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Everything You Need to Know About Brazilian Private Equity: Part II

PART 2

Financial Transparency

This is perhaps the mother of all issues when considering the more common challenges in successfully raising private equity capital.  And it's not an issue solely relevant to Brazil and/or Latin America, as it is an issue facing any early-stage or middle-market company worldwide looking to raise capital via the private equity market.  It is the subject of much frustration among private equity professionals and company executives alike, and perhaps the single most common reason why most potential transactions reach an unfortunate and untimely death.

Let's first remember that a principal factor of the current financial crisis was the simple annihilation and obliteration of trust.  Investors lost trust in the financial system, they lost trust in bankers, ratings agencies, federal regulators, the words "collateral" and "obligation," and in the American dream of home ownership.  Even "In God We Trust" lost plenty of strength and credibility as the US greenback fell to and continues to trade at historic lows.  Call it "The Great Recession," "The Great Depression 2.0," or just the global financial system going to hell in a hand basket.  The point is that financial transparency fell by the wayside and with it went investor trust.

At the 2009 World Business Forum in New York City, David Rubenstein of The Carlyle Group, Nobel Prize winning economist Paul Krugman and former President Bill Clinton addressed many of the important issues regarding the current global economic conditions as a result of the crisis.  But Dennis Nally, Chairman of PricewaterhouseCoopers International Ltd., said it best and most succinctly, stating that a global recovery rests upon the notion of restoring trust and "transparency is the lifeblood of investment."

Amen, Mr. Nally.  Sounds easy enough.  Now let's just get out there and apply that simple principle to private equity investments in Brazil and other emerging markets.  As we say here in America, "Giddy up."

Unfortunately, it is the very rare occasion that typically family-owned companies will maintain the accounting and financial controls and reporting sufficient to thoroughly satisfy a comprehensive due diligence process of a private equity fund.  Therefore, any sort of summary report prepared by the company's accounting staff or even by the company's accounting firm on the company's financial results and condition will not suffice.  Period, end of story.  In a nutshell, many family-owned companies do not have the adequate financial and accounting infrastructure to produce the level of information that is typically expected by private equity investors.  What might be clear as day to a company executive looking at only two line items of revenue and net income for a seven-month period ending two months prior to the fiscal calendar year and compiled by his sister's husband's second cousin who just graduated with a degree in anthropology and now forms part of the internal accounting staff, will very likely cause most private equity professionals to start breathing into a paper bag.

Again, this is not a criticism in any way imaginable.  A privately-held, family-owned company has no legal or regulatory obligation to maintain a complex financial accounting system.  As any owner of a family-operated company might tell you, keeping expenses down is the important issue and keeping a tier-1 accounting and financial department is costly and thus very rarely on the agenda.  But a lean accounting department that predominantly focuses on daily operational issues and the year-end close will not likely be able to provide the necessary reconciliations and minutia required by private equity investors.

Unfortunately, many companies involved in the due diligence process will inundate the potential investors with endless reams of useless information that only create more confusion and raise even more questions.  Perhaps the belief is that if they inundate the potential investors with so much information, maybe they will just stop asking and go away.  And the fact is that they will go away.  Away from the deal, that is.

The main problem is that few companies seeking private equity capital adequately prepare or take a proactive approach to engage an advisor to prepare them for the due diligence process, most notably the accounting and financial due diligence.  Perhaps that's yet another discussion altogether, but having the accounting and financial due diligence performed by an independent third party brings considerably more confidence to the potential investors and provides a higher probability for success in a transaction.

"A transparent and orderly diligence process leaves either a positive or final impression on an investor," said Jose Miguel Fuster, a Senior Vice President with Darby Overseas Investment, Ltd. who focuses on investments in Latin America.  "Adhering to accounting and transparency best practices is also about maximizing value for all shareholders at exit."

Active Middle Management

Management gurus worldwide like to discuss the importance of "building the right team" around the CEO, and they often get paid a lot of money to develop great expressions like "getting the right people on the bus."  Jack Welch, the legendary CEO of General Electric says in his best-selling book Winning, "You've got the right players on the field.  Now they need to work together, steadily improve their performance, be motivated, stay with the company and grow as leaders."

That's all good stuff, and somewhat related to another important challenge for companies looking to raise capital in the private equity market:  maintaining an active middle management.  We say "somewhat related" because, unfortunately, we really are the last people in the world that anyone should ever want to talk to when it comes to building management skills in an organization.  We have our own dysfunctions to deal with and can comfortably say that we will never be included in the same sentence as General Electric, Kraft, Google or others when the discussion centers on the topic of effective management.  Highly recommended reading would be books like Patrick Lencioni's The Five Dysfunctions of a Team or Jim Collins' Good to Great: Why Some Companies Make the Leap...and Others Don't.  Again, that's another discussion altogether, but a good read if you haven't picked them up yet.

What we refer to as "active middle management" concerns the importance of maintaining active participation of middle management in the capital raising process.  Keeping middle management involved in the capital raising process is an extremely important aspect to the successful closing of a transaction.  And as is so often the case, such a simple statement can be a very difficult concept to implement successfully.

Putting aside any private equity transaction over US$500 million, most potential private equity activity in Brazil in the next few years will be in what can be defined as the "small- to middle-market."  How one specifically defines "small- to middle- market" is not really the issue.  The more important issue is that we continue to converge on typically family-owned enterprises where the patriarch, matriarch or a small group of family members serve in the most senior-level positions at the company, including that of the CEO or president.  It's very normal –- though Jim Collins might disagree with us –- in such family-owned companies for one or two individuals to maintain relatively firm control over the company's operations.  It's not an issue of authoritarianism, and it most definitely doesn't fall within the parameters of any Venn diagram in any of the leading management books on effective team-building.  It just is.  At least in Brazil, this is often a function of trust, or a lack thereof.  Family-owned companies will have a CEO who effectively coordinates all aspects of strategy, finance, marketing, administration and who probably has a strong say on the color, pattern and ply-numerage of the company's toilet paper.  Dysfunctional, perhaps.  Normal, absolutely.

The CEO or president of a company will most definitely be the person most involved in the capital raising process.  That's relatively obvious.  The CFO and perhaps one or two other executives may also get involved now and then, but problems arise when the senior management fails to involve, at a minimum, members of the middle management team.  It is probably quite subjective as to how far down the organizational structure one should go in terms of involvement in the capital raising process.  Our general view is that it can be good when the entire company is at least aware of the capital raising process.  However, we're certain that there are numerous examples where such might not be the case.  This is an interesting conversation in and of itself, but yet another topic of discussion altogether.

It is extremely important to have active participation of middle management for various reasons.  First, private equity investors, while clearly interested in the management and leadership capabilities of its senior management, are similarly interested in the capabilities of middle management, because it provides them with a better understanding regarding the potential necessity to bring outside management into the company once their investment is made.  Second, while private equity investors do attempt to keep senior management level positions as stable as possible once an investment is made, the reality is that many members of senior management –- typically major shareholders as well in family-owned companies –- will often not be as involved in day-to-day operations.  Funny how that works.  Therefore, even if private equity investors install their own CEO into the operations, they will want a capable middle management layer at the portfolio company.

Many company executives and business owners might counter by saying that it is important for senior management to maintain a high level of confidentiality when speaking with potential investors and they therefore argue that it is important to exclude middle management from any discussions pertaining to a potential transaction.  Here's why that's a really bad idea.  Aside from any discussion relevant to the works of Jim Collins or Peter Drucker, the private equity teams and their battalions of consultants performing the due diligence will specifically seek out all levels of middle management, employees, suppliers, vendors, bankers and anyone else that will talk to them about the company.  Therefore, while the CEO might very brilliantly and convincingly describe the expansion into a given market as the two of you twirl your Brandy on the deck of his country club overlooking the 18th hole, the two senior engineers who actually install the company's equipment might in fact be more willing to discuss the company's failed initiatives to do just that.  Or the accounting employee might fall off his/her chair when they tell you that the aggressive CAPEX program so beautifully displayed in the financial projections and PowerPoint presentations would never be financed because nobody in the banking community will speak to the company.  You get the point.

As Mr. Valenzuela of The Carlyle Group previously stated, it is important that all levels of management as well as employees consistently convey the same message with respect to any given issue.  "When the CEO discusses a given marketing strategy, you want the head of marketing and all of the marketing people that you speak with to be saying the same thing," he explained.  "They might have differences of opinion as to certain details, but they all recognize the company's overall marketing strategy."

Finding the Right Partner

Most of you just rolled your eyes back much in the same way that your teenager would if you ever dared ask them if you could join them at the mall with their friends.  "Finding the right partner" sounds as cliché and corny as it gets.  However, it is an extremely real issue and a significant challenge for any Brazilian or Latin American company seeking private equity capital.  Finding a partner to write a check is a relatively easy feat to accomplish if you happen to be in an industry that is especially trendy at the time.  Finding the "right partner" is a real challenge most notably because it's one of the most important decisions that a company can make.

What is extremely important to recognize is that private equity funds are much more than a simple source of capital.  In fact, while private equity professionals are indeed excited about closing a transaction with a good company, they also recognize that their work is just getting started.  The right partner –- the right private equity fund –- will bring a literal smörgåsbord of resources to its new portfolio company.  Perhaps you always felt that your finance and accounting department was never that good or effective.  Enter stage left the new CFO, new head of finance and new accounting system capable of tracking receivables to the nearest minute.  Or perhaps your retail food business always showed promise but you always felt that your head of marketing could always use some help.  Enter the former CEO of Kraft Foods to meet with your sales and marketing department to improve the marketing strategy.

A significant opportunity for early-stage and middle-market companies in general and for Brazilian companies in particular in this current market cycle is the ability to professionalize their business operations to the highest levels.  For the family-owned company that has successfully operated in the local market for decades, the opportunity to enter regional and international markets can finally become a reality.  For the family-owned company that might not have the right heir apparent to take over the company, it now has the opportunity to take several first round draft picks to augment its starting rotation.  In addition, by bringing in a private equity partner, it can allow a family-owned company to generate a certain level of liquidity in the near-term, yet continue to maintain a significant ownership in the company with the potential to own a portion of a substantially larger company.

Unfortunately, it's only fair to say that it's not always about holding hands and singing kumbaya.  Many family-owned companies don't want anyone coming in and telling them what to do, and it doesn't matter if it's the former CEO of Kraft or anyone else from that league.  Also, there are plenty of private equity funds that bring little more than a checkbook, and companies will spend more of their time explaining the business to the new private equity board members than receiving any type of operational insights or benefits.  In fact, it can often hinder the company, because major decisions will take longer if the new members of the board have to be schooled on everything regarding the business and the industry.  Simply beware of the private equity professionals that like to hear themselves speak industry idiom, throwing out impressive sounding buzzwords like "value proposition," "paradigm shifts," "margin compression," and "multiple arbitrage."  In fact, many companies soon realize that the benefits of bringing in a private equity partner can be quickly be outweighed by the more burdensome baggage that they can bring as well.  Like any marriage, you really need to know your private equity partner before you make your way up to the altar.

Assuming that a company's interests and objectives are properly aligned with their new private equity partner, the relationship between a company and its private equity partner can reap significant benefits, and not simply financial ones.  It can help professionalize the business, it can open a company up to new markets, it can bring managerial resources, it can bring a network of contacts never imagined, and, most important, it can launch your company into the major leagues.

For Jack A. Smith, the founder and CEO of The Sports Authority, the relationship with his private equity partners provided the company with the ability to grow at a more aggressive pace than on its own.  After leaving his position as COO of Herman's World of Sporting Goods to found The Sports Authority in 1987, Mr. Smith brought in private equity funds Bain Capital and First Chicago Investments, aggressively expanding the company before selling it to Kmart three years later.  "Finding the right VC partner is one of the most important decisions an entrepreneur can make," said Mr. Smith.  "Having that investor serve on your board is more important to the strategy contribution he can make versus his dollar investment.  I was fortunate to have investors who were successful in the retail world that I could rely on their opinions in helping me make the right decisions."

Meritas, founded in Ft. Lauderdale, Florida, and now headquartered in Chicago, Illinois, found it beneficial to partner with Chicago-based private equity fund Sterling Partners.  The company is a consortium of elite college preparatory schools around the world, including a school in Latin America, and working with a fund that knew the education sector was important to them.  Sterling Partners, having successfully backed such successes as Sylvan Learning Centers and Laureate Education, Inc., was, therefore, the right choice for the company.  "We had a few funds that approached us that were interested in giving us capital, but Sterling stood out as someone who clearly understood our company and our strategy," said Mac Gamse, the CEO of the company.  "In addition to the significant capital commitment that they provided us, we had access to all kinds of people and other resources from Sylvan, Laureate and many of their other education companies, and that has been invaluable to us as we continue to aggressively expand our operations worldwide."

Conclusion

Brazil has a unique opportunity to establish itself as a serious economic power in the world hierarchy.  In addition to its strong foothold in the commodity markets, its prowess in the global trade arena, and its overall increasing presence in the global spotlight, the country will need to continue to attract greater amounts of capital to sustain its aggressive levels of growth.

Successful private equity investments in Brazil can prove to be very beneficial for the companies in which the investments are made, as well for the Brazilian economy at large.  A strong business environment means more jobs, and a business environment that is receptive, open and transparent to capital investment will allow companies to access the capital, skills and technology it needs in order to sustain growth and profitability.  In addition, private equity capital is long-term capital.  An investment in a privately-held company is not the same as an investment in the local capital markets, which can often prove to be speculative and short-term in nature.  We, together with the rest of the world, hope that Brazil capitalizes on this unique opportunity to benefit not only in the near term from the recent increased interest in its economy, but we hope that it recognizes that long-term economic prosperity for generations to come lies within its grasp.

Brazil stands at a tremendously opportune moment to attract a level of private equity capital perhaps unseen in its history.  We can't promise that it will be easy, because there are so many challenges that it will face, and each and every company that enters the private equity market in search of capital will undergo its own unique set of difficulties and challenges.  But what we can say with a great degree of certainty is that the world is watching, because we all recognize that this is a once in a lifetime opportunity for the wonderful country of Brazil.  Muito bom indeed.

About the Author

Zach Henry, Principal, and Eric Saucedo, Managing Director, are with the investment banking firm of Tricap Partners & Co. With offices in New York, Miami and São Paulo, Tricap Partners & Co. is an investment banking boutique specialized in advising companies, institutions, family offices and individuals in complex financial strategies and investment decisions. Tricap Partners & Co. is a financial advisory firm specializing in the areas of Mergers & Acquisitions, Restructurings, and Private Placements of debt and equity for early-stage and middle-market growth companies. www.alternativelatininvestor.com

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