As the Lava Jato corruption investigation snowballs in Brazil, drawing in increasing numbers of companies and garnering countless headlines, the country’s ranking in the global graft scorecard is somewhat of a surprise.

The country places third among large Latin American economies in Transparency International’s annual corruption perception index. Indeed, Brazil ranks in front of the rest of South America — with the notable exceptions of Uruguay and Chile — in the most recent scorecard. Brazilians think their country is less corrupt than Colombians, Mexicans and Peruvians judge their own.

Still, at 69th place globally, Brazil’s ranking is perhaps less of a reflection of clean dealings and more of a general resignation across Latin America to incidences of bribery and corruption in everyday business. Indeed, LatinFinance spoke to many specialists for this article who said that, frustrating as it may be, corruption is often seen as simply part of doing business in the region.

“I don’t think there’s anybody naïve enough to think that corruption doesn’t exist in the world at all, and even more so, that corruption doesn’t exist in the emerging markets,” says Walter Molano, chief economist at US-based BCP Securities.

Yet those on the ground in São Paulo say the Lava Jato investigations look set to change, fundamentally, the way business is done in Brazil.

“For Brazil, even compared to Brazil’s past experience, this is definitely a game changer,” says Rodolfo Spielmann, head of Latin America for the Canada Pension Plan Investment Board.

“I would even dare to say it’s an inflection point in how the private sector deals with the private sector, but mostly with the public sector and with state-owned companies and regulatory agencies.”

Brazil may be the most prolific example. But across Latin America the specter of corruption is changing the way international investors evaluate risks and, ultimately, where they allocate their portfolios.

Entrenched corruption has clearly noxious consequences. At the most basic level, the cost of doing business rises and efficiency suffers. There are knock-on effects, also. Confidence in Mexican President Enrique Peña Nieto, for example, took a hit last year when questions were raised about state contracts given to a construction firm that owned his wife’s house.

“While he and his team have a lot of good ideas and seem to be doing an okay job, or a good job, in terms of implementing and modernizing many things in Mexico, this puts that at risk,” says Jorge Piedrahita, chief executive of Torino Capital in New York. “Because, if he’s not politically strong to push for these issues, then that reform agenda gets delayed.”

For some, the scandals add up to little more than background noise. Those with money to put to work will continue doing their homework and working through a checklist of potential risks, they say. Corruption worries may simply have moved up the list of potential concerns, to fight global monetary policy uncertainty for top position.

“A lot of deals are getting done,” says Taisa Markus, partner at Paul Hastings. “For investors in these markets, there have always been risks. There was currency control risk, political risk, economic risk, risks that the judiciary may not be capable of judging fairly or enforcing judgements.

“So now, anti-corruption concerns are new in the mix. The risks of investing in this region are counterbalanced by the fact that the economies are growing and the returns can be very attractive.”

A way in

Topping that list of deals getting done are private equity transactions.

For these buyers, the asset prices depressed by Brazil’s scandal, coupled with better financial metrics thanks to weaker currencies, offer a chance for savvy investors to pick up assets at good prices.

Private equity deals are said to have continued apace this year, in spite of recent scandals. That goes for Mexico, where the scandal involving the house of the president’s wife did not derail investment.

“When that happened, we took a step back and said, ‘this will be interesting’, because we were seeing so many big international private equity firms and a lot of the energy investment firms making trips to Mexico, and in some cases opening offices there,” says Cate Ambrose, president and executive director of the Latin American Private Equity & Venture Capital Association (LAVCA).

“We really wondered whether that would influence the appetite from those investors — and that has absolutely not been the case. We have continued to see really committed interest to taking stakes in that market and defining investment opportunities.”

The long-term view of many investors in public, and particularly private, equity means that rising accountability among local industry is particularly welcome. Indeed, many investors are already well-accustomed to dealing with potential risks, she says.

“I don’t mean to be flippant in any way about the seriousness of what’s going on. But it’s also part of doing business in emerging markets,” says Ambrose.

“Understanding how to invest in a country and deliver returns, without being exposed to corruption scandals and corruption in businesses, is a core skill that emerging markets private equity investors have to have, by definition.”

LAVCA was preparing its half-year figures for Brazilian private equity activity as this edition of LatinFinance went to press. But Ambrose says that anecdotal evidence suggest the first six months of 2015 were “absolutely” very strong.

“We have not seen a slowdown in investment opportunity from local managers or from international firms,” says Ambrose. “This is not speaking so directly to the corruption issue, but the fact that what’s going on has not stopped private equity investors from being active in these markets, because they know that now could be a very interesting time to acquire companies.

“There’s been a devaluation, so for anyone investing with dollars it’s positive, and there may be less competition for deals and the opening up of new opportunities. None of that changes the fact that the private equity firms will be incredibly diligent in seeking out any possible corruption in their portfolio companies or opportunities. It takes a lot of due diligence.”

Canada’s Pension Plan Investment Board has a $269 billion global portfolio, of which $7.7 billion is allocated to Latin America. The board maintains a positive view on Brazil in the longer term. Although the noise and headlines of the corruption investigation may depress prices in the short term, they also are worthy of attention.

“[Lava Jato revelations] shed new light on some of these practices in some sectors but that’s definitely very valuable input to our investment decision,” says CPPIB’s Spielmann. “It doesn’t change our medium to long term positive view on Brazil. But it does richen our judgement on sectors and companies and where to invest.”

More homework

Investment may continue, but decisions on where to allocate cash are tougher than ever.

In many cases, firms are stepping up their homework before committing cash. “Companies more often than before are hiring specialized firms to do background checks,” says Antonio Felix de Araujo Cintra, a partner at TozziniFreire Advogados and a member of the Emerging Markets Private Equity Association’s legal and regulatory council. “We see that the procedure for due diligence has become stricter. We are sent many times to personally interview management… We have to ask questions to a number of people, especially whenever one is dealing with state-owned companies, or when people are looking at buying a company that was a participant in government bids.”

The theme of stricter due diligence is a common one.  

Felix says the firm’s corporate investigation, corruption and compliance departments are among its busiest areas: “No-one knocks on our door today without asking, as a first question: ‘how do I make sure that this company is clean? How do I make sure that I will not inherit any liabilities here?’”

Paul Hastings’ Markus also says that investors are paying greater attention to due diligence procedures. While processes vary according to the deal type — a strategic investor looking at an acquisition will approach things differently to a highly regulated entity such as a bank considering a loan — the focus on diligence is increasing, she says.

“We see companies want to be, and are, better prepared going into a deal. New corporate governance, anti-corruption, anti-money laundering regulations have been enacted in various jurisdictions and companies that are seeking outside financing are aware of both home country and international standards.”

Heightened caution

The depth of due diligence varies depending on the type of transaction, of course. Banks, already highly regulated entities, have to consider a swath of rules and procedures before they grant loans.

The arrangers on Petrobras’ market-stunning bond return in June were understood to step up their background checks in an “extensive” two-week window ahead of proceeding with the deal.

“The level of diligence that was done was way higher than what Petrobras has been doing over the last few years,” says a person familiar with the transaction. “Petrobras agreed to broaden the scope of the diligence, not only on the business side but also on the legal side.”

Equity investors, private or strategic, may have fewer regulators to answer to — but being a long-term owner makes caution critical.

“Fund managers that raise capital from third party institutional investors, like pension funds or endowments and foundations, or any group, be they Latin American institutional investors or international institutional investors, cannot put themselves at any risk of being exposed to an environment of corruption,” says Ambrose, of LAVCA.

“They simply will not take a stake in a company or participate in a project if they can’t be sure that there is no risk of corruption. All it takes is even the perception that something is wrong, for them to lose institutional investors in their next fund.”

CPPIB’s due diligence process has always been “very, very rigorous”, says Spielmann. That hasn’t changed, he says. He declines to give further details on the procedure, quipping that it is part of the recipe for the firm’s “secret sauce”.

“Given we are long-term investors and we look for long-term partners, we have a relatively high bar for corporate governance agreements with our partners. This is not a short-term investment, or one that we would get out of very quickly, so having the right partner and the right corporate governance in place is a very high priority for us.

“We spend lots of time selecting our partners and then discussing with them what the best partnership model is, what the best agreement is, what the best contracts are, what the best governance is,” adds Spielmann. “This is not just board positions, this is actually what type of decisions we share, what type of agreements we make up front, in order to avoid misunderstandings later. This is absolutely key and paramount for us.”

Taking a view

The bond market has been less badly affected by the developments, argue some. Brazilian borrowers were notably absent from the cross-border bond issuances in the six months to June, and have been scarce since. Yet global monetary policy is set to impact investor demand more directly than the corruption investigation, say analysts.

“Most of the big corporations in Brazil borrowed way ahead on the expectation that the US Federal Reserve was going to increase interest rates,” says Ramón Aracena, chief economist of the Latin America department at the Institute of International Finance. “They already had their financing sources relatively secure. That’s probably the main driver for fewer bonds at the moment.”

David Rees, EM financial markets analyst at Capital Economics, also stresses the importance of “not getting too carried away” from a bond market perspective.

“Clearly these scandals are not good for the image of the respective countries. But it is not clear that they are necessarily leading to problems with accessing capital per se.”

Events such as the 2013 Taper Tantrum and the drop in oil prices have a more lasting impact on borrowing costs, he says.
Not everyone is as relaxed. Corruption rumors and concerns can offer an example of when it’s better not to buy a favored company when the price dips, argue some.

“I have had many talks with clients about Brazil,” says Torino Capital’s Piedrahita. “One of the more usual talks is that there is noise in some name, it sells off five, 10 points and they say, ‘should we jump in? It’s a good company’.

“My advice is always the same: we really don’t know the extent of all this. So I wouldn’t just buy simply because you think it’s a good company and it has dropped 10 points. I would request more information.”

Worries about a given entity can ultimately be self-reinforcing, he cautions.

“At the end of the day, complete lack of confidence on a name can kill the company itself,” says Piedrahita. “You need confidence to deal with your suppliers. You need confidence so that your employees trust you. You need confidence so that your clients consume your products. And of course you need confidence from the banks, from the capital markets, from your investors. So, once confidence is broken, it’s very difficult. It has a huge cost.”

Brazilian bonds are trading wider than a year ago as investors question just how far the country’s corruption investigation will reach. That means that some issuers not implicated in Lava Jato are nonetheless suffering the consequences in the trading levels of their debt.

“People just don’t give [them] the benefit of the doubt,” says BCP’s Molano. “That’s the only way that investors can deal with it. They reprice the risk: it makes it that much more expensive for these companies to come out to the market. So it will temper their expansion.”

New issues, Molano predicts, will require more covenants and asset pledges.

Yet he highlights another reason why bond investors may be quicker to take a cautious approach today, compared to a few years ago. “Investors become very forgiving when there’s a very high level of liquidity and capital mobility, as there has been for the last 15 years because of all the quantitative easing and monetary expansion that we’ve seen,” says Molano. “Maybe investors will become more discerning once this liquidity starts to dry up.”

Mixed consequences

Regardless how equity and debt investors play the market movements as Latin America’s corruption investigations unfold, the underlying practices have serious consequences for the countries themselves.

“[Corruption] increases the cost of doing business, either in the country, or the specific economic activity,” says Aracena of the IIF.

“It also has a deterrent effect on large corporations that have strict governance rules. If they perceive in a specific country that corruption is widespread, they might stay away from the place.”

And while Brazil may be copping the headlines for corruption today, observers are quick to highlight the positive flipside of the investigation.

“The bad thing is that there is corruption,” says Piedrahita, of Torino Capital. “But the good thing is that in some places, it seems that prosecutors and the judiciary seem to be doing their work, which provides some hope. That’s the case in Brazil: prosecutors keep digging and digging and digging.”

Whether business practices in other parts of the region are cleaner — or whether they simply have less institutional strength to pursue wrongdoing is hard to tell. Transparency International’s 2015 corruption perception index will be closely watched. LF