People joke that Brazil is the country of the future … and always will be.

Brazil is the 5th largest country in the world. It has 7% of the world’s fresh water, is one of the world’s most biodiverse nations with more than four million plant and animal species, and has more available farmland than any other nation. And … its climate is largely free of natural disasters.

But Brazil is suffering a disaster that is entirely manmade. This 30-year-old democracy is presently roiled by a political corruption crisis with far-reaching consequences, including the potential impeachment or indictment of President Dilma Rousseff and the alienation of her and former President Lula da Silva’s Workers’ Party, the Partido dos Trabalhadores (PT).  Like pulling on a string that unravels the whole sweater, the now two-year-old Lava Jato (Car Wash) investigation into corruption at state-owned oil company Petroleo Brasileiro (Petrobras), led by Federal Judge Sergio Moro, has revealed endemic corruption on a massive scale. Corruption at the political level, board level and business levels across multiple states and industries. The people of Brazil themselves have taken to the streets to protest this corruption. They bang pots and pans in the street in a uniquely Latin American style of mass protest called ‘panelaço’ whenever the President or former president speaks on TV.  The people and the media encourage Judge Moro to press onward with his investigation.

Meanwhile an economic recession continues to deepen, unemployment rises and inflation spikes.

Brazil is entirely capable of righting its wrongs and setting itself down a new path of political accountability, and the reward for doing so would be significant.  But Old Brazil isn’t giving up easily.
Here are some examples of the battle between Old Brazil and New Brazil.

Protection for the Political Class

A watchdog group called Congresso em Foco highlighted in a report that 40% of Brazil’s 594 members of Congress are facing charges for various crimes. The Supreme Court is the only court allowed to try members of the political elite.  In the last 27 years the Supreme Court has investigated 500 congressional members – 16 of whom were ever sentenced.

Many in Brazil believe that President Rousseff offered former President Lula a ministerial post in her cabinet last month as a means to shield him from the Petrobras investigation. That appointment is awaiting a verdict from the Supreme Court.

Federal Judge Sergio Moro, on the other hand, has become deft at using newly passed anti-corruption laws that offer reduced sentences in exchange for information.  Every day it seems there is more information, so much that a key party in the ruling coalition, the PMDB, voted on March 29th to withdraw support from President Rousseff entirely — potentially making way for impeachment proceedings. Should President Rousseff be impeached in 2016, the presidential election will be recast across the country. If the event were to happen in 2017 then the Brazilian Congress will select the new president.

Petrobras Tug-of-War

Created in 1953 as Brazil’s National Oil Company, Petrobras established world-class expertise in deep water oil exploration and development.  The centrist government of President Fernando Henrique Cardoso partly privatized the company in the 1990s. Petrobras was considered the crowning jewel of Brazil.

In 2007, President Lula’s Workers’ Party government created a new set of regulations and controls designed to keep the promising and massive “pre-salt” oil fields out of private and foreign hands while also reasserting state control of the oil company. Much of the Lava Jato investigations center around the alleged fraudulent use of funds from the company to pay off the political party’s leadership and to fund election campaigns. Recent reports suggest over R$6B in bribes were paid and over R$30B in state revenue was lost. Between 150 and 200 people have been arrested so far with nearly 100 convictions and 40 sent to jail, including construction magnate Marcelo Odebrecht. Lava Jato is now in its 27th phase and reaches the office of President Dilma Rousseff herself (who was Chairman of the Board at Petrobras during those years but has not been implicated in the investigation).

Novo Mercado (New Market)

In 2000, a group of leaders within Brazil’s leading stock exchange recognized that investors were shunning domestic equities in favor of fixed income or Brazilian company ADRs listed on foreign exchanges.  One-third of the volume traded in that year was from ADRs in companies such as Ambev, Vale and Petrobras. Lack of accountability and transparency, fears of fraud and unfair treatment for common shareholders kept investors away.

The Novo Mercado listing – and its Level 1 and Level 2 counterparts – was created to encourage companies to adopt strong governance standards such as equitable treatment of shareholders, high standards for corporate boards and comprehensive disclosure rules.  These were (and remain today) voluntary. Early adoption was hindered by fears over the incoming left-leaning administration of President Lula and the ongoing devaluation of the Brazilian Real. It was only once the commodity boom took hold and global investors desired Brazil exposure that Novo Mercado behaved as envisioned.  In 2004, Natura listed its IPO, followed by nine others in 2005 and 11 in 2006; by 2007 over 150 companies were participants in Novo Mercado, Level 1 and Level 2.  More than half of these IPOs were from industries not previously represented on the BOVESPA.  Families and private equity firms found the ability to divest, diversify and recycle their capital. Demand for these equities was so strong that their PE multiple was twice as high as those not participating. While there hasn’t been an IPO in Brazil since 2013 due to the political crisis, corruption scandals and deep economic recession, 130 companies remain members of the Novo Mercado. These companies are likely to be the first basket investors revisit once investor appetite returns.

Brazil’s currency rallied 15% from its lows earlier this year as Lava Jato appeared to have reached a turning point.  The world is now watching. Once the lengthy investigation process concludes, investors can focus again on all that Novo Brazil offers.

 

Carolyn Trabuco has over twenty years of global equity investment experience. She is an Independent board member of Azul Linhas Aereas, a commercial airline in Brazil, which she co-founded in 2007.