Brazil: Venture Capital's Next Hotbed?

Investments in Brazilian startups are surging, but high taxes and strict labor laws could hamper returns

Brazil is best known around the world for soccer, samba music, and supermodels. Now it's emerging as an attractive destination for investment capital.

At a June 25 conference in New York, a Brazilian venture capital trade group announced some impressive figures. As of the end of 2008, local and foreign investors had committed $28 billion in venture and private equity capital to Brazilian companies, said Luiz Figueiredo, president of the Brazilian Association for Private Equity & Venture Capital. That's up from $6 billion in 2004, amounting to a hearty 50% compound annual growth rate over the last four years. Investors have financed 500 Brazilian companies to date with venture or private equity capital, and there's $12 billion left to invest over the next few years from that $28 billion kitty.

Venture and private equity players see ample opportunity in Brazil, which boasts a stable financial system and a strong base of local investors. But the country's business challenges, including high taxes and restrictive labor laws, could hold back growth.

The conference on investment opportunities in Brazil was hosted by the Brazilian-American Chamber of Commerce and drew more than 150 investors, executives, and technologists. An initial public offering and a large investment underscored the event's theme.

On June 25, Brazilian stock exchange Bovespa hosted the world’s largest IPO this year, a $4.3 billion offering by Brazilian credit-card processor VisaNet. The same day, Boston private equity firm Advent International announced that it has bought a 50% stake in Brazilian holding company PAP for $142 million. PAP controls Kroton Educational, a fast-growing education company. It was Advent’s fifteenth investment in Brazil since 1997.

a legal system that respects property rights

Investors are planning to increase their exposure to emerging markets, and Brazil is becoming a more attractive place for investments, according to an Apr. 6 survey by Coller Capital, a secondary investment firm that buys stakes in venture capital. Brazil ranked as the second-most-attractive choice for private equity investments, behind China but ahead of India. Last year, Brazil ranked fourth.

Why is Brazil an investment hotbed? During a panel discussion, Figueiredo pointed to several factors. Among them: a large, stable, growing economy; a modern financial system that has largely escaped the global financial crisis; a legal system that respects property rights; a strong base of local investors; and robust capital markets.

Brazilian pension funds have contributed to more than half the growth in venture capital and private equity funds. In Brazil, pensions are allowed to invest up to 20% of their funds in alternative investments, such as private equity and venture capital, a much higher percentage than U.S. funds can allocate to these risky investments. "The industry is getting new money, and we are ready for it," says Figueiredo.

One of those new foreign investors is venture capital firm Draper Fisher Jurvetson. In May 2007 the Silicon Valley firm began a partnership with Brazilian venture capital firm FIR Capital Partners, launching a $170 million fund. Marcus Regueira, a founding partner of FIR Capital who appeared on the panel, said his firm is targeting investments in information technology, mining technology, and agribusiness. "We’ve never had the quality of entrepreneurs that we have now," said Regueira, a former Bank of America (BAC) executive who has an MBA from the University of Pennsylvania's Wharton School.

The Next China?

Still, Brazil has its share of challenges that may make some investors think twice about putting money into Latin America’s largest nation. Compared with the U.S., taxes are high and labor laws inflexible. Brazilian taxes can account for nearly 40% of an employer’s payroll expenses. And under Brazil’s extensive labor laws, workers are entitled long paid vacations, mandatory bonuses, and free transportation, food, and health insurance. "Laws have changed, but they are still extremely protective of the employees," says Antonio C. Rego Gil, president of the Brazilian Association of Information Technology & Communication Companies. In addition, Brazil has yet to produce a technology startup that's a global leader.

The influx of capital into Brazil could alleviate some of its failure to produce a home-run investment for VCs. FIR Capital's Regueira cited the experience of Akwan Information Technologies, a Brazilian search engine in which FIR invested. In 2005, Google (GOOG) bought Akwan and used it to set up a research-and-development center for Latin America.

Akwan and its investors needed to sell the company because it couldn't attract follow-on investments, Regueira said during the panel discussion. Foreign capital will likely alleviate problems like that. Thanks to the flood of new money, "now is the time to invest in Brazil," he said. DFJ director Elizabeth Clarkson, who was also on the panel, predicted that the new vintage of Brazil funds will produce extraordinary returns. "DFJ was early in China," she said. "We are looking for Brazil to be a similar experience."

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