Funding Infrastructure Through Capital Markets: Brazilian Infrastructure Mutual Funds

Maurcio Jayme e Silva*

I Introduction

One landing today in the United States with any knowledge about its current political and electoral momentum could genuinely conclude that, when it comes to the role played by the US government in the national economic development, two distinct theories clash with each other and fought for every single vote in the last elections: On one side, a theory advocating for a more active government in the economy, meaning a scenario where the government would make its presence and regulations be felt in the economy. On the other side, a theory supporting a liberal state, where the government should not interfere in private businesses, leaving the economy to be majorly regulated by its players.

This clash is everything but novel or limited to the American context. In fact, since the Stock Market Crash of 1929, political forces, supported by economist aligned with John Maynard Keynes for a more active and present government or with Friedrich Hayek for a minimal and liberal State, have been taking the political stage throughout the world to apply economic policies consistent to the University of Cambridge or to the London School of Economics doctrines, respectively.1

By the time this article is published, there are no empirical evidences to support the prevalence of any of these economic doctrines, and this author personally believes this time will never come. Despite this everlasting debate, countries around the globe especially the developing ones have been managing the challenge of financing their development with or without private investments.

But when it comes to infrastructure development, developed and developing countries face an even more challenging toll, charged by the gargantuan amount of investments required to fund economic infrastructure such as transport logistics, energy generation and distribution, oil and natural gas exploitation, and telecommunication infrastructures; leaving alone social infrastructure such as hospitals, public sewage systems, child day-care centers, schools, shelters and nursing homes. Recent studies from

For more information about the clash between John Maynard Keynes and Friedrich Hayek, see Wapshott, Nicholas. Keynes Hayek: The Clash that Defined Modern Economics. W.W Norton & Company. 1st ed.

OECD estimated global infrastructure requirements to 2030 to be in the order of US$ 50 trillion.2

In Brazil, most economic infrastructure-related services were provided exclusively by the government through public-held companies until early 1990, when former President Fernando Henrique Cardoso skillfully managed the Brazilian political vicissitudes to amend the Brazilian Constitution in order to authorize private investments in the oil & gas, telecommunications and energy industries.

However, the Brazilian reality has demonstrated that merely allowing private investments in infrastructure is not sufficient to even narrow the historical infrastructure gap, not to mention for catching up with the actual demand for infrastructure goods and services. Studies from the Brazilian think tank Institute for Applied Economic Research pinpoint that Brazil is investing an average 2% of its GDP in infrastructure whereas Chile is investing 6%; Colombia, 5.8%; India, 5.63%; China, 7.3%; Vietnam, 9.9%; Thailand, 15.4%; and Philippines, 3.6%.3

In light of this, the Brazilian government is coming up with creative incentives to further foster private infrastructure investments such as tax benefits and exemptions, subsidized loans, and eased access to the Brazilian National Development Bank (BNDES) as guarantor to private loans. One of the most recent targets of the Brazilian government initiatives to finance infrastructure projects is the Brazilian capital market through tax benefits and exemptions to infrastructure bonds and private equity funds.

By changing the bond and private equity funds regulations, the Brazilian government is clearly aiming the trillions of dollars in assets from the largest domestic and international pension funds to help it funding the development of its economic infrastructure. According to OECD Global Pension Statistics4, private pension funds in OECD countries hold US$28 trillion in assets, looking forward to being invested in longterm projects in stable, predictable and well-established markets.

Unfortunately, these characteristics of the target markets for OECD countries pension funds investments are the very exact reason for their focus being on brownfield infrastructure projects in mature, developed markets. The very rare exemptions lie on few
2

Croce, R.D. (2011), Pension Funds Investment in Infrastructure: Policy Actions, OECD Working Papers on Finance, Insurance and Private Pension, No. 13, OECD Publishing. http://dx.doi.org/10.1787/5kg272f9bnmx-en. 3 Frischtak, C.R. (2009). O Investimento em Infra-Estrutura no Brasil: Historico Recente e Perspectivas. Available in Portuguese at http://ppe.ipea.gov.br/index.php/ppe/article/viewFile/1129/1033. Access in 10/24/2012. 4 Available at http://www.oecd.org/finance/private-pensions/globalpensionstatistics.htm

investments from Canadian and Australian pension funds in Latin American infrastructure projects, especially in Chile, Peru, Mexico and Brazil5.

However, as emerging countries are working within their own borders to make their institutional, economic and regulatory frameworks more stable, predictable, reliable and enforceable; the worlds largest pension funds will consequently respond to such favorable scenario, driving their investments towards much needed long-term infrastructure projects.

In this vein, the purpose of this article is to bring a brief introduction to two Brazilian investment vehicles - Infrastructure Bond Fund, and Infrastructure Private Equity Fund - which regulations were recently amended in order to become more financially attractive to private investments by offering tax exemptions or benefits to their investors.

II Infrastructure Bond Fund (IBF) and Infrastructure Private Equity Fund (IPEF)

The Brazilian Law No. 12,431/11 amended corporate income tax regulations to grant tax reliefs to several security transactions within the Brazilian stock market. Two of them are particularly interesting to this article as relating specifically to infrastructure financing: (i) the amendment set forth in its Section 3 related to IBF; and (ii) the amendment set forth in Section 4 related to IPEF.

Notwithstanding, it is noteworthy that Section 2 also intends to fund infrastructure projects to the extent that it reduces to zero and 15% the tax rates payable, respectively, by resident individuals and entities on income arising from long-term bonds which weighted average term is above four years and that comply with certain requirements, provided that such bonds have been issued by Special Purpose Entities (SPE) seeking to finance infrastructure projects.

However, this article focuses on IBFs and IPEFs as they resemble the US mutual funds regulated by The Investment Company Act of 1940, and for that reason the author considers them as being more appealing to this Report.

Stewart, F. and J. Yermo (2012), Infrastructure Investment in New Markets: Challenges and Opportunities for Pension Funds, OECD Working Papers on Finance, Insurance and Private Pensions, No. 26, OECD Publishing. http://dx.doi.org/10.1787/5k8xff424vln-en

II.1 Infrastructure Bond Fund (IBF)

IBFs are a type of mutual fund, open or closed-end, regulated by Rule No. 409/04 issued by the Brazilian Comisso de Valores Mobilirios (CVM, equivalent to the US Securities and Exchange Commission). IBFs are only qualified as such when in compliance with Law 12,431/11, Section 3.

Under CVM Rule No. 409/04, IBFs shall comply with certain general regulations applicable to most Brazilian mutual funds, except those listed in CVM Rule No 409/11, Section 1, such as: (i) prior registration with CVM; (ii) professionally managed by highly skilled security experts registered with CVM; (iii) by-laws and prospectus duly filed with CVM that describe for example the funds investment objectives, criteria and approach, target companies, permitted investments, net asset value (NAV), evaluation criteria, management and custody fees; (iv) full disclosure of accounting information; and others.

But for the sake of this article, the importance of mutual funds regulated by CVM Rule No. 409/11 lays exclusively when qualified as IBF to the extent that it is only under such qualification that these mutual funds are allowed to offer tax benefits to private capital market investors willing to invest in Brazilian infrastructure projects.

In this sense, Law No. 12,431/11, Section 3, sets forth that mutual funds investing at least 85% of their NAV in bonds described in its Section 2 (as mentioned above: longterm bonds with weighted average term above four years, issued by Special Purpose Entities (SPE) seeking to finance infrastructure projects); and funds of mutual funds, investing at least 95% of their NAV in such mutual funds; shall be able to offer tax-free incomes to their individual investors and to non-resident investors not located in tax havens; and a reduced 15% rate income tax to their resident legal entities.

A recent amendment to Law No. 12,431/11 (Law No. 12,715, from 09/17/2012) now drops the investment percentage to 67% of IBFs NAV in the first two years after closing the initial public offering of its shares.

Lastly, both IBFs and funds of IBFs shall have 180 days after their incorporation to comply with the requirements listed above in order to be able to offer this tax special treatment to their investors; and 90 days to correct any non compliance.

II.2 - Infrastructure Private Equity Fund (IPEF)

IPEFs are a type of closed-end mutual fund regulated by Law No. 11,478/07, and by CVM Rule No. 391/03 and CVM Rule No. 460/07, as amended by CVM Rule No. 501/11. IPEFs shall target listed and unlisted companies that carry out greenfield infrastructure projects in energy, public transportation, sanitation, irrigation and other high priority sectors as classified by the Brazilian government, aiming to participate in their decision making processes.

In case of investing in unlisted companies, IPEF shall target those complying with corporate governance standards set forth in CVM Rule No. 391/03, Section 2, 4 at least, namely prohibition to issue or trade beneficiary shares; one year term for members of the Board of Directors; disclosure of contracts, shareholders agreements, stock or any security acquisition option program; submission to arbitration to settle corporate conflicts; and annual audit by independent auditors registered with CVM.

Regarding the greenfield aspect of the infrastructure projects, CVM Rule No. 460/07, Section 4, 1, 2, consider as greenfield infrastructure those projects which have been carried out since January 22, 2007; or expansions of brownfield infrastructure projects that are already implemented or in the process of being implemented, as long as the expansion investments and respective outcomes are segregated by incorporating a SPE.

With respect to the participation in the decision making process of target companies, Law No. 11,478/11, Section 1, 8; along with CVM Rule No. 391/03, Section 2, set forth that IPEFs shall influence it by joining the shareholder controlling block; entering into a shareholder agreement with the shareholder controlling block; or entering into any sort of private agreement to effectively ensure IPEFs participation in the decision making process of strategic planning and administration of the target company.

Like IBFs, IPEFs regulations require a minimum percentage of their NAVs to be invested in target companies in order to grant tax benefits to IPEFs investors. In this case, Law No. 11,478/07, Section 1, 4; and CVM Rule No. 460/07, Section 4, sets forth that IBFs shall invest at least 90% of NAV in securities from their target companies.

In addition, Law No. 11,478/07, Section 1, 6; and CVM Rule No. 460/07, Section 6, determine that each IPEF shall have at least five investors being none holding more than 40% of its shares or profiting more than 40% of the IPEFs total income.

Lastly, IPEFs shall have 180 days after their incorporation to comply with the requirements listed above in order to be able to offer this tax treatment to their investors, pursuant to Law No. 11,478/07, Section 1, 10, and CVM Rule No. 460/07, Section 4, 3.

Currently there are ten IPEFs operating and trading in the Brazilian stock market. An empirical analysis on the IPEFs by-laws available at CVM website demonstrates that (i) all of these mutual funds were created at least two years ago (with the exception of one operating since 2009); (ii) their maturities are ten or fifteen years, being one with an 8-year maturity; (iii) their minimal investment range from BRL 100K to 10M; and (iii) their cap NAV range from BRL 15M to BRL 10B.

III Conclusion

Arguing about the role of the government in an economy carries inherently individual, ideological and political perceptions of ourselves, of the government and of our fellow citizens; rather than an individual understanding of the economic and financial impacts of the needs of the people or the demands of corporations.

When we speak of infrastructure, it is undeniable that neither the state or the private initiative has sufficient available resources to stand alone and face the challenge of matching the investments needed to close the infrastructure gap and to build it up for the next generations. This is especially true after the 2008 financial crises the worst since the 1929 Stock Market Crash that originated the clash between Keynes and Hayek mentioned in the first lines of this article.

The good news is that if both sides are able to put this ideological veil aside, they would see what some countries are already seeing throughout the globe. First, this is not an all-or-nothing issue, meaning that the government or the corporations should be exclusively in charge of developing and carrying out infrastructure projects. There is a third way, a joint way of investing in infrastructure. Just to mention a not-too-far example, Chile has done so in 1998, when Chilean regulators allowed investments in unlisted infrastructure projects, via project bonds. These bonds were fully-guaranteed by international insurance companies, which has peaked their credit rating to AAA and consequently has turned them investible by international pension funds.

Second, and indeed very important: both government and corporations could benefit and profit from joining forces for infrastructure development. The government would be beneficed by its indirect outcomes. The World Bank, through its Sustainable

Infrastructure Action Plan and updates, has thoroughly demonstrated that investing in infrastructure is crucial for sustainably delivering growth, reducing poverty and creating jobs. On the flip side, corporations would profit directly by entering into concession contracts with the government under a BOOT or other sort of engineering contract arrangement; or indirectly, by being beneficed by the fact that better infrastructure drops down logistics and intakes costs and consequently makes their products more competitive locally and globally.

This article intended to demonstrate how Brazil is trying to finance the development of its own infrastructure. Pushed by the hosting of two major sports events 2014 FIFA Soccer World Cup in Brazil, and 2016 Olympic and Paralympic Games in Rio de Janeiro - the Brazilian government is rushing to come up with creative solutions to attract private investments in infrastructure. Granting tax reliefs to capital market investors is only the capital market facet of numerous possibilities for government and private corporations to work together towards better infrastructure.

For all that is being happening throughout the world, especially after the 2008 Financial Crisis and Basel III Convention that have restrained credit growth and impacted infrastructure projects adversely, sometimes what is needed is just to lift the ideological veil, roll up our sleeves and work. Together.

*Maurcio Jayme e Silva is a foreign attorney licensed to practice in Brazil. Mauricios expertise is focused on infrastructure and project finance transactions, with vast expertise in advising private and public sector clients in connection with M&A, joint ventures, private equity investments, and project financing and leveraged finance transactions. Mr. Silva has substantial experience in the oil & gas, construction & infrastructure, and energy Brazilian regulations.