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Thursday, 23 November 2017

ECM 2005 - Reaping the benefits of reform

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Riding the wave of multi-year economic prosperity, Latin American equities have assumed a new place in investor portfolios. A region once known for its capital-deficient, high-growth economies is showing signs of maturity, leaving growth as the stand-alone consideration for investors. Stephen Lacey reports.

Brazil’s surging economy, which grew 3.9% in the second quarter and boasted a trailing twelve-month trade surplus of US$39.9bn, has attracted the interest of foreign investors. The country’s Bovespa benchmark index was up 10.3% to 28,855 as of early September, a performance that was all the more impressive taking into account the 23.6% appreciation in the Real relative to the US dollar over the same time period.

“The macro situation in Brazil has provided a positive backdrop,” said Sebastien Chatel, executive director of ECM at UBS. “The risk spreads are very tight and that is a function of the twin trade surpluses; lower government spending and higher exports.”

“Assets in non-domestic funds are attracting an increasing proportion of overall net inflows to equities funds,” noted Robert Adler, president of AMG Data Services, an independent firm that tracks such figures. “US investors appear to be using international funds as vehicles to both hedge currency risks and in pursuit of higher returns. This trend has begun to accelerate this year.”

Underpinning some of that interest are the structural reforms adopted by Brazil to protect the rights of minority shareholders. The 2001 launch of the Novo Mercado, a listing segment of the Sao Paulo stock exchange where issuers voluntarily comply with more stringent set of standards on corporate governance practices and disclosures, has been a key catalyst for equities issuance.

The most significant aspects of the Novo Mercado are that all shares have equal voting rights and that arbitration be used for the resolution of investor disputes. The adoption of a single share class is significant because Brazilian companies previously had two share classes, enabling a takeover through purchases of the controlling, preferred shares at the expense of minority, ordinary shareholder rights.

“Investors are interested in participating in emerging markets, and the Novo Mercado has given them a way them a way of investing that is much better than the PN [preferred share] format,” said UBS’ Chatel.

Another important development was the reform of Brazilian pension laws in 2002 to allow for greater allocations into alternative assets. This has led to the emergence of more seasoned class of institutional investors and, as a result, a growing receptivity of private equity as an asset class. When combined with improved corporate governance, the reforms mean deals can be both sourced locally and listed on the local markets.

“I know of multiple private equity firms that are looking to raise US$500–$1bn that are devoted solely to investment in Latin America,” said Alex Lehmann, director in ECM at Merrill Lynch. “Because private equity investors are always looking for their exit that ultimately should continue to feed the new issue market.”

Indeed, all of this suggests that the latest upturn in equity issuance is more sustainable than in prior cycles. There have been 13 IPOs (US$2.6bn) in Brazil since the beginning of 2004, with six of those companies receiving backing from private equity firms. GP Investimentos, one of the leading private-equity firms, insisted on Novo Mercado-like levels of governance on the June 2004, US$188.5m IPO for Brazilian railroad operator America Latina Logistica (ALL).

While regulatory constraints prohibited listing on the Novo Mercado, ALL did adopt all of its significant provisions, such as 100% tag-along for minority shareholders, US GAAP, independent board representation. Such investor protections were key to attracting the interest of foreign investors in the company’s IPO, which was led by Banco Pactual and Merrill Lynch.

ALL, whose majority shareholders are required by the government to retain at least a 50% stake, gave minority shareholders a large voice as part of its US$209.3m follow-on offering in March. The offering consisted of 7.9m units, comprised of one common stock (voting) and four preferred shares (non-voting), and followed a one-for-five reverse split of the preferred shares and right to convert into the units, thereby increasing overall trading liquidity.

Aside from Gol Linhas Aereas Inteligentes and Tam SA, which are also required to retain controlling ownership above a 50% threshold, the remaining IPOs all listed on the Novo Mercado. The local-market exchange enables companies to forgo the costs and complexities of listing in the US, post adoption of Sarbanes Oxley in that country, while offering similar levels of investor protection. “The only time that you would choose a US listing is if you have a global business and want to be compared to competitors on that basis,” noted one ECM source.

These factors, in turn, have opened the capital markets to progressively smaller companies. In a culture that historically has relied upon financial backing from families or the government, however, there have been some growing pains. Brazilian retailer Lojas Renner struggled to solidify investor interest in a US$328.7m IPO that represented all of former parent JC Penney’s entire stake despite both a Novo Mercado listing and registration with the US securities regulators.

“The 100% freefloat turned out to be a major hurdle," confided one banker at the time of the June 2005 IPO. Merrill Lynch and CSFB placed the majority of the 20.9m-share offering with international investors in pricing at R$37, the low end of R$37–$43 price talk. “The Brazilians couldn’t figure out who was going to bail out the company if conditions deteriorated,” said the banker.

The use of dedicated domestic and international tranches generally, however, has resulted in a dislocation of demand against international investors not only on Brazilian deals but and across Latin America. In Mexico, for example, homebuilders have benefited from government initiatives designed to encourage home ownership.

To tap into name recognition as well as establish trading, UBS and BBVA-Bancomer predominately relied upon Mexican retail in placing a US$183.3m IPO for Urbi Desarrollos Urbanos, the country’s second-largest homebuilder, in May 2004. With a 70%/30% domestic/international split, international investors were forced to fill positions in the aftermarket – Urbi shares were seen recently at MX$69.00, 115.6% over its MX$32.00 offering price.

A month later, Citigroup and Merrill Lynch flipped the allocation strategy to 70%/30% in favour of international investors, in an effort to accommodate demand a US$183.3m IPO for fellow homebuilder Desarrolladora Homex. The company, which boasted financial backing from a private equity fund affiliated with US real estate mogul Sam Zell, chose to list on the NYSE. Its shares were seen recently at US$31, 96% above its June 2004 offering price.

In Chile, retailers have taken advantage of the country’s mature pension programmes to fund their plans for expansion across the continent. On the September 2005, US$216m IPO for Ripley SA, one of three retailers from the country to access the markets in the past two years, Deutsche Bank and Santander Investment Chile pursued a broad-based allocation strategy in the domestic markets (22,000 investors) and a more focused strategy (20 institutions) on international commitments.

“We wanted to have a significant international tranche,” said Juan Aguero, managing director in ECM at Deutsche Bank. “It is important to create high-quality demand from a long-term investor base that can add value in the future.”

By historic standards, however, the current financing cycle has almost run its course and, as remains the case throughout LatAm, the favourable political and economic underpinnings quickly can deteriorate. There were a mere 13 equity offerings in Brazil from 1995–2003, and just one from 2001–2003, as the country grappled with a devaluating currency and concerns and a changing political regime.

The appreciation of local currencies could just as easily reverse course and political elections across LatAm next year could add to the uncertainties. “If you play Brazil, you’re also playing the currency,” notes Juan Vogeler, a VP in ECM at JP Morgan. “The markets are betting on stable to continued appreciation, and some economists are saying the opposite.”

JP Morgan economists predict that the Brazilian real will fall from its current level of R$2.31 per US dollar to R$2.55 by year-end and R$2.90 in 2006. One catalyst for such a depreciation are expectations that the government will lower short-term interest rates, currently 19.25%, ahead of the elections next autumn, thereby decreasing the attraction of the real.

Recognising just such a possibility, companies are stepping up the pace of equity issuance. “There’s going to be a push to issue equity before this year is out because issuers are very aware of the noise that surrounds political elections,” notes Merrill’s Lehmann, whose firm is projecting a R$2.65 exchange rate on the real within the next 12 months. “There are probably another 6–10 deals that could come between now and year-end.”

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