PE&VC in Brazil

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Management Report - Is Brazil a good opportunity for private equity investments?

Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive Maturing Discipline Opportunity Hardworking Competition Positive

The picture is intended to describe the Brazilian private equity industry from the perspective of the interviewees.

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IntroductionDespite the 2007-2009 financial crisis that has shaken the world and has been a major challenge for all world economies, the economic outlook for Brazil is still very positive. Brazil is expected to become the fifth largest economy in the world by 2032*. Its resilient economic performance over the recent years has attracted the worlds attention. A great number of investors want to increase their exposure to the Brazilian market. Equally positive are the prospects for the relatively young private equity industry in the country. Private equity has the potential to play an important role in the Brazilian economy as only 380 of the nation's 12 million companies are publicly traded. But the complexity of the Brazilian business environment requires careful consideration from private equity firms that want to succeed in this market.2*GOLDMAN SACHS. The Long-Term Outlook for the BRICs and N-11 Post Crisis. Global Economics Paper No: 192, 4th December 2009.

ScopeThis paper considers whether Brazil is a good opportunity for private equity investments. The findings were based on desk research carried out in London and interviews conducted in a field trip to Sao Paulo. The recommendations were synthesized in three major themes: key drivers and challenges for private equity investments in Brazil, Brazils private equity business model idiosyncrasies and, pitfalls to be avoided by new entrants. The findings in this paper indicate that there are indeed compelling reasons to believe that Brazil is a good opportunity for private equity investments and that the private equity industry in the country will evolve fast. Nonetheless, a number of internal and external factors will come into play that will either help to propel or hold back this process, over time. 3

Acknowledgements4Francesca Cornelli, supervisor & academic director of Coller Institute of PE; Florin Vasvari, professor of PE&VC; Fernando Borges, The Carlyle Group; Doug Scherrer, General Atlantic; Mario Spinola, DLJ South American Partners; Nemer Rahal, Patria Investimentos; Guilherme Passos, Pragma Patrimnio; Marcos Ayala, Gvea Investimentos; Chu Kong, Actis; A number of people have contributed to the production of this management report. I am very grateful to those who provided me guidance and shared their professional experiences. I would particularly like to thank:Luiz Antunes M. Mssnich, Bawm Investments; Emilio Pschmann, Hamilton Ventures; Antonio Caggiano Filho, Deloitte; Leonardo Zylberman, Integration; Cludio Vilar Furtado, GVcepe; Alexander Appel, GVcepe; Leonardo L. Ribeiro, OCROMA; Paula Abreu, UKTI;Jorge Maluf Filho, Korn/Ferry International; Paulo Weinberger, Heidrick & Struggles.

Assessing the opportunity

Research Methodology & Framework

Brazilian ScenarioBrazilian PE&VC landscapeRecommendationsAgenda

Research Methodology & Framework6

PEI Brazil Forum

Events

Desktop Research

Interviews

Top down analysisEconomic & Political Scenario Growth rate & Economic outlookMarket Size & Growth driversOpportunitiesChallenges & BottlenecksOverview of Brazilian PE&VC industryDrivers for investmentsCompetitive landscapeChallenges

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Economic & Political ScenarioBut will economic policy change with the new president? Source: Price Waterhouse Coopers. 8Size USD 1.6 trillion (2009 GDP)Growth potential and regional leaderStrong internal demand (60% of GDP)Active and independent regulators and CB

Low credit issuance room for expansion RE/consumer+15 years of political stability (democracy)

Strong financial system (public and private)Diversified exports base

Solid macroeconomic indicatorsHigh/stable foreign exchange reservesFiscal discipline

Massive deposits of natural resources

It looks like a stable environment for investments. Do investors feel comfortable with the government transition?Most likely Roussef will provide policy continuity in terms of macroeconomic policy orthodoxy. The fear of a radical shift to economic policy no longer exists. Evidence: Petrobrass US$70bn rights issue a few days before the national elections.

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Brazil has overcome the crisis stronger and more attractive

9Source: Goldman Sachs Global ECS Research * Consensus Economics September 2010. GDP growth rate forecasts to selected countries

2XWhat enabled the country to be in this favorable position?Discipline and conservative behavior.Flexibility to adopt stimulus measures to boost internal consumption.Credit expansion (45% of GDP in 2009).OK. It sounds good.

But will Brazil really become an economic power?

Is economic growth sustainable?

What is driving growth?

Good investment opportunities?

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Things turned out to be better than we had thought

10Source: Goldman Sachs Global ECS Research.

GS projections vs. actual figures.

2.4X

In 2009 Goldman Sachs reported: BRICs economic health post crisis suggests that GS long-term projections are more, rather than less , likely to be realised. Now GSs projections show that Brazil will become worlds fifth largest economy 18 years earlier. Updated projections for the largest economies in 2032.

Source: Goldman Sachs Global ECS Research.

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Brazils sustainable growth and competitivenessGES, a tool to monitor a countrys potential and measure the strength of a countrys sustainable growth. In 2009 Brazil has scored 5.3 surpassing China and becoming the highest-placed BRIC in the GES ranking.The report indicated Brazil is now one of the 35 best performers globally.

Growth Environment Score (GES)

The index varies from 1 to 10. Source: Goldman Sachs Global ECS Research, n. 19211GCI, enhances the understanding of the key factors determining economic growth in a country. In 2009-2010 Brazil has scored 4.2 moving up 8 positions to 56th place out of 133 countries. Within the BRICs Brazil ranks 3rd, having for the first time overcome Russia, whereas China ranks first followed by India. Global competitiveness index (GCI), 2009-2010The index varies from 1 to 7. Source: GCI 2009-2010 report.

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Market size & Growth drivers12

Brazilian economyIt ranks 10th in terms of market size (CGI index) It has benefitted from rise of commodities pricesGrowthDrivers Credit expansion Real income rise Growth of investmentsPressPressPress

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OpportunitiesUrgent need of infrastructure investmentsPoor infrastructure (airports, roads, ports, etc).2014 World Cup and 2016 Olympic games.Recent oil discoveries, Pre-salt, potentially making Brazil the fifth largest country for proven oil reserves. Large pool of private owned companiesOnly 380 of the countrys estimated 12 million companies are publicly traded. Sizable number of middle market companies of around 250-1000 employees and annual revenues of US$ 20-200 million.13Growing middle classLimited access to financingAverage lending interest rate in 2010 (estimated 42% p.a.*). That encourages private owned companies to look for partners (equity rather than debt). * Source: Economist Intelligence Unit

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However, still many challenges ahead 14

Most problematic factors for doing business (GCI)Source: GCI 2009-2010 report. Tax regulations ................................................................19.0Tax rates ..........................................................................18.5Restrictive labour regulations.........................................14.0Inefficient government bureaucracy...............................11.0Access to financing..........................................................10.4Inadequate supply of infrastructure ................................9.5Corruption.........................................................................7.0Inadequately educated workforce....................................4.9Policy instability..................................................................1.1Inflation .............................................................................1.0Poor work ethic in national labour force ...........................0.9Foreign currency regulations.............................................0.9Crime and theft ..................................................................0.7Poor public health..............................................................0.6Government instability/coups ..........................................0.3This chart summarizes those factors seen by business executives as the most problematic for doing business in their economy. The information is drawn from the 2009 edition of the World Economic Forums Executive Opinion Survey. From a list of 15 factors, respondents were asked to select the five most problematic and to rank those from 1 (most problematic) to 5.. Source: GCI 2009-2010 report.

----- Meeting Notes (25/11/2010 15:03) -----Complex tax systemRestrictive labour laws

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BottlenecksPoor infrastructure (increases costs of doing business).Low labour productivity (insignificant improvements in the last 20 years).Lack of skilled professionals available in the Brazilian market.High cost of capital (bench market interest rates - SELIC 10.75% p.a.).15

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Penetration, fundraising and investments 17Penetration PE investment % of GDP, 2008.

Source: EMPEA - Fundraising and Investment Review 2009.

The PE industry in Brazil is maturing but still has a long way to go.

3x7xPE ecosystem in BrazilSource: Interim results 2010 Census, Gvcepe research. 140 managing PE type investment firms surveyed.236 investment vehicles.554 portfolio companies.1,600 professionals and staff employed within the industry.Source: LAVCA, EMPEA * Figures estimated by LAVCA.Approximately half of all funds raised in 2009 were targeted for Brazil; 62% of investments in dollars were in Brazil.Brazil is the regional leader in LatAm

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Evolution of capital committed18Source: Interim results 2010 Census, GVcepe research. 2.3%36

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271.2%

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0510152025303520002001200220032004200520062007200820090%0.5%

40

1%

1.5%2%

2.5%

The evolution of committed capital is impressive, increasing more than 6 times since 2004 and 2 fold as percentage of GDP.

2 x

2%2 x15% p.a1%

Committed Capital as % of GDPCommitted Capital allocated to Brazil (US$ Bn).

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Deal profile19Source: Ocroma Alternative Investments research. Average deal size of EMPE inv. by region, 2008-2009, (US$ m)Source: EMPEA - Fundraising and Investment Review 2009.

Deal flow Brazilian market, 09/2008 to 05/2010.

Since the crisis in 2008 the Brazilian PE industry has been very active, Ocromas study reports a total investment of US$ 4.8 billion in 63 deals from 2H2008 to May2010. Average deal size since the crisis has increase to US$ 75 million. The most common deals were in the range US$ 50-200 million.The PE deal profile enables GPs to set up local offices and hence improve the quality of their transactions in Brazil.

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Investment exits20Source: GVcepe, June-2008 report. Investment exit by value, 01/2005 06/2008 Investment exit by number, 01/2005 06/2008

In the period Jan-2005 to June-2008, there had been 111 exits valued at approx. US$ 2 Billion.PE backed exits slowed down significantly during the economic downturn mainly due to: high levels of uncertainty, less attractive valuations and limited access to liquidity in the market.In 2009, trade sale was the primary exit and there was just one PE backed IPO. In 2010, there have been 3 PE backed IPOs, far down from the 17 registered in 2007.

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Stage of development of capital markets21CountrySize of equity market as % of GDPNumber of listed companiesMarket Capitalization % market cap of totalBrazil74%3771,1672.4%China100%1,7005,00710.3%India90%4,9551,1792.4%Japan67%3,2083,3776.9%Russian Fed70%2798811.8%UK129%2,1792,7965.7%US106%4,40115,07731.0%World81%48,56148,713100.0%

IPO & Follow-on, 2004 Sep 2010, (BRL Bn).Source: BM&Fbovespa.

Brazilian exchange (BM&FBovespa) already accounts for 2.4% of worlds total market capitalization. And is expected to increase its share of the pie in the next 20 years. 24 public offerings in 2009 (6 IPOs and 18 Follow-Ons).15 public offerings in 2010 (8 IPOs and 7 Follow-Ons) through September. Capital Markets , 2009.Source: World Bank.

EM capital markets as % of world, 2010 - 2030Source: Goldman Sachs Global ECS paper N. 204.2030: Global market cap compositionSource: Goldman Sachs Global ECS paper N. 204.EM equities may represent 55% of global market cap by 2030; 59% of global GDP.

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Business environment for PE22Receptiveness for PE Investments in BrazilTax incentive: Foreign investment in regulated Private Equity funds in Brazil is exempt from income and capital gains taxes (if not registered in Low Tax Jurisdictions).Caveat: Gov. has imposed a 6% tax on capital inflows trying to curb hot money. Scorecard highlights:Brazil ranks second in LatAm;Positives: well regulated business environment & favourable tax treatment for funds.Negatives: perceived corruption & poor IP rights.LAVCA ScorecardSource: LAVCA scorecard 2010.

Scale of 1-100, 100 being the most friendly business environment.

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Positive outlook Highlights: Brazil - second most attractive EMPE, (next 12 m).Investors with existing exposure to EMPE plan to grow their exposure from 6-10% of total PE commitments to 11-15% (next 24m).The majority of LPs expect EMPE funds to outperform PE as a whole. 61% of LPs consider themselves to be just as aligned with their EM GPs as with their developed market ones, while an additional 23% of LPs consider to more aligned. EMPEA / Coller Capital 2010 SurveySource: EMPEA EM PE 2010 Survey.

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How Brazilian PE creates IRRSource: IFC, The case for Emerging Markets Private Equity.

It is not driven by leverage and aggressive cost cutting; rather IRR is driven mostly by growth and efficiency (focus on operational improvement).Emphasis on providing funding and strategic plan for consolidation of fragmented industries.24Four ways to create IRR: Many funds use a blend of the four.For further details press

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Stable cash flowLow fixed costsLow CapexHigh profit margins Scaling business model

InvestmentThesis

IndustryBrazilianEconomy

CompanyMajority stake

CompanyMinority stake

High growth rates Fragmented (Roll up strategy)Non-cyclical sectorsHealth competitiveness (no price war)Low governmental regulation Aligned with GPs expertiseLack of financial sophistication from managementSuccession problems

Good management teamDomain knowledge of the sector from managementHigh entry barriersHigh market share & strong brandLow customer concentration Attractive entry valuationClear exit strategy

Key company-industry features for PE investments in Brazil Companys common features25Note: The findings above described do not depict the PE industry in Brazil as a whole. It cannot be considered as proxy of the investment approach of the executives that contributed with the research rather it is intended to provide deeper knowledge of the practices that have been applied.

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Competitive landscape26

ButThe percentage of deals that have been done through auctions is still low (estimated 20%).The number of GPs is relatively small compared to that of other emerging markets such as China and India.

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Key identified challenges for PE investments27

Note: FIP stands for Fundo de Investimento em Participao, which is the most typical private equity fund vehicle in Brazil.

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Assessing the opportunity29 Selected 16 drivers and challenges for PE&VC investments and then classified them between favourable and unfavourable. 6) Limit access to financing7) Stage of development of capital markets8) Deal size and flow9) Good alignment of interests with LPs10) Higher returns expected 11) Tax incentives for FDI 12) Moderate competition1) Shortage of skilled professionals2) Corruption3) Slowness of the judiciary system

4) Currency risk1) Political stability2) Market Size3) High GDP growth rate4) Enormous needs for investments 5) Large pool of private owned companies

CountryPE industryFavourableUnfavourableThe PE&VC landscape in Brazil looks like a good opportunity indeed. But should investors enter this market now or in a few years? What else is favourable in the Brazilian PE&VC industry? What pitfalls can be avoided by new entrants?

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Timing: it would be better entering the market now30

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Brazils PE business model31Drivers of returnsMature MarketsBrazil Comments on the Brazilian modelLeverageGrowthMultiple expansionEfficiency gains

Much less reliant on debt.Key component for creating IRR. Greater need of the type of skills and business knowledge provided by PE firms. Many more opportunities with macro conditions improving and opportunities for proprietary deals.

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Not only finance but also operational background. GPs are looking for team members that can add value to the businesses of their portfolio companies.

Diversified teamLocals GPs have advantage of sourcing (capillarity) and finding management for portfolio companies.

LPs are looking for GPs with strategies that can be replicated in future investments.

Brazil has a complex and multi-layered tax system. Close consideration is required to this issue. Much money can be legally saved through the right tax planning.

Replicating strategiesTax PlanningLocal presence

Lessons learned from the past.

Deep knowledge of the market is also key. 33

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Thank youfor your attentionVictor Carlos Casabona FilhoSloan Fellowship 2010London Business School

Phone: +44 (0) 7872 [email protected]

Appendices35

Investments36Growth of gross fixed investment (% of GDP)UNCTADs World Investment Prosp. Survey, 2010-2012.

Go backThe 2010-2012 WIPS shows Brazil among the top 5 priority-host economies for foreign direct investment (FDI). Brazil has moved up one position, raking 3rd after India and China.

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Credit expansionLeveraging as the rest of the World De-leverages

37Credit expansion

Go back

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Income rise Source: Economist Intelligence Unit

2XPopulation, Inc. growth & consumption, 2005-2014Income per Capita in 2050, (2007 - US$)

12thSource: Goldman Sachs Research, GES n. 169, 2008.38

Go back

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Selected macroeconomic indicators Source: Economist Intelligence Unit

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Operational improvement includes growth and EBITDA expansion.Business plan development & implementationStrengthening of managementRoll-up strategy (acquisition)New management incentive programBest practices of corporate governance Cuts of headcount & Capex & renegotiation of suppliers contractsEfficiency improvementsInnovation (new products, channels, markets, etc.)Credibility improvement - Efeito Certifio

Financial engineering (leverage with caution)Leverage for funding acquisitions

Buy undervalued assets and sell at higher valuationsMacroeconomic scenario improvement market timing Phase IBuyPhase III SellPhase IIValue Creation

BasicValueMarket- premium

BasicValue

LeverageMultipleArbitrageOperationalImprovement

Private equity value creation40

Go back

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Fund manager skillsSource: IFC, The case for Emerging Markets Private Equity.

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ReferencesABVCAP - Private Equity e Venture Capital - Analysis of Brazilian Industry, 2007.

ABVCAP - Monitor Group. Private Equity and Venture Capital Analysis of Brazilian Industry.

ASSUMPCAO, Alfredo , The Brazilian economy, The blackout of Talent and Strategic Hiring.BAIN & COMPANY. Global Private Equity Report 2010.

Baker & McKenzie. Private Equity in Brazil November 2008 paper.

Brazil country report, November 2010, Economist Intelligence Unit.

EMPEA - Insight: Brazil, 2010.

EMPEA - Brazil Private Equity in Global Perspective, 2010.EMPEA - Fundraising and Investment Review 2009.

EMPEA - Coller Capital Emerging Markets Private Equity Survey 2010.

Gvcepe, Overview of The Brazilian Private Equity and Venture Capital Industry research report. June 2008.Getting it together at last - A special report on business and finance in Brazil. THE ECONOMIST - November 14th, 2009.

Groh, Alexander Peter, Private Equity in Emerging Markets, 2009.

HSBC Holdings plc, & Economist Intelligence Unit, Brazil Unbound, 2010.INTERNATIONAL FINANCE CORPORATION, Doing Business 2010: Reforming through Difficult Times, 2010.

INTERNATIONAL FINANCE CORPORATION, The case for Emerging Markets Private Equity.

INTERNATIONAL FINANCE CORPORATION, The case for Emerging Markets Private Equity.

LAVCA 2010 Scorecard.GOLDMAN SACHS. EM Equity in Two Decades: A Changing Landscape. Global Economics Paper No: 204, 8th September 2010.GOLDMAN SACHS. Building Better Global Economic BRICs. Global Economics Paper No: 66, 30th November 2001.GOLDMAN SACHS. Ten Things for India to Achieve its 2050 Potential. Global Economics Paper No: 169, 16th June 2007.GOLDMAN SACHS. The Long-Term Outlook for the BRICs and N-11 Post Crisis. Global Economics Paper No: 192, 4th December 2009.

Ocroma Alternative Investments. Private Equity Update, Fundraising Report Brazil, Leonardo L. Ribeiro, 12/2008.

Ocroma Alternative Investments. Private Equity Update, Rising Star: Brazilian Private Equity after the crisis, Ricardo Kanitz and Leonardo L. Ribeiro, 6/2010.PRICEWATERHOUSECOOPERS PWC. Highlights of Brazil An overview of Brazils performance during the 2008/2009 international financial crisis.

TALMOR and VASVARI, International Private Equity, John Wiley, 2011.RIBEIRO, Leonardo de Lima Modelo Brasileiro de Private Equity e Venture Capital, 2005.UK TRADE & INVESTMENTS UKTI. Private Equity e Venture Capital in Brazil, 2010.United Nations Conference on Trade and Development Unctad. World Investment Prospects Survey 2010-2012.World Economic Forum - WEF. The Global Competitiveness Report - 20092010, Klaus Schwab, 2010.

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Economy & Finance

PE&VC in Brazil