Hedge Fund Intelligence – Brazilian Style Runs Low on Substance

By Gillian Kemmerer  |  HedgeFund Intelligence

Brazil is approaching a recession, beleaguered with currency devaluation, inflation and political volatility. While many domestic investors look abroad to escape the chaos, some battle-­tested managers and value­seekers are finding new reasons to venture south.

The financial world has long been fascinated with Brazil’s potential, but continuously finds itself disappointed when the “country of the future” misses targets and expectations. Absolute Return decided to revisit the country after its pivotal presidential election to perform a temperature check on the hedge fund industry. The following feature is the result of interviews conducted in Sao Paulo, Rio de Janeiro and New York with prominent managers, investors, prime brokers and administrators.

The addresses of Rio’s largest asset managers read like a set of postcards: Leblon, Copacabana, Ipanema. Modest skyscrapers rise a stone’s throw from the country’s famed white sand beaches, housing billion­dollar brand names from JGP to Gávea. From the top floors, you can just make out the bronzed joggers who run between the rocks at Arpoador and the beachfront Copacabana Palace, a luxury resort famed for its riviera architecture and roster of scandalous guests, including author Orson Welles who once threw a piano into the hotel’s star­studded pool.

Through the windows of sparse, western­facing conference rooms — not wholly different from their American counterparts in Manhattan — the lush Corcovado mountain provides a pedestal for Rio’s iconic Christ the Redeemer statue, constructed in 1920 and weighing 635 metric tons. He appears negligible from a distance, barely discernible in a period of grey skies, yet carefully keeping watch over the Maracanã, the city’s celebrated soccer stadium. A hedge fund manager gestured toward the statue on a late Wednesday morning from his offices in Leblon, a ritzy patch of the crescent coastline that has become a financial center. “I ride my bike up that mountain every day,” he said with a mix of bravado and nonchalance, “and stop in the waterfalls on the way down.” This seemingly glittery existence — called the carioca lifestyle, singular to Rio — attracted many asset managers from the crime­ridden streets of São Paulo over the past decade. The sun soaked and carefree attitude that permeates the city does well to mask the inescapable truth about Brazil for a little while. But as soon as the conversation transfers from the mundanity of introductions to the country’s economic outlook — a favorite topic among local cab drivers, several of whom swore that President Dilma Rousseff’s reelection was a fix — the oxygen seems to escape the room. In these interactions, the true character of the Brazilian financial industry rises to the surface: a generation of permabears, battle­hardened and wary of promises. “Someone once said that Brazil is like a submarine,” recounted Alexandre Rezende, the co­founder of $800 million equity shop Oceana Investimentos. “It is capable of floating, but it was built to sink.”  

Stormy skies

The dichotomy between the sunny optimism that has become a stereotype of Brazilian culture and the jaded view of its prominent financial managers is not new, and has intensified in recent years. Once grouped among the BRICs (a high­growth, emerging market category comprised of Brazil, Russia, India and China), Brazil is not expected to stay in the black. Turkish economist Cem Akyurek hosted a talk entitled “Brazil: beyond the noise, what are the fundamentals?” at the October 2014 Everest Capital Emerging Markets Forum in New York. A director for the emerging markets­focused hedge fund ( now defunct after a bad call on the Swiss franc), Akyurek told a packed house of financiers at The Asia Society that he believed lack of investor confidence was driving GDP growth lower than traditional models and metrics predicted. His thesis was that Brazil was “down, but not out,” and called for a return to policy orthodoxy and fiscal reform in order to inspire investors to reconsider the world’s seventh­largest economy. At the time, there was a glimmer of hope that divisive President Rousseff would lose the pivotal election, scheduled less than three weeks after the forum. To the dismay of growth economists and politicians alike clamoring for a regime change, the incumbent — a former guerilla, once imprisoned and tortured for her activities against the dictatorship of the 1970s — triumphed over Aecio Neves, sinking many investors’ interests further into the ground. Veteran asset manager and former Central Bank Governor Arminio Fraga, head of $5.5 billion Gávea Investimentos, called attention to the dire economic situation in his March 2015 letter to investors. “The combination of poor domestic policy and challenges on the global macro scenario leads to a perfect storm in Brazil,” he wrote, “which is largely self­inflicted.” Fraga specifically underscored lack of discipline in policymaking and a series of corruption scandals (the largest of which centered on Petrobas — the country’s colossal oil producer, comprising approximately 10% of the fragile BOVESPA market cap). While Fraga has repeatedly called attention to the market downturn, he has certainly made money off if it — Gávea profited from well­timed short positions in both Brazil’s currency and equities market this year. In a move characterized as conservative by many left­wing supporters, Rousseff appointed former Bradesco Asset Management head Joaquim Levy as minister of finance, a fiscal hawk who pledged austerity measures to restore Brazil’s ballooning debt­to­GDP ratio (which totaled at 62% of GDP as of May 2015, according to Brazilian Central Bank (BCB) reporting). Levy has since unveiled proposed budget cuts of nearly $23 billion and a series of tax increases on banks. The months following his appointment presented further­deteriorating fundamentals, and a renewed urgency for reform in the face of questions regarding Brazil’s status with the major rating agencies. According to Sarah Glendon, head of sovereign research at Gramercy Funds Management and former Moody’s senior analyst, confidence boosted by Levy’s appointment may be dwarfed by Brazil’s political uncertainty, and its recent downgrade to Baa3. “When the Speaker of the lower house of Brazil’s Congress, Eduardo Cunha, publicly split from President Rousseff — decreasing the likelihood that further fiscal measures would be approved by Congress later this year — we raised a red flag,” Glendon wrote in an editorial for Absolute Return. “Our views became even more negative when, shortly thereafter, the government publicly revised downward its primary surplus target for 2015 — from 1.1% of GDP to just 0.15%. Although few actually believed the original target was viable, arguably even fewer expected it to be revised to nearly zero.”

While the investment community’s sentiments toward Levy’s reform measures — predicated on his political ability to implement them — are positive in the long term, recent economic woes have worsened. In a June quarterly inflation report, the Central Bank’s Comitê de Política Monetária (committee on monetary policy) projected a recession of 1.1% in 2015, a larger decline compared with earlier forecasts of ­0.5%. It additionally raised its inflation forecast from 7.9% to 9%, which would be the country’s highest in over a decade. The government’s primary weapon against inflation — the SELIC, or short­term interest rate — rose to 14.25% on July 29, in line with analyst predictions from a Central Bank survey earlier in the summer. The risk, according to Glendon and many domestic hedge fund managers, is that a fragmented Congress will object to Levy’s belt­tightening in the face of short­term pressures.  

The hedge fund landscape

Brazil’s distinct breed of hedge fund is called the multimercado, or multimarket fund. For years, multimercados followed a formula called the “Brazil kit,” which described a portfolio primarily allocated to government bonds, with a smattering of other investments including currencies, stocks and interest rates. Brazil has a long history of inflation woes and large debt­to­GDP ratios, leading the Central Bank to maintain a high SELIC and therefore generating attractive yields for bond holders. A relative period of economic stability in 2010­2011 brought the rate down to single digits, and asset managers diversified their holdings as a result. According to Sao Paulo­based data provider Economatica, fixed income has resurged in recent months, though its “trough” has not dipped below 74% of total fund industry allocation since 2010. As of May, fixed income represented more than 80% of allocations in Brazil — hardly a surprise as government bonds yield over 14% — and equity exposure has continued its downward trend since 2011, comprising approximately 6% of all fund portfolios. While many managers now hold quantities of other instruments such as global currencies, the CDI (the average overnight rate for interbank loans, which tracks the SELIC) remains the performance benchmark for Brazilian asset managers, many of whom make their performance fees based on their profit above the interest rate. “It’s very hard to build an investable benchmark for hedge funds, especially equity hedge funds,” Adilson Ferrarezi, head of HSBC’s Latin American fund of funds unit, told Absolute Return. “The Brazilian market is small, managers’ investment approaches and styles change over time, survivorship bias removes underperformers from the industry, and the strategy capacity is limited such that top­performers close to new client subscriptions. Equity hedge funds are structured as multimarket funds, which is an asset class that historically competes with traditional fixed income. In this case, the opportunity cost to invest in a multimarket fund is the CDI.” In an attempt to mitigate the survivorship bias of the Brazilian fund industry, the Absolute Return Brazil Index (graph below) was constructed to include funds that shuttered within the period of 2009 to 2015. Even with this inclusion, the index consistently outperforms the Absolute Return Composite Index of all funds in the database. The BOVESPA outperforms both indices until 2013, and has since lagged both U.S. and Brazil­based hedge funds. “The talent in the Brazilian hedge fund industry is incredible,” said the founder of a major third party marketing firm based in Rio de Janeiro, who asked to remain anonymous. “The pre­crisis winners — Fraga [Gávea], Jakurski [JGP], Stuhlberger [Verde] — are battle hardened, have survived decades of Brazilian economic downturns. But still, investors are scared.”  

And then there is the dual blessing and curse of intense regulation. The Brazilian fund industry is remarkably transparent compared to its U.S. and European counterparts, reducing the competitive advantage of stock pickers who relish a degree of secrecy. The Securities and Exchange Commission equivalent in Brazil, called the CVM (Comissão de Valores Mobiliários), requires all managers to publish daily NAV reports, and disclose the fund’s positions monthly. There is a special privilege recently instituted for the firm’s largest position, which can be disclosed with a three month lag. Given domestic preferences for short (or no) lock­ups, many managers offer daily liquidity, hence making asset bases among equity managers unstable and illiquid investments virtually impossible.

Some managers such as São Paulo­based Equitas Investimentos are encouraging investors to take a longer lock than the traditional Brazilian multimercado dictates, pointing to a “flight to quality” that has occurred in recent years, with secure names trading at peak valuations and mid and small cap companies trading at or below book. “Brazilian less liquid small­caps were the stocks that suffered the most in the recent bear market, and that is where the most compelling long­term opportunities lie,” said Equitas managing partner Luis Felipe Amaral. Private equity­style long lock vehicles, are being launched to take advantage of this trade. Equitas offers a five­year time horizon in its version, which is scheduled to close on September 1, seeking to profit from the rebound of well­managed companies hit hard by currency fluctuations, and to anchor an increasing number of IPOs scheduled to come online due to regulation changes outlined in Amaral’s editorial, featured here.“While demand for long­biased Brazilian equity strategies has been challenged, we have seen an increased interest in distressed strategies such as non­performing loans and private equity,” said David Frank, chief executive of third­party marketing firm Stonehaven. Several firms including Blackstone’s asset manager Pátria Investimentos and Gávea secured over $1 billion late last year for private equity funds that invest in Brazilian companies.

The grass is always greener

Among domestic investors, the appetite for far­flung shores is growing, cast against a backdrop of a highly correlated and sluggish stock market, as well as the country’s volatile currency, the Real (BRL). The avenues to invest abroad are widening in thanks to new regulations, and some Brazil­based managers are taking note of the increased appetite for geographic diversification. Still, the industry remains far more insular than its European and American competitors; according to Economatica data, only 1.82% of all assets in the Brazilian fund industry are allocated abroad (see graph). Sat in the Rio de Janeiro offices of asset management firm Vinci Partners — a bright and spacious headquarters awash in flamboyant, surrealist art — Bruno Cordeiro is one industry veteran responding to the call. The former head of commodities proprietary trading at investment bank BTG Pactual, Cordeiro launched global macro shop Ciclo Capital last year, securing seed capital from Vinci and another, unnamed investor. “The majority of Brazilian hedge funds are focused on local markets,” Cordeiro told Absolute Return. “We believe that there is a growing demand among Brazilian investors to have access to funds with different risk profiles. Strava [the flagship fund] is truly a liquid global macro and commodities fund.” Stonehaven’s Frank echoed the sentiments. “We’ve seen increased interest from Brazilian investors to diversify further in terms of currency, geography and alternative strategies,” he said. October regulatory changes will make it easier for both domestic managers to invest offshore, and qualified investors to allocate more of their wealth to overseas investments. Previous restrictions named any fund with over 20% offshore exposure as a “super qualified vehicle,” setting a minimum investment of $1 million BRL. “According to the new legislation, if a client’s wealth is larger than $15 million, this investor will be able to invest in any type of fund with 100% exposure abroad, and the minimum initial investment amount will be freely defined by the fund manager,” said Adilson Ferrarezi, head of the HSBC Multimanager Offshore Fund. Ferrarezi further elucidates the changing regulatory landscape here.  

While some domestic investors are setting sail for other destinations, Christian Rogers, head of sales for Brazil Prime Services at Credit Suisse in São Paulo, sees renewed interest among foreign managers for lower­priced Brazilian securities. Rogers notes that the high rate, weak currency environment has attracted global macro managers seeking better buys. “Foreign investment in interest rate futures, known as Interbank Deposits, or ID, has climbed to about 35%, up from 21.6% in 2013,” he told Absolute Return. (For more on the increased appetite for Brazilian securities, read Rogers’ full editorial).

According to Mark Yusko, chief investment officer of $4 billion fund of hedge funds Morgan Creek Capital Management, the Brazilian stock market is becoming a fertile ground for value investors. “If we look at Brazil, there are a lot of really cheap assets,” Yusko said in a BRIC­focused presentation on July 30. He pointed specifically to steel­maker Companhia Siderúrgica Nacional, mining giant Vale, and airline Gol Transportes Aéreos, all of which have weathered double­digit declines in the past year.

“These are good companies. These companies are not going away. We think there has been a lot of bath water thrown out, and we think there’s a few babies in there.” Yusko noted that Morgan Creek had not made any purchases in Brazil yet, but believes “there will be some really good opportunities to make money” as prices continue to deteriorate.

Back to the future

Viennese author Stefan Zweig moved to the Brazilian “imperial city” of Petrópolis in 1941, impressed with the sheer expanse and racial tolerance of Brazil at a time when Europe was torn apart by war. Before taking his own life, Zweig authored a book entitled, “Country of the Future,” praising his adopted home and unintentionally inspiring a common joke that continues to deride it.

“Brazil is the country of the future — and always will be,” the exhausted refrain goes, and as the domestic economy prepares for yet another period of recession and austerity, it appears to ring true.

But as many investors have learned throughout the world’s emerging economies, sometimes the transition period is more lucrative than the destination. “Changing environments often provide opportunities,” Credit Suisse’s Rogers wrote, “and the winds have certainly changed in Brazil.”

While it remains to be seen whether or not Levy will be successful in turning Brazil into the BRIC it was once heralded to be, it appears that opportunities exist for intrepid investors who do not plan to wait for the elusive Brazilian future.