Brazil Internet Investments: Lessons Learned

by Kevin McDonald

Compared with the expectations of two years ago, the Internet in Brazil might seem to be a commercial failure. Indeed, dozens of dot-coms have closed their doors, and investors have lost a lot of money. Many of the remaining Internet companies have yet to generate a profit. One year after the fall of the NASDAQ, these companies are still struggling to raise the capital they need to survive. A new economy is not replacing the old one. Instead, old economy companies are adapting to the Internet.

Does this mean that all those dot-com start-ups were a failure? That they were not worth creating? Not at all. Many of them were successful: they provided employment, profits for entrepreneurs and excellent returns for investors. Equally important, they shattered important myths about investing in Brazil ? and other Latin American countries.

Understanding these myths and how they were destroyed is the next step in the evolution of private equity investing in Brazil.

Myth # 1:  There are no reliable exits for investors.

For years, private equity investors have avoided Brazil because there was no market for selling a Brazilian company. The Bovespa (São Paulo Stock Exchange) is not for small companies. And the NASDAQ is too selective for most foreign firms. Consequently, most private equity investors stayed away from Brazil, despite the country's large economy and abundant natural resources.

Internet companies have demonstrated that this premise is now out of date. Our firm, McDonald Lehner, has sold twelve Brazilian Internet companies in the past two years. Most but not all of the buyers - PSINet, IFX, StarMedia, Vesper, for example - have been foreign companies that wanted to establish a presence in Brazil. Many other transactions - including those of Mandic (Impsat and later El Sitio), Zaz (Telefónica de España), Matrix (Primus), Netstream (AT&T), and Zipnet (Portugal Telecom) - have demonstrated that there are good exits for good companies.

This trend will continue, even though the NASDAQ lost half of its value last year and many potential buyers of Brazilian companies do not have the necessary cash or shares for an acquisition. There are new potential buyers that are taking the place of those that came earlier. Already in February of 2001 we have witnessed the sale of Zip.net to UOL.

We will see other Internet transactions, large and small, as the sector is consolidated. And there are some jewels remaining.

For instance:
 - Iconet, an innovative, corporate ISP in São Jose dos Campos;

 - BRBusca, an outstanding search engine in Belo Horizonte; and

 - important domain names such as shopping.com.br and mall.com.br.

Myth # 2:  roll-ups (consolidations) don't work in Brazil.

Many successful companies - from high tech to no tech - have been created in the U.S. via a series of acquisitions. But investors have feared that a roll-up will not work in Brazil, where mergers are unfamiliar, regional and cultural differences prevent integration of personnel, and physical distances are too great to be surmounted easily. They point to the difficulties faced by PSINet and IFX as they integrated the ISPs they acquired.

The truth is that PSINet and IFX needed more capital than they could raise. They were victims of the falling NASDAQ, not the cause of the crash. And their management was not responsible for the lack of adequate funding. Fortunately, neither company is finished in Brazil, despite the need for more capital. One week ago PSINet sold Inter.net, its global consumer, dial-up business, which represented a lot of PSINet's activity in Brazil. Now Inter.net in Brazil, managed by Clovis Lacerda, can complete the integration and resume investments that were started before the fall of the Nasdaq. Meanwhile IFX, led in Brasil by John Weimer, is also working hard to improve operations despite limited capital.

An easier consolidation in the same field was concluded by Terra, which bought Zaz and dozens of smaller ISPs. Terra integrated them successfully and has become a market leader. Significantly, Terra had abundant capital with which to do this work.

There are other opportunities for consolidation in the Internet field today. One example is the development of wireless applications for the Internet. In Belo Horizonte, TakeNET has 20 programmers writing code to enhance the Internet services of cellular operators/wireless data operators (RingTones/Icons applications) and also corporations that need to stay in contact with a mobile work force (the business-to-employee or B2E segment). A few other companies - located in other regions of the country - combined with TakeNET would make a powerful entity, and an irresistible target for a larger firm to acquire.

Myth # 3:  You need to build the business on a Pan Latin-American scale.

Many private equity investors have insisted on establishing a pan-Latin American company, or at least a MercoSul enterprise. They have imposed this condition because they consider it necessary for attracting someone to buy the company. Many entrepreneurs have had the same vision: open up in Brazil, then expand to Buenos Aires and either Santiago or Mexico City.

This requirement is expensive, difficult, and unnecessary. Several firms - UOL, for example - have tried to cover the region, only to change their plans after learning the hard way. Other companies - StarMedia and AOL among them - are still trying, but they are facing a big challenge despite a lot of time and capital.

It turns out that Brazil is a rich enough market to support large companies, and that strategic and financial buyers will pay a high price for a company that is strong in this one country. In most cases, it is more sensible to focus right here and let someone else worry about expanding to other countries.

Myth # 4:   Brazil lags behind the U.S., and cannot produce successful Internet companies.

This view has led some investors to seek high returns in low-tech fields, and to shun the Internet. The concept is wrong, because there are businesses that require local service and are thus best performed by local companies. We have already seen many local Internet companies built and sold for an attractive price. And there are more to come soon.

Brazil today has a variety of home-grown technology companies, including first-mile service providers (Alta), hosting companies (ComDomínio), web-development firms (BHTec), systems integrators (Saga), some ASPs and web-enabled software developers (MXM), and even B2C sites (ikids, selling high-quality toys). These companies will eventually be acquired by larger players, and for a good price. The Brazilian entrepreneurs are in some cases only hours behind their foreign counterparts in terms of technology; they read the same newsletters, attend the same conferences, and buy from the same vendors.

Myth # 5:   Brazilian management must have a Harvard MBA to be reliable.

Many private equity investors looking at Brazil have chosen to invest with only those local entrepreneurs who have received a foreign MBA, or who have worked for a large foreign company for 10 years. They claim the institutional credentials are essential indicators of aptitude, commitment, and resourcefulness. As a result, they have refused many good ventures that later proved successful.

One of our former clients was founded and managed by three high-school graduates. Private equity investors were worried because the three did not have MBAs or a former career with IBM. But the record of the three founders was astounding. They created one of the largest ISPs in the third largest city in the world (São Paulo). They eventually sold their firm to a foreign strategic buyer who appreciated their accomplishment and thus the managerial talent of the three founders. The three have recently formed a new company called WebForce, an investment and consulting firm, and they are having a much easier time raising capital this go-round.

Fortunately, there are now many Brazilian entrepreneurs who have built valuable companies and sold them to large buyers, thereby gaining credibility for their next attempt at fundraising. Many of them serve to remind investors that historical performance on the job is more important than an institutional pedigree.

This is the playing field for the next phase of private equity investing in Brazil. This is not a projection of easier times, but an acknowledgement that considerable progress has been made in a short time in terms of defining what will and will not work. The Nasdaq may be down, but the opportunity for private equity in Brasil is still just taking off.