Brazil’s Second M&A Wave: Best Practices for Approaching Acquisitions in Brazil

Multinationals’ interest in mergers and acquisitions (M&A) in Brazil is increasing as valuations fall and the real depreciates. Additionally, the divestment of non-core assets by other companies and the need for growth capital in the SME space is generating new strategic acquisition targets for multinationals in Brazil.

However, M&A is a very time-consuming and resource-intensive activity, and many acquisitions fail to deliver expected returns to shareholders (see chart). In Brazil, M&A failure can stem from a multitude of factors, including not having a structured process for mapping and screening potential targets; failure to assess tax, labor and environmental contingencies correctly; not including price adjustment mechanisms; failure to retain key employees; and conducting a poorly-structured post-acquisition integration process.

Chart: Brazil M&AFSG recently published a report specifically addressing ways to overcome common pitfalls in the execution of an M&A deal in Brazil. In our research we focused on best practices in the following areas:

1. How to determine whether an acquisition is the right strategy for growth in Brazil

Not all companies are suited for a strategic acquisition in Brazil, and even if they feel they are, it might not be the right moment to embark on such a time- and resource-consuming endeavor. Before you decide on an acquisition in Brazil ask yourself whether growing inorganically fits your company’s culture and strategy, and whether your company is ready for an acquisition in Brazil.

Finally, even if the answers to the questions above in “Yes”, there is a final question you should be asking yourself, which is whether an acquisition is a better alternative than growing organically. The decision between organic and inorganic growth will depend on the capabilities you need to grow in Brazil, on whether or not you will be able to find an appropriate target that has those capabilities, and ultimately on the time and cost of building up those capabilities organically versus the time and cost of acquiring them through an acquisition.

2. Tactics for tackling key challenges that arise during the execution of a strategic acquisition in Brazil: 

Conducting a strategic acquisition in Brazil can prove a long and challenging road. From the first phase of an acquisition – mapping and screening potential targets, to the final step – post-acquisition integration, multinationals should be equipped with the tools and best practices to successfully navigate the acquisition process.Just to give an example, since observing tax, labor and environmental laws is so challenging for most SMEs in Brazil, many of them choose not to be fully compliant with those laws in order to gain cost advantages and stay profitable. As such, most companies in Brazil have learned to coexist with pending litigations, however a multinational is likely to attract more attention from regulators and tax authorities, which could result in significant contingencies were the multinational to acquire a non-compliant SME. Therefore, when conducting due diligence, multinationals should be very diligent in finding all the “skeletons in the closet”, which also implies getting external help from local lawyers and tax advisors.

3. Assessing the pros and cons of partnering with a private equity fund as an overarching risk mitigation strategy: 

The rise of private equity in Brazil and entry of foreign funds present interesting alternatives to standard acquisitions. Acquiring a company from a private equity fund is the most effective way to find a target that is already compliant with multinational corporate standards in areas such as governance, accounting or systems, as well as with local tax, labor and environmental standards.

Some private equity funds have specialized in investment opportunities that they can later exit selling to multinationals via strategic acquisitions. However, buying from a private equity fund comes at a price. Therefore, multinationals will need to assess whether they can generate enough additional value from the PE fund’s asset to still achieve the desired return on investment on that acquisition. This is especially crucial in Brazil, where payback periods tend to be longer than in other emerging markets as a consequence of “custo Brasil”, or the high cost of doing business in the country.

For more on best practices when approaching mergers and acquisitions in Brazil, FSG clients can access reports on the client portal.

Emerging Market View: What Our Analysts Are Reading

EM View

On Thursday, EU diplomats will consider increased Russian sanctions. The sanctions include a proposal to ban all Europeans from purchasing any new debt or stock issued by Russia’s largest banks, according to the Financial Times, and FSG’s Head of Research for EMEA says it’s time for multinationals to make contingency plans.

“If some or all of the proposed measures are approved by the EU, MNCs operating in Russia will be significantly affected. Executives should build a targeted contingency plan for their Russia operations to prepare. Read FSG’s report Protecting Your Russia Business for analysis and suggested actions for building a contingency plan in the case of further sanctions against Russia.” – Martina Bozadzhieva

In Southeast Asia, a rising middle class and strong demand for more expensive foods has led to increased investment by Japanese food companies, mirroring FSG predictions on the rising competition from multi-ASEAN corporations.

“The increasing sophistication of regional firms and growing demand is attracting several global players to partner/acquire ASEAN firms. MNCs should explore all types of partnerships with such regional firms; they understand the market better, tend to have deeper distribution networks, and lower-cost operations.” – Shishir Sinha, FSG’s Senior Analyst for Asia Pacific after reading this WSJ article.

Good news for Argentina this week. Last Friday, the Latin American country struck a deal to borrow $7.5 billion from China for power and rail projects, according to Reuters.

“Argentina has reached a deal with China to borrow US$ 7.5 billion to finance energy and railway projects, and the two countries have also signed a three year, US$ 11 billion currency swap, in which Argentina will receive Chinese yuan that it can then use to finance Chinese imports or exchange to USD to bolster reserves. This news is welcome given Argentina’s balance of payment concerns.” – Christine Herlihy, FSG’s Senior Analyst for Latin America.

FSG clients can keep up to date with the latest emerging markets headlines and exclusive analyst commentary on the client portal.

Protecting Profits and Managing Prices in Latin America

Companies are increasingly looking to adapt their pricing strategies and tactics to deal with macroeconomic volatility and shifting corporate mandates in Latin America.

As Latin America’s operating environment has become more volatile and bottom lines begin to receive more scrutiny from the corporate center, regional executives are focusing on how they can shift their pricing strategies to maximize profitability mandates while protecting volumes. FSG’s recent study Protecting Profits and Managing Costs: Pricing Strategies and Tactics for Latin America (clients only) focuses on the best approaches to manage pricing and maximize earnings in Latin America’s evolving operating environment.

LATAM Pricing ManagementIn this study, FSG concludes that multinationals’ approaches to pricing strategy are often dictated by organizational constraints, in particular  the degree to which regional teams have the capabilities to adjust prices in response to macroeconomic shocks. This depends in large part on how centralized both risk management and pricing strategies are within a given company.

Companies seeking to maximize the focus of local teams on executing a pre-determined market strategy often find that a centralized approach to pricing and risk management is optimal. By leaving the management of transaction and operational exposure to the corporate treasury, companies can help to ensure that local teams are not distracted by short-term fluctuations in the market environment.

However, a centralized approach to pricing and risk management often means that companies lose the ability to adapt pricing to local market conditions. This makes it more likely that an organization will leave money on the table or lose market share when adjusting prices.

To succeed, companies should ultimately seek to deploy a mix of hedging and operational strategies, coordinated across centralized and decentralized functions within the company. FSG’s study provides a set of best practices and case studies for companies to learn from and consider as they determine the optimal approach to pricing for their business in the region.

For FSG clients interested in learning more about these best practices, the full report is available here. Not a client? Contact us.

Central America Offers its Own Set of Challenges and Opportunities for MNCs

As Latin America’s largest markets have struggled in recent years, multinationals are taking a closer look at the opportunities that the smaller markets of Central America can offer, particularly they seek to diversify their regional portfolios. However, the opportunity must be kept in perspective, as Central America only represents around 3.5% of the Latin America’s GDP, making the region the eighth-largest market in Latin America, just behind Peru.

Graph 1 LATAM Blog Post

That said, Central America is expected to experience growth on par with some of the fastest growing markets in Latin America over the next few years. However, individual markets within Central America will experience widely divergent growth prospects, making prioritizing investments within the region absolutely essential.

  • Panama will remain one of the fastest-growing economies in the region, with multinationals increasingly considering the country as a viable hub for operations in Latin America
  • Costa Rica offers a solid business climate, but chronic budget deficits and legislative gridlock cloud its medium-term outlook
  • Guatemala, Honduras, and El Salvador continue to be plagued by weak government finances and drug-related violence, limiting the potential for higher economic growth that might alleviate these countries’ extreme poverty
  • Nicaragua is projected to experience solid growth over the next several years, in part because of its financial position, but the market also remains at risk of severe political and economic instability
  • Belize is suffering from high debt loads and limited opportunities for growth over the medium term

Graph 2 LATAM Blog post

FSG recently published a report that provides multinationals with an extensive overview of the region’s macroeconomic outlook, forward-looking market and industry sentiment, and deep-dives on each of these markets.

Chile’s Moderate Growth Path in 2014

As President-elect Michelle Bachelet prepares to take power in March, she will be tasked with responding to domestic demands for improved access to lower-cost, higher quality public services, including education and healthcare, and helping Chile to weather the impact of exchange rate depreciation and slowing growth, driven in part by weaker global copper prices.

Chile's Growth Trajectory 2014

Multinationals will be impacted by these dynamics in two primary ways:

  • Rising domestic demands and the need to fund ambitious education and healthcare reforms ensure that fiscal reform will be a priority. Corporate taxes are likely to rise from 20% to 25%, but Chile’s pro-market stance and sound economic management are expected to remain in place.
  • Currency depreciation and weaker copper prices will drag down gross fixed investment and pose pricing and profitability challenges for companies importing into the market. Companies selling capital-intensive goods and machinery will be most impacted, but the pass-through effects will be visible across the economy and will drag down expectations at the margins.

Copper Prices 2014

In general, the stage is set for slower, yet steady growth. Given strong labor market dynamics and relatively moderate price pressures, domestic demand will remain resilient, boding well for retailers. FSG clients can access our full Q1 quarterly report on Chile here.

Forging New Links: Overcoming Obstacles to Supply Chain Integration in Latin America

Latin America Supply ChainLatin America’s history of pervasive economic and physical trade barriers has proven a significant impediment to the integration of multinationals’ regional supply chains. Tariff and non-tariff trade barriers, complicated and inconsistent tax rules, and the nearly-impenetrable Amazon Basin and Andes Mountains have forced many companies to take an ad hoc approach to supply chain development in Latin America.

This ad hoc approach has meant that supply chains in Latin America are often a fragmented and inefficient drag on bottom-line performance, rather than the streamlined competitive advantage they can be in developed markets. Indeed, according to a report by JDA Software Group, longer lead times and less flexible supply chains means that days inventory outstanding for manufacturers averages 133% higher in Latin America than in the US, while days inventory outstanding for retailers averages 77% higher.

Despite these impediments to supply chain integration, growing corporate pressure to improve bottom-line performance, coupled with the threat posed by increasingly sophisticated local competitors, is causing some savvy LATAM executives to take a second look at opportunities to improve supply chain performance. Supporting this trend are emerging regional supply chain enablers like the recently-enacted Pacific Alliance agreement, growing government investment in transportation infrastructure, and the deepening presence of world-class third-party logistics providers.

Major companies taking advantage of these enablers include Diageo and Proctor & Gamble, both of which recently announced investments aimed at consolidating their Latin America supply chains. Companies that are able to differentiate themselves by cutting costs and improving customer service through supply chain integration will find themselves better positioned to navigate growing competitive threats as Latin America enters a phase of stronger macroeconomic headwinds.

Tomorrow’s Latin America Won’t be Won with Yesterday’s Playbook

Frontier Strategy Group is witnessing a dizzying array of changes to the business landscape in Latin America. Some are highly visible shifts in the external political and economic conditions in key markets such as Brazil, Mexico, and Venezuela, to name a few, while others involve subtle evolutions in internal corporate mandates for Latin American business units of multinational corporations. For this reason, FSG recently released a new Regional Overview of the factors influencing the results of our clients as well as emerging trends likely to impact performance and shape strategy for the coming years. The research is drawn from extensive interviews with senior executives at leading multinationals, independent experts, and analysis of surveys of FSG’s client base. Below are featured trends from the report, accessible to FSG clients:

Economic Performance is Strong, but Risk – and Skepticism – is Growing
Compared to global averages, and even in comparison to other emerging market regions, Latin American growth remains, in the aggregate, relatively robust. Yet many industries in Latin America in 2012 either just met or underperformed expectations, and now with a persistent slowdown and protests in Brazil and crisis always on the horizon in Venezuela and Argentina, skeptics are growing louder, forcing executives to justify further investments in the region. Furthermore, FSG’s data indicates that slow growth in Argentina, a weak Q1 in Mexico, and the devaluation in Venezuela threaten goal attainment of sales targets in 2013 as well.

2013 Performance Targets in Key LATAM Markets

2012 Sales Performance by Sector in LATAM

Latin America Splitting into Two Distinct Groups: Pacific and Atlantic
The dynamic Pacific economies are integrating rapidly, as evidenced by the creation of the Pacific Alliance trade group, creating new trade dynamics and opportunities for increasing scale and reorienting supply chains. In contrast, the Atlantic economies are increasingly insular and crisis prone, a trend typified by the increasingly dysfunctional Mercosur customs union. These distinctions are growing and becoming more tangible as companies position to mitigate risk from reliance on Mercosur and maneuver to gain from new opportunities presented by the Pacific Alliance.

The “Grow-fast, Worry about Profitability Later” Days are Coming to an End
Many executives perceive a strong shift in corporate mandates for Latin American business units towards bottom line results, rather than purely on top line growth. This shift is changing the way executives prioritize markets, evaluate organizational structures, measure and orient workforces, and make the case for resources.

New Blueprints for Success
As both internal corporate and external dynamics have changed, senior executives are drawing up new blue-prints for success by examining existing assumptions around optimal organizational footprints and structures and by prioritizing markets and communicate opportunity based new criteria such as relative profitability and operating margins.

3 Year Growth Outlook v Relative Profitability

Conclusion
FSG’s LATAM Regional Overview expands on these trends and shares analysis of client survey responses on how they are responding to these shifts. FSG believes that despite increasing volatility and growing macroeconomic and political risks, Latin America continues to offer excellent opportunities and high returns relative to other regions. That said, today’s business environment already is significantly different from that of just a year or two ago, and regionally-focused executives are wise to recognize that their strategies must evolve in tandem.

Latin America’s Moment: Making the Case and Capturing Opportunity

Making the Case for Latin America Has Historically Revolved around the Region’s Untapped Growth Potential

Making the case for resources has long been a challenge for emerging markets executives—while emerging markets represent tremendous growth opportunities, they have historically been viewed as risky, volatile, and fragmented, undermining corporate willingness to commit large amounts of resources. On a regional level, many of the Latin America executives we work with have expressed frustration at having to defend the region’s potential when top-line growth has been higher elsewhere in the world, particularly in Asia.

At Frontier Strategy Group, we have long strived to help our clients overcome such skepticism and communicate upwards effectively by emphasizing the region’s hard-won macroeconomic stability, relatively under-penetrated markets, and growing middle class. While these drivers remain in place and multinationals’ growth targets for Latin America are now on par with those seen in Asia, sluggish global growth has raised the stakes, and emerging markets are increasingly expected to deliver both top- and bottom-line growth.

However, Sluggish Global Growth & Underperformance in 2012 Have Undermined Confidence in Latin America

In the wake of Venezuela’s recent devaluation and the death of President Hugo Chávez, as Argentina continues to impose heterodox capital and import controls and Brazil edges towards stagflation, it is easy to understand why multinational executives face growing skepticism from risk-averse corporate centers as they strive to make the case for resources in Latin America.

Fortunately, Executives Compelled to Reassess the Region’s Potential Can Walk Away Reassured

While we certainly acknowledge the endogenous and exogenous factors undermining Latin America’s near-term outlook, we remain bullish about the region’s potential over the medium-to-long term, and our optimism is grounded in a demonstrable belief that the region’s core advantages have in fact remained intact, and will be reinforced by positive secular trends.

Not Only Do Latin America’s Core Advantages Remain Intact…

Latin America’s core advantages can be divided into four buckets, including profitability, relative growth, stability, and concentrated financial resources. Of these four advantages, profitability stands out as the most salient given the pivot to profitability that emerging markets executives are experiencing. As growth remains stalled in developed economies and corporate places increasing pressure on emerging markets, 73% of FSG clients in Latin America have experienced or expect to experience a shift in corporate emphasis towards bottom-line growth over the near-term. With this in mind, it is certainly reassuring to consider that available data on publicly traded companies indicate that average operating margins in Latin America are 55% higher than in the BRICs excluding Brazil.

At present, Latin America derives its profitability advantage vis-à-vis other emerging market regions primarily from a host of demand-side factors which allow multinationals to sell at higher margins and maximize the gains associated with realizing economies of scale. However, these advantages have the potential to diminish over time as competition within the region increases, meaning the time to build market share and brand loyalty is now.

When it comes to GDP growth, while the pace of growth in other emerging markets is expected to decelerate in comparison with pre-crisis rates, LATAM has remained relatively resilient and will accelerate in the coming years.

If you’re tempted to dismiss growth and profitability out of fear of resurgent instability, think again. More conservative corporate centers have historically associated Latin America with hyperinflation, uneven growth, and overexposure to commodity boom-and-bust cycles. Part of the story we’re striving to help our clients communicate is that while these sorts of risks persist in specific markets, the region as a whole has progressed tremendously thanks to orthodox macroeconomic reforms.

Inflation targeting regimes, reduced deficit spending, and the liberalization of trade and capital flows have brought down inflation, empowered consumers and provided the stability necessary for sustained growth. Latin America also remains well-positioned to ride out any future global downturn, as its economy is less dependent on trade than APAC, and less integrated into the global financial system, reducing the risk of Eurozone contagion. Concentrated financial resources also bode well for B2C and B2B multinationals—per capita private consumption spending and government expenditure in LATAM outpace other EM markets including India and EMEA, and are on par with China.

But investment and reform are positioning the region to build on these strengths moving forwards, unlocking new opportunities for multinationals:

Most importantly, Latin America is well-positioned to build on these core advantages, and secular trends are already yielding proof points. Trends we’re tracking range from Peña Nieto’s ambitious reform agenda and the resurgence of manufacturing in Mexico to Colombia’s peace dividend and Peru’s rapid rise. On a pan-regional level, energy resources will bolster government coffers and empower investment in infrastructure and human capital, while the rise of the Pacific Alliance will provide a decidedly pro-business counterweight to the increasingly anachronistic Mercosur. The region is on the rise, and there has never been a better moment to make—and win—the case.

Emerging Market View: What Our Analysts Are Reading – 3/8/2013

Here’s a look at a few of this week’s global headlines with added commentary by our research team members:

Market Watch’s Post-Chavez Venezuela: oil’s next Saudi Arabia?:

“As Associate Vice-President for Latin America Clinton Carter is quoted in this article, oil production is unlikely to experience any increase over the short term, as a necessary shift toward investments in PDVSA are likely to continue to be secondary to the need to fuel social spending and support any post-Chavez government.”
- Antonio Martinez, Senior Analyst for Latin America Research

The Financial Times reports new property market cooling measures put doubt on China’s economic recovery:

“China has launched yet another round of of cooling measures, including a 20% capital gain tax on property sold in the secondary market, higher down payment and mortgages, to contain property prices. This is will impact property and construction related industries, which represent a big chunk of the Chinese economy, adding new pressure to the fragile recovery.”
- Shijie Chen, Practice Leader of Asia Pacific Research

Reuters had an article on Brazil’s industrial recovery:

“Any sustainable economic rebound in Brazil will have to be led by the industrial sector, making this heartening news for multinationals concerned about a seemingly interminable slowdown in Latin America’s largest market.”
– Ryan Brier, Practice Leader of Latin America Research

Hugo Chavez’s Death: Considerations for Multinationals

According to Venezuela’s vice president, Nicolas Maduro, Hugo Chavez died at 4:25 PM, local time, on Tuesday from complications related to cancer.

FSG has been predicting for some time that it was unlikely that Hugo Chavez would be able return to lead the country, as his health has been in serious decline since he underwent his fourth cancer-related surgery in December.

While there might be a temptation for multinationals with operations in Venezuela to greet this news with cautious optimism, FSG stresses that executives should focus on managing expectations for any material change in the operating environment over the near-term.

The government is constitutionally mandated to hold presidential elections within 30 days; however, there is a possibility that this requirement could be ignored, with elections falling as far out as June.

Regardless of the timing of the elections, the most likely candidates will be Vice President Nicolas Maduro and Governor Henrique Capriles. FSG expects Maduro to win a clear electoral mandate due to a strong sympathy vote as well as the relative weakness of the opposition, which is still suffering the after effects of two big electoral defeats at the end of 2012. Recent poll results casting Maduro as a legitimate heir to Chavismo bear this prediction out.

Given Maduro’s ideological affinity for the key social tenets of Chavismo, as well as the fact that most legislators will not be up for reelection until 2015, it is highly unlikely that multinationals will see any major policy adjustments over the near-to-medium term. The one exception to this is a probable second devaluation sometime after the elections, along with the establishment of a new parallel exchange rate system to replace SITME.

The long-term picture is somewhat more optimistic as it is unlikely that Chavismo will hold together as a cohesive political force without a strong and charismatic leader at the helm. As such, there is a strong possibility that the opposition will slowly gain strength, leading to a modest opening of the economy to investment over the next few years. While this would be a welcome scenario for multinationals, it is also one fraught with a good deal of risk if the fragmentation of Chavismo leads to social unrest and instability.