Brazilian Privatization: Stepping up the pace

A SUPPLEMENT TO EUROMONEY – MARCH 1997

Unlocking Brazil’s potential

Brazil’s ambitious privatization programme could help to free the potential of what is comfortably the largest economy in Latin America. Sao Paulo state alone has a population twice that of Chile, and its own privatization programme rivals that of many countries. Factor in the state of Rio de Janeiro and the mining riches of the interior of the country, and the opportunities for foreign investment are clearly immense.

Co-ordinating such a sweeping programme is a complex matter, especially when the federal government, the states, and the municipalities are all involved, sometimes in the same industry sector. For this reason the federal development bank, Banco Nacional de Desenvolvimento Economico e Social (BNDES), sees a central role for itself in the overall process.

The bank has been instrumental in selling the message of privatization to the states, using its own sale of federally owned assets as a blueprint. It is now offering its services as consultant to the states on their own programmes, addressing such issues as the viability of trade sales versus public offerings and the extent to which Brazilian ­ as opposed to foreign ­ investors should be involved.

The participation of BNDES may not be a formal one in all cases since it does not have powers to interfere in the autonomous decisions of the state governments. But the development bank is to be found in the background on most deals. “It is natural for the states to come to BNDES, even if we are not participating directly,” says Mariane Sardenberg Sussekind, general manager of the federal privatization office at BNDES, noting that the top officials have a close relationship with the state governors. In addition to this informal role, BNDES is acting as a consultant on some state sell-offs providing a blueprint on technical matters such as how to conduct a bidding process for advisory mandates and how to evaluate the proposals.

There are also examples of closer involvement, where BNDES has taken shares in companies as collateral on loans to states, with an agreed timetable for their privatization. “We have the role of managers in the federal programme but we are also stimulating the programme at state level,” Sussekind explains. The privatization loans are part of this effort.

One example of BNDES’ funding centres upon the electricity utility Cemig. Last year the state government of Minas Gerais issued $430 million-worth of debentures convertible into Cemig voting shares. These were purchased by BNDES, in effect providing the state with an advance on privatization proceeds.

Most investment bankers involved in privatizations are happy to see BNDES take such an active role. They argue that it will help to co-ordinate what otherwise could turn into a free-for-all as the states compete to unload assets.

“You certainly have to avoid selling the electric generators at the same time because the potential buyers are the same,” says Paulo Ferraz Pereira, president of Banco Bozano Simonsen, which has its headquarters in Rio de Janeiro. This view is echoed by Luigi de Vecchi, managing director at Dresdner Kleinwort Benson in Rio. “This issue will be important in the electricity sector, where there will be a lot of assets for sale at once,” de Vecchi says. It will be important for BNDES to keep an eye on the overall process, especially with regard to timing.

Another issue being discussed between BNDES and the state governments is the extent to which domestic Brazilian shareholders will be involved in the sell-offs. This is a politically sensitive matter, since the various authorities wish to build up popular support for the idea of privatization. “It is politically correct to allow small shareholders to participate,” says one Sao Paulo-based observer, “and it will also help develop the domestic capital markets.”

Bringing first-time share buyers on board is clearly important, although de Vecchi at Kleinwort Benson acknowledges that there is little broad-based retail demand in Brazil. But, he points out that this was the case in the UK at the outset of its privatization in the 1980s. “The challenge will be to create it,” he says.

To this end BNDES is studying ways to interest small investors and make it easier for them to subscribe to offerings, such as paying for shares by instalment. Employee share allocations will play an important role and it is hoped that around 5% of the total capital of mining conglomerate Companhia Vale do Rio Doce (CVRD) will be bought by its employees. But BNDES clearly has more to do to convince small investors to participate. Last year employees at Rio de Janeiro’s electricity utility, Light Servicos de Electricidade (Light), were offered 10% of the company but subscribed only to a disappointing 5.3%.

“It is very important to have the participation of the people,” says Patrick Ledoux, director at Banco de Boston in Sao Paulo, “and it is the government strategy to have the issues widely distributed.” He notes that this will include employee share-buying programmes and domestic public offerings.

There is also the participation of Brazilian pension funds to consider. Brazil’s array of retirement funds gives it the largest amount of assets under management in Latin America ­ more than $68 billion. And Brazilian fund administrators have a higher percentage of funds invested in stocks than is the case elsewhere in Latin America. This makes them natural candidates to buy into privatization issues.

Also, as Walter Stoeppelwerth, head of research at Robert Fleming in Sao Paulo, points out, the current 30% weighting that Brazilian pension funds have invested in stocks still falls short of the 45% maximum allowed by the authorities. “They have a lot of room for more stocks and I think they are waiting for the privatizations,” he says.

Some analysts believe that the pension funds will have an active role to play in the sale of CVRD. This could be done in two ways. First pension funds may offer themselves as partners in bidding consortia, giving a Brazilian flavour to the bid, and possibly even gaining a board seat as a major shareholder. Or they could acquire stock at the time of the domestic public offering.

Involvement of the pension funds would help to boost the domestic ownership of CVRD and other privatized companies. However, analysts point out that there is little tradition of the funds being activist shareholders.

While wide distribution remains an eventual goal, 1997 looks likely to be a busy year for the mergers and acquisitions (M&A) departments of the investment banks, rather than the capital markets side. This is because the immediate focus of the privatization programme involves transactions with strategic investors, equity offerings generally being viewed as complementary, following six months or so after the initial sale.

“The rationale is that you get a control premium and also that bringing in large, strategic shareholders will allow for technological and operational improvements,” says Victor Moraes, research director at Banco Patrimonio de Investimentos in Sao Paulo. He cites the stemming of energy losses as one example, with a company such as Companhia de Electricidade de Rio de Janeiro (CERJ), which distributes electricity in Rio, set to benefit from its new Chilean management. For this reason Moraes expects to see the trade sale of control blocks as the main avenue for upcoming privatizations, followed by public stock offerings at a later date.

This dual process means that consortia bidding for advisory mandates need to have a strong M&A department as well as capital-markets distribution muscle. Bidders on the Companhia Energetica de Sao Paulo (CESP), Companhia Paulista de Forca o Luz (CPFL) and Electropaulo electricity utility sell-offs were asked to propose success fees for a trade sale and underwriting fees for a public offering; this is viewed as the way forward for most deals.

Bankers in Sao Paulo say that the trend on fees is undoubtedly downward, given the large number of foreign investment banks fighting for a piece of the Brazilian privatization process. And in future, foreign investment banks are also likely to encounter more competition from local Brazilian institutions which are pressing to be included as partners on more advisory mandates.

Banco de Investimentos Garantia, together with Credit Suisse First Boston, advised the state government of Rio de Janeiro on the CERJ sale, its first experience on the selling side. Garantia has also teamed up with Goldman Sachs and JP Morgan to bid for mandates on the Sao Paulo electricity utility transactions. In underwriting, Garantia in New York has foreign clients to interest in buying into Brazil. “We will definitely be interested in all deals involving a capital-markets component and as far as trade sales are concerned we will examine carefully in which ones we can add value,” explains an executive at Garantia in Sao Paulo.

Brazilian banks also want a stronger presence in international equity underwriting syndicates, given that the domestic tranches are generally going to be relatively small. For example, Banco Bozano Simonsen already has a broker-dealer operation in New York and at the time of going to press had an application pending for a licence in London. It is also looking at opening an office in Hong Kong or Singapore to give it an Asian presence. Banco Bozano Simonsen president Ferraz sees the establishment of this network as underlining the importance the bank attaches to serving its international clients by underwriting Brazilian privatization share offerings.

Regardless of their battle for underwriting fees, all parties are confident that the international equity markets will comfortably absorb the stock offerings associated with the privatization programme. Certainly Brazilian securities are popular with international investors at present; overweight positions for Brazil are common in Latin American stock portfolios. Says Octavio Castello Branco, managing director at JP Morgan in Sao Paulo: “If the process is properly managed, and under a balanced and clear regulatory framework, I don’t see any danger of there not being sufficient demand to complete the privatizations slated.”

Francisco Gros, managing director at Morgan Stanley, and a former head of the Brazilian central bank, agrees with this assessment. “Right now there is a great deal of liquidity in the market, a great deal of interest in Brazilian equities, and not a great deal of supply,” Gros says. “We think that large issues will create their own demand, so we are fairly optimistic that if the market here [in the US] stays on an even keel these issues will find a home.”

Luiz Antonio Macedo, director of privatization advisory and project finance at Citicorp in Sao Paulo, notes that appetite appears strong in all areas, including from commercial banks providing acquisition finance in the syndicated loan market. Citicorp is focusing on advising potential buyers in the Brazilian privatization programme and recently structured a $300 million refinancing for an equity put for two of the shareholders in Light. “The bank market has accepted this deal very well,” says Macedo, who envisages bank debt being readily available for privatization deals involving Brazilian risk.

On the equities side it is advantageous that privatization issues will not have to compete with many private-sector stock offerings. Most companies in Brazil are underleveraged and find it attractive to access the international bond markets rather than issue new shares. And there are few initial public offerings on the horizon.

“At this point most Brazilian companies are very well capitalized, and I suggest they are going to be looking for more debt before they are looking for equity,” says Gros at Morgan Stanley.

The one major private-sector equity issue coming up involves Unibanco, which took over Banco Nacional last year. As part of this process the central bank ended up with an approximate $1 billion stake in Unibanco, which it now wishes to sell. JP Morgan will lead the stock offering, expected in the first half of this year. The other major international equity issue coming up is the final stage of the Light privatization, where the last 28.8% block of its capital is to be sold in a deal also worth around $1 billion. This offering will be led by Goldman Sachs and is also expected to happen in the first half.

These could be followed late in the second half of the year by a global offering for CVRD, if the trade sale goes ahead mid year. But some observers think that the CVRD global offering, which could involve shares worth $2 billion to $3 billion, may not take place until early 1998.

The government is also likely to proceed with an offering of Petrobras shares, to reduce its holding in the oil company. This will probably be done in tranches, in the first of which, stock worth $1 billion-plus could be sold. Again, there is debate over whether this is likely to take place late in 1997 or early in 1998.

But even without the gobal offering, a successful trade sale in stage 1 of the process will make 1997 the busiest year yet in the Brazilian privatization process. Total receipts to the federal government and the states were $4 billion for 1996, making the busiest year since the programme began with the sale of steel company Usiminas in 1991. That first year some $1.6 billion-worth of assets were sold, and the total for the six years to December 1996 now stands at $13.6 billion.

It is very important to step up the pace, particularly at a time when the macroeconomic picture in Brazil is changing for the worse. The federal and state governments are pursuing privatization with the stated objective of directing resources toward health, education, housing, social security and high-tech research and development. In addition to removing these financial drains on their budgets, they see the new owners as reducing the cost of producing and delivering goods in Brazil.

Large capital-expenditure programmes to develop sectors such as power, transport and telecommunications are simply not feasible within the state and federal budgets, and the slowing down of the economy is not going to take the pressure off cash-strapped state and federal governments.

Economic data from Brazil reveals a disappointing performance in the export sector and a corresponding increase in the trade deficit. These numbers helped to create a lukewarm reception for Brazil’s $750 million global five-year bond offering last October.

Gross domestic product growth was 2.9% in 1996. Salomon Brothers estimates a slowdown to 2.2% for 1995, although this is at the low end of various private-sector and government estimates.

Certainly Brazil has made impressive strides in the battle against inflation, considering that as recently as 1993 it was experiencing hyperinflation of 2,491%. The stabilization plan helped achieve an inflation rate of 9% for 1996, but the optimism caused by this figure has been tempered by a worse-than-expected fiscal deficit and widening deficits on the trade and current accounts.

Clearly a lot has to be done to maintain international confidence in Brazil and to keep foreign capital coming in. Better economic fundamentals would push privatizations forward, despite delays caused by political interest groups opposed to the programme.

Waiting for the big one

The timetable for the sale of Companhia Vale do Rio Doce (CVRD) has a habit of slipping back a few months at a time, and always being about to happen in three months’ time. The latest deadline slippage has been a result of political wrangling about a constitutional amendment to allow presidents to run for a second term in office, an issue which was the main focus of the government at the start of the year.

In addition, the discovery late last year of huge new iron ore and other mineral riches in the Amazon region forced a rethink on the valuation of the company. Nonetheless, there is optimism among bankers that the deal is moving forward and could be closed as early as June or July. The sale will represent the biggest Brazilian privatization to date: the government’s stake of 51% of total capital (comprising 76% of the ordinary shares of the company) is estimated to be worth more than $6 billion.

The buyers will gain control of the world’s largest iron ore producer, which is also Latin America’s largest gold producer. CVRD and its subsidiaries are also involved in fertilizer production, manganese, steel and alloys, and forestry. And the company’s own transport infrastructure comprises rail operations, seaport terminals and a shipping division.

During the first six weeks of 1997 political developments overshadowed all else in Brazil. The party of ruling president Fernando Henrique Cardoso faces elections in October 1998 but under the Brazilian constitution a president is permitted only a single term in office. Cardoso wants to change this, and his campaign led to an intense period of political manoeuvring ahead of a vote in the Chamber of Deputies in late January. Cardoso achieved victory in this vote, and at the time of going to press was tipped to win the Senate’s vote as well. This is seen as important to the privatization process, for Cardoso has achieved great popularity in Brazil and analysts are hoping for a period of continuity which will allow the economic restructuring process to be completed.

Walter Stoeppelwerth, head of research at Robert Fleming in Sao Paulo, says that the constitutional reform is of great importance, particularly since there is no strong candidate to succeed Cardoso. “If you look at other Latin American countries there seems to be some sort of track record established, with presidents serving two terms getting a lot more done,” he says, pointing to Fujimori in Peru and, despite economic problems encountered during his current second term, Menem in Argentina.

A few days after the vote in the Chamber of Deputies came more positive news for the CVRD sale process: an apparent solution to the tricky problem of how to deal with the new mineral riches discovered in Para. On February 5 a meeting of the powerful Brazilian Privatization Council was convened, chaired by the minister of planning and including the president’s chief of staff and the minister of finance. At this meeting it was decided to add a third element to the sale mechanism to take the Para reserves into account.

It had previously been decided that mines already in production would be included in the valuation of the company and that the government would protect its position vis-a-vis certain other properties (where exploration has not been thoroughly pursued) by holding debentures which will give it a share in future profits. At the February 5 meeting it was decided that the latest discoveries will be explored by the new owners and the federal development bank, Banco Nacional de Desenvolvimento Economico e Social (BNDES), in a 50:50 risk-sharing joint venture.

Meanwhile, a steady stream of potential buyers has been flowing to the CVRD data room at the BNDES building in downtown Rio de Janeiro. At $150,000 access does not come cheap, but this fee includes expenses such as flying potential buyers to remote parts of Brazil to look at mines and other installations.

The stage 1 plan is that by mid-April bids will be invited from consortia for a 40-45% stake in the ordinary shares of CVRD. This first block, including a control premium, is estimated to be worth over $3 billion. Stage 2 will incorporate the sale of shares to employees in which 5.1% of the company’s total capital is expected to be taken up. Employees will have the right to a seat on the supervisory board. In stage 3 there will be a combined domestic and international stock offering of a planned 26.5% to 31.5% of the ordinary shares. The deadline for this stage has been set by BNDES as within nine months of the closing of the trade sale to the core shareholder group.

Immediately after the auction the controlling group will put their ordinary shares into a Special Purpose Corporation (SPC), the government retaining a golden share in both the operating company, on a permanent basis, and the SPC for a period of five years.

The core shareholding group will be the driving force behind modernizing the company, bringing in new exploration and mining technology and providing much-needed capital investment to fully exploit its properties. But complex restrictions will ensure that the control held by big competitors, clients and trading companies will be individually restricted to 10% of the company. And no single SPC shareholder may hold more than 45% of the SPC’s capital. These measures are seen as a way to protect CVRD from its competitors, who by turning it into a cost centre, might try to keep most of the value-added processes in their home market.

The government, which wants long-term strategic planning and investment in CVRD, is also protecting itself from buyers coming in with a quick exit strategy. After the auction the SPC is free to buy more CVRD shares on the market, or at the time of the global offering, but thereafter there is a two-year lock-up period during which the SPC shareholders may trade only on an intra-group basis unless the government authorizes the entry of new groups. After the lock-up expires, another three-year period begins during which the SPC is required to hold as a minimum the CVRD stake purchased at auction.

Beyond this the golden share in the CVRD operating company will continue to give the government a say in sweeping changes which it would regard as detrimental to the Brazilian economy. These veto powers cover such activities as a change of head office location, selling or closing down iron mining, rail and port operations, or winding up the company.

With all these restrictions to take into account, the various visitors to the data room have begun to sound each other out regarding possible alliances which will bring together a bidding group which meets the specifications. South African and Japanese names are to the fore in speculation by investment bankers about possible bidders, and the sheer size of the transaction and the necessity of multiple partners in order to satisfy the restrictions, has led to speculation that there will be no more than three bids.

Getting the CVRD transaction done is viewed as central to the credibility of the entire privatization process, and bankers think that the latest sale structure agreed at the February 5 meeting has succeeded in putting it back on track. This new structure helped to disarm opponents which included two former Brazilian presidents, Sarney and Itamar Franco, who have both publicly denounced the sale. Mineral rights have traditionally touched nationalistic feelings in Brazil yet bankers point out that despite appeals to nationalist sentiment, opponents have been unable to whip up much popular indignation about Brazilian mineral rights being sold to foreign multinationals.

“The majority of the people in Brazil have shown many times that they are in favour of privatization,” says Paulo Ferraz, president of Banco Bozano Simonsen. He notes that opposition is localized in groups such as the trade unions, who have opposed privatizations in most countries.

Peter Negus, international director at Banco Bamerindus do Brasil, in which Hongkong & Shanghai Banking Corporation holds a 6% stake, says that the successes of some of the early privatizations and the stability brought about by the Real Plan have helped to win backing from voters for Cardoso and his economic restructuring programme. “Steel privatization was a successful exercise and there has been a reference to that in some of the political exchanges,” says Negus.

Indeed the government is holding up the steel industry as an example of what it is trying to achieve through privatization and has highlighted the performance of Usiminas, which was sold by auction in October 1991 to a consortium led by Nippon Steel.

The government is working hard to maintain popular support for privatization but opposition remains and for that reason all eyes are on CVRD as a test of political will.

“I think it is really important for the government to show that it is moving ahead soon ­ it sends a message that this is for real,” says one investment banker in Sao Paulo. “In CVRD you are talking about the perceived jewel in the crown, and once they have sold CVRD, why wouldn’t they be able to sell the others?”