Lexology GTDT Market Intelligence provides a unique perspective on evolving legal and regulatory landscapes. This interview is taken from the Private Equity volume featuring discussion and analysis of emerging trends and hot topics within key jurisdictions worldwide.
1 What trends are you seeing in overall activity levels for private equity buyouts and investments in your jurisdiction during the past year or so?
Despite political turmoil in the recent years, in 2018 Brazil’s private equity (PE) industry recorded its highest amount of committed capital for the past few years. Also in 2018, despite the drop in PE investment, Brazil recorded a record high number of target companies, with a lower average ticket. In our view, this conundrum shows a positive outlook for the Brazilian market in coming years – with lower investment volume in 2018 and a relevant upsurge in the amounts raised, this is good indication that there is cash available in the market and appetite from PE firms and investors. Brazilian financial markets are bullish with the reformist stance of the new government, led by Economy Minister Paulo Guedes. To this day, the government has been able to approve important reforms to the national social security system, largely reducing the deficit of the system, and a new piece of legislation called the Economic Freedom Act, which targets reducing the regulatory burden on Brazilian businesses. A comprehensive tax reform is also expected. These changes should generate a boost in competition within the Brazilian market and create a positive outlook for Brazilian investments in the medium-long term. This bullish perspective of the market, alongside lower prices of Brazilian assets (boosted by the devaluation of the Brazilian currency), should be an important driver of acquisitions in the short-term. Considering current trends, we expect a big surge in investments in start-up companies, in particular in fintech and retail. Investments in the healthcare industry are also likely to continue its steady growth, in particular in view of the great success and optimal returns obtained by PE firms investing in the sector so far. For big-ticket PE firms, we are expecting to have prolific years to come, with the government announcing a series of privatisations. We are already experiencing a surge in this type of transaction.
2 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?
We have seen a surge in lower ticket investments in the past year. These were likely driven by a combination of opportunities of the market, uncertainty over the Brazilian presidential elections and the new economic team, and the more aggressive risk profile of big-ticket deals. Add-on acquisitions, in particular in the healthcare and education industries, have also been commonplace, in view of the success of deals in this industry for relevant players. In terms of trends for 2019 and the coming years, we are expecting to see more partnership and minority investments. Investments in start-ups are often for minority stakes and include several players investing in the same tranche. On the other hand, with the large privatisations to come, we expect that PE companies will play an important role – although it is likely that at least some of these investments will come in the form of partnerships with strategic investors, in particular in highly specialised sectors. I am not separating large sovereign wealth funds (SWFs) from straight PEs for the purposes of this answer, but we are under the impression that the SWFs will take part in large consortia investing in big-ticket privatisation assets, while the more traditional PEs will concentrate in the renewed interest in B2B deals. An area of huge interest in Brazil – due to the level of concentration and deriving opportunities for cost reductions – is fintech. The Brazilian banking system is highly concentrated, and the level of pricing of services charged to clients is much above global average. This is creating a surge in low cost fintechs that have been capturing the bulk of the attention of the capital markets.
3 What were the recent keynote deals? And what made them stand out?
In our opinion, keynote PE deals in 2019 include SoftBank’s investments in Gympass, Creditas and Rappi, as well as TCV’s investment in Nubank. All these deals show an increasing interest of PE houses in Brazilian-based start-ups, particularly in fintechs that have been growing steadily and rapidly becoming unicorns. These deals also mark the definitive entrance of SoftBank in the Brazilian and Latin American market with the creation of the SoftBank Innovation Funds, the largest technology fund focused on the Latin American market. SoftBank is expected to gain great relevance in the continent in the coming years. The bidding war between Magazine Luiza and Centauro for the acquisition of Netshoes is also worth noticing. Never in the history of the Brazilian capital markets have so many unsolicited offers been made in such a short time frame. The difference between the initial price offered by Magazine Luiza and the final price paid (around 80 per cent more) is also worth note.
4 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?
PE deals in Brazil come in all forms. There is probably an even distribution between purely Brazilian deals and cross-border M&A. When advising clients in cross-border M&A, two topics are of great importance: regulatory and tax. Brazilian regulatory and tax environments are very complex and require an experienced counsel to help the client navigate through the various questions that usually arise from diligence. Spotting issues and helping the client to identify what is truly material in diligence are often tasks that demand a local counsel that is very familiar with the local regulations and that is experienced enough to differentiate red flags from course of business issues.
5 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?
A recent decision of the administrative tax courts in favour of the taxpayers is causing significant changes in the level of sophistication of deals and the appetite of investors to risks related to tax planning. In a nutshell, the administrative courts (CARF) recognised that because Brazilian PE funds (FIPs) cannot take debt, it is legitimate that ‘newcos’, which are 100 per cent controlled by the FIPs, are created for the sole purpose of taking the acquisition debt. These newcos are, in practice, merged into the operational entities right after the acquisition, which causes the operational entities to acquire a tax shield (deductibility of the interest of the acquisition financing loan). This makes the transactions cheaper from a taxpayers’ perspective and has had influence over recent past structures.
6 How has the legal, regulatory and policy landscape changed during the past few years in your jurisdiction?
Brazil is currently going through a transformational period that is likely to materially change the regulatory landscape over the course of the next few years. The Brazilian congress recently approved an Economic Freedom Act, which is aimed at reducing bureaucracy and the regulatory burden on Brazilian businesses. Although the effects of this new regulation are uncertain at this time, it brings relevant principles to the public administration, namely that regulation should not prevent competition, create market reserves or bar the entry of new players. This is likely to be a very recurrent topic in Brazilian discussions in the next few years. Besides this new regulation, the new government seems to have an appetite for change. The Brazilian congress has already approved changes to the social security system and is starting a discussion to make a complete reform of the tax system. In a nutshell, the Economic Freedom Act puts a very well-known concept in developed markets – law and economics – at the top of the agenda of policymakers in Brazil. The mere fact that they are now forced by law to consider the economic effects of their actions is, per se, a cultural change that in the long term has a huge effect in the country.
7 What are the current attitudes towards private equity among policymakers and the public? Does shareholder activism play a significant role in your jurisdiction?
The Brazilian government in general welcomes foreign investment and has historically created mechanisms – such as the amortisation of goodwill – to stimulate them. There is no specific attitude or increased focus among policymakers on private equities, but the tide is shifting in the sense of a decision being made that is more favourable to the taxpayers – the recent decision of the tax regulatory bodies regarding the tax shields being chief among those (see question 6). There is shareholder activism in Brazil, especially after the scandals of the lava jato corruption probe. However, it is still not an industry where players create problems to gain leverage and negotiate positions as in other jurisdictions (although this is an increasing trend in Brazil).
8 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?
Exit activity certainly increased if compared with the previous 24–36 months. However, due to the shallowness of the Brazilian capital markets most of them still happen on private transactions. Sale to strategic buyers or rolling of investments to other PE funds are more frequent than initial public offerings. No specific exists caught my eye in the past 12 months, but I am guessing – based on increased levels of activity that are not yet public – that PE investments made in fintechs and, in general, in the internet business, are likely to pick up in the next 12 months. In general, my take is that the model adopted by some of these new economy companies (which do not consider profit as important as it really – in my personal opinion – is) is not sustainable in the long term and we are likely to start to see a wave of consolidations that aim at increasing the use of synergies. At the same time, some of these will fail ‘crash and burn’ style.
9 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?
Fundraising levels are increasing, and this trend is likely to continue for the next couple of years. From the analysis of available data, we can clearly see that we have been going through the end of the investment cycle of several funds. This has been accompanied by increasing levels of fundraising for new investments, which provides a very positive outlook for the industry’s future in the short to medium term. This is a time that favours both investors and sponsors. With very favourable exchange rates, investments in Brazil are being facilitated and the price of assets are a lot cheaper than they used to be. As the country is currently going through a transformational period, we are optimistic in relation to the gains that PE houses can turn in some of the Brazilian investment in the radar.
10 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?
Upstream PE funds are frequently raised abroad for investment in Brazil. PE funds raised locally have historically been driven more by tax efficiency (in light of some applicable tax exemptions) than by demand in the market, though this is slowly changing as a result of the sophistication of the local capital markets. That being said, the level of participation of investors in funds, their corporate governance and the rules applicable to conflicts of interest are among the issues more intensely debated when local funds are raised.
11 How closely are private equity sponsors supervised in your jurisdiction? Does this supervision impact the day-to-day business?
It is the type of fund, rather than the sponsor, that is regulated in Brazil. The main regulations are issued by the Securities and Exchange Commission of Brazil (CVM). Such regulation needs to be interpreted jointly with tax rules that, combined, allow for advantages (mainly regarding the income tax on capital gains). This trend has been strengthened given the recent decision by regulatory authorities (CARF) applicable to use of tax shields generated by newcos (see question 5). Supervision of Brazilian participation funds is carried out by the CVM and is intense. However, the scrutiny is more on ‘box-checking’. This is, however, evolving quickly, as the CVM invests more and more of its time and resources in scrutinising the capital markets. Two key events have occurred in the recent past with regard to the Brazilian capital markets. The first was that the CVM issued new, clearer regulations and the second, which is ongoing, is that the CVM is investing in the means to monitor compliance with the new regulations by market players.
12 What effect has the AIFMD had on fundraising in your jurisdiction?
Upstream PE and fundraising activities are making a slow comeback in the Brazilian market (they have been largely absent due to the intense economic and political crises). The AIFMD has not, therefore, had any practical effect thus far, but local PE funds are looking at the AIFMD regulations and are willing to adapt their business, organisational structures, remuneration policies, among others, to be in line with it. This is essentially because the Brazilian business sector usually adopts European and US standards shortly after they take effect in an effort to keep its market standards in line with its overseas counterparts in order to attract investors. The adoption of widely used standards – such as the AIFMD – makes the Brazilian environment easier to understand for foreign investors, whose investment accounts for the majority of local markets.
13 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?
The most important tax issues that affects PE in Brazil are those deriving from the type of foreign capital registration that it requires. In a nutshell, there is a difference in the treatment of foreign direct investments made under Law No. 4,131 on foreign direct investment and foreign investments made under Regulation 4,373 of the Brazilian Central Bank on portfolio investments, which may enjoy a favourable income tax on capital gains treatment. The problem is that, in general, such beneficial treatment only applies if the equity is acquired and sold through the capital markets. It is possible to transfer a direct investment into a portfolio investment through a complicated corporate restructuring that includes capital markets registrations and de-registrations of capital with the courts and the Central Bank. The mechanics around the transfer are, however, very complicated and may lead to additional taxation. There is no sign that this specific treatment will change. Another important issue is the ability that buyers have to amortise the goodwill arising from acquisitions. Unlike the benefits arising from a portfolio investment, however, this particular tax feature is under intense scrutiny by the government, despite changes being introduced in late 2013. The calculation of the size of the goodwill, for example, was changed to make it more in line with the International Financial Reporting Standards, which, in essence, reduces the size of the goodwill. The Brazilian tax authorities also closely monitor the economic substance of the goodwill when it starts to be amortised by Brazilian companies. It is thus very important, when tax planning is being designed, to ensure that the entities used to generate the goodwill have more substance and purpose than merely the creation of the goodwill. Last, but not least, the recent decision of the regulatory courts that upheld the use of a tax shield deriving from taking debt through a newco (that is subsequently merged into the operating entity) could be a landmark for leveraged buy-outs in the country. This is still to be seen (as it can be changed through a simple change in Brazilian regulations applicable to PE funds).
14 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?
I think that the levels of activity will increase. For good or ill, Brazil has been for the past 30 years a countercyclical country. While consumption and investment levels are deaccelerating globally, in Brazil they are recovering following an intense crisis. Moreover, the new government is retreating from the economy with large-scale privatisations. That alone will create opportunities that will be seized by capital pools that can correctly price and add value to assets – which is precisely the case of private equities. Fundraising in local currency is also likely to get better, as interest rates paid by the government move to historically low levels (thus pushing investors towards more aggressive investments). I still have doubts about foreign fundraising though. The foreign exchange rate is very volatile. If returns are calculated in foreign currency and exits occur at the wrong time it would be tough to achieve the US or UK levels.
The Inside Track
What factors make private equity practice in your jurisdiction unique?
Brazil is a very unique jurisdiction for PEs. Classic exits (for example, through initial public offerings) are rare, which makes it very important to ensure that other liquidity strategies (sale to strategic partners or teaming up with other PEs) is contractually sound. The role of corporate governance in transactions is also increasing exponentially. The classic family-owned business that receives PE investments in Brazil is not always permeable to international governance standards (such as the existence of board committees). It is thus of utmost importance that a PE advisor puts pen to paper and establishes very clear corporate governance guidelines at the time of the negotiation of the deal – it is usually very hard to do so once the deal is done. Finally, tax issues in Brazil shift rapidly and local PE houses are able to follow such movements, which provides them with a competitive edge towards new entrants. So, in a nutshell, Brazilian PE is unique in the sense that sometimes you need to diagnose the most important variables of a transaction at its outset – changing rules ‘on the fly’ is extremely difficult.
What should a client consider when choosing counsel for a complex private equity transaction in your jurisdiction?
Depth and experience. There is a common saying in Brazil that states that ‘the country is not for beginners’. This could not be more accurate. A PE house doing business in Brazil must choose counsel that has resources from a broad range of areas of law - specially tax, corporate and contractual – at hand. Things happen very quickly at negotiation tables. An inexperienced and unresourceful advisor can cause a lot of damage.
What interesting or unusual issues have you come across in recent matters?
The keynote issue is undoubtedly the recent strengthening of the defence of tax shields deriving from decisions of regulatory authorities. This is causing a lot of movement in Brazil, as the ability to deduct the interest of leveraged acquisitions affects the returns of PE funds significantly and for the better, which is not frequent in the country. This could be, however, a short-lived experience, as it would be very easy for the securities and exchange commission to change the regulation and allow direct debt taking by PE funds, which would make the whole structure less efficient.
Demarest Advogados - São Paulo - www.demarest.com.br/en