As interest rates remain relatively low and financial liquidity levels remain high, investors with a higher risk appetite will continue to find increased opportunities with distressed assets. In Brazil, these have already reinvigorated the trend of M&As in Q3 of 2020.
A revigorated trend
While M&A transactions in Brazil dropped sharply in the first half of the year, in large part due to the uncertainties caused by COVID-19, Q3 has seen a 46% increase compared to the same period in 2019, according to statistics by private database Refinitiv. Evidence suggests that distressed assets account for a significant share of this growth. According to an August report in local media outlet Valor Invest, the “alternative funds” market – which is primarily comprised of funds focused on distressed assets – grew by 15.4% year-on-year between January and June, and has the potential to grow by 58% by 2023, reaching USD 185 billion (BRL 1 trillion).
This positive outlook for the market is due to the persistently high levels of liquidity worldwide coupled with increased opportunities across multiple sectors in Brazil in the context of the pandemic-induced recession. Overall, and despite the challenging economic situation in Brazil – which includes growing fiscal concerns and record-high unemployment rates – investors continue to find relatively positive regulatory and financial prospects for long-term investments.
New bankruptcy law
In coming years, investors with a focus on distressed assets will likely benefit from the progressive modernization of Brazil’s legal framework for bankruptcies and judicial recoveries. On November 25, the Senate approved a bill to adapt Brazil’s 2005 Bankruptcy Law, reducing legal and economic risks from assets associated with judicial recoveries. It will provide investors with increased legal certainty and financial flexibility in the context of turnarounds; for example, it establishes extended periods for the payment of financial liabilities (such as pending taxes) associated with distressed assets. The bill, which has been sponsored by President Jair Bolsonaro’s administration, is unlikely to face significant resistance from the Senate given the broad consensus across the political spectrum on the need for such legal improvements and will likely be approved in the next six months. It is worth noting that, according to the Ministry of Finance, there are approximately 7,000 companies across all sectors that are currently under judicial recovery processes in Brazil.
Financial environment
Foreign investors with a long-term strategy will likely continue to benefit from a mostly favourable exchange rate to conduct acquisitions in Brazil over the next two years. While the Real has remained volatile in 2020, the new paradigm of record-low interest rates means that Brazilian assets will continue to be comparatively attractive vis-à-vis those in other emerging markets. Although growing fiscal constraints (including a significant deficit in 2020) have the potential to lead to a partial reversal of such a benign panorama, monetary risks are unlikely to escalate due to the autonomy of the Brazilian Central Bank.
Anecdotal evidence suggests that local financial institutions have increased the variety of their portfolios of alternative funds in the past three years, further highlighting the welcoming financial environment, in addition to providing investors with increased funding alternatives for their projects.
Opportunities economy-wide
While the infrastructure, sanitation and energy sectors continue to be the main targets for private equity and sovereign funds in Brazil, sectors that have been particularly affected by COVID-19 but that have maintained strong economic fundamentals (including a resilient demand) for the longer term – such as retail, aviation, entertainment and hospitality – will likely continue to represent attractive opportunities for investors with a high appetite for risk in the two-year outlook.
Other significant opportunities have continued to arise against the backdrop of “green” trends in Brazil – both in sectors directly associated with climate change agendas, such as renewable energy, and in companies that have been successful in developing and communicating strong green credentials, including in retail, transport and finance. The fact that Bolsonaro has not, and is unlikely to, significantly change his highly controversial approach has not meant that Environmental, Social and Governance (ESG) trends will take a backseat. On the contrary, these continue to rely on growing support by multiple institutions, including the Brazilian National Development Bank (BNDES) which has specific credit lines for sustainable projects.
What about risks?
Investors should remain aware of the likely persistently slow pace of structural reforms promised by Finance Minister Paulo Guedes since he took office in January 2019. This is due to the government’s significant policymaking challenges in addition to its minority and fragile coalition in Congress, and this situation is unlikely to improve significantly in 2021. As such, economic growth rates will likely remain low in the coming years. Despite this, a shift in the government’s pro-business platform remains unlikely – and businesses will remain more exposed to longstanding political risks (such as those related to the persistence of Brazil’s notoriously complex and onerous tax code) than to abrupt and/or adverse changes in economic policy.
Most risks associated with investments in distressed assets will likely continue to be mitigatable by sound pre-investment plans that include proper due diligence and risk assessment processes. These will ultimately allow investors to focus on the strategic turnover of the assets rather than on unmapped political, regulatory and integrity threats.