy framework to external shocks, a faster reduction in the government’s debt burden including an improvement of the domestic debt composition, and further strengthening of the country’s external solvency and liquidity ratios would enhance Brazil’s prospects of reaching investment grade in the future.”

Sign of progress

To even be talking about investment grade for Brazil illustrates the rapid progress made in the past few years but some of the legacies of the past still live on and partly account for why local markets are feeling the impact of the subprime crisis.

Everyone agrees that there remains considerable work for the government in the areas of tax, ease of doing business, infrastructure bottlenecks and labour flexibility if Brazil’s growth engine is to move beyond a 4% to 5% trend level and up to double-digit, Asian-style rates.

Brazilian investors, mindful of past high inflation and defaults, demand liquidity in their investments and remain wary of committing their funds in the long term. Banks find it difficult to launch an investment fund in Brazil that does not price daily and investors are quick to switch vehicles if sentiment turns. For example, there was a migration of money in January from investment funds to bank certificates of deposit as banks raised the rates that they were paying.

Red tape obstacles

 

With little in the way of a secondary market in corporate bonds in Brazil, fund managers have always preferred sovereign issues, and over-zealous regulation of bond funds (they must have the word credit in the name of the fund, and investors have to sign documents acknowledging they understand the risks) have stymied demand growth for these instruments.

The banks themselves have huge opportunities on the asset side of the balance sheet and are constrained by limited fund-raising opportunities and lack of long-term funds. “At the moment there is a lack of alternatives to CDs [certificates of deposit] and savings accounts and banks do not have significant long-term funding,” says Unibanco’s Mr Pinho Neto. “Brazilians are still oriented towards the short-term. The inflation neurosis is still with us.” For the banks’ part, as they are extending tenors to both corporates and home owners, the classic short term borrowing/long-term lending dilemma is developing.

One banker says: “The elements in Brazil that still make doing business fairly difficult are the labour market, which is highly regulated and inflexible, taxes are complex and onerous and the country is still relatively bureaucratic. It can be difficult to get things done. It can be difficult to open companies, difficult to close them down and tough to get licences.”

One area where improvement is at hand is in the processing of documents for equity and debt issuance that can get bogged down for two to three months. The current proposal is for the securities and exchange commission of Brazil to hand this task over to the national association of investment banks to improve efficiency.

Consolidation

The market infrastructure itself continues to evolve with the proposed merger of Bovespa and the Bolsa de Mercadorias & Futuros, set to lead to technology and marketing efficiencies if it goes ahead. This would see Brazil following the international trend for exchange consolidation.

Yet for all the improvements that Brazil may make, full decoupling seems an unlikely prospect. Brazil, like Russia, India and China (known as the BRIC countries) has developed by engaging with the international economy. However much better the shape of its finances becomes, it cannot expect to remain immune from all international developments.

Conversely, the inflation-fearing and short-term mentality of Brazilian investors may disappear over time, but the danger is that in pursuing more diverse opportunities, they also fall victim to market hubris – just like their international colleagues did with subprime.

If Brazil was not ‘unique’ when it was failing, i.e. it was not a hopeless case but only required good policy to turn it around, as was always argued in The Banker, it cannot claim to be ‘special’ now in that it has somehow guaranteed immunity from international market trends and incorrect policy – as positive as things look right now.

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