An Assessment of Dual-Class Shares in Brazil: Evidence from the Novo Mercado Reform

The issue of dual-class shares has been a hot one over the past few years. Dual-class shares have been a staple of several markets for years, but have gained increased attention recently because of the preponderance of tech firms in the United States that have gone public with dual-class structures. One high-profile example was the 2014 Alibaba IPO that took place in the United States after Hong Kong refused to change its rules to allow dual-class companies. Currently, Singapore and other markets are reviewing whether to allow dual-class listing structures.

There has been some research on the impact of dual-class listings on performance, mainly in the developed markets of the United States and Canada, which have a number of high profile dual-class companies. There is a dearth of similar research, however, in several markets with dual-class structures, some of which have only allowed dual-class ownership structures in recent years. CFA Institute decided to help further research on the issue of dual-class shares by taking a look at the issue of dual-class shares in Brazil. Future studies may also look at other markets that allow dual-class shares, but where the connection between dual-class structures and performance has not been vigorously analyzed.

History of Dual-Class Shares in Brazil

Historically, Brazilian companies have had a dual-class structure with common shares (voting) and preferred shares (nonvoting). To compensate for no voting rights, preferred shares pay (in theory) higher dividends or have “tag-along” rights (takeout rights on a sale of control). This enables holders of voting shares to control companies by owning less of the company’s total equity, which is a deviation from the proportionality principle (“one-share one-vote”). The high level of share ownership concentration in the hands of the government or founding families can be detrimental to shareholder value creation.

In 2000, BM&FBOVESPA stock exchange in Brazil launched the Novo Mercado — a voluntary listing segment with enhanced protections for shareholders. One of the key rules of the Novo Mercado listing is the requirement to issue only common shares (one-share one-vote). Intermediate listings levels (Nível 1 and Nível 2) offer between 80% and 100% tag-along rights to all shareholders (i.e., the same conditions provided to controlling shareholders in the transfer of the controlling block). A Novo Mercado listing entails further requirements in terms of transparency, monitoring, and share dispersion.

The core design of the Novo Mercado listing was to enact equitable treatment of all shareholders according to international best practices, which is the reason why we focus on it in our study. The Novo Mercado reform offers the opportunity to test the potential benefits of eliminating dual-class share structures.

Key Findings of the Study

1. A strong macroeconomic environment and the new Bovespa listing rules led to IPOs in 2004–2007 as well as a spike of secondary offerings (follow-ons) in 2009–2011, but that momentum has slowed in the last five years. By mid-2016, there were a total of 154 IPOs and 123 follow-ons with a total capital raised of R$374 billion and there were also migrations of companies to the premium governance segments. Novo Mercado (the one-share one-vote segment) now represents close to 40% of the number of listed firms and market capitalization. However, this has not stopped the net drop in the number of listed companies from 2000 to 2016.
2. There is still a high level of controlled companies in Brazil. As of 2016, dispersedly held firms represent only 10% of the total market cap (and 24% in the Novo Mercado segment). The largest blockholders are families, affiliated foundations, and top managers, which control 36% (examples include Bradesco and JBS, which we discuss in the report). The second most frequent case is government-controlled companies, which represent 19% of the total market cap (including such companies as Petrobras or Banco do Brasil). The remaining stock listings are other closely held company controlled by joint ventures or subsidiaries of multinational companies.
3. The stock index of Novo Mercado single-class firms (IGCNM) outperformed the market index IBovespa over the last decade. However, the performance of the Brazilian stock market was not stellar, producing only single-digit average annual returns.
4. The Novo Mercado firms with single-class shares produced better operational results in terms of accounting profitability (ROA) and have higher valuations (M/B ratios), while paying lower dividends. Estimates from multivariate regressions (that control for “tag-along rights” and other factors) indicate that Novo Mercado single-class firms exhibit a 6% higher ROA (accounting performance) and up to 0.45 higher M/B ratio (market valuation). Additionally, the regressions show that a Novo Mercado premium governance listing is incremental to just “renting” governance from a US cross-listing via an American Depositary Receipt (ADR). We conclude that a Novo Mercado listing helps ameliorate the potential conflicts between controlling versus minority shareholders. There is some evidence that a Novo Mercado single-class share listing is rewarded by investors with a higher M/B ratio, particularly in the cases of the presence of a controlling shareholder.
5. There is some (albeit weak) evidence that Novo Mercado single-class firms experienced less risk in the last decade, both in terms of lower total return volatility and less pronounced stock price drawdowns, such as in the recent “Petrolão – Operation Car Wash” market episode.

Overall, we found that the firms that moved to the Novo Mercado single-class structure experienced higher firm performance. However, there are continuing criticisms that these reforms did not eliminate the dominance of controlled companies even in single-class firms and have not reinvigorated the local equity markets.

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Photo Credit: ©Getty Images/Adolfo Santos Sonteria