Month: November 2019

The XP IPO and Market Efficiency in Brazil

The Brazilian capital markets are among the most sophisticated in the world. During periods of hyperinflation in the 1980s and 1990s, market participants adopted highly complex financial instruments for hedging and protecting returns. Over the past 25 years, as the country went through several boom-to-bust cycles and suffered a profound deindustrialization, Brazil has increasingly become a FIRE economy, driven by Finance, Insurance and Real Estate. During this period, Brazil’s best and brightest have flocked to financial jobs where salaries are multiples of those available in more productive sectors. At the same time, a steady rate of consolidation in most financial activities has led to a few preeminent dominant firms with strong pricing power and high profitability.

The incumbents – mainly, large dominant banks — over time may have become vulnerable to new entrants that introduce disruptive models and more efficient cost structures. A wave of new fintech firms have taken advantage of abundant global venture capital funding to take on the incumbents with new business models. At the forefront of these there is XP, a Brazilian brokerage firm/financial advisor, which is currently in the process of launching an IPO on Nasdaq. Founded in 2001 by Guilherme Benchimol, XP is probably the best Brazilian entrepreneurial success story of this generation. Influenced by the philosophy of Brazil’s Jorge Paulo Lehman (3G/Inbev) and by American discount brokers such as Charles Schwab, Benchimol  created a financial service platform which aims to democratize finance in Brazil and disrupt the entrenched incumbents (e.g., Banco Itau and Banco Bradesco).  Benchimol has largely achieved his goal and XP is now a major force in Brazil’s financial sector, with 1.4 million clients. The IPO’s bank underwriters are looking for a valuation of BRL 60 billion (USD 15 billion), about half that of banking behemoth Bradesco.

Ironically,  XP’s huge success may have now turned it into somewhat of an incumbent. Though much of the IPO prospectus extols how well positioned XP is to exploit the inefficiencies of the investment industry, a look at the details paints a different picture.

XP’s most profound innovation has been its open platform, which allows it to provide a financial supermarket of products, in contrast to the “walled-gardens” historically preferred by the big banks.  It has exploited this advantage with technological and marketing savvy. But, the one thing it hasn’t really done is attack the very high fee structures that characterize the Brazilian asset-management industry. In fact, XP has become the biggest distributor of the independent asset management industry and benefits from the juicy distribution fees that fund managers pay to raise assets.

The problem is that the Brazilian asset management industry today is an aberration in terms of the fees that investors pay for investment products, with 1% management fees common for bond funds and 3% (including prevalent performance fees) common for equity funds. These kind of fee structures exist in Brazil only because of the powerful pricing power enjoyed by the large banks.

The persistence of high fund management fees in Brazil is justified by the claim that the domestic markets are highly inefficient and present abundant market “alpha” (returns above those available from the market) to be harvested by active managers.

However, evidence of this market inefficiency is scarce. One might expect “alpha” to be available for professional investors in markets that are dominated by retail investors (e.g. China, India, Turkey), but Brazil is a market trafficked predominantly by sophisticated and highly-paid professional investors.  Also, most funds in Brazil invest in a very narrow cohort of some 100 stocks which are very closely followed by competent analysts; most funds are also short-term oriented trend followers, with low appetites for small and less liquid stocks.

The best analysis of the Brazilian domestic funds market is done by S&P Dow Jones Indices (Latin America Scorecard, SPIVA). A summary of the latest review (through 2018)  below shows how difficult it is for funds in Brazil to generate alpha, particularly in bonds, where 100% of funds underperform the benchmark. In equities, about 85% of Brazilian funds underperform the index for 3,5,and 10 year periods. Most likely, this is a consequence of the combination of market efficiency and very high fee structures.

Ironically, XP, to a degree, may be more vulnerable than the incumbents it purports to undermine. XP’s earnings stream relies heavily on brokerage revenues and fund distribution fees, which represent only a small part of the highly diversified revenues stream enjoyed by its competitors. These fees are high today, supported by the  large inefficiencies of the Brazilian financial sector but these are now ripe to be disrupted by innovation.   Of late, we have seen some of the incumbents slashing commissions, following in the foot-steps of the U.S. industry.

Also, Bradesco and Itau have taken the plunge and launched U.S.-style low cost ETFs.

If the name of the game is raising assets, the future in Brazil looks like the U.S, with a heavy presence of systematically managed passive products, both in the form of ETFs and mutual funds. This is not a space  where XP, in its current form, will prosper. So, it’s not surprising to see the budding ETF space in Brazil dominated by Itau, Bradesco and Blackrock’s Ishares.

In fact, a U.S. style transition to passive products is in full swing in the Brazil domestic market. Blackrock’s Ishares Bovespa ETF (BOVA11) has raised USD2.3 billion in Brazil. As the chart below shows, volumes are exploding. Interestingly, BOVA11 is priced at 30 basis points (.30%) annually, which is about half of the fee charged on its NYSE Brazil Ishares (EWZ). Itau has also launched a Bovespa ETF (BOVV11) for which it also charges 30 bp, and Bradesco has its own Bovespa ETF (BOVB11), with a 20 basis points management fee (currently, the cheapest Brazilian stock market ETF in the U.S. is Franklin’s, with a fee of 19 basis points.)  Itau’s ETF undercuts its own Bovespa Index mutual fund, for which it charges an astonishing 2% fee, a reminder of legacy practices.

As we have seen in the U.S., the growth of passive investing is very likely to force a consolidation of the Brazilian asset management industry and a dramatic reduction in the fee structure. Firms like Schwab are now staking their future on asset management and have become leaders in ETF issuance. The same will have important consequence for the fund distribution industry in Brazil, and this may resent a short-term challenge to XP’s talented management.

A Guide to Investing in Emerging Markets: BAM on the India Opportunity

For anyone interested in investing in emerging markets, these comments from Brookfield Asset Management’s India Managing Partner made during the company’s 3Q conference call are elucidating.

BAM is a major investor in emerging markets, and has been in Brazil for decades (originally Brascan). Ranjan explains the time-proven process:

* Start slow and build local expertise.

* Focus on secular opportunities with very long runways.

* Focus on cash-generating businesses

* Most importantly, be aggressive during economic downturns when there are many distressed assets and capital is scarce.

Brookfield Asset Management Quarterly Conference Call (Link)

Anuj Ranjan – Managing Partner and CEO, India and Middle East

Anuj Ranjan

Thank you, Brian, and good morning, everybody. Today, I want to talk about our journey in India, our outlook on the Indian economy and where we see investment opportunities emerging. We’ve now been in India for more than a decade and have over $16 billion of assets under management with investments across all of our businesses, real estate, infrastructure, power and private equity. Now while we entered India in 2008, we did not close our first major transaction until 2014. Since India was a new market for us then, we were guided by our philosophy of being patient and invested capital only where we saw value opportunities. Initially, when we arrived in India, the country was going through an economic boom that was reflected in valuations that we thought were too high. So we decided to spend the first 5 years really understanding the market and building out our operating capabilities on the ground. We did this by creating operating platforms that would provide services to domestic real estate and infrastructure companies. By 2012, we saw signs of distress and a dislocation of capital emerging, and we spent 2 years putting together what became our first significant transaction in the market, which was a commercial office property owner.

This was a large and complex situation that involved privatizing an offshore public company, backing the local banks and the foreclosure of debt and ultimately, taking over all operations of the business. We learned a lot in the process, and this was truly the start of our journey in India. Maintaining this investment and operating discipline, we’ve incrementally built what is now one of the largest foreign investment platforms in the country. In our real estate business, we own more than 30 million square feet of high-quality office space across several key markets. And more recently, we acquired a vertically integrated luxury hospitality group, which has 3,000 owned and managed keys. Our infrastructure business consists of a roads platform with 5 national highways, the only cross-country gas pipeline and more recently, we signed agreements to acquire the second-largest telecom tower portfolio in the world through a large corporate carve-out. Our renewable power business owns and operates over 500 megawatts of capacity across solar and wind assets. And our private equity group has created a financial services business, which provides credit to residential developers who aren’t able to access traditional bank financing.

Through this growth, we have built a strong investment and operating team. Our team is over 40 investment professionals and support staff across our operating businesses, though we also employ well over 6,000 people. This gives us a unique competitive advantage when evaluating opportunities. Not only can we provide large amounts of capital where it’s needed, but we can more easily assess the risks, challenges and operating requirements of the asset or business. We’re also able to implement and execute our business plans, not necessarily requiring a local partner. This is very useful, especially when you’re using the opportunity to acquire businesses from banks where the prior owner is in some distress.

Moving on to the economy. There are certainly some near-term challenges in terms of a slowdown being driven by a tightening of credit availability that has led to multiple defaults. However, we believe the long-term fundamentals of the country continue to be quite strong, and India remains one of the most attractive markets in the world. More specifically, over the last few years, there have been some significant developments that are very encouraging for the country’s long-term growth. First, to set the context on the economy, it’s hard to generalize a country as big as India. We like to think of it as three economies, which we will refer to as India 1, 2 and 3.

India 1 includes the wealthiest 100 million people, which make up only 8% of the population and have very similar metrics to Mexico. GDP per capita, spending habits and consumer behavior, almost exactly the same as Mexico. They contribute 40% of India’s economy today and have largely historically driven consumption.

Next you have India 2, which is another 100 million people and could be described as the middle-class. It’s similar in economic makeup to the Philippines in terms of GDP per capita and spending. And finally, we have India 3 with a population in excess of 1 billion people who have a GDP per capita of Sub-Saharan Africa. These are the poorest people, largely in rural areas who have not historically been a part of the formal economy.

For the first time ever, we’re seeing a transformation in which India 2 and India 3 are becoming included in the formal economy, and this is happening for 3 reasons: data penetration, reforms targeting inclusion and a strong government that’s driving change. Let’s start with data. India has risen from being 150th to the first ranked country in the world in mobile data consumption in only the last 3 years. This explosive growth has been brought about by affordable data plans and falling smartphone prices. India now has 600 million Internet users, but what is shocking is this is only 40% of the population, implying a sustained and continued growth in the future. This digitization has contributed substantially to the inclusion of India’s large population, and it is translating to high growth across most businesses. We’re excited about this trend and actively evaluating opportunity in data infrastructure, including the acquisition, I earlier mentioned, of the country’s largest telecom portfolio.

Secondly, we witnessed landmark steps being taken to create an inclusive, transparent and formal economy. Policies such as the creation of the Aadhaar card, which is a unique biometric identifier for every Indian citizen and banking for all in which over 300 million bank accounts were rolled out for the rural population have created an integrated ecosystem that can form the backbone for delivering grassroot reforms and growth. As one small example, in a very short time, this has already led to an increase in bank deposits of $15 billion. Thirdly, we’re in a period of sustained political stability with a strong government at the helm. The government has launched some breakthrough reforms, including the Insolvency and Bankruptcy Code, goods and services tax and a 10% reduction in corporate rates. While the processes are being streamlined and there’s some teething issues which remain, as a result of these initiatives, India has moved up 67 places in the global ease of doing business rankings in the past three years. This has, in turn, led to record foreign investment inflows.

This is all supported by the fact that the Central Bank has done an incredible job targeting inflation and getting it under control. Consumer price inflation, which used to be as high as 10%, is now under 4% and has been in the target range for over 5 years. This gives India one of the highest spreads in the world between the current bank rate and inflation, leaving ample room to cut rates further.

Now while data inclusion and good government are creating a platform for India to, one day, become a $5 trillion economy, there exist some immediate challenges that the country is grappling with. India’s banking system has saddled with close to $130 billion of nonperforming loans, which at roughly 10% is the highest ratio among the top 10 economies in the world. This is compounded further by the crisis in the shadow banking sector, which makes up over 20% of India’s overall credit.

Unlike developed markets where shadow banks do only specialty or high-risk lending, in India, due to regulatory restrictions, the nonbanking financial companies are also providing credit where banks can’t lend, for example, loans against property, margin loans against shareholder equity. Most of the distressed debt is in wholesale or corporate credit, which presents a sizable opportunity for us to acquire high-quality businesses at a time when capital is needed.

To conclude, we’re excited about the opportunity India provides. On the one hand, we have the fastest-growing major economy in the world, taking steps to access their enormous population by including them in the formal economy. On the other hand, in the short term, liquidity is scarce and the credit markets are in distress, creating a tremendous opportunity for private capital providers like us.

The challenge is that while businesses or assets can come at attractive valuations, operating them under Indian conditions can be a challenge, which is where our 6,000-person strong operating platforms give us a unique advantage. To navigate India in this period, our key investment themes are to focus on businesses that benefit from inclusion of that final 1 billion people, acquiring assets or businesses from over-labeled corporates, making stable bond-like investments that generate a high cash yield, and lastly, looking at private credit opportunities where banks cannot lend.

Thank you. That concludes my remarks. I will now turn the call back to the operator for questions.