Brazil’s Shrewd Banking Strategy

Last year when Brazil’s second largest bank, ITAU Unibanco, sold 400 million reais (USD$200 million) of bundled corporate loans (technically referred to as CLO’s or Collateralized Loan Obligations) to foreign investors, the news media viewed the move as a signal that Brazil’s lending capacity was drying up.  Just like a business that sells its receivables to raise cash quickly, Brazilian banks were replenishing their lending capacity by selling their attractive loan portfolios at a discount to foreign investors. To date, sales of CLOs have been brisk exceeding 50 billion reais (USD$25 billion).  Should investors be concerned that Brazilian banks might be unloading their inventory of corporate loans to avoid a liquidity crisis?  If not, what is really going on? 

Brazil’s commercial and industrial backbone consists of over 14,000 mid-cap size companies that range in sales between USD$30 million and USD$200 million. These companies are mostly privately-held, which makes buying and selling equity shares for foreign investors that much more challenging. Funding resources for these companies are limited, and the Brazilian government believes that the bulk of financing for these mid-cap companies, going forward, will have to come from outside sources.  For these and other reasons, the Brazilian government has deliberately used the sale of its double-digit interest rate CLOs, ranging between 12% and 16% per year, to entice hedge funds, private equity firms, and investment banks worldwide to consider Brazil as their next port of call. Compared to the 1% and 2% returns earned back home, it is no surprise that these CLO sales have generated a strong buying demand from foreign investors. Brazil banking authorities hope that these transactions will catalyze a comprehensive consolidation of its mid-cap companies through cross-border mergers and acquisitions activities. In preparation to receive foreign investors, Brazilian companies have started to hire professionally-trained  management teams. Their CEO’s realize that unless they conform to internationally accepted best practices, their firms could either miss out on a huge funding opportunity or be left behind.  It is not up to foreign investors individually to decide where their funds can be invested but rather their shareholders who, by design, require sound investments that include third-party auditing, financial transparency, and evidence of proper governance practices.

At a recent breakfast meeting titled ‘Brazil Investment Management’ sponsored by the Brazilian-American Chamber of Commerce, a distinguished panel of experts shared their thoughts on viable approaches for Brazilian investments.  One of the panelists, Mr. Pedro Soares from Eurovest S.A., highlighted one of his company’s success stories, namely, the Brazilian clothing manufacturer, Hering. By restructuring its high interest debt and installing a professional management team, Eurvest unleashed Hering’s true growth potential from an initial valuation of USD$50 million to that of a public company currently valued at $7.5 billion.

Hering’s huge success was in large part attributed to Brazil’s growing domestic market which included over 40 million new consumers that had been lifted from poverty and could afford to buy beyond their basic needs.  However, without the organizational and financial structural changes spearheaded by Eurovest, Hering could never have achieved this incredible milestone.

Eurovest’s success story prompts the following two questions:

Q1. – How many more ‘Hering-like’ potential success stories are hidden within Brazil’s 14,000 mid-cap firms?  …probably a good number!
Q2. – If potential profits are so readily available in Brazil, why would Brazilian banks be so eager to sell their loan portfolios to foreign investors?

Central to the answers to both of these two questions is Brazil’s antiquated and neglected infrastructure followed by two Brazilian nuances that investors should heed.

Brazil’s Infrastructure
It is no secret that Brazil’s infrastructure, which includes highways, airports, railroads, and shipping terminals are vastly inadequate to support its rapidly growing commercial base.  Very often the cost of transporting goods from the interior of the country to a nearby port is more expensive than moving the goods from a port to its intended destination (i.e. China or US).  City roads for commuters are also an issue.  In May of 2012, underground metro workers in Sao Paolo held a strike that resulted in a 249 kilometer vehicle traffic backup!

Building a new highway, for example, is an immense project that not only can take a long time to complete (i.e. 30-40 years) but also can tie up capital funding that otherwise could be used elsewhere to help grow the economy.  However, one cannot exist without the other, which, in short, illustrates Brazil’s current dilemma.  If Brazilian banks extend credit to the private sector without investing in the country’s infrastructure, the higher cost associated with transporting finished goods and workers throughout Brazil would eventually hurt their exports by making their products too expensive and hence less competitive to global markets.  On the other hand, if Brazilian banks neglect the private sector’s financial needs, good companies would fail, which in turn would increase unemployment and hurt the overall economy.  As part of an optimal response to this dilemma, Brazilian banks have sought out the assistance of foreign investors by selling them their prized portfolio of loans or CLO’s.  They promote these high interest investments as ‘sure bets’, since the government’s overall strategy is hinging upon its success to attract more direct investments.  Should foreign investors be concerned and what Brazilian nuances should they take into consideration?

Brazilian Nuance #1 – ‘Local Knowledge’ Premiums
At the Brazilian breakfast panel meeting, a representative from Triunfo Participacoes e Investimentos, Mr. Sandro Lima, proudly announced his firm’s three recent concession awards, which included the Campinas Airport near Sao Paolo (soon-to-be the largest airport in Latin America), two hydroelectric power plants with a combined total of 300 MW capacity, and a container terminal port.  When asked what business the firm was in, since all three concessions were vastly different from a business model perspective, Mr. Lima explained that Triunfo’s core business was not managing construction projects but rather navigating through the Brazilian government’s network of officials to secure these concessions.  Although there is nothing wrong with leveraging 30-years of government relationships to gain access to lucrative contracts, investors might have good reason to question the company’s ability to deliver an economically crucial project on time and on budget.

As shown by Triunfo’s example, being ‘well connected’ in Brazil is a key consideration to succeeding in business, so much so that Brazilian firms with market shares larger than 80% are considered more valuable by Brazilian brokers and usually priced at a premium above and beyond their normal valuations.  On paper this rational may make perfect sense, but Brazilians sellers may discover a tepid response from foreign buyers. Dominant players from emerging technologies usually involve family-run businesses that may not have earned their dominant position through free market competition but rather from strong-arm tactics.  Smaller players with more agile technologies and better aligned management teams will be seen as the more likely disrupters and hence better investments.  One might expect that this arbitrage will self-correct as more investors purchase mid-cap winners such as Hering who over time can be expected to take market share from the ‘overpriced’ dominant firms in their respective industries.

Brazilian Nuance #2 – Extended Tax Liabilities
CLOs may look attractive on paper to foreign investors but when matched to the balance sheets of the companies these loans represent, the advantages may start to look fuzzy to the financially astute.  At the breakfast meeting, panelist explained, as a matter-of-fact, that over 90% of Brazilian individuals and company taxpayers today openly hold a past due tax liability with the government.  In some cases the amounts in arrears are staggering and could cause great alarm with any investor group not in ‘the know’.  As it turns out, those that choose to pay their tax bill hire specialized firms to negotiate with tax collectors.  That may appear similar to a developed country such as the US, however, the negotiating leverage falls largely on the taxpayer who can decide either to postpone payment to the government for another twenty to thirty years at will or to pay a significantly smaller settlement.  Some firms go as far as capitalizing their debt using clever accounting maneuvers.

Humored by the panels ‘very relaxed’ attitude toward the importance of paying their back taxes, I wondered if the Brazilian taxpayer’s past experience with hyper-inflation between 1980 and 1994 had forced the government to over tax as a means of keeping its public sector payrolls funded. Now that the Brazilian currency is stable and inflation under control, the supposed brazen attitude of tax collectors during the hyper-inflation era may have created a sense of animosity among taxpayers.  There is an interesting irony to this story.  Due to recent turn of events, Brazil’s tax authorities may win out after all.  Brazilians who became accustomed to not paying their ‘inflated’ taxes are now being forced to comply, not because the Brazilian government has clamped down on tax evaders, but rather because firms like Hering would otherwise not get funded by foreign investors who are required by their board of directors to invest in companies that pay their taxes in full.

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Not-to-be-underestimated, the Brazilian authorities know that they must focus on the large and less attractive public investments in order to modernize their current infrastructure. Luring foreign investors with high interest rate CLO’s has helped gain the attention and commitment of global fund managers to meet Brazil’s pressing mid-cap company needs.  At least for now, these foreign investors will bring the contacts and expertise needed to sift through Brazil’s rich inventory of 14,000 mid-cap companies and select the ‘Hering-like’ winners that could one day, qualify for a listing on Brazil’s Bovespa Stock Exchange.

In retrospect the Brazilian fire sale of CLO’s had nothing to do with a crisis of liquidity but rather everything to do with a renewed set of government priorities, based on an optimal allocation of global resources.  Brazil’s banking strategy is not only shrewd but brilliant!

Occupy Brazil

With European banks repatriating funds from their overseas investments, emerging economies such as Brazil have been left to their own devices to attract alternative sources of funding from elsewhere, hence a recent Brazil Summit in New York on April 23, 2012.  Just what Brazil was asking from the Big Apple’s investment community is not exactly clear and for the most part reminded me of the infamous Occupy Wall Street movements where the overall message lacked focus.  However, there was a striking difference.  

‘Occupying Brazil’ is not about a 1% wealth disparity but rather a living success story of wealth distribution where, in contrast, 55% of the Brazilian population today are considered part of the middle class. According to Brazilian experts, over 46 million consumers qualify as recent entrants and are ready and able to buy beyond the basics.  Companies selling furniture, electronics, autos, and more are lining up with good reason to earn a piece of this burgeoning market.  Unfortunately, the onslaught of companies has introduced a new set of problems, namely, where to accommodate everyone including their offices and how to transport them around efficiently throughout each city.

Brazil’s infrastructure, which includes its roads and highways is at the heart of both its greatest success and its most severe problems.  A 45 minute drive to Sao Paolo’s airport often becomes a 5 hour ride with only minutes to spare to catch an international flight.  Having too many cars circulating through poorly maintained roads is costing the Brazilian economy billions in lost productivity.  Fortunately the government is  aware and is aggressively seeking innovative solutions to address these and other pressing issues.

Even though Brazil is considered a developing country, Brazilian leadership is not to be underestimated.  Henrique de Campos Merirelles, a former Brazilian central banker and known for his poker-face style, won the highly coveted prize of hosting the 2016 Olympic summer games against a formidable slate of candidates, which included Madrid, Tokyo, and Chicago.  Equally as impressive, Brazil will host the 2014 World Cup Soccer games for a combined investment bonanza estimated at USD$53b.  Other milestone achievements include a $225b capital investment for extracting 95 billion barrels of pre-salt oil reserves located miles under the ocean.  These type of herculean investments have helped Brazil become the sixth largest global economy with a GDP of $2.5 trillion, surpassing the United Kingdom.  By comparison, the USA is the largest economy at $15.1T followed by a distant China (but growing rapidly) at $7.3T.

How will Brazil host two world class games, accommodate a vibrant and growing middle class, monetize its oil reserves, and maintain a sustainable economy for decades to come?

If you ask Guido Mantega, Brazil’s Finance Minister, he will undoubtedly point to lower interest rates and longer term debt.  But despite his assessment to solve his country’s problems, Mr. Mantega and other well-trained government officials are log jammed in a political quagmire among themselves, which in an uncanny way resembles the notorious traffic congestions on Brazilian streets.  Similar to vehicles sitting in traffic, the many ideas and suggestions from Brazilian officials are getting caught up in an antiquated political system that, like its roads, needs to be redesigned and overhauled.

Is there a Danger of Runaway Inflation?
Some experts fear that the increasing demand for goods and services in Brazil will overheat its economy and potentially trigger runaway inflation; however, a closer look at the numbers shows that nothing could be further from the truth.  Just recently Brazil reduced its interest rates to 9%, a level considered high by global standards but, when evaluated with other extenuating factors, falls in line with the norm.  First, not every loan in Brazil is treated equally.  For example, local industries can get access to subsidized rates that are closer to 1% through its national development bank, BNDES.  Banks loaning at 9% to consumers are borrowing at 1% and using a portion of their profits to support government-backed savings accounts that offer tax-free annual interest of 6.17% to consumers.  With an inflation rate of around 5%, Brazil is actually operating within the real interest rate range of other global economies.

Is there a Danger of a Real Estate Bubble?
According to the World Bank, Brazil would need an annual growth rate of 10% for the next 10 years, just to meet its growing demand.  Today Brazil’s GDP growth rate is fluctuating between 4 and 5%.  On its own, Brazil clearly cannot meet its soaring demand.  For example, Brazil’s annual growth of 4% for its roads and highway projects matches the 4 to 5% annual expenditures needed to maintain existing structures.  In essence, Brazil’s roads and highway infrastructure is experiencing zero growth on a net basis.  Another example is in real estate.  As long as developers continue building for current rather than future demand, a real estate bubble could never form.

However, not all is rosy for Brazil.  Without the efficient injection of long term affordable debt funding, the economy could stall.  Demand for goods and services from an onslaught of global consumers could force prices to rise causing havoc for the newly minted middle class who will demand more from their politicians and become adamant to vital social and economic changes.  Why then has Brazil not experienced economic collapse due to runaway inflation?  Part of the reason may be attributed to Brazil’s uncanny ability to foresee its own future in a manner that no global index has been able to capture.  I like to refer to this stealth trait as ‘Brazilian foresight’.

Brazilian Foresight
To appreciate the power behind ‘Brazil’s foresight’, one should ask two key questions:

Q1. Was it not Brazil who 40 years ago decided after the oil embargo during the Carter years to launch a biofuels industry that today provides the country with unprecedented energy independence?
Q2. Was it not Brazil that after pegging its currency to the dollar to control inflation, reverted back to its local currency, the Real, to regain its economic independence by shifting from local consumption to an export-led economy?

Truly, if an index for foresight were established, Brazil would be ranked among the top five!  A follow-up question might be, “Is the influence of ‘Brazilian foresight’ present today?”  Perhaps.

Traces of ‘Brazilian foresight’ emerged from the recent Brazilian Summit organized by the Brazilian Chamber of Commerce and held at the Harvard Club of New York.  Brazilian panelists who addressed the pressing need for cheap long-term loans, discussed an alternative financial arrangement known as public-private partnerships or PPP’s.  These complex arrangements between the public and private sectors combine strategic companies with a combination of government concessions and long term revenues.  A recent example is a soccer stadium that will be used for both the World Cup and the Olympics.  The 33-year deal involves the government and a group of strategic private companies whose expertise is expected to reduce investment risk and ensure a viable return over the long term.

Another trace of ‘Brazilian foresight’ was a recent bilateral agreement between Presidents Rousseff and Obama.  As part of a program called ‘Innovation in Sciences’, 100,000 Brazilian students will be sent abroad on full-paid scholarships to earn their Masters or Doctorate degrees at academic institutions worldwide.  Half are expected to attend US universities including Harvard and MIT.  This bold initiative will move Brazilian presence at prominent US universities along side 160k Chinese students, 100k Indian, and 70k South Koreans who are already present.  The Brazilian government hopes to entice their returning graduates to to fill the 900k engineering positions expected to open by 2020 in the IT industry alone.

Proposed Solutions
Clearly Brazil’s future will depend upon its ability to attract low interest, long-term debt.  But with political time horizons that seek short term victories, one might expect Brazil’s President Rousseff to decouple long-term debt financing initiatives with current politics.  For starters, floating a 3 billion Real 40-year sovereign bond at a low rate would not only send a strong message to the international investment community but also help investors set rates for their own projects.

Taking into consideration the potential foresight of Brazilians, one can only expect that both reason and smart solutions will eventually prevail.  Outside investors should take note, if indeed, they intend to some day ‘Occupy Brazil’.