Raining on Brazil’s Banking Carnival

For investment banks betting on a big deal and fee bonanza in Brazil, the slump in capital markets activity comes as a rude shock.


According to the old joke, Brazil is the country of the future — and always will be. Investment bankers can be forgiven if they don’t see the humor.

International investment banks that were counting on Brazil to make up for problems in their home markets have been sorely disappointed as Brazilian deal volume has slowed down this year and domestic players have won a larger share of the business. Unless the market recovers soon, foreign banks are likely to put their expansion plans on hold or even make cutbacks, industry executives say.

Virtually all the major international firms, including Bank of America Merrill Lynch, Barclays Capital, Deutsche Bank, Goldman Sachs Group and JPMorgan Chase & Co., have been building up their Brazilian operations in recent years, hiring bankers, traders and back-office staff. In contrast to the weakness in the firms’ domestic markets, Brazil’s strong economic growth, unfettered capital markets — a stark contrast to the other BRICs — and surging deal flow persuaded many bankers that the country offered seemingly boundless opportunity.

The foreign invasion coincided with a big domestic buildup. Leading local players such as Banco do Brasil, Banco Bradesco de Investimento, BTG Pactual, Caixa Econômica Federal and Itaú BBA have beefed up their businesses substantially, as have international banks with a long-standing presence in the market, such as Credit Suisse and Banco Santander. The result is one of the most competitive investment banking markets in the world, with at least ten firms slugging it out for supremacy.

The growing army of bankers is chasing fewer and fewer deals, though. The pace of equity offerings this year has slowed to the lowest level since 2005 as stock prices have tumbled. São Paulo’s Bovespa Index was down 23.1 percent for the year as of late last month. With prospective valuations reduced, a number of companies have postponed plans for initial public offerings of stock. Merger activity has suffered an even bigger decline, running at barely half of last year’s pace. The sudden evaporation of fees is squeezing banks and arousing tensions among domestic banks and some of the newer arrivals.

“I think most of the international banks — including Barclays Capital — that have invested in Brazil recently have done so with a medium-term view of around three years,” says Alceu Lima, head of investment banking for Brazil at Barclays Capital and president of Banco Barclays. “However, the slow equity capital markets activity this year will probably lead some of our competitors to review their head counts.”

A look at the data explains why. The drop in activity is enough to give bankers pause. As of September 12 the market had seen 28 equity offerings this year, worth a total of $10.49 billion, a far cry from the 42 deals worth $49.3 billion that hit the market in 2010, according to data provider Dealogic. This year’s activity consisted of 16 secondary equity offerings worth a total of $5.99 billion, 11 IPOs worth $4.37 billion and one convertible bond issue that raised $122 million.

Brazil’s decline is relative as well as absolute. The country had fallen to 12th place globally by ECM activity as of last month, down from fourth place in 2010. Brazil trailed far behind the U.S., which led the nationality league table with 543 transactions worth $153.9 billion, and China, which ranked second with 387 deals worth $71.2 billion, according to Dealogic.

“Basically, the market for IPOs is on hold for now,” says Jean-Marc Etlin, head of investment banking at Itaú BBA. “Whether we see activity pick up depends largely on what happens next in Europe. An orderly resolution of the ongoing regional debt problems could provide the market with a more positive tone.”

Bankers hoping that a strong M&A market might cushion them from a drop in equity issuance will be disappointed. Brazil had 404 mergers and acquisitions valued at a total of $60.5 billion as of September 12, compared with 523 deals worth a total of $153 billion for all of 2010. The country dropped to eighth place globally by M&A volume, far behind the top-ranked U.S., with 7,132 deals worth a total of $805 billion, and No. 2 China, which saw 2,787 deals worth $132 billion.

The only bright spot for investment banks in Brazil: the debt capital markets. Companies raised a total of $42.79 billion with 102 debt offerings as of September 12, compared with 101 deals worth $48.3 billion in calendar-year 2010.

“On the M&A front strategic players continue to engage,” says Etlin. “If a deal is more financially driven, there is a greater sensitivity on valuations. The DCM market remains pretty active, as it tends to be less impacted during times of greater risk aversion.”

The decline in IPO activity has dealt a harsh blow to banks because they had held such high hopes. At the start of the year, Deutsche Bank predicted that about 40 Brazilian companies would go public in 2011. However, a number of companies have responded to weak market conditions by postponing their plans.

The biggest deal to be shelved was a planned July IPO by Copersucar, the country’s largest sugar and ethanol producer, which cited “unfavorable” market conditions in postponing the deal indefinitely. Bankers had expected an offering worth $1.1 billion, which would have been Brazil’s biggest IPO in two years. The company had selected Itaú BBA, BofA Merrill Lynch, Credit Suisse and Goldman Sachs as book runners, according to Dealogic.

Two other companies also pulled deals in July. Perenco Petróleo e Gás do Brasil Participações, the Brazilian subsidiary of French oil and gas exploration company Perenco, postponed an IPO that bankers had expected to raise some $460 million; Itaú BBA, BTG Pactual and Morgan Stanley were scheduled to be book runners on the deal. And Los Grobo, Argentina’s second-biggest soybean producer, put on hold plans to list a newly created subsidiary, LG Agronegocios & Participações, in São Paulo. The deal was expected to be valued at $370 million and handled by book runners Credit Suisse, Itaú BBA, BTG Pactual and Bradesco.

Commodity names make up 50 percent of the Bovespa index and telecommunications companies and utilities a further 25 percent, according to Credit Suisse. However, the index no longer reflects the real shape of the Brazilian economy, in which retail and consumption have become much more important. Bankers say issues from these hot sectors — especially consumer — are in the greatest demand by investors and most likely to have a successful flotation, especially if they are priced at a discount to established names in the sector.

The weakness of the stock market and a drop in valuations have deterred many potential issuers, bankers say. Of the 27 IPOs and secondary offerings that have taken place this year, 17 were priced below their indicated ranges, two were priced above the indicated ranges, and eight were within the range, according to Dealogic.

“Companies just do not want to come to the market when there is very little future visibility about valuations,” says Glenn Mallett, head of equity capital markets at Santander in Brazil. “A number of deals have been treading water for some time. The issuers will keep filing the deals in the hope that market conditions will improve and a window appears in which to push ahead with the listing.”

To a large extent, Brazil has suffered from the general retreat by international investors from emerging markets. The European debt crisis has prompted many investors to pull back and build up their cash positions. Brazil experienced a net outflow of $4.45 billion in international capital from its equity market in the first quarter of this year, a turnaround from net inflows of $31.5 billion for all of 2010, according to the International Monetary Fund. Outflows probably increased in the second quarter, although official figures aren’t available yet, bankers and analysts say. About 70 percent of the investors in equities traded on Brazil’s BM&FBovespa stock exchange are foreign, according to PricewaterhouseCoopers.

The Brazilian market has been weaker and more volatile than most other emerging markets, however. In the 12 months ended September 15, the Bovespa was down 20.85 percent, compared with declines of 3.86 percent in the Standard & Poor’s 500 Index, 8.94 percent in the Shanghai market and 6.6 percent in Russia’s Micex Index, according to LatAm Alternatives, a hedge fund consulting firm based in Weston, Florida. Only the Bombay Stock Exchange’s Sensex Index performed worse during the period, falling by 22.64 percent.

Analysts say one reason for the recent market weakness is the apparent interference in monetary policy by the administration of Dilma Rousseff, who took over the presidency in January. Under pressure from the government, Banco Central do Brasil cut its policy rate by half a percentage point, to 12 percent, at the end of August, despite the fact that the inflation rate had climbed to 7.02 percent that month from 6.75 percent in July. The bank justified the move by saying that the deterioration in the global economic outlook would reduce Brazil’s growth rate to 3.5 percent this year from a previous forecast of 4 percent. Market participants, however, are concerned that the bank could be departing from its inflation-targeting policy, which is regarded as one of the key factors behind Brazil’s economic turnaround during the past decade.

The slowdown in Brazilian equity activity also stands in contrast to the buoyancy of other markets in Latin America. Brazil’s share of ECM volume in the region had dropped to only 45 percent this year as of September 12, down from between 85 and 90 percent in the past three years, according to Dealogic. Argentina, meanwhile, has come from almost nowhere to account for 16.9 percent of equity volume this year. Chile has seen its share rise to 16.3 percent from 2.7 percent in 2010, Colombia’s share has increased to 7.5 percent from 2.2 percent, and Mexico’s share has grown to 13.8 percent from 4.4 percent.

Whatever its cause, the decline in equity offerings in Brazil is putting pressure on banks that had scaled up for boom times. That pressure, in turn, has prompted many foreign bankers to criticize the tactics of local players, which lately have increased their dominance of the market.

In the 12 months ended September 12, Itaú BBA had a 24.9 percent share of ECM activity in Brazil, according to Dealogic, followed by BTG Pactual with 18.1 percent and Bradesco with 15.5 percent. By contrast, BTG Pactual led the market in 2010 with a 10.8 percent market share, just ahead of Credit Suisse at 10.7 percent and Itaú BBA at 10.3 percent. For most market participants Credit Suisse is effectively regarded as a local player because the executives who run its Brazilian operations came from its 1998 acquisition of Garantia, which at the time was the leading local investment bank. The last time a genuine outsider broke into the top three of the ECM league table was in 2008, when J.P. Morgan finished third with 8.8 percent of the market.

The biggest complaint of foreign banks is the recent expansion of book-runner ranks. Traditionally, Brazilian deals had two banks as book runners, but this year many IPOs and secondary offerings have had four. The additional book runners tend to be local houses.

Book runners in Brazil earn fees of about 3 to 3.25 percent of the listing price of a company. They can also receive an incentive fee of about 1 percent of the listing price. The terms of the incentive fee are discretionary. In principle, a bank can claim the fee if a transaction is priced at the top end of the valuation range or if the order book has more than 100 accounts. But some bankers say issuers frequently pay incentive fees even if a deal is priced below the valuation range.

Since the financial crisis erupted, Brazilian companies have put more importance on maintaining their commercial banking arrangements with local institutions. The leading domestic banks are highly capitalized, have deep pockets and are able to provide companies with loans at the time of their IPOs or secondary offerings, often to the tune of $500 million or more. Issuers have a strong incentive to keep the domestic banks sweet, so they will award multiple book-runner mandates. But adding more banks to a deal can simply lead to confusion or mistakes in the pricing of an equity offering, bankers say.

“Too many book runners is detrimental to a deal’s success,” says Marcelo Kayath, co-head of Brazilian investment banking at Credit Suisse in São Paolo. “Good execution of the process of taking a company public is vital.”

Local banks reject the complaints, arguing that they have in-depth knowledge of the Brazilian market based on decades of experience. “We conduct our business with the highest ethical standards,” says Itaú BBA’s Etlin. “We run our underwriting and conflict management committees in absolute compliance with best-in-class procedures of our industry.”

The growing importance of private equity in Brazil is another factor that has led to the profusion of book runners, bankers say. Private equity investment has taken off in Brazil in recent years, and many of the companies making equity offerings these days are doing so to provide an exit for their private equity backers. Such issuers have an incentive to expand the number of book runners on a deal because that is likely to lead to more, and more positive, research coverage by the banks that received the mandates, bankers say.

“Private equity groups have an incentive to have as many investment banking relationships as possible,” says one leading international banker in Brazil, who asked not to be named. “This helps the banks to obtain better rankings in investment banking league tables and makes them more likely to support the managers in the future.”

The debate over book runners may be starting to have an impact on underwriting. Following the downturn in the IPO market this year, bankers say, corporate issuers have begun to realize that more banks are not necessarily better when it comes to syndicating a deal. There is no sign yet that issuers are prepared to reduce the number of book runners, for fear of jeopardizing their commercial banking relationships, but bankers say companies are creating an effective division between the lead banks that do the bulk of the work on a deal and those that play a more passive role.

The foreign carping about the domestic banks can be overstated. Most foreign banks are not competing in all areas of the Brazilian market, and their deal-making skills are often complementary to those of local players.

“Some domestic banks in Brazil secure investment banking business on the back of their corporate banking and lending relationships with issuers. Domestic banks also compete in the local M&A deals,” says Hans Lin, co-head of investment banking for Brazil at BofA Merrill Lynch. “However, international banks are more competitive in the cross-border M&A deals because of the global reach and the relationship with multinational companies.”

Alex Lehmann, head of equity capital markets for Brazil at Deutsche Bank, sees a symbiotic relationship between Brazilian and foreign investment banks, and notes that they frequently split mandates 50-50 on major equity offerings. “Issuers appreciate the benefits of both groups,” he says. “Often the domestic banks have an important lending relationship with the issuers. The international banks have significant global distribution networks, which are very useful in ensuring that a deal succeeds.”

For now, most international banks remain committed to the Brazilian market, but they acknowledge it can be tough to penetrate. Brazil is a large and relatively closed economy, and for cultural reasons most Brazilian companies feel more comfortable dealing with local bankers. Foreign banks need an entrenched local presence to succeed, something that takes time and money to develop.

Morgan Stanley has spent seven years building up its presence in the country, notes Christopher Harland, the firm’s chairman of Latin American investment banking. “Some international banks, such as Morgan Stanley, are deeply local but are also able to connect Brazil with their international networks and their international distribution channels,” he says. “Investors are much more discerning at the moment, and book runners must be much more nuanced in the way they promote deals. Strong distribution networks among international institutional investors are very important.”

Will such patient work by foreign banks pay off? Some bankers have their doubts. “Whether all the international banks will succeed in Brazil is a good question,” says BofA Merrill Lynch’s Lin. “The industry is a bit like the auto industry, where the players aggressively occupy a growth market with investments. The Brazilian market is extremely competitive.”

Lin is confident that the Brazilian market will continue to grow and provide plenty of opportunities for Wall Street heavyweights. But, he adds, “success will only come with a solid platform in Brazil. It requires a strong research department and a good sales team, as well as experienced investment bankers. Our strategy is to try to provide a one-stop shop for ECM, M&A and DCM transactions. We are also able to leverage on our corporate banking strength in Brazil and provide cash management services.”

Local experts say that even though the domestic banks’ stock market valuations have dropped this year, the banks are probably sufficiently well capitalized to weather the storm and not be forced to change the size of their teams.

Some international banks believe this will be a good time to recruit local talent if their domestic competitors start to shed staff. Barclays Capital says such cutbacks last occurred in the first quarter of 2009, when some domestic banks thought that the Brazilian economy and markets were going to suffer much more than they did. “Barclays made some important hires during the last market trough, and we will do the same this time around,” says Lima. “We do not expect that there will be significant new issuance in the next six months, but as markets improve we will be well positioned to take a lead role on new mandates.”

Since snatching up the North American business of Lehman Brothers Holdings in September 2008, a move that bolstered its presence across the Western Hemisphere, Barclays Capital has increased its head count in Brazil from 80 to just under 200 people. The bank is looking to take advantage of the current market downturn and recruit to bolster its equities and M&A teams.

The future hasn’t yet arrived in Brazil, but most bankers remain confident that better days will come. Investment banking activity should rebound with the economy, providing significant growth opportunities in the years ahead. Success isn’t guaranteed, though. The Brazilian market today is as competitive as New York in the 1980s or London in the ’90s. Bankers will have to fight for their piece of the pie.