Rarely has there been a better-timed deal. When the auction of the Brazilian state’s controlling stake in Telebrás, the national telecoms company, took place on July 29, world markets were jittery and investors were nervous that impending presidential elections would undermine Brazil’s fragile stability programme. But the deal was done $19 billion was raised from trade buyers in Latin America’s biggest transaction ever. Then, within a month, Russia had devalued the rouble and defaulted on its domestic debts. Brazil’s stock market lost half its value as investors fled emerging markets. And within six months, Brazil had been forced to devalue its own currency. Those investors who hoped Latin America would escape the worst of the emerging-markets crisis were proved wrong.
Last month a second telecoms sell-off was due to take place. This time the Brazilian government planned to auction four licences for companies to compete with the country’s fixed-line and long-distance monopolies. Only two bids were received. Amid the collapse of Brazil’s currency, it was yet another sign of lack of confidence in Brazil. The auction was scrapped. Officials say it may take place later this year.
In July it had been so different. The government was selling controlling stakes in 12 holding companies. It hoped for a minimum $11.5 billion; 64% more than that was raised. There were several bidders for almost all of the companies. Some received as many as eight.
A who’s who of international telecoms was in the Rio de Janeiro stock exchange for the auction. The bidders included recently privatized European fixed-line operators with strong balance sheets, secure cashflows from their domestic operations and dreams of global communication empires. The most acquisitive US long-distance carriers were there with facilities arranged for big leveraged buys. There were also Brazilian groups, funded by local and US venture capitalists.
This auction was the culmination of years of tortuous planning and tense negotiations. The drama included: a race against time to complete the deal before the October elections; the trauma of breaking Brazil’s largest company into 52 separate pieces; and the death of the chief protagonist.
The privatization of Telebrás and the modernization of Brazil’s telecoms system was led by Sérgio Motta, Brazil’s communications minister. “Motta was the driving force,” says Jim Allen, senior telecom specialist with Morgan Stanley Dean Witter’s global telecoms group. “His approach was to take no prisoners and insist that the deal get done at all costs.”
A close political ally of Brazil’s president, Henrique Cardoso, Motta was determined to complete the privatization before the elections. A successful sell-off would, he hoped, provide the crowning glory of Cardoso’s presidency and help to re-elect him. He was also worried that if the sale was postponed until after the elections it might never happen at all.
“At our very first meeting five months before the sale,” recalls Celso de Barros, director of Salomon Smith Barney’s Latin American group, “Motta insisted that the sale had to be completed by a certain date. And that was the timetable we worked to.”
Motta died of a lung disease in late April 1998. It was a bad week for the president. Cardoso lost another key ally, Luis Eduardo Magalhães, leader of the lower chamber of parliament, who died suddenly of a heart attack the day after attending Motta’s funeral.
Fortunately Motta’s replacement, Luiz Carlos Mendonça de Barros, was also a keen advocate of telecoms privatization. He had been closely involved as president of Brazil’s national development bank, BNDES.
Bankers who advised the government give both men the credit for achieving the near impossible completing a major Brazilian privatization project on time. Almost every other planned auction in recent years has been delayed by bureaucratic inertia or the failure of Brazil’s notoriously fractious legislators to approve the necessary legal framework.
In many ways this was Brazil’s most complicated ever reform. It began soon after Cardoso became president in 1994. Brazil’s telephone system, 90%-run by state-controlled provider Telebrás, had suffered from years of underinvestment. Though it had begun to feel its way into the modern era developing higher-margin services such as mobile telephony, for example the fixed-line service remained dire for most users. The government began to seek a new structure that would encourage telecoms companies to invest in infrastructure, reduce prices and would bring in much-needed privatization revenue.
The solution was to split the Brazilian telecoms market into two parts fixed-line and cellular. First Telebrás was broken up into 26 regional companies. Each was then to be split into a fixed-line and a cellular company. Finally, these companies, along with long-distance provider Embratel, were allocated among 12 holding companies. These new companies three regional fixed-line companies, eight cellular companies and Embratel came into formal existence at privatization.
The other part of the plan was to open up the market. Licences would be given for “mirror” companies to compete with each of the Telebrás spin-offs. The cellular mirror licences were granted before the Telebrás sell-off, with further competition from operators of a new cellular spectrum to follow within two or three years. The auctions for mirror fixed-line services were held last month.
In spite of its mind-numbing complexity, this plan gave the whole process an inevitability and transparency that played a key role in encouraging foreign investment. The new structure was largely the brainchild of consultancy firm McKinsey and the government was also advised on the restructuring by Lehman Brothers and Dresdner Kleinwort Benson.
The break-up of Telebrás into smaller companies served another purpose, to make it attractive to a variety of buyers. The regional cellular companies would be small enough for a local Brazilian group or a minor international player to buy. The fixed-line companies and Embratel were big enough to tempt larger international telecoms companies. “The decision to separate the industry into fixed-line and cellular companies was a wise one,” says Allen. “It made it possible for some bidders to enter the process who would not have been able to contemplate bidding for a much larger integrated company.”
The decision to do a trade sale rather than an IPO was also made for strategic reasons. The government wanted foreign companies with deep pockets and a wealth of experience to have a large stake and to have an incentive to invest in building infrastructure.
There was one further consideration that would have long-term repercussions. Telebrás was not majority-owned by the state. Although it held 51% of the voting shares, most of the company’s equity was preferred, non-voting shares. The authorities decided that how these “minority” shareholders who actually owned over 80% of Telebrás were treated would send an important signal to the market. The biggest concern of these shareholders (who would be given shares in each of the new Telebrás companies in exchange for their old Telebrás holding) was that the new owners most of them foreign telecoms operators would vote themselves contracts on lucrative terms. The government put safeguards in place to prevent this. New service contracts would have to be put to vote by the company’s non-voting shareholders; the first time preferred shareholders had been given such rights in Brazil.
At the beginnning of 1998 a consortium of three firms Salomon Smith Barney, Morgan Stanley Dean Witter and Brazilian investment bank Patrimônio began to work with the government on completing the sale. Bidding for the mandate had been tight. The team’s fee would be only seven basis points of the proceeds; not much for five months’ intense work. De Barros at Salomon Smith Barney defends the fee. “It was pretty tight for a lot of work,” he says. “Tight, but profitable. And we were only three banks. Some of the other bidders [for the government mandate] were consortia of up to five.” But plenty of banks wanted to work on one of the most prestigious privatizations ever.
The hard work began with persuading the government that it would need to be flexible in order to get the deal done on time. It agreed to drop some of its original requirements it had wanted bidders to provide early evidence of their financing plans and it had planned to restrict bids to “qualified” telecoms operators. To speed things up and to encourage a broad range of bidders, registration was streamlined. Bidders would not have to get their financing in place until the week of the auction. And the auction would be open to all bidders.
The government also resisted pressure to limit foreign participation. In earlier privatizations, foreign ownership was capped at 49% of the companies being sold. That would have deterred many potential buyers. But in Brazil, with its long history of protectionism and economic nationalism, allowing majority ownership of such “strategic” industries as telecoms was bound to provoke protest. A presidential decree of June 1998 eliminated this last obstacle to the privatization.
Reorganizing Telebrás was tricky. “Coordinating the management restructuring was a big part of our job,” says Allen at Morgan Stanley Dean Witter. “Creating 52 new companies was no simple matter. A lot of managers would be taking up new roles in the new companies and there was a lot of virtual management taking place in the meantime.”
But in many ways the biggest difficulty facing the bankers selling Telebrás was to persuade bidders that the privatization was going to go ahead by the date intended. “We had to say to people: ‘Yes, this really is going to happen on time and you have to be ready’,” says de Barros. Roberta Fisher, principal at Morgan Stanley Dean Witter’s investment banking division, believes the government deserves a lot of the credit for persuading bidders that it was serious about the timetable. “Obviously it was part of our job to persuade the bidders to get their deal teams ready,” she says. “But it was also important that they saw no wavering on the part of the government.”
Most of the likely bidders were well known. The two most acquisitive European telecoms companies, Spain’s Telefónica and Telecom Italia, seemed certain to buy something. BellSouth, perhaps the most Latin America-focused US regional operator, also seemed a good bet, as did MCI, a fast-growing long-distance carrier. But there was also interest from surprising quarters. Portugal Telecom, for example, emerged as a key bidder. “They were really off a lot of people’s radar screens,” says a banker who worked on the deal.
Live on TV
As the day of the auction approached the tension rose. “Even on the night before the auction we still weren’t sure who was definitely going to show up,” recalls de Barros. “Local TV was transmitting the auction live and at Salomon Smith Barney in New York we had set up a live feed into the broadcast. The day before the auction we found out that MCI was planning to do the same thing. So we said: ‘Well, that’s one we can tick off. They’re definitely in.'”
The auction began early on the morning of June 29. It was held in the Rio stock exchange because, although it was in effect a series of trade sales, the privatization was technically a share offering. The different bidding groups huddled in separate rooms so that they could discuss their bids in confidence. There were three bidding sessions, each separated by an hour-long break to give the unsuccessful bidders time to regroup and consider bids for other parts of Telebrás. Bidding for each of the 12 companies was by sealed bids, but, if any of the highest bids for a company were within 5% of each other, there would be a second phase of bidding and this would be done by open outcry between the two top bidders.
But before the auction could begin, the participants faced a last obstacle getting into the building. The privatization had inevitably attracted demonstrators concerned about the sale of assets to foreigners. De Barros recalls the scene around the stock exchange that morning. “I arrived early, at about 6:30am, and already there were a few groups of protestors. The streets in Rio are paved with heavy Portuguese slabs and I could see a few piles of these paving blocks ready to be thrown at bankers and foreign investors. Everyone had to dress in casual clothes when they entered the building so they wouldn’t be attacked by the protestors.”
Inside the stock exchange, the proceedings were orderly but far from quiet. As it became clear that the bids were higher than most had dared hope, the excitement began to rise. “A great cheer would go up every time a high bid came in,” remembers one of those present.
But the real drama came with the open-outcry bidding wars. The most bitterly fought was for Embratel. Two US companies, Sprint and MCI, had bid within 5% of each other so a further round of bidding was triggered. For some 20 minutes the bidding went back and forth. There were six or seven rounds in all. The senior managers of both companies were present and they would send a representative out to make each bid in person. “You could see from the body language how much it meant to them,” says a banker involved in the deal. Finally, Sprint gave way and MCI bought Embratel for a 47% premium over the minimum price and some 5% more than it had offered in the sealed bid.
“Aside from the individual bidding situations, the thing that was exhilarating was the premiums obtained,” says Fisher. “And there were some real surprises. Telefónica’s very aggressive bid for Telesp, for example, and Portugal Telecom’s aggressive solo bid for Telesp Celular.”
The deal’s success, and the huge amount raised for the Brazilian government, was largely thanks to Europe’s newly privatized telecoms companies. Portugal Telecom bid more than double the minimum for Telesp Celular, the biggest of the cellular companies. Telecom Italia, alone and in a consortium with Brazilian media group Globo, bought two cellular and one fixed-line company, paying well over the minimum. And a consortium led by Telefónica bid more than 60% over the minimum for the biggest company of all, São Paulo fixed-line operator Telesp.
With the exception of MCI and Sprint, the US companies were notable by their absence. BellSouth did not bid. Nor did any of the other baby Bells. Allen at Morgan Stanley Dean Witter believes there were two reasons. “First, I think they were preoccupied by events at home, such as the SBC-Ameritech merger. Second was the realization that the European companies were prepared to pay so much.”
Did the Europeans overpay? Possibly, especially if the Brazilian economy takes years to recover from its current crisis. But some believe the bidders knew what they were doing. “You can see from Telefónica’s experience in Peru [it bought the Peruvian monopoly operator in 1994] that Latin American telecom operators have a lot of hidden potential,” says de Barros. “They paid more for Telefónica del Peru than people at the time believed it was worth, but they have turned it around and it’s now very profitable. Telefónica and the other successful bidders were buying control of these companies, and they had done their homework in calculating how much they thought they could make from them.”
So, the privatization was a good deal for the winning bidders; a good deal for the bankers (assuming they can convert the prestige of doing the deal into lucrative work in future); a good deal for Brazilian telephone customers who should soon benefit from better services and lower prices; and a great deal for the Brazilian government, which raised more money than it could have hoped for at just about any point in 1998.
Brazil’s president was another winner. The success of the deal enhanced Cardoso’s reputation as Brazil’s economic saviour. He romped home to victory in the October election.
Mendonça de Barros, was less fortunate, being forced to resign because of a scandal during the election campaign. Taped conversations between Mendonça de Barros and a former colleague at BNDES came to light in which the minister appeared to be favouring one particular bidder. His defence plausible, since that particular bidder was not in the end successful was that he was merely attempting to ensure as many bidders as possible.
The incident is, in a strange way, a compliment to the transparency of the privatization. And it is a measure of how far Brazil has come that a minister was forced to resign having been accused of something that not long ago would have barely raised an eyebrow in Latin America.
