Reacting to equity shortage

Brazil’s rapidly expanding private pension fund industry is facing a difficult challenge: how to increase exposure to equities in the face of limited local availability of liquid securities. One attractive investment is the small but vocal group of recently launched activist investment funds; these funds seek to boost shareholder value and increase the liquidity of second and third-tier stocks by actively promoting improved practices of corporate governance and vigorously defending minority shareholder rights.
Total assets of private pension funds, including both open and closed retirement plans as well as disability plans, have grown threefold since 1994 and now exceed R$130bn (e81bn). A relatively small percentage of this total is invested in stocks, with the balance mainly in fixed income funds and government securities.
Continued reform to the government’s still-shaky social security system will invariably result in reductions of future retirement benefits, thereby stimulating steady growth of the private pension industry as Brazilian workers seek a supplemental source of retirement income. The increase in total assets is only one source of anticipated growth in demand by pension funds for equity investments. The main reason is the dramatic decline in returns available in the fixed income market, where rates on government notes have fallen from a high of 45% last year to 16.5% today. Given low inflation and the continued generation of primary surpluses in the government’s budget, interest rates have further room to fall over the coming 12–18 months, stimulating a migration to equities by pension fund managers. The key question is, will an adequate supply of liquid stocks be available?
Increased demand for equities will collide with the reality of declining turnover and liquidity in the local stock market. Trading in the most liquid Brazilian stocks is steadily shifting to New York, where they are listed in American depositary receipt (ADR) form. Recent listings include two of Brazil’s largest companies, Petrobras and Companhia Vale do Rio Doce. Brazilian pension funds are prohibited from owning ADRs and also barred from owning locally traded depository receipts (BDRs ) of foreign companies. Spain’s Telefonica recently swapped shares in its Brazilian subsidiaries for BDR’s of the parent company, further reducing the availability of liquid equities suitable for pension funds. A new regulatory constraint was created by Resolution 2720, restricting pension fund investment in second tier (‘average liquidity’) stocks to 20% of fund portfolio, with another 2% permitted for third tier (‘low liquidity’) equities.
The government’s 0.3% tax on financial transactions, known as the CPMF, penalises trading in the local market, especially for foreign investors with easy access to the ADR market. Nevertheless, market participants increasingly cite the poor state of corporate governance practices as the primary impediment to the development of a vibrant equity market in Brazil. In response funds have been created by asset managers that take an activist approach to managing portfolios of second and third tier stocks for institutional investors. These can provide an important alternative for pension funds wanting to increase equity asset allocations but wary of investing in less liquid issues due to the lack of protection for minority shareholder rights.
Although the government is currently attempting to improve corporate governance practices and strengthen minority rights through amendments to the Corporations Law, we believe that activist investors, especially in the form of large institutional funds, can play a decisive role in this effort. In addition to defending minority shareholders from abuses by controllers, activist managers can enhance the returns of their portfolios by encouraging (or forcing, when necessary) companies to adopt better corporate governance practices.
For historical reasons the ownership, power and management of Brazilian companies have not evolved independently. Family-controlled businesses still predominate, even for publicly traded companies. Furthermore, Brazilian Corporate Law allows for the effective control of a company by those holding only a minority interest (16.5% of total capital), due to the large percentage (two-thirds) of non-voting shares that a company may issue. Brazil’s weak model of corporate governance has led to a reduction in the efficiency of asset allocation, and the inability of Brazil’s private sector to produce higher rates of sustainable growth and competitiveness in the global marketplace.
Even well managed companies with good corporate governance practices are contaminated by pervasive factors such as poor management, lack of transparency and accountability and conflicts of interests, thus reducing their market value and limiting their access to long term funds. A growing number of companies are offering to buy back outstanding shares, generally with the intention of de-listing their shares.
To improve economic fairness and efficiency and create a better environment for internal and external investment in Brazil, local companies should adhere to a code of corporate governance best practice. This will improve the confidence of investors, assuring that interests of controlling shareholders, investors and management are aligned and committed to create value for all stakeholders.
Both the CVM (the Brazilian Securities and Exchange Comission) and BNDES (the Brazilian National Development Bank) have recently set up programmes to promote good corporate governance.
Investments in firms following best practices of corporate governance could be viewed by the market as a new asset class, thereby contributing to the reduction of risk, and increase in return, of portfolios invested in Brazilian securities. For pension funds, this new type of investment can provide an effective vehicle for profitably increasing asset allocation to equities.
Stephen H Dover is chief investment officer at Bradesco Templeton Asset Management in São Paulo

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