Emerging financial markets cannot afford to ignore corporate governance. Instead, they should ‘overshoot’ in good governance, says José Luiz Osorio, former chairman of Brazil’s Securities and Exchange Commission (CVM) and now a partner in the asset management firm Jardim Botanico Investment Partners.
“In the case of Brazil, there is no alternative path other than best practices in corporate governance. In countries such as ours, where capital markets are not highly developed, where investment culture is still weak and where entrepreneurial risk does not receive its due reward, overshooting in best practices in corporate governance will help us cross the line from seed capital to public markets. It is precisely because of our current deficiencies that we need more transparency, more credibility, more accountability,” he explains.
For Mr Osorio, the link between economic development and good corporate governance stems from companies gaining easier access to capital. “Markets do a better job at allocating capital than a central system does – whether it’s a development bank or a government that chooses the winners and losers, as has been the case in Brazil for years. There is no sustainable growth without capital markets playing a major role in access to financing,” he says.
Otherwise, high-quality companies risk being unduly penalised. “If good companies that are making good profits and have good corporate governance can’t get capital, that’s a tremendous cost for a country,” says Mr Osorio. Such was the case in Brazil as recently as 2001, he adds.
In the past, Brazilian companies have mostly relied on internal growth and development agencies for long-term capital. Recourse to equity markets has often been driven by government policies more than by business needs.
In the mid-1970s, the government provided fiscal subsidies to encourage individuals to invest in the local market, creating demand for equities that led to a series of IPOs. Later, when the subsidies were cancelled, investors abandoned the market. Then, in 1985, the Cruzado Stabilization Plan resulted in a 12-month stock market bubble. A number of companies listed, but when inflation returned the market dried up. Then, at the beginning of the 1990s, foreign institutional investors became a major force in the market but their interest faded as Brazil's economy again deteriorated.
The São Paulo stock exchange operator Bovespa began to question why the bourse was not providing Brazilian companies with sufficient means to access long-term sources of capital, and in early 2000 commissioned leading economists to make recommendations. This resulted in the creation of tiered listing requirements, classified as Levels 1 and 2 of Differentiated Corporate Governance Practices, along with the more demanding Novo Mercado rules.
The new listing categories reflect graduated levels of voluntary disclosure. Level 1 slightly increases disclosure beyond Bovespa’s basic requirements, while a Level 2 or Novo Mercado listing requires companies to present their financial results in accordance with US GAAP as well as Brazilian GAAP. More importantly, Level 2 requires that companies extend 70% tag-along rights to non-voting shares while a Novo Mercado listing makes 100% tag-along mandatory. This is particularly important in Brazil where most of the market’s liquidity is concentrated in non-voting shares.
The first issue under the Novo Mercado rules came in 2002, nearly two years after the exchange introduced the regulations. But the turning point was in early 2004, with the listing of Natura, the leading Brazilian cosmetics company.
Since the new rules were created, 22 companies have raised around US$ 6.7 billion in 26 separate primary or secondary issues. All but five of these companies have listed under the more stringent Level 2 or Novo Mercado requirements. By comparison, from 1995 to 2003 there were a total of just five IPOs. “Moreover, most of these issues were priced at higher multiples than their Bovespa equivalents and are performing better than the market,” says Mr Osorio. “It is clear that a new standard has been created in Brazil.”
In February of this year, Bovespa will make Level 2 and Novo Mercado regulations even more stringent. For instance, the board of directors of these companies will now be required to have at least 20% independent membership. Level 2 companies will need to increase mandatory tag-along for preferred shares to 80%. The changes were approved by at least two-thirds of the Bovespa’s listed member companies.
Mr Osorio believes that the IPO process is the right time to instil good corporate governance practices in a company. “[Corporate governance] overshoot should come from investors asking it of new companies coming to market. The only time investors have the upper-hand is when companies come to the table asking for money,” he explains.
But he also cautions that the rush to list might at times hurt the quality of corporate governance. “I’m beginning to have the feeling that some companies in Brazil are coming to market too soon, that they are jumping ahead of themselves. There’s a necessary time to mature a company before going to market,” he warns.
Part of this haste may be driven by unreasonable expectations. “The Novo Mercado is not a guarantee of returns. People tend to over-emphasise good corporate governance’s efficiency. Companies first of all have to make money,” says Mr Osorio.
He also concedes that the strong performance demonstrated by the Bovespa IGC Special Corporate Governance Stock Index – which tracks the performance of all Level 1, Level 2 and Novo Mercado companies – could be driven by broader market factors. “It may be that the [general market] liquidity is causing all of this,” he says.
But asked if the São Paulo stock exchange would have performed similarly without the Bovespa’s new rules and the CVM’s push for improved corporate legislation, he is decidedly optimistic. “It is too early to know if in the long run companies with better governance will continue to maintain higher valuations than their peers in the traditional markets. However, I do not believe Brazil would have experienced such volume and diversity of companies accessing the market if these steps had not been taken.”
Perhaps the best indicator is the growing faith of Brazilian companies in financial markets. Mr Osorio says that 2005 was the first year in which the amount of money that companies raised through local equity and debt markets far exceeded the money raised from development banks. And 2006 is likely to be another record year.
