This country-specific Q&A provides an overview of the legal framework and key issues surrounding private equity law in the Brazil.
This Q&A is part of the global guide to Private Equity.
For a full list of jurisdictional Q&As visit http://www.inhouselawyer.co.uk/index.php/practice-areas/private-equity-2nd-edition/
What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?
The last 24 months have certainly granted a unique chapter in Brazil’s political and economic history. With huge turnovers around the presidency, the civil society has stepped into a deep debate about the left and right wings parties, being constantly stimulated by an anti-corruption inquiry that supported the election of the current Brazilian president.
According to PricewaterhouseCoopers’s (“PWC”) data review regarding the mergers and acquisitions transactions in Brazil, in 2018 financial investors were present in 136 transactions, a decrease of 7% compared to the same period of 2017 (147 transactions) and represented approximately 20% of the total amount of transactions in Brazil.
Even though, after the presidential election the market begun to demonstrate signs of improvement and re-acceleration. Differing from 2018, in 2019, according to PwC’s data review, from January to August, financial investors in Brazil were present in 116 transactions, an increase of 32% compared to the same period of 2018 (88 transactions), approximately 23% of the total amount of transactions in Brazil. From those transactions that have involved a financial sponsor, 67% are domestic (78 transactions) and 33% foreign sponsors (38 transactions). If the number of transactions involving a financial sponsor continues to grow as in recent months, it will represent an increase of approximately 30% compared to 2018 and a proportion of approximately 23,5% of the total transactions in Brazil. The scenario for transactions in Brazil is growing compared to the last 24 months. The economy shows a strong liberal policy and is focused in privatizations in many sectors of the economy which gives to financial sponsors a huge demand for transactions. The environment for deals in Brazil seems to be back on track.
What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?
In general, financial sponsor backed sellers are reluctant to grant anything other than the fundamental representations and warranties.in these types of sell are also common not to have escrow payments or earn out mechanisms. In other hand, the trade seller shall give all types of reps and warranties and the “fight” between purchaser and seller will be the findings in the due diligence to be inserted in this section of the SPA. Also, it is standard to have escrow or earnout payments after a period of time (normally five years).
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
Brazilian tax legislation does not provide for a transfer taxes to be levied over the transfer of shares transaction. Notwithstanding, it is important to mention that seller may be required to pay capital gains tax over the difference between the tax cost and the realized amount in connection with the sales event.
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
Normally the financial sponsors issue a binding and irrevocable equity commitment letter to the acquiring entity and/or parent guarantee from the purchasing entity. The relevant letters customarily contain an enforceable obligation for the financial sponsor to provide equity funding at closing of the acquisition.
How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?
Although locked-box pricing mechanisms are becoming more common in Brazil, closing accounts mechanisms still prevail in private acquisition or disposal of equity interests and assets. We may perceive the use of locked box pricing mechanisms in Brazil in cases which the parties have an amicable and trustful relation, setting a comfortable scenario for the parties to rely on the financial statements given by a financial detailed audit. Another circumstance to assume locked box pricing mechanisms is a conjecture of costs avoidance with a fast pace to conclude the transaction.
What are the typical methods and constructs of how risk is allocated between a buyer and seller?
Traditionally, there are three general criteria related to the risk allocation structure in M&A transactions commonly used in Brazil, each with different impacts on the pricing of the transaction, as follows:
i. "closed gate sale" criteria (also known as sale "as is"), according to which the buyer acquires the company subject to the transaction in the condition in which it is, without protection in relation to risks generated up to the closing date, materialized or not. In this structure, the buyer assumes, therefore, all risks of the target company, including those related to facts, events and omissions that occurred prior to the closing of the transaction, when the company’s management was still under the control of the seller. This structure is most commonly used in mergers transactions involving publicly held companies, since any risks tend to be diluted among the combined company's shareholders and the quality of the target company's public information is much higher, or in exceptional cases, such as when the target company is in a situation of severe economic and financial stress and the price to be received by the seller is a very low value – in this context, the seller tends to do not accept to risk compensation for losses that are likely to be greater than such nominal value received by him;
ii. "virtual company" criteria (also known as "purchase of a company without a past"), according to which the seller remains responsible for all risks related to facts that occurred prior to the closing of the transaction, regardless of whether such risks are disclosed by the seller through the statements and guarantees provided for in the contract and/or in a separate disclosure letter. This structure tends to facilitate price negotiation, as it prevents known and declared risks from being priced by the buyer, but increases the relevance of guarantees to be granted by the seller, since it is very likely that the company object will suffer indemnified losses in relevant amounts and, therefore, that the buyer will trigger the seller's indemnity obligation; and
iii. "violation of representation and warranties" criteria (also known as "compensation for hidden liabilities"), according to which the buyer – except exceptional risks, generally contractually treated as "special indemnification" – assumes all risks known and declared by the seller in the purchase and sale contract, with which the seller only remains responsible for the undeclared risks (also known as "hidden liabilities"). This structure creates greater balance between the parties, but significantly increases the need for the buyer to be comfortable with the risks identified in the due diligence phase and, at the same time, the probability that the buyer wants to discount the purchase price part of the value posed by the risks that will be assumed by him.
Regardless of the risk allocation criteria negotiated between the parties, the seller is often required to assume liabilities for unlimited indemnification in relation to representation and warranties generally referred to as "fundamental" (e.g., authority and power of the seller to negotiate the object of the transaction, ownership by the seller of the object of the transaction, existence of the object of the transaction, etc.). More recently, unlimited indemnification liability has also been extended to representations and warranties relating to compliance with anti-corruption laws.”
How prevalent is the use of W&I insurance in your transactions?
The use of W&I insurance still is quite uncommon for most of the transactions in Brazil. However, according to a well- known brokerage insurance firm in Brazil, W&I insurance demand in Brazil over the first half of 2018 grew by 35%, compared to the same period in 2017, indicating a possible turnover on the risk allocation methods that the companies should assume for the next years.
How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?
In recent years, the interest of financial sponsors in acquiring infrastructure assets has been increasing for two main reasons:
The first one is due to the lack of public policies in sectors as health, airports, highways and construction. With short public investments, but with a demand of approximately 220 million citizens, Brazil shows itself as a land of investments opportunities for the financial sponsors. According to a 2019 McKinsey Report, Brazil still lags in infrastructure quality, and there is huge potential to increase investments to eliminate current gaps in the Brazilian infrastructure. As the report shows, to reach world average, Brazil needs to invest approximately 4.7% of GDP/year for the next 20 years to reach the ideal investment index.
The second reason is that due to the corruption inquiry already mentioned in item 1 above, some of the most important infrastructure companies in Brazil had been involved in corruption scandals. Thus, with this type of damage with these Brazilian companies, an enormous market raised for financial sponsors.
Regarding the acquisition of publicly listed companies, financial sponsors have been very active, especially in the health sector, as demonstrated by Carlyle's acquisition of “Rede D'Or” and Advent investment in “Laboratório Fleury”. Other sectors, such as technology, also attracted attention of financial sponsors, as the sale of the cellular tower company T4U to the Blackstone Group.
Outside of anti-trust and heavily regulated sectors, are there any foreign investment controls or other governmental consents which are typically required to be made by financial sponsors?
The Central Bank of Brazil (“BACEN”) is also heavily regulated, especially regarding the foreign exchange market. In Brazil, the foreign exchange market, which is regulated and monitored by BACEN, is the environment where exchange operations are carried out between agents that are authorized by BACEN, as well as between such agents and their clients, directly or through their correspondents.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
The risk will be always higher when we will have large transaction that will need to observe the following rules of our antitrust authority: (a) meet the double revenues’ threshold, (b) is defined as an “act of concentration”; and (c) takes place or produces or may produce effects in Brazil.
Have you seen an increase in the number of minority investments undertaken by financial sponsors and are they typically structured as equity investments with certain minority protections or as debt-like investments with rights to participate in the equity upside?
There has been a recent increase of minority investments undertaken by financial sponsors. However, with regard to its structuring, it depends on the structure and on the risk of the company as to how this investment is made (notwithstanding, it can be said that debt-like investments with rights to participate in the equity upside are most common nowadays).
How are management incentive schemes typically structured?
In Brazil, management incentive schemes are typically based on productivity and usually represented by cash bonuses and stock option programs, which can be part of broader compensation packages providing for other benefits such as allowances, insurances and special pension plans.
In M&A transactions in which senior management is also on the sell side, especially in private equity deals, earn-out arrangements are extremely common and can be structured under an equity or a cash compensation.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
Brazilian legislation does not have a specific provision regarding management’s incentive schemes. To this extent, the assessment of the applicable tax treatment will depend on whether the arrangement or payment has a compensatory or commercial nature, in a case-by-case analysis.
For example, payments made under stock options plans (SOP) that have compensatory nature (e.g., Phantom Share Plans) will be treated as ordinary income at the time the option is exercised; subject to personal income tax (up to 27.5%), employer’s social security contribution (20% rate) over the net amount received by the beneficiary, plus any other payroll charges including those that are owed by the beneficiary but withheld by the company. At the time the shares are sold, the individual will also be required to pay capital gains tax on the difference between the amount paid for the shares at the time of exercise and the amount received at the sales event; at progressive rates of 15% up to 22.5%.
On the other hand, in case the SOP has commercial nature (e.g., Employee Stock Purchase Plans), there should be no imposition of individual income tax, social security taxes and payroll charges upon exercise, being the beneficiary only required to pay capital gains tax on the future sale of the shares.
Moreover, in general, earn-out bonuses paid to management are deemed as ordinary compensation, subject to the abovementioned taxes (i.e., income tax up to 27.5%, employer’s social security contribution, calculated at a 20% tax rate, added by other payroll taxes and charges). It is noteworthy that in general bonuses paid to officers will be treated as non-deductible expenses for corporate income tax purposes. When the executives of the target entity are also shareholders, it may be possible to structure earn-out payments in connection with the M&A transaction. Under such scenario, payments made to shareholder executives would be subject to capital gains tax due in connection with the M&A transaction. Case-by-case analysis necessary.
Payments made under profit sharing plans may be deemed as exempt from social security contributions, if certain thresholds are complied with. Currently there are on-going discussions before administrative courts regarding the application of the social security exemption when payments are made to officers.
Are senior managers subject to non-competes and if so what is the general duration?
It is very usual for contracts with senior management to establish exclusivity and non-compete restrictions. These restrictions, as well as other limitations, such as non-soliciting obligations, are even more common in M&A transactions in which senior managers are also on the sell side.
Brazilian courts may disregard the enforceability of these restrictions in view of individual protections related to the constitutional right to work. For such reason, the general duration of such agreements is usually no longer than 12 months and it is common that a compensation for the compliance with these obligations is set forth.
How does a financial sponsor typically ensure it has control over material business decisions made by the portfolio company and what are the typical documents used to regulate the governance of the portfolio company?
Governance provisions are usually set forth on the portfolio companies’ bylaws.
However, it is also standard to enter into Shareholders' Agreements in order to regulate such provisions, as well as to establish rules related to direct and indirect restrictions on equity transactions.
There are numerous mechanisms for these purposes as the issuance of different share classes/types with specific economic and political rights, including, for example, the right to appoint specific members of the management, such as a CFO, as well as the use of qualified majorities for certain reserved matters, provisions related to rights of first refusal, tag along, drag along, etc.
Is it common to use management pooling vehicles where there are a large number of employee shareholders?
The use of management pooling vehicles is not common in Brazil. The usual practice is that management and employees hold shares in their own names.
What are the most commonly used debt finance capital structures across small, medium and large capital financings?
The most common debt finance capital structure in Brazil is debt securities issued in form of debentures, regardless of the size of the financing (small, medium or large). Debentures may be unsecured, secured, benefiting from a floating charge or subordinated. They may also be convertible into shares. In addition, debt securities in Brazil issued through a public issuance have certain tax benefits when compared with other financing structures.
Many different types of debt securities are offered in Brazil other than Debentures. Some common forms include:
- commercial papers and promissory notes, which are short term securities;
- credit bank notes (cédulas de crédito bancário), which represent loans from banks and may be secured or unsecured;
- quotas of investment funds;
- derivative instruments such as securities linked to the value of one or more reference assets including shares, commodities, interest rate, currency rate or index and credit-linked notes;
- depositary receipts (a security issued by a depositary conferring on the holder’s beneficial ownership of certain underlying assets held by the depositary for the holders); and
- warrants (bônus de subscrição), which are securities giving the holders the option to purchase the equity of the issuer or a related company.
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
Financial assistance (which under Brazilian law includes assistance by way of loans, guarantees, security or reduction of liability) is not specifically regulated by Brazilian law. However, depending on the legal status of the company (regulated entity, financial institution, publicly or privately held corporation, limited liability, etc), and the relationship between the grantor and the beneficiary of the financial assistance, restrictions may apply.
For example, financial institutions are prohibited to carry out credit operations with related parties (as defined in specific regulation), except in some limited circumstances.
Additionally, if financial assistance involves a company located outside Brazil, certain foreign exchange rules will have to be observed. It will be necessary to take advice on a case-by-case basis as to whether restrictions apply to a particular scenario.
For a typical financing, is there a standard form of credit agreement used which is then negotiated and typically how material is the level of negotiation?
Normally, the financial institutions have their own standard form of credit agreement that are used as a first draft for the negotiations of these transactions. The level of negotiation will depend on the leverage held by the counterpart mainly in relation to: (i) credit risk; (ii) total amount of the financing; (iii) security package involved and (iv) timing for the conclusion of the transaction. Also, it is important to mention that in Brazil the financing transactions are concentrated mostly in major banks (i.e. Itaú, Banco do Brasil, Santander and Bradesco) and therefore, such banks have the power decisions and the leverage on the negotiations.
What have been the key areas of negotiation between borrowers and lenders in the last two years?
The key areas of negotiation between borrowers and lenders are:
- Precedent conditions;
- Affirmative and Negative Covenants (including financial covenants);
- Representations and Warranties; and
- Events of Default.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
Yes. Recently, mostly due to the corruption scandals and some economic instability in our country, the players need to be creative and search alternatives for sources of capital debts (or mezzanine structures). The private equity industry is active as a source of debt capital, specially in the distressed industry.