20

PART

Global Financial Environment

MINI - CASE

C O R P O R AT E G O V E R N A N C E

AT

BRASIL TELECOM
Brasil Telecom
The Brazilian privatization process, meant to encourage diversity of ownership and a healthy competitive market, actually resulted in significant fragmentation. As a result of the Telebrs-ownership structure and the auction process whereby a single buyer could purchase controlling interest, but not necessarily the entire business, a major bidder could gain control at roughly half the cost. In the July 1998 sale, a consortium called Solpart purchased the Brazilian governments stake of Telebrs, gaining 51.8% control of the voting stock. Solpart was a consortium composed of Telecom Italia, a group of Brazilian pension funds who had partnered with CVC/Opportunity, and a telecom investment holding company owned outright by CVC/Opportunity. CVC/Opportunity was itself a partnership between Citibank Venture Capital (CVC) and the Brazilian investment banking firm, Opportunity. As a result, Brasil Telecom (BT) was controlled by two separate and powerful groups, Telecom Italia and CVC/Opportunity (Exhibit 1). These two groups were increasingly at odds as to the appropriate growth strategies for BT, primarily because of the overall strategies of the two owners themselves. Although it appeared on a constructive voting-rights basis that Opportunity held control, this was dependent on its ability to maintain an alliance with the Pension Funds. The Pension Funds were increasingly frustrated with Opportunitys leadership.

In the spring of 2001, the management of Brasil Telecom (BT) found itself in the middle of a bitter and disruptive competitionamong its own owners. The two largest investors in BT, Telecom Italia and CVC/Opportunity (an investment banking firm), had very different ideas about where the Brazilian telecommunication industry was going, and how they as individual entities would attempt to exploit it. At a time when BT needed access to global capital markets, the infighting between owners was creating an image of a company not in control of its own destiny. BTs share price, listed on the New York Stock Exchange, was less than half of its peak of early 2000. BTs management team was faced with real challenges, in the marketplace and in the firm.

Privatization of the Brazilian Telecom Market

On July 29, 1998, Telebrs, the Brazilian telecom giant, was sold by the Brazilian government in 12 pieces to the highest bidders for a total of R$22 billion (US$19 billion). The auction, which was carried live on Brazilian television, yielded nearly US$5 billion more than expected. The sale of Telebrs was the second largest telecom privatization in history, falling second only to the US$70 billion sale of Japans NTT in 1986. The sale broke Telebrs into 12 separate units over the three basic dimensions of telecommunications services: 1) one long-distance and international operator, Embratel; 2) three fixed-line phone service companies; and 3) eight A-band cellular companies for mobile cellular communications. The bidding for Embratel became so heated and active between Sprint and MCI that the process reverted from sealed written bids to open outcry bidding on the floor of the Rio de Janeiro stock exchange. Each bidder sequentially bested the competitor in $8.5 million increments until Sprint withdrew at $2.2 billion. Telebrs had a rather complex ownership structure, before and after privatization. The government of Brazil held 51.8% of the voting share rights to Telebrs, and sold this effective control through the auction. But most of Telebrs equity (80%) was in the form of preferred nonvoting shares. This meant that after privatization, roughly 49% of the voting shares and 80% of all shares would still be free float (traded publicly). This created a great deal of concern over what rights the minority shareholders would have in the post-privatization world. The government responded with additional restrictions and regulations requiring the new companies to hold votes of their entire shareholding body, voting and non-voting share owners, on any new service agreements.

EXHIBIT 1
The Ownership Structure of Brasil Telecom (BT)
Opportunity 100 % Telecom Italia 38% voting 38% preferred 38% Total Shares Timepart Participacoes 68 % Pension Funds 32 %

Techold Participacoes 51% voting 0% preferred 28% Total Shares 11% voting 62% preferred 34% Total Shares

Solpart Participacoes

51.8% voting shares 19.3% of total shares Brasil Telecom Participacoes

Holding Company

NYSE: BRP

93.6 % voting shares 74.7% of total outstanding shares Operating Subsidiary Brasil Telecom S.A. (Telepar) Sao Paolo: TEPR4.SA

Chapter 1: The Globalization Process

21

Growing Debate
BT had been very vocal throughout 2000 that it intended to meet government-mandated infrastructure targets early, probably by end of year 2001, so that it could expand services beyond its current coverage area to Regions I and III (Exhibit 2) and international long distance early. Externally, the company planned a media campaign to promote its brand in new areas beyond current coverage. Internally, it was putting together an incentive plan for employees that would effectively double annual bonuses if the company met targets by end of year 2001. Achieving the goalseither on-schedule or early required BT to install lines in low population/low density areas, a high-cost low-return activity. If BT postponed these investments, it could redeploy the capital toward investments with higher expected returns. The $3 to $4 billion investment could not be postponed indefinitely, but time was money. The downside risk was that it could lose two years in its ability to expand to other areas and other telecom services. By June 2001, BTs management was facing an industry in rapid consolidation and owners who could not agree on any avenue of action. Speculation turned from which directions in wireline and wireless to move, to how to resolve the conflict between owners. The debate focused on meeting targets early, and spending large sums of capital, versus staying on the previously accepted slower expansion schedule and allowing the market to continue

its own consolidations and shake-outs. The first path was one of choice; the second appeared to be one of default. Brasil Telecom recently confirmed market suspicions that there are differences of opinion among the companys main controllersTelecom Italia and Opportunityand the dispute has deepened over the last few months. This has generated uncertainty regarding the companys long-term operating strategy and whether it will be able to take part in the PCS [personal communication services] auction. We believe that the conflict that exists between BTs controllers is negative for the company and adds to the risk associated with the share prices in the short term. In our opinion, these differences of opinion will not be resolved in the near future, as we believe that Telecom Italia will (1) wait until the PCS auctions are over to decide on whether or not it sells or not its stake in BT, and (2) make it as difficult as possible for BT to take part in the auctions... As such, we are assuming a discount rate of 17% for BT, higher than the rate of 16% used for TNE [regional competitor]. Our target price of US$17.43 per ADR [American Depositary Receipt] indicates potential upside of 36%. However, we expect the performance of the stock to continue to be weak until conflicts between shareholders are solved. Brazilian Telecoms, Picking the Winners in Troubled Waters, Santander Central Hispano Analyst Report, January 2001.

EXHIBIT 2
The Three Brazilian Wireline Regions

Roraima Amapa Para Rio Grande do Norte Maranhao Ceara Paraiba Piaui Acre Rondonia Mato Grosso Tocantins Bahia Minas Gerais Espirito Santo Rio de Janeiro Pernambuco Alagoas Sergipe

Case Questions
1. What do you believe a government expects to gain from privatizing major sectors like telecommunications? 2. Why would two major investors like CVC/Opportunity and Telecom Italia create a partnership to gain control of a firm and then be unable to agree on the firms future strategy? 3. If you were in management at Brasil Telecom, how would the fighting between your owners alter your ability to do your job? What could you do to manage your owners? 4. If you were a minority investor in Brasil Telecom, holding some of the publicly-traded shares, what rights do you believe you should have in the ownership-control debate?

Amazonas

Wireline Regions Region I: North East Region II: Center South ~ Region III: Sao Paulo

Distrito Federal (Brasilia) Gois Mato Grosso do Sul

~ Paran Sao Paulo Santa Carina Rio Grande do Sul