ArpexCapital

Some of my close friends often repeat the mantra to practice “restraint of pen and tongue”. In other words, think through whether you really need to send that flaming email or verbalize that stinging barb that’s on the tip of your tongue. If you are convinced that you really do need to write/say it, I would recommend a second consideration: take a moment to honestly consider your motivations: are they to improve the situation, or are they to make yourself feel better at someone else’s expense?

In the age of email and text, as well as blogs and their comments, this restraint becomes even more difficult (it’s only some typing and a mouse-click away). Especially with regard to email and text, a bad temporary moment – when you are feeling tired, anxious, frustrated – can lead to an act that worsens things and makes them considerably less temporary.

Last week I sent an email that I really regret. I sent it while I was rushing to get out of my car and into a meeting, after I had spent the previous fifteen minutes holding a kangaroo court of anxious, caffeinated discussion in my head. Did the email represent where my head was at that moment? Sure. Did it represent an accurate, integrated view of how I felt about the situation? Not at all. But the email went out and the damage was done.

Fourteen years ago something similar happened – I spent some time in my head stewing about how I felt a family member was behaving, phoned him and promptly opened a family rift that stayed open for a decade.

I thought I had learned my lesson 14 years ago but this week I had to re-learn the importance of restraint of pen and tongue (and Blackberry).
I read some blog posts and comment trails this morning that indicates that perhaps many of us are in the same boat.

Opinions on the US economy come fast and furious these days. Some think the worst has past and that we are on the cusp of stable growth. Others believe we are looking at a double-dip recession, i.e., we may have a short-lived recovery but will then slide into another recession.

Personally, I think the short-term problems in the US are underestimated and the long-term problems are overestimated. Our economy has fundamental problems that have yet to be worked out and we are not likely to recover much in the next two-three years. On the other hand, the US will come back in the long-term, as it always has, as long as we don’t overreact to this crisis by crippling our free-market system.

Brazil, on the other hand, is on the rise and the next two-three years (and beyond) will be a great time to have your money in that country. In addition to the many bullish factors regularly described in this blog, there is one very specific reason to invest in Brazil right now: the appreciation of the Brazilian currency (the Real, pronounced “hay-al”) against the US dollar.

Simply put: the US faces serious inflation in the coming years, which will reduce the value of the dollar. This post will not explain inflation or currency exchange. Suffice it to say: the US is mired in a deep recession, i.e., the economy is shrinking. In order to reverse this and spur economic growth, the US government is borrowing heavily and increasing spending, pumping dollars into the economy. This may spur economic activity but flooding the market with dollars will reduce the value of the dollar. As the value of the dollar decreases, you will need more dollars to buy the same product or service. This is inflation.

Relative to the US, Brazil is in a much better position. The economic slowdown did not hit Brazil nearly as hard and they are already coming out of it. They have $200 billion in reserves to defend the weakening of their currency and a strong export surplus to increase money coming in, i.e., they do not have to go out and borrow as much money. I believe that if you put a given amount of money into Brazilian reals today, it will be worth more in four years than if you put the same amount into US Dollars.

The markets have already anticipated the near future of the dollar and real: from the panicked days of December 2008 to today, the real has increased 30% versus the dollar. At one point in December, it took 2.67 reals to equal one dollar, now it takes just 1.83.

If one believes that trend will continue on the next several years, it makes sense to have money in Brazil. The appreciation of the real will provide a hedge against the decline of your investments and a boost in the event they increase.

Take a highly simplified example:

– Today I buy one share of a Brazilian entity for $1.00 US dollar, equivalent to $1.83 BR reals.
– Let’s assume the investment treads water and, after a year, the value of that one share has not increased. Too bad.
– At the same time, however, the value of the Brazilian real has increased relative to the US dollar by, say, 15%.
– I sell my one share. Instead of getting back $1.00, I get back $1.15.

The investment in the Brazilian entity didn’t appreciate but the Brazilian currency did!

As I said, that is a highly simplified scenario – there are taxes and transaction costs to consider, for example – but you get the idea.

In sum, the likely weakening of the dollar versus the Brazilian real is another reason to invest in Brazil now.

At the fourth US-Brazil Learning Lab , last week, I was on a panel with Simon Olson, a well-known and respected VC for FIR Capital in Belo Horizonte. We talked about various drivers and inhibitors of the Brazilian VC market and one of the things I emphasized was falling interest rates as a primary driver of VC growth in Brazil.

As I previously wrote , high interest rates inhibit the growth of a VC ecosystem for a number of reasons. First and foremost, high rates raise the cost of capital for entrepreneurs. Perhaps less appreciated, however, is that it also discourages potential VC investors: why would a potential Limited Partner or angel investor take a chance in venture capital when they can put their money in the bank and earn 12%-15% a year in certificates of deposit? Falling rates will force investors in Brazil to look elsewhere, e.g., to venture capital, to seek high returns. Lower interest rates will also enable the use of consumer debt in everything from mortgages to cars to appliances. This will boost economic growth and create more potential consumers of startup products and services.

Randy Mitchell of the US Commerce Department, who I mentioned in a previous post , sent me a great article, posted below. I think it gives as clear a picture of the impact of lower rates on Brazilian VC/PE as one could hope to find. As I mentioned previously, Randy is a huge asset for the US and its commercial partners such as Brazil — he spearheads the US-Brazil VC Task Force, among many other projects, and in general goes above and beyond the call of duty to help anyone and everyone.
___________________________________________________________________________________________
Fall in Real Interest Rate to Spur Investment

The Central Bank (BC) announced the fifth consecutive reduction of the
Selic, the Brazilian economy’s basic interest rate. In a unanimous
decision of the Monetary Policy Committee (Copom), the Selic fell 0.5
percentage points, to 8.75% per year. The decision reset Brazil’s
historical interest rate floor and moved the country from third to
fifth in the rankings of the world’s highest interest rates.
To explain the decision, Copom cited that the new level contributes to
the convergence of the actual inflation rate with the target rate and
helps in the “non-inflationary recovery of economic activity.” Since
the cuts began in January, the interest rate has fallen 5 points.
Now, analysts predict that the Selic will remain stable until at least
2010.

As reported by the Estado de São Paulo newspaper, the Central Bank
affirms that the new level is “consistent with the benign inflation
scenario.” They also affirm that the diminishing of the rhythm of the
cuts—the rate fell one point in June—took into account that the
reductions since January “have lagging and cumulative effects on the
economy.”

With the cut of 0.5 percentage points, the real interest rate (nominal
interest rate minus the projected inflation for the next 12 months)
has fallen to 4.4% per year. This position is considered
unprecedented, especially if the recent economic scenario—with
inflation levels below 5%—is considered. “In other epochs, like in
2003, we had real rates in the neighborhood of 5%, but it was a result
of a Selic above 20% per year and elevated price indexes,” says the
chief economist for Austin Rating, Alex Agostini.
There is, still, a new aspect, announced by the Central Bank at the
end of June: the monetary policy decisions are taking longer to
generate results in the economy. If before the change in the Selic
was felt in the economy in six months, now the effects take up to a
year. This occurs, says the Central Bank, because the terms of
financial contracts have become longer as a result of the country’s
economic stability. As such, the cut of five points since January
will only be fully felt in the economy in 2010.
The recuperation of the economy, a small rate of inflation, and the
slowing effect of past cuts reinforce the expectation of analysts that
the Central Bank should maintain the rate stable at 8.75% for the next
few months.

“It is improbable to believe in new reductions in the next few months
because we already have a situation of recuperation of activity.
Cutting the rate even more heightens the risk of high inflation in the
coming year,” says the economist from Santander, Maurício Molan, who
predicts a stable Selic until the end of 2010.

In his evaluation, the principal benefit of the fall of the real
interest rate is the development of the capital markets, with the
growth of participation of corporate securities (such as stocks,
bonds, and receivables funds) in the country. “We saw this happen in
industrialized and developed nations,” argues Agostini.
The economist goes further to say that lower interest rates
incentivize direct investment into the productive sector. “Instead of
reaching for the telephone and applying the money in a [Certificate of
Bank Deposit] or other type of application that presents an easy
income without great risk, now the investor will have to risk more, to
look for more attractive assets. This opens space for investments in
infrastructure, for example, which is the sector most needing
investment in Brazil.”

Beyond the general stimulating effect that the rate cuts will have on
the Brazilian economy, investment managers in particular could also
benefit from the interest rate fall. Traditionally, Brazilian
institutional investors allocate an extremely large portion of their
investments to fixed income; pension funds, on average, allocate over
80% of their investments to the fixed income market. However, lower
interest rates make government bonds less attractive, causing many
investors to seek returns elsewhere. What was once a relatively
simple job for investment managers—buy Brazilian government bonds and
collect double digit rates of return—has now become much more complex.
For Brazilian fund managers, the percentage of non-governmental
credit as a total of their assets under management has already grown
from 16% in December 2004 to 24% in June 2009 according to the
National Association of Investment Banks (Anbid). Part of this is
because government bonds are no longer as attractive, but part of it
also has to do with the falling interest rate stimulating local
capital markets. Falling interest rates make capital market financing
more attractive to companies and make it easier for these companies to
service their debt, thus reducing debt risk for investors. The equity
market should also feel a stimulating effect from the reduction of the
Selic rate. With thriving capital markets Brazilian institutional
investors increasingly need investment managers who can deliver
consistent returns. American investment managers could fill the void
of investment management expertise caused by the rapid expansion of
the Brazilian capital markets.

I got back yesterday from three weeks in Brazil. The trip was a mix of business and family (e.g., a large wedding). It was fun and productive although, I have to admit, I often thought about business when I was supposed to be present with family. My constant companion, Mr. Blackberry, didn’t help that problem.

After almost four years of doing business in Brazil and nearly three years looking at the startup/VC ecosystem, I remain as optimistic as ever about the future of venture capital in Brazil. As I wrote previously, I think Brazil has gone through its first phase venture capital cycle – from 1999-2008 – and is now ready to move onto a second, more successful phase.

More success will come in the second phase for a variety of reasons, including 1) the continued strengthening of Brazilian macro-economic fundamentals, 2) more managers and entrepreneurs with solid experience in the venture capital cycle and 3) the Brazilian government’s continued dedication to fostering innovation, entrepreneurialism and venture capital investment.

The three factors above contain many detailed variables, risks and opportunities but, on the economic side, falling interest rates will have the biggest impact on venture capital in Brazil. As interest rates fall, investors will look for new places to boost their returns and many will test the waters in venture capital. This includes both institutional and high net worth investors. Falling interest rates will also decrease the “hurdles rates” that VCs have to hit before they can share in the carry on their funds, which will make the VC fund business model more viable. Finally, falling interest rates will eventually usher in the use of debt for consumers and entrepreneurs; the former will mean more customers for startup products and services, the latter will mean more option for financing.

Aside from falling interest rates, I believe that, in the next two to three years, Brazil will see one or two huge startup successes that will serve as the tipping point for the VC industry. In the US, the Netscape IPO in August of 1995 provided one tipping point for venture capital and the ascent of Google provided another. When Brazil’s Netscape or Google comes along, a mass of entrepreneurs and (global) investors will jump in and take risks that, as of this moment, seem too high.

In sum, I see the next 6-12 months as the final lull in between the first and second phase of venture capital in Brazil. Although there have been a few “wins” in the first phase, the second phase will see larger and more widespread successes. Those that take educated risks now will be rewarded greatly when the second phase begins in earnest, while those that wait will compete in a more crowded market.