The struggle for transparency

“The Brazilian business elite is trash,” snorts Walter Appel, a São Paulo fund manager. Like many other equity investors, Appel, a partner in São Paulo’s Banco Fator, is furious at the stiff opposition from big business to plans to rewrite the country’s company law and strengthen minority shareholder rights. “It is inconceivable that at a time like this we should have a new law that is so conservative, so anti-capitalist and continues concentrating power in the hands of a few,” he says. “The [business] lobby is trying to make the law even more conservative than before.”

The controversy dates back to 1997, when the Brazilian government scrapped many minority investor rights as it geared up to sell its power and telecommunications monopolies. Rather than return to the relatively pro-market legislation prior to 1997, Appel says the new legislation would entrench the power of management and dominant shareholders at the expense of minority investors and to the detriment of the country’s shriveling equity market.

Other fund managers are just as scathing about the government’s lack of interest in pursuing the matter. Congress has debated the draft law for over a year now. The Chamber of Deputies, the lower house, approved the legislation in March and sent it on to the Senate for approval where it has languished ever since. Bruno Rocha, president of Rio de Janeiro asset manager Dynamo, says, “The government has become weaker. It lacks the political will to fight for it.”

This is a pity because weak corporate governance norms are one of the main factors undermining the equity market in Brazil and so denying companies an important source of financing for growth. The most common complaint from non-core shareholders concerns the country’s two-tier share structure. Companies may issue up to two non-voting preferred shares for every voting or ordinary share issued. This means that a core group of investors, usually family members, can control a company with as little as 17% of total equity.

A Macroeconomic Issue
Rocha says, “Corporate governance is a macroeconomic issue because if this country is to grow it needs financing from the equity markets. The budget of BNDES [the national development bank] is too small. The international capital markets are only open to bigger companies. There is no long-term credit market here. So one has to look at the stock market as the only source of financing for growth.”

The major government agencies share his views. The finance ministry, central bank and BNDES all want to modernize Brazil’s corporate governance standards and reinvigorate the equity market. Says Eleazar de Carvalho, president of BNDESPar, the development bank’s investment arm, “There’s been a wake-up call from foreign and local investors that [premiums] are not compensating for the risk of investing in Brazil.” This matters because “to finance growth and compete, companies [realize] that the capital markets need to be used and transparency and corporate governance must be addressed.”

Unfortunately, more companies have quit the market than have listed and trading is heavily concentrated in a few names, condemning most companies to various degrees of illiquidity. Dynamo, for instance analyzes about 300 listed companies but only 20 to 30 meet its investment criteria.

The reason for such anguish is easy to understand. The São Paulo Stock Exchange, usually known by its acronym Bovespa, has seen a precipitous slide in trading volumes over the years. Foreign investors have decamped and the largest and most liquid stocks have followed. Nearly all the country’s most popular stocks are listed as ADRs on the New York Stock Exchange, where trading costs are lower, liquidity is greater and where the international investment funds prefer to trade. Above all, transactions in New York are not required to pay the 0.38% Brazilian tax on financial transactions.

Francisco Gros, BNDES president (see page 26) says the CPMF tax “is a nightmare from a capital market point of view. It is an obstacle to building a strong capital market that we will have until there is fiscal stability. Until then, companies will continue raising [capital] abroad more than domestically.” Although ministers concede that the tax is stunting the equity and debt capital markets, the government renewed the “provisional” CPMF for a further 18-month period in June because it is easy and quick to collect.

Already 27 Brazilian stocks list in New York, including oil giant Petrobras, the biggest company, supermarket chain Pão de Açúcar and Embraer, the regional jet maker. More are joining every month. In July, Banco Itaú, the country’s biggest private-sector bank by market capitalization, began trading its non-voting preferred stock under the NYSE’s Level 1 over the counter ADR program. All three major locally owned banks now trade in New York.

Raymundo Maglione, the Bovespa’s president, says “In 1996, [the São Paulo exchange] was the same size as Madrid’s and now it is just 20% as big. We are fighting to survive. We are not just going to give up and close the market.” But he has few convincing ideas about how to attract liquidity back to São Paulo. He says, “We are making enormous efforts to increase our volumes. The idea is to create a consistent market, widening its base and allowing the entry of more small investors and workers.”

The exchange has signed agreements with labor unions to encourage workers to invest in the market. Maglione was jubilant as he described attending a recent meeting of the Força Sindical union where the Bovespa distributed 11,000 T-shirts.

The Bovespa’s creation earlier this year of the Novo Mercado, literally the New Market, for companies meeting more exacting standards of transparency and corporate governance than required by the current legislation, is a step in the right direction. So far 15 companies have entered the Novo Mercado (see box). Investors are not complaining, but they are hardly cheering either. Those companies that have entered are among the most market-friendly in Brazil and had to make few adjustments to qualify for membership. Most see a Novo Mercado listing as little more than a seal of quality and doubt it alone can reverse the drain of liquidity to New York.

Jório Dauster, who quit recently as president of Cia. Vale do Rio Doce, the privatized iron ore mining company, says “It is frustrating to be sold at a lower multiple when we have better margins than the competition. We are not in the portfolios of the biggest [mining] funds because we are based in Brazil. Being in the Novo Mercado is like having a medal that you can wear.”

In spite of all the hand-wringing, there is some room for optimism. BNDESPar’s Carvalho points out that “The cost of equity finance is high. There is the 50 basis points equity risk premium, plus 800-900 basis points Brazil risk. But this premium will come down with economic stability.” He adds that companies not large enough to list on the NYSE still need to raise equity on their home market, where investors know them and follow them.” Furthermore, future privatizations especially of Furnas Centrais Elétricas, the hydropower generator, are likely to be retail offers carried out through the equity markets instead of sales to strategic investors.

Last year’s $4 billion secondary public offering of Petrobras stock by the government, staged simultaneously in New York and in Brazil was a milestone on the way to creating an equity culture in Brazil. One-third of the shares went to Brazilians, many of whom had never owned stock before. It is true that government changed the rules to increase the placement of stock-it allowed workers to use half of their severance funds to buy the shares, which were sold at a 20% discount-but 330,000 Brazilians bought Petrobras stock in the offering, proof that Brazil’s markets are large enough to absorb comparatively big issues.

More important still is the growth of Brazil’s pension and mutual fund industry. Banco do Brasil, the state-owned banking group, alone has $67.0 billion in assets under management or 16% of the market. Most of this money is still invested in fixed income assets, nearly all of them government securities. It will take a long time for the proportion of money invested in stocks to rise substantially, especially as companies are still under-leveraged with average debt-equity ratios of about 25%. Companies are more likely to increase their debt load before taking the plunge and entering the equity market. The weak performance of stocks during the recent crisis has deterred retail investors while institutions can still buy long-dated government stock paying real interest of over 10% a year. Yet funds are not allowed to invest outside Brazil and so their growing pool of captive liquidity should sooner or later revive the equity markets.

If the immediate outlook for the market is gloomy, investors and companies alike still sound remarkably upbeat. Rocha says, “Short term, I am not very optimistic but long term I am because long-term changes will come. Even if the law does not pass, there are enough changes in the culture of investing in equities.”

Luiz Chrysostomo, head of investment banking at JP Morgan, agrees: “Clients and investors have become more sophisticated. The institutions are more sophisticated. BNDES and the government have understood the importance of the capital markets.”

Companies that have begun experimenting with the domestic and international equity markets are becoming more confident. Organizações Globo, the media group, has only one listed subsidiary but is toying with the idea of more IPOs. Mauro Molchansky, executive director of Globopar, the group’s financial arm, says “The greatest problem is to generate funding for growth. We have many ideas for future growth and we need to access the market. The challenge is to do this with an adequate cost of capital. Maybe we should look at equity in the near future.”