Years of unfulfilled potential for Brazil’s capital markets may finally be coming to an end. Until recently, Brazil’s stock markets were little more than a forum for often reckless speculation. Its fixed income markets were apparently there only to feed the public sector’s unquenchable appetite for borrowing.
Now, both equities and fixed income instruments are taking on a new and unfamiliar role – that of providing capital for the corporate sector.
The highest-profile development has been a rash of equity issues: 16 companies issued shares on the São Paulo Stock Exchange (Bovespa) in 2004, of which seven were initial public offerings (IPOs). Six more companies went public in the first seven months of 2005 (see table download).
This level of issuance may be normal for some markets but in Brazil it is almost unheard of. The last time there was activity on a similar scale was before the Asian crisis of 1997. This time around, issues have been of a markedly higher quality than in the past. Standards of corporate governance among issuers, for example, have been of the highest level. Retail investors, previously all but absent, have bought a third of the new shares.
Strides forward
On the fixed income side, which accounts for about four fifths of instruments traded in Brazil, there have also been great strides forward. Corporate issuers, previously crowded out by the government, have become increasingly active. Tenors of corporate debt have lengthened substantially, to be counted in years instead of months. Companies that would previously have issued bonds overseas now choose instead to tap the home market. There has even been progress towards that holy grail of Brazil’s capital markets, the development of a secondary market in corporate debt.
What is going on? “There is basically one fundamental explanation, which is the stable macroeconomic environment,” says Rubens dos Reis Cavalieri, director of corporate finance at Unibanco, Brazil’s third biggest private sector bank and one of the leading players on capital markets.
Brazil has indeed been enjoying a period of remarkable macroeconomic stability. Improvements in public finances have boosted investor confidence. Among the biggest achievements has been a dramatic improvement in the country’s balance of payments, helped by a record trade surplus of $34bn last year. That surplus, driven by manufactured goods as well as commodities, is expected to be surpassed in 2005, despite a steady appreciation of the currency. Investors’ nerves have also been calmed by improvements in the profile of the government’s domestic debt, much less of which is linked to the dollar.
Such has been the improvement in Brazil’s fundamentals that at the time of writing, markets appeared to be shrugging off a political crisis triggered by accusations of vote-buying involving leaders of the left-leaning Workers’ Party of President Luiz Inácio Lula da Silva. In the past, far lesser crises have sent Brazilian assets into freefall.
But macroeconomic stability is not the only explanation for the renaissance of Brazil’s capital markets. Regulatory changes and, above all, self-regulation have played a big role.
Regulatory changes
The need for regulatory change has been apparent since the mid-1990s, when steel, electricity and telecommunications companies were sold as part of a wider privatisation programme. Instead of selling through equity markets, the government chose to sell controlling stakes to strategic investors for a premium. Most of these investors were foreign, and many had little interest in having their Brazilian subsidiaries traded on the Bovespa. Poor disclosure, mandatory tender offers and an almost total disregard for the interests of holders of the non-voting “preferential” shares beloved of Brazilian issuers in the past led to a rising chorus of protest.
An attempt was made to do away with preferential shares in changes to company law enacted in 1997. But the law ran up against powerful business interests in Congress and the changes introduced, while positive, fell short of what was needed.
Nevertheless, in the period between the Asian crisis of 1997 and the beginnings of the rebirth of Brazil’s stock markets in late 2003, two important things happened. One was that the government sold off large minority stakes in oil group Petrobras and mining group Companhia Vale do Rio Doce (CVRD). It did so on the stock markets, and it allowed Brazilian workers to buy shares with money otherwise locked away in their employment security funds. The seeds of popular capitalism were sown.
Corporate governance
The other development was that companies and stock markets had a good long think about the importance of corporate governance. The Bovespa acted early by introducing the Novo Mercado (New Market) and Levels 1 and 2, which are special listings categories that are restricted to companies offering much higher standards of corporate governance than those demanded by law.
Companies trading on the Novo Mercado may issue only voting shares, and must offer full tag-along rights – meaning that, in the event of a change of control, a buyer must make an offer to minority shareholders equal to the price being offered per share for the controlling stake. Issuing companies have jumped at the chance to display their credentials.
“The big standard bearer is Natura [which launched the first of last year’s IPOs],” says Nelson Rocha Augusta, president of BB DTVM, the asset management arm of government-owned Banco do Brasil, Brazil’s biggest bank. “It shows the value placed on good corporate governance, and also that when you have a good company in a new sector [for the stock exchange], it’s even more attractive.”
Almost all the companies making IPOs between May 2004 and July 2005 did so on the Novo Mercado. The exceptions were ALL and Gol which, because they are public concession holders, could not comply with the Novo Mercado’s requirement for a free float of at least 25% of share capital (because this in theory would open them to the possibility of foreign ownership in excess of legal limits). Both ALL and Gol, however, offer full tag-along and other rights beyond those required of companies listing (like them) on the Bovespa’s Level 2.
The importance of good governance and the attractiveness of well-managed companies operating in sectors with little presence on the Bovespa are demonstrated by the performance of the newcomers’ shares since launch, almost all of them outperforming the Bovespa Index. “The message is that the market is open and investors are interested in new stories,” says José Olympio Pereira, managing director and head of investment banking at CSFB in São Paulo.
Private equity
The issues also mark an important advance for private equity houses and strategic investors that need an exit. The sale of 100% of capital in Lojas Renner was a disinvestment by US retailer JC Penny (and Renner became the only company of any size in Brazil to be owned entirely by stock market investors with no single controlling shareholder or controlling shareholder group). Gol’s IPO last year included the sale of part of a 12.5% stake owned by AIG Capital. “When AIG invested initially, going public wasn’t an option,” says Mr Pereira. “But AIG stepped in. If the market supplies an exit for early stage investors, that makes more early stage money available.”
Although issuance season is in full swing, it is still not for everyone. As well as a strong story, companies need critical mass, as Maças Renar, whose shares have slumped since their issue earlier this year, illustrates. Too small to attract institutional investors – who are interested only in large investments but do not want to dominate a company’s equity – Renar’s R$16m ($6.8m) issue went almost entirely to retail investors, who were quick to sell at the first sign of volatility.
While equities have grabbed most of the headlines, there has been no less of a revolution in fixed income. Most remarkable is a surge of issuance of debentures – about R$24bn in the first half of this year alone, up from less than R$9bn in the whole of 2004. Most issues have tenors of about five years, and many 10 and even 20 years, especially those involving leasing operations. At the same time, issuance of short-term commercial papers is dwindling.
“Companies are lengthening their debts and stopping taking money overseas,” says Luiz Fernando Resende, president of Anbid, the investment banks’ association. “It’s much more interesting to raise money in [Brazilian] reals because most companies’ income is in reals.”
Local option
Companies have not stopped issuing overseas altogether. In May, Bradesco, Brazil’s biggest private sector bank, surprised markets with a $300m perpetual bond, the first ever by a Brazilian issuer. Braskem, the country’s biggest petrochemicals company, followed suit with a $150m perpetual bond in June. Other innovative international operations include a $345m securitisation by Itaú, the second biggest private sector bank, in July. But more and more issuers are now using the option of local markets, deciding according to market conditions whether to issue at home or abroad.
Borrowing costs have come down although, with the Central Bank’s target overnight rate at 19.75% in July, borrowing is still far from cheap. But even while costs remain relatively high, issuing in reals is attractive compared with issuing overseas because local issues require no currency hedge.
The cost of hedging is becoming prohibitively high. At the start of the present government’s tenure, in January 2003, the exchange rate was about R$3.50 to the dollar. In July it fell below R$2.35. The risk of a correction mounts as the real goes on strengthening, and that risk is reflected in the high cost of currency hedges.
Far from ideal
Even while they celebrate the huge advances on Brazil’s markets over the past two years, however, market players concede that the situation remains far from ideal. For many companies – those without triple A ratings and with a less compelling story for investors – Brazil’s capital markets still do not provide a source of funding. Alfried Plöger, president of ABRASCA, the association of publicly traded companies, says the level of satisfaction with capital markets among his members is very low and that, for most Brazilian companies, the renaissance of Brazil’s markets “really has not happened”. Indeed, many more companies have closed their capital over the past few years than have opened it.
Mr Plöger says one big battle ahead is to persuade investors that equities are long-term investments, to remove the culture of short-termism that makes Brazil’s markets so volatile and therefore so off-putting for retail investors.
Another challenge being addressed by regulators and market players is the creation of a secondary market in corporate debt. Even with the huge increase in issuance of debentures, a secondary market has not emerged. The main reason is crowding out by government debt, and the fact that banks see corporate debt as an asset to be held to maturity.
“There is very little incentive for them to trade,” says Mr Cavalieri at Unibanco. His bank was hired last year by paper and pulp company Suzano as market maker to encourage trading in its debentures issued in 2004. The move, Mr Cavalieri admits, has produced “less liquidity than we hoped for”.
As market maker, for example, Unibanco must bid for and offer the debentures on a daily basis, but it is hard to guarantee offers because lending of debentures to cover positions is an untested idea for most market players. Anbid and the CVM, Brazil’s securities commission, are working on this and other issues. The rewards would certainly be high. “With no secondary market, the primary market is stalled,” says Mr Resende at Anbid. “But with an exit route on a secondary market, the primary market could triple overnight.”
He and other players are cautiously optimistic on the prospects for progress, but for the time being caution outweighs optimism.
Mixed feelings
Optimism and caution, indeed, are both appropriate responses to the changes under way on Brazil’s capital markets. Much change has taken place, and much of it is resoundingly positive. But two fundamental obstacles to further change remain. One is interest rates. While investors can make attractive, almost risk-free returns on highly liquid government debt, there is little incentive to seek alternatives. The other is crowding out by the government – even as rates fall, the government’s appetite for debt will continue to soak up most of the available capital.
Yet both obstacles, in fact, show signs of weakening. Interest rates are high, but markets are confident they will fall. Faced with the need to maintain earnings, institutional investors are already looking around for higher yield, with the resulting upswing in issuance of corporate debt.
“The fact is that some companies are issuing [at home] even while it remains expensive to do so,” says Mr Rocha Augusta at BB DTVM. “One day interest rates will fall, and expansion [of issuance] will be all the greater. The markets are preparing for take-off.”
