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.

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!