Private Equity 2017 Brazil 1 Overview 1.1 What are the most common types of private equity transactions in your jurisdiction? What is the current state of the market for these transactions? Have you seen any changes in the types of private equity transactions being implemented in the last two to Chapter author three years? The types of transactions we see are acquisitions of either relevant minority stakes, or a controlling interest by private equity investors. In both structures, the private equity fund usually puts a strong shareholders agreement in place, which takes into account corporate governance rules, registration rights and exit mechanisms, and founding shareholders usually have a key role in the company s management. The private equity industry has been very active in the last few years, as most players raised new funds for the region. Because of recent local currency devaluation, the size of deals is likely to grow in this new capital deployment round. We may also experience an increase in the number of private equity investors supporting take-private and PIPE deals. 1.2 What are the most significant factors or developments encouraging or inhibiting private equity transactions in your jurisdiction? Eduardo Paoliello Pinheiro Neto Advogados The tax benefit enjoyed by private equity funds in Brazil is certainly the main factor, alongside macroeconomic factors (such as currency devaluation, increase in consumer spending, etc.). Current political and economic crises have inhibited investors from deploying large amounts of capital in 2016. PE firms also focused their efforts in sectors that have a negative correlation with the country s economic growth. 2 Structuring Matters
2.1 What are the most common acquisition structures adopted for private equity transactions in your jurisdiction? Have new structures increasingly developed (e.g. minority investments)? Private equity investments are usually made through Fundos de Investimento em Participações ( FIPs ). The FIPs are investment funds regulated by the local Securities and Exchange Commission ( CVM ). As in other forms of Brazilian funds (and as opposed to other jurisdictions where investment funds are organised as partnerships), the FIP is a non-personified condominium of assets managed and represented by an administrator registered with the CVM. The FIPs then invest in target companies directly, or through a corporation. FIPs are authorised to invest in shares, convertible and non-convertible debentures, subscription warrants (bônus de subscrição) and other convertibles. The FIPs must play an active role in the company s management. PE investors usually invest in growth strategies (by acquiring relevant stakes from founding shareholders or making capital injections). Although less common because of the high interest rates in Brazil, some PE investors also structure LBO transactions by either taking loans from financial institutions or financing the acquisition through a seller s note. 2.2 What are the main drivers for these acquisition structures? Tax efficiency and other legal issues are usually the main drivers. The FIP structure streamlines the funding process and optimises investment returns through its friendly tax regime. The FIP can make the investment directly or through a holding company, depending on the protection and goals an investor wants to achieve. In case of LBOs, for instance, it is mandatory in the creation of a holding company, as FIPs cannot take loans. 2.3 How is the equity commonly structured in private equity transactions in your jurisdiction (including institutional, management and carried interests)? Usually, foreign institutional investors invest in the FIPs, which then invest in shares (most likely) or convertibles of the target companies. Founding shareholders/management generally remain in the company and are not required to invest alongside with the equity fund. Whenever a long-term incentive plan is designed for a deal, management invests directly in the target company. The structure of carried interests varies from fund to fund, and takes into account the jurisdiction of investors, whether the equity fund invests only in Brazil or has a broader mandate, and in which jurisdiction the investment team is located. 2.4 What are the main drivers for these equity structures? Equity structures are usually driven by a mix of tax efficiency and legal protection. 2.5 In relation to management equity, what are the typical vesting and compulsory acquisition provisions? Management equity plans are usually structured as typical stock option plans or phantom stock plans. It is also common to have plans in which vesting is partially time-based and partially return-based, tied to a minimum return on the investment made by the private equity fund. Some companies also use management equity plans which require members of management to invest part of their bonus in shares - 2 -
of the company. The plans also provide for rules on compulsory acquisition if the beneficiary leaves the company, at different pricing for situations of good or bad leavers. 2.6 If a private equity investor is taking a minority position, are there different structuring considerations? There is no difference in terms of equity investment structure. Some funds prefer to invest in different types of securities (preferred shares/convertibles) when taking a minority position, though. 3 Governance Matters 3.1 What are the typical governance arrangements for private equity portfolio companies? Are such arrangements required to be made publicly available in your jurisdiction? FIP rules set out certain governance requirements that investees must abide by, such as a unified two-year term of office for the entire board of directors of the investee, an obligation to disclose related-party agreements, adherence to an arbitration chamber for settlement of corporate disputes, or compulsory annual auditing into financial statements. The FIPs also negotiate shareholders agreements which usually contain more specific governance arrangements, such as veto rights, disclosure rights, the right to appoint executive office members (usually at least the CFO), compulsory instatement of special committees to support the board of directors, etc. Shareholders agreements for private companies are non-public. Listed companies are required to make any shareholders agreements public. At any rate, the bylaws are a public document, and most governance rules are usually duplicated there. 3.2 Do private equity investors and/or their director nominees typically enjoy significant veto rights over major corporate actions (such as acquisitions and disposals, litigation, indebtedness, changing the nature of the business, business plans and strategy, etc.)? If a private equity investor takes a minority position, what veto rights would they typically enjoy? Yes; PE investments in Brazil usually involve the execution of a shareholders agreement containing corporate governance rules. Veto rights usually depend on the size of the stake held by the PE investor. Discussions usually revolve around major corporate actions, such as: (i) approval for the business plan and annual budget; (ii) indebtedness above a certain threshold; (iii) M&A; (iv) CAPEX investment; (v) corporate reorganisation; (vi) capital increase and issuance of convertible securities; (vii) stock buyback programmes; and (viii) approval for related-party agreements. Private equity investors holding a minority stake are usually successful in getting most of the typical veto rights. 3.3 Are there any limitations on the effectiveness of veto arrangements: (i) at the shareholder level; and (ii) at the director nominee level? If so, how are these typically addressed? - 3 -
Veto arrangements are effective in Brazil. Under Brazilian law, the obligations set out in a shareholders agreement at both shareholder and BoD levels are subject to specific performance. Additionally, the Chairman of the relevant meeting may disregard the votes cast in conflict with the existing shareholders agreement. 3.4 Are there any duties owed by a private equity investor to minority shareholders such as management shareholders (or vice versa)? If so, how are these typically addressed? No special duties arise from the fact that the shareholder is a private equity investor. Brazilian corporate law establishes the duties imposed on a controlling shareholder towards the company and other shareholders. As a rule, shareholders must exercise their voting rights in the company s best interest. Controlling shareholders are liable for the damage resulting from acts taken in abuse of power. 3.5 Are there any limitations or restrictions on the contents or enforceability of shareholder agreements (including (i) governing law and jurisdiction, and (ii) noncompete and non-solicit provisions)? Shareholders agreements must be kept on file at the company to be enforceable on the company itself and on its management. This is an important but simple formality, usually met by having the company as an intervening party to the agreement. The laws of a different jurisdiction may be elected to govern agreements involving Brazilian parties or companies established in Brazil. If a foreign jurisdiction governs the shareholders agreement, enforcement of any foreign court decision is subject to an exequatur, which is a potentially complex and time-consuming recognition procedure before the Brazilian Superior Court of Justice. As most effects from the agreement take place in Brazil, and given the difficulties in enforcing a foreign court decision, virtually all shareholders agreements involving Brazilian companies contain the choice of jurisdiction of Brazilian courts. Non-compete obligations are enforceable if some requirements have been met, namely: (i) proper compensation is paid for it (i.e. a portion of the purchase price); (ii) there is a limitation on the territory, which cannot be greater than the entire country (i.e. clauses limiting competition to Latin America as a whole are not enforceable); and (iii) the term cannot be longer than five years. For ease of enforceability, it is also advisable to have a well-crafted language describing the prohibited activities. The rationale is the same for non-solicit obligations, which are also enforceable. 3.6 Are there any legal restrictions or other requirements that a private equity investor should be aware of in appointing its nominees to boards of portfolio companies? What are the key potential risks and liabilities for (i) directors nominated by private equity investors to portfolio company boards, and (ii) private equity investors that nominate directors to boards of portfolio companies under corporate law and also more generally under other applicable laws (see section 10 below)? Appointing a director is subject to confirmation that such designee is not impaired by special law, or sentenced for bankruptcy crime, fraud, bribery or corruption, misappropriation of public funds or embezzlement, crimes against the economic system, good morals or third-party property, or else subject to any criminal sanction that precludes, even temporarily, access to public offices. Additionally, unless otherwise waived by the general meeting, persons who hold positions in companies that may be regarded as market competitors or who have a conflict of interests visà-vis those of the company cannot be appointed as directors. In certain regulated - 4 -
sectors (banking, insurance and others), the appointment of any member of management is subject to the regulator s approval and other experience requirements. Directors/officers can be held jointly liable for the company s obligations in some stress situations. If a company is unable to pay its liabilities, labour courts usually allow a creditor to hold a member of management and shareholders jointly liable for the claim. Tax and social security courts are not as aggressive as labour courts. The involvement of members of management in a claim is usually limited to situations where such managers acted in abuse of power or in breach of the law or bylaws. As a form of mitigating this potential liability of management, PE investors usually have the investees take out D&O insurance for all members of management. 3.7 How do directors nominated by private equity investors deal with actual and potential conflicts of interest arising from (i) their relationship with the party nominating them, and (ii) positions as directors of other portfolio companies? Firstly, a director must comply with eligibility criteria set out in Brazilian law and cannot occupy any position within a competitor or else have any conflicts of interest with the company. Secondly, the directors appointed by one group of shareholders have the same duties towards the company as any other member of management, so they should always act in the company s best interests (regardless of the interests of shareholders nominating them). The fact that a person takes other management positions in other portfolio companies does not per se affect his ability to exercise his position or duties at the company. A director is prevented from voting in any matter involving an objective conflict of interest. 4 Transaction Terms: General 4.1 What are the major issues impacting the timetable for transactions in your jurisdiction, including competition and other regulatory approval requirements, disclosure obligations and financing issues? FIPs formation and funding. The formation of FIPs is subject to CVM s approval, and this must be taken into consideration when structuring the deal. Moreover, assuming the investment will come from abroad, non-resident investors in the FIPs must, at least, nominate: (i) one or more representatives in Brazil (for purposes of Resolution 4,373 of 2014), which must be either financial institutions or any other institution authorised by the Brazilian Central Bank to act in such capacity; (ii) a representative for local tax purposes; and (iii) a securities custody services agent (custodian/depositary) in Brazil. Regulatory. There are several regulated sectors in the Brazilian economy (banking, insurance, healthcare plans, public utilities, etc.). Most types of investment in these sectors are likely to require prior authorisation from the relevant authority. Antitrust. Effective since May 2012, the new Brazilian Competition Law (Law 12,529 of 2011) introduced several significant changes, especially with respect to merger control, in particular through the adoption of a pre-merger review system where antitrust approval is a condition precedent for the closing or consummation of the deal. Transactions that meet the filing thresholds must go through antitrust - 5 -
clearance. The thresholds are: (i) one of the economic groups involved in the deal has recorded an annual gross turnover above R$ 750 million; and (ii) at least another group involved in the deal has recorded an annual gross turnover in Brazil above R$ 75 million. 4.2 Have there been any discernible trends in transaction terms over recent years? LBOs had gained momentum on account of the relaxed credit environment in recent years. This situation has changed more recently because of the increase in interest rates and credit tightening policies, but may come back in the near future as a result of the decrease of the interest rates. Anticorruption due diligence has also become a hot topic since enactment of Brazilian anticorruption legislation. 5 Transaction Terms: Public Acquisitions 5.1 What particular features and/or challenges apply to private equity investors involved in public-to-private transactions (and their financing) and how are these commonly dealt with? There are two typical alternatives for acquiring control of a public company: (i) a private agreement executed with the controlling shareholders of the public company, followed by a mandatory tender offer (tag-along); or (ii) a voluntary tender offer is launched to acquire the company s control. The first alternative is favoured because of the low level of public companies with dispersed ownership in Brazil. The mandatory tender offer allows minority shareholders to receive 80% of the price paid to controlling shares (if the company is listed on the traditional segment) or the same price paid to controlling shares (if the company is listed on the segments with enhanced governance rules). Companies that went public during the IPO boom in the last decade often adopt punitive poison pill provisions in the bylaws, which impose on those acquiring control, in some cases, an obligation to launch a tender offer for a price per share greater than the company s equity value, thus reducing the appetite of investors to pursue public deals. Until 2015, the CVM regulations considered the push-down of debt used to finance the acquisition of a public company as an abuse of controlling power. Thus, leveraged buyouts involving public companies that would then remain public were not usual. With new regulations in place, we may see, in the near future, this type of transaction structure also being considered for public company s deals, followed by ensuing discussions over valuation. 5.2 Are break-up fees available in your jurisdiction in relation to public acquisitions? If not, what other arrangements are available, e.g. to cover aborted deal costs? If so, are such arrangements frequently agreed and what is the general range of such break-up fees? Break-up fees may be negotiated, but this is not a common market practice in public deals when the target company is required to pay it (given the adverse impacts to management). - 6 -
6 Transaction Terms: Private Acquisitions 6.1 What consideration structures are typically preferred by private equity investors (i) on the sell-side, and (ii) on the buy-side, in your jurisdiction? Usually, PE buyers structure deals with maximum legal protection, including a package of warranties/indemnities that is meant to protect investors from pre-closing liabilities, even those disclosed during due diligence. On the sell-side, PE investors usually push for a locked-box structure or, at least, set a limit on indemnification (given the difficulties in making payments after the sale proceeds have been distributed to investors). 6.2 What is the typical package of warranties/indemnities offered by a private equity seller and its management team to a buyer? The package of warranties/indemnities depends on the PE investor s involvement in the company s management and on the size of its stake. Assuming that the PE fund is a non-controlling passive shareholder, it will try to limit its package of warranties/indemnities to the basic representations. Conversely, if the PE fund has a controlling position, it will be hard to negotiate anything different from the other shareholders in terms of warranties, and discussions will primarily gravitate around the cap on indemnification and time limits. 6.3 What is the typical scope of other covenants, undertakings and indemnities provided by a private equity seller and its management team to a buyer? As in any M&A deal, the private equity investor and the management team usually undertake to run the business, from signing through closing, in the ordinary course of business. Private equity investors also try to avoid undertaking any noncompete/non-solicit provisions, as this could have a negative bearing on their future investments. It is also standard to set confidentiality provisions. 6.4 Is warranty and indemnity insurance used to bridge the gap where only limited warranties are given by the private equity seller and is it common for this to be offered by private equity sellers as part of the sales process? If so, what are the typical (i) excesses / policy limits, and (ii) carve-outs / exclusions from such warranty and indemnity insurance policies? Indemnity insurance is a new product in Brazil and is still unusual, so there is no standard market practice yet. On the few cases this product has been used, it covered hidden liabilities, but not the materialisation of the disclosed or identified contingent liabilities. 6.5 What limitations will typically apply to the liability of a private equity seller and management team under warranties, covenants, indemnities and undertakings? In terms of indemnification, two important factors should be considered: (i) time limits; and (ii) the indemnification cap. As to time limits, market practice is to tie them to the statute of limitation for tax claims (5 6 years). As for the indemnification cap, a limit is usually set, but there is no standard on that. Negotiations will take into account the level of organisation a company is able to show, and the comfort a - 7 -
buyer is able to obtain during due diligence, the competition to the asset, etc. It is also typical to negotiate certain mitigation clauses, such as de minimis, baskets, etc. In special cases, carve-outs to limitations apply. 6.6 Do (i) private equity sellers provide security (e.g. escrow accounts) for any warranties / liabilities, and (ii) private equity buyers insist on any security for warranties / liabilities (including any obtained from the management team)? Security is defined on a case-by-case basis. To the extent PE investors have their limitations to indemnify after distributing the cash to investors, escrow accounts are good alternatives for them. When on the buyer-side, PE investors usually get security from founding shareholders, such as liens on remaining shares or other assets and/or escrow/holdback. 6.7 How do private equity buyers typically provide comfort as to the availability of (i) debt finance, and (ii) equity finance? What rights of enforcement do sellers typically obtain if commitments to, or obtained by, an SPV are not complied with (e.g. equity underwrite of debt funding, right to specific performance of obligations under an equity commitment letter, damages, etc.)? Private equity buyers are usually reluctant in offering any kind of comfort as to the availability of debt/equity financing. They are usually successful in arguing that the PE fund has enough capital commitment to face its obligations under the SPA. In some cases, the PE fund manager may undertake to make a capital call if all conditions precedent are satisfied, and sellers could enforce such obligation if the capital call is not made. Whenever available prior to signing, a commitment letter to the bank is also presented to the seller, but it is more usual to have the PE investor bearing the risk to obtain the loan, with an open door if banks do not disburse the loan. 6.8 Are reverse break fees prevalent in private equity transactions to limit private equity buyers exposure? If so, what terms are typical? Reverse break fees are unusual. 7 Transaction Terms: IPOs 7.1 What particular features and/or challenges should a private equity seller be aware of in considering an IPO exit? During the last decade, Brazil has achieved substantial development in capital markets. The menu of available financial instruments has expanded, market infrastructure has been reformed and strengthened, and a diversified investor base has been built. However, Brazil has historically suffered from woeful fiscal and monetary policy management, which leads to one the highest interest rates in the world, affecting the progress of such developments and ultimately causing a low liquidity in the secondary market. In view of that, private equity sellers should be aware that an IPO exit at this moment may not be the best alternative. 7.2 What customary lock-ups would be imposed on private equity sellers on an IPO exit? - 8 -
If PE investors are exiting or continuing as a minority stake, it would not be expected from them to execute a lock-up. If PE investors continue as a relevant shareholder, a six-month lock-up is to be expected. In the case PE investors continue as the controlling shareholder, a six-month lock-up is expected, as is an additional sixmonth lock-up for 60% of the remaining position. 7.3 Do private equity sellers generally pursue a dual-track exit process? If so, (i) how late in the process are private equity sellers continuing to run the dual-track, and (ii) were more dual-track deals ultimately realised through a sale or IPO? Yes, this is a common strategy: (i) PE firms continue to run dual-track strategies until just before launching the deal (i.e. after an initial filing with the CVM, but before the disclosing of the red herring prospectus); and (ii) it is difficult to assess, but in our experience PE exits on dual-track deals are more often realised through IPOs. 8 Financing 8.1 Please outline the most common sources of debt finance used to fund private equity transactions in your jurisdiction and provide an overview of the current state of the finance market in your jurisdiction for such debt (particularly the market for high yield bonds). The most common sources are term loans or debentures, which are usually underwritten by local banks. The public debt capital markets in Brazil for this type of issuance are still incipient at the acquisition stage, although buyers could access such markets when refinancing the debt after the deal is closed. 8.2 Are there any relevant legal requirements or restrictions impacting the nature or structure of the debt financing (or any particular type of debt financing) of private equity transactions? Under Brazilian law, FIPs cannot incur debt. Thus, whenever a private equity investor decides to fund its acquisition with debt, it must do so through a company that will be funded with equity from the FIP and debt from the creditor. 9 Tax Matters 9.1 What are the key tax considerations for private equity investors and transactions in your jurisdiction? Are off-shore structures common? The main key tax consideration associated with private equity investments in Brazil is the tax benefit available to FIPs. The most relevant tax advantages in connection with FIPs are the following: (i) the tax-exempt status of their portfolio on income and gains from investments, as taxation is deferred to redemption of shares by the FIP investor; and (ii) provided certain requirements laid down in tax regulations are met, non-resident investors holding shares in FIPs may also be exempt from income tax upon redemption of FIP shares (generally levied at a 15% rate, in this case). Offshore structures may have tax advantages (i.e., potential exit strategies carried out at the level of the foreign entities which, in principle, would not be subject to Brazilian - 9 -
WHT) as long as one can provide substance to the foreign vehicles (i.e., investing in other jurisdictions besides Brazil, etc.). 9.2 What are the key tax considerations for management teams that are selling and/or rolling-over part of their investment into a new acquisition structure? Assuming the management team is located in Brazil and fully composed of individuals, they are probably already enjoying the friendliest tax regime one could get in Brazil with respect to capital gain taxes. If the idea is to roll over the investment into new acquisition structures, the key tax consideration is to structure it in a way that it is not treated as a disposal of equity, but rather as a contribution of assets into a new vehicle, which should be tax neutral. 9.3 What are the key tax-efficient arrangements that are typically considered by management teams in private equity portfolio companies (such as growth shares, deferred / vesting arrangements, entrepreneurs relief or employee shareholder status in the UK)? Brazilian law does not provide clear guidance regarding the tax effects applicable to long-term incentive/compensation plans, such as stock options or phantom shares plans. The main potential tax benefits arising from this structure are: recognition by the beneficiaries of capital gains on positive results (generally taxed at progressive rates from 15% up to 22.5%), as opposed to being taxed as ordinary income (up to a 27.5% rate); and non-assessment of social security contributions (around 20% for the paying company, and up to 11% for the beneficiary, but capped at around BRL 4,100). However, in order to obtain the desired tax effects without bearing material tax risks, it is important that the plan includes: (i) the need of beneficiaries making an effective investment, by means of disbursement of own funds; and (ii) the existence of risks to beneficiaries on the investment made. 9.4 Have there been any significant changes in tax legislation or the practices of tax authorities (including in relation to tax rulings or clearances) impacting private equity investors, management teams or private equity transactions and are any anticipated? We are not aware of any relevant developments in Brazilian court precedents involving private equity transactions, or of questioning in respect to the adoption of FIPs with the purpose of enjoying tax benefits in the context of such investments. 10 Legal and Regulatory Matters 10.1 What are the key laws and regulations affecting private equity investors and transactions in your jurisdiction, including those that impact private equity transactions differently to other types of transaction? CVM sets out the rules applicable to FIPs. Besides, general corporate law governs the relationship with management shareholders and shareholders agreements, whereas general contractual obligation principles apply when negotiating the purchase agreements themselves. - 10 -
10.2 Have there been any significant legal and/or regulatory developments over recent years impacting private equity investors or transactions and are any anticipated? A new FIP regulation has been enacted in 2016. The main changes are: (i) FIPs are now able to invest up to 20% of its committed capital of Brazil; (ii) FIPs can acquire non-convertible debt securities up to a certain level; and (iii) FIPs can also invest in Brazilian limited liability companies (sociedade limitada) and not only in joint stock companies (sociedades por ações). 10.3 How detailed is the legal due diligence (including compliance) conducted by private equity investors prior to any acquisitions (e.g. typical timeframes, materiality, scope etc.)? Do private equity investors engage outside counsel / professionals to conduct all legal / compliance due diligence or is any conducted in-house? Private equity investors commonly carry out a full and detailed diligence exercise, engaging local counsel, auditors, and business consultants. Compliance has also became an area of attention, as PE investors are increasing the scope of their exercise in this area by engaging firms to not only do a background check, but also to conduct interviews with senior management and sometimes to carry out some limited forensic exercise. 10.4 Has anti-bribery or anti-corruption legislation impacted private equity investment and/or investors approach to private equity transactions (e.g. diligence, contractual protection, etc.)? The Brazilian anticorruption law, which became effective on 29 January 2014, has brought about heightened anticorruption standards, including the introduction of concepts from the Foreign Corrupt Practices Act and the UK Bribery Act. PE investors are taking that into account, not only in the diligence exercise but also in the postacquisition phase, pushing the companies to implement compliance policies. 10.5 Are there any circumstances in which: (i) a private equity investor may be held liable for the liabilities of the underlying portfolio companies (including due to breach of applicable laws by the portfolio companies); and (ii) one portfolio company may be held liable for the liabilities of another portfolio company? In theory, no. As explained above, under some circumstances Brazilian courts apply the disregard doctrine and shareholders end up being held liable for the portfolio companies liabilities. Piercing the corporate veil is more common in favour of labour creditors, as Brazilian labour courts understand that anyone from the economic group should be held liable for a company s labour liabilities. This could also go for consumer and environmental liabilities. 11 Other Useful Facts 11.1 What other factors commonly give rise to concerns for private equity investors in your jurisdiction or should such investors otherwise be aware of in considering an investment in your jurisdiction? The amount of litigation involving a Brazilian company tends to be higher than in other jurisdictions. Therefore, the due diligence exercise must be conducted - 11 -
thoroughly to identify the items of concern for the expected returns. PE investors usually target mid-size family run businesses. One should bear in mind that these companies are unaudited and often have weak controls, so (i) PE investors models should factor this in when projecting returns and predicting how the company would operate after the investment is made, and (ii) a strong management team should be able to immediately start working alongside the founding shareholders to implement the business plan. - 12 -