After years of being the next big thing, Brazil’s time has come. We explore how to succeed when investing in South America’s largest state

In the past, the arid northeast of Brazil was a region that international business people would usually just fly over on the way home. Now, the area is exactly the kind of place where foreign investors can take advantage of Brazil’s consumer boom. Over the past decade, the region’s GDP rose, on average, by 4.2% each year.

One company leveraging this growth is Kraft Foods, which last year opened its first factory in the northeast region, in the state of Pernambuco. Meanwhile, Italian automotive giant Fiat is building a car factory with an investment of R$3b (US$1.5b) in the same state.

Dynamic growth in the region typifies Brazil’s changing role on the world stage. Last year, foreign direct investment (FDI) into Brazil hit a record US$66.7b, according to the Central Bank of Brazil. The Bank’s poll of economists, released on 16 April, showed that expectations for FDI in 2012 are somewhat down — but a still healthy US$56.4b is anticipated.

M&A activity has also been robust. According to mergermarket, deal values rose to US$86b last year, while the number of transactions was up by 35%. However, it has not been immune from the global crisis. Between 2010 and 2011, year-on-year M&A value only rose by 9%, compared with a 52% increase from 2009 to 2010.

A land of opportunity

Ever more businesses are discovering the benefits of investing in Brazil, as this market of 190m people becomes a core part of business strategy for multinationals. “It was always said that Brazil is the country of the future and will remain that way. But that’s no longer true. Brazil’s day has arrived,” says Alexis Karklins-Marchay, Ernst & Young’s Emerging Markets Center Leader.

Recent deals have shown the enthusiasm of foreign investors. The Brazilian Government raised a total of R$24.5b (US$14b) in February from the privatization of three major airports — three-and-a-half times more than the Government’s minimum asking price. South Africa’s ACSA and French operator Egis were among those bidding.

Investors are spoiled for choice. The country has one of the most diversified economies of all emerging markets, with a strong industrial base, growing service sector and strengths in soft and hard commodities. “The opportunities are so broad, that there is no single sector that we could point to as dominant,” says Karklins-Marchay.

However, while Brazil may be a BRIC country, it is not growing as fast as China and India. Brazilian GDP growth was 2.7% last year, while China and India grew at 9.2% and 6.9% respectively. Brazil is predicted to accelerate to 3.2% this year, according to a Central Bank poll of leading economists. “This is healthy, and more than Europe and the US, but not spectacular,” says Karklins-Marchay.

In many ways, the global economic crisis has re-emphasized Brazil’s importance, says Luiz Claudio Campos, a partner in the project finance area of Ernst & Young Terco in Rio de Janeiro. Portuguese and Spanish investors, who have a long tradition of investing in thecountry, appreciate the necessity to diversifyinto emerging markets. For example, last year Portugal Telecom bought a 22.4% stake in Brazilian phone operator Oi for US$5b.

“This year, we will see something less in terms of total volume of FDI compared with 2011, but it will probably be higher than 2010,” Campos predicts.

Source: Central Bank of Brazil, mergermarket, CIA World Factbook

Commodities are still king

Foreign investors are still heavily involved in both hard and soft commodities. Mining, particularly of iron ore, as well as oil and gas have led to some of the biggest deals over the last five years. Indeed, huge oil deposits were discovered off Brazil’s coast at the end of 2007. In 2010, Chinese petrochemical giant Sinopec signed a US$7.1b deal with Repsol Brazil to create one of the region’s largest energy groups and explore oil and gas opportunities.

“We have seen lots of foreign players interested inacquiring companies in the local supply chain for Petrobras (the state oil company),” says Campos. Brazil’s huge soya production capability — as well as strengths in beef, sugar and coffee — makes agriculture a major attraction. Last year, US-headquartered Bunge announced plans to invest US$2.5b in the country to increase its sugar and biofuels footprint.

But it is two relatively new themes that are really exciting foreign interest: the urgent need to modernize infrastructure and the explosive growth of the middle class.

São Paulo’s underground system has just 74km of track to serve 4m passengers a day. This compares, for example, with 402km of track serving 3.4m in London. Airports, ports, roads, rail, water and sanitation, housing, electricity and energy all feature as priorities in the Government’s strategic Growth Acceleration Program, which was initiated in 2007 and is designed to improve logistics.

“These sectors are in the spotlight and are coming to dominate deal flow,” says Campos. Santos, the country’s largest port, has seen heavy investment in the last two years including the US$907m deal for the massive expansion of Brasil Terminal Portuário.

Source: mergermarket

The burgeoning middle

However, a shifting dynamic in the lower-middle class — known in Brazil as the “C class” — is currently the most talked-about phenomenon. According to data released at the end of March by one of Brazil’s top universities, Fundação Getúlio Vargas (FGV), 105.5m Brazilians are in this class, i.e., earning between R$1,064 (US$523) and R$4,561 (US$2242) per month. In two years,a further 13m Brazilians are likely to join the ranks of the C class, an increase of 12%.

These are voracious consumers. The FGV study found that 40% of computers and nearly 40% of mobile phones sold in Brazil go to this group. Among their findings were that70% of new credit cards go to the C class and 34% of them already have cars.

This new class is found all over Brazil. This explains why retail firms are lookingbeyond São Paulo and Rio de Janeiro to regions of Brazil that were long ignored, such as the Northeast. Indeed, there have been 52 shopping malls built in this region alone since 2006. Meanwhile, Walmart, the world’s largest retailer, invested R$1.2b (US$600m) to open nearly 80 new stores across Brazil.

In selected areas of goods and services, including consumer cosmetics, Brazilians spend heavily. The country is the third-largest market for cosmetics after the US and Japan. Brazilians spend R$1b (US$500m) in beauty salons, according to the Commerce Federation of the State of São Paulo.

Closing the infrastructure gap

The increased movement of goods together with the volume of new cars on the roads is putting strain on Brazil’s road transport network. Brazilian automobile sales rose 2.9% to a record 3.4m units in 2011, according to industry sources quoted in the daily newspaper Estado de São Paulo.

Several foreign companies are already making significant investments. For example, Spanish construction firm OHL operates 3,200km of Brazilian highways.

Foreign interest in infrastructure doesn’t only depend on the 2014 FIFA World Cup and the Rio 2016 Summer Olympics — both of which will be hosted in Brazil — says Campos. The country has substantial bottlenecks in areas such as water, sanitation and urban mobility and is bringing in foreign money to solve these problems. The São Paulo metro is working on a new round of auctions for new train lines, for instance.

Some individual states, including Pernambuco, São Paulo and Bahia, are also keen on foreign participation in infrastructure and are experimenting with public–private partnerships, Campos points out. Compesa, a water and sanitation company in the Northeast, is structuring a US$2.5b, 35-year contract through a public tender that was being issued as Capital Insights went to press.

“Lots of foreign engineering and construction companies are looking for opportunities. However, opportunities also exist in sectors such as IT and telecoms. In a country with the continental size of Brazil, you need to have everything linked via satellite,” Campos explains. So it’s not surprising that Spanish multinational Telefonica announced R$24.3b (US$11.9b) of investments in Brazil last year.

However, for foreign companies seeking to invest in Brazil, there are a number of key practical areas to consider.

Face-to-face pays off

In Brazil, more meetings are generally required than in Europe or North America. “Brazilians only tend to do business with you when they feel comfortable. That means plenty of visits and meeting the right people within the company,” says Martin Raven, founder of Martin Raven Consulting in London and former Consul General and Director of UK Trade and Investment at the British Consulate General in São Paulo. Developing such relationships can be time-consuming and requires multiple trips to Brazil, so commitment to the country is imperative and that requires a thought-out, long-term business plan. “The rewards can be so huge that it’s worth making that investment,” he says.

Listen, and don’t preach

During meetings, it is essential to avoid hectoring or assuming that you can impose your business model, says Karklins-Marchay. There is increasing pride in the country as the economy develops and Brazil plays a more important role on the world stage. “Brazilians don’t want to be told by Americans and Europeans how to operate. Clichés about Brazilian football and carnival should be avoided,” he says. Perceived slights can be highly damaging. “We had one CEO client who refused to fly to São Paulo to sign a deal, whereas his competitor was prepared to do just that. The competitor won the business,” Raven says.

Keep it personal

Brazilians emphasize and prize their personal contacts, and multiple generations of one family are often involved in a business. According to the government-supported Brazilian service to support micro and small-sized enterprises, Sebrae, Brazil has 6m–8m companies, of which 90% are family owned. In family deals, it is essential to get to know the key people. “In all the successful deals that I have worked on, you need to involve the key decision-makers early on and give them a future in the new organization,” recommends Karklins-Marchay.

An example of how the personal touch really worked comes from the company Eprimecare, which targets efficiency and cost improvements to outpatient care. Eprimecare CEO Dr. Leonardo Florêncio says he was initially suspicious of bringing in outside investors, but after several face-to-face meetings with the Brazilian venture capital firm Confrapar, a deal was struck in 2010.

The tax and labor cost burden

Bureaucracy and tax laws in Brazil are complex. Direct and indirect taxes, social contributions and industrial taxes can be cumulative along the production chain.

The rise of the middle class is underpinned by huge recent wage rises. And the already high costs of labor can be doubled when employment taxes are factored into the cost equation. The minimum wage has risen nearly 14% in the past year alone. “This is a large burden for Brazil when you compare cost competitiveness,” Campos notes.

“Labor and tax laws are tricky,” says Karklins-Marchay. “We have worked on many transactions and getting the tax structure right is very complex and takes time. You need to get the best advisors to deal with this. You risk losing money if you do not.

“Although tax laws are complex, they can still be navigated and even transformed into an advantage — for example, goodwill is tax deductible in Brazil.”

Bureaucracy can also be particularly onerous in Brazil. It can take as long as six months to register a company, says Campos. Indeed, the country scores poorly across a host of business indicators and came 126th (out of 183) in the World Bank’s Doing Business survey.

Such a web of regulation makes the way companies structure a deal a key determinant of ultimate success. In general, Karklins-Marchay believes that buying a 60%–70% stake in the target company is best. It gives the acquirer the majority while making sure that there is a role for the seller. “Make the seller your ally. They need to be willing to participate in the success of the company. If they get frustrated, there is a risk they will start a new one up next door,” he says.

The Real deal

It’s important to note that investment in Brazil has driven up the currency substantially over the medium term. It was trading at R$2.40 to the US dollar 10 years ago, compared with the current exchange rate of R$2.00. Nowadays, São Paulo has the second highest cost of living in the Americas, according to Mercer’s Worldwide Cost of Living survey 2011.

For foreigners, that means takeovers can be expensive when translated into the home currency. “Brazil has been through a startling corporate governance transformation and is now recognized as Latin America’s market leader,” says Sandra Guerra, Chair of the Brazilian Institute of Corporate Governance, a group that brings together Latin America’s top companies by corporate governance standards. Campos feels there are compensations for the higher price: Brazilian firms have progressed well in terms of corporate governance and are a safer buy, but diligence is still required.

A huge local market, a thriving economy, an open culture and growing economic sophistication can all outweigh the cons of Brazil’s complex regulatory environment, if properly managed. Right now, Brazil is in the spotlight, and it seems it will remain a target country for business opportunities in the coming years.

Source: mergermarket