Acquisition operations, distressed assets and the protection of foreign capital: distressed M&A in Brazil

Brazil is undergoing a continuous period of financial instability. High interest rates, however, justified, have proved themselves to be a financial strain too burdensome to bear for a relevant number of enterprises. This has prompted a new wave of bankruptcies (Chapters 7 and 11), rising exponentially compared to 2022 (respectively, 44,1% and 37,6%).

The financial distress the companies experienced has demonstrated as an interesting investment opportunity: assets are usually liquidated at discount rates, achieving very competitive prices.

For a long time, hedge funds have been top investors in troubled companies, believing in a favorable balance of high yields and high risks.

In the past, this was not seen as an opportunity. The risks were too high, interfering with the usual balance. Unaware of the praxis of acquisitions, Brazilian Courts proceeded to erode aspects of legal certainty related to those types of operations, attracting an illegal understating of succession on the operations: the buyer was often held accountable for the debts of the acquired target.

The Legislative, however, underwent a mission to rationalize and optimize the economic value of the restructuring and bankruptcy procedures. It seems logical that distressed assets would retain more market value if the position of the Courts was revoked. This would, in turn, more efficiently serve the interests of both creditors and distressed companies. And this modernizing movement for the Brazilian Law of Bankruptcy and Judicial Recovery (Court mandated restructuring) finally came to pass.

Approved in March 2021, Law 14.112, also known as the “New Law of Bankruptcy and Judicial Recovery” promoted a revolution on the evaluation of Distressed M&A in Brazil, prompting two important revolutions: DIP Financing and UPI.

DIP Financing is the acronym for the debtor in possession. DIP-F states two types of operations: loan-oriented and loan-to-own, a common practice abroad and very in sync with the practices of more structured investment funds. The first is a traditional loan that will allow for a legally guaranteed preference on payment, typically allowing for higher yields, considering the risk of the venture (this, however, proves itself a valuable option in Brazil, given that its financial markets are still concentrated). The loan-to-own variation is less than known in Brazil but should become a staple of niche financial services, enabling trigger clauses that allow the replacement of debt with equity and, in some cases, prompting even a takeover.

The UPI stands for Isolated Productive Unit (Unidade Produtiva Isolada). By a combination of legislative reforms, the UPI enables the sale of a whole body of assets, protecting the buyer against accountability for any labor, tax, and general debt obligations held against the previous owner. In summary, the UPI allows the dismemberment of part of the production chain (or the entire production chain) by selling it to a third party, which will continue the business activity in its name. The general economic interest is protected with the continuity of the activity and the buyer is protected not being held accountable for the past.

Both reforms, either with DIP-F or with the UPI, ushered in a new and safer environment for investors in Brazil, allowing for practices that are usual in the US and Europe. This shall prove most valuable to foreign investors, given that the appetite of the Brazilian financial sector has not been overwhelmingly swayed by the reform – a consequence more of tight financial regulation than of the economic scenario –, allowing early access in a profitable but less competitive market.