* BTG Pactual shedding assets after founder's arrest
* Some investments may struggle as bank protects cash
* BTG Pactual is putting noncore assets up for sale
* Sete Brasil, Leader among troubling investments
By Tatiana Bautzer and Guillermo Parra-Bernal
SAO PAULO, Dec 10 (Reuters) - When Grupo BTG Pactual SA took control of apparel and home furnishing retailer Leader Participações SA about three years ago, it looked like a classic turnaround play: a threadbare chain that could be revamped to serve Brazil's burgeoning middle class.
That wager backfired when Leader's once free-spending clientele slammed their wallets shut as the South American country slid into its worst recession in 25 years. A troubled merger with rival Seller then helped sour a tense relationship with Leader's founding Gouvêa family.
The investment, one of the two dozen purchases that BTG Pactual founder André Esteves made with proprietary and client money during a half-decade of frenzied deal making, is now under threat following his alleged involvement in a corruption scandal. Esteves was arrested Nov. 25 on obstruction of justice charges related to a graft investigation surrounding state-controlled oil producer Petroleo Brasileiro SA.
BTG Pactual, which Esteves built into Latin America's No. 1 independent investment bank this decade, is quickly exiting assets and tapping emergency funding from Brazil's deposit guarantee fund as investors, fearful it will be dragged into the sweeping probe, run scared.
The bank's woes mean that investments such as Leader, which employs 6,000 people, or Brasil Pharma SA, a debt-laden drugstore chain, will struggle to lure fresh capital. Drilling rig supplier Sete Brasil Participações SA, which Esteves himself described as his "biggest fiasco ever," risks collapsing with $4 billion in debt before delivering its first ship.
BTG Pactual, Sete Brasil, BR Pharma and Leader declined to comment.
A one-time systems analyst, Esteves rose to international fame in 2006, when, at the age of 38, he became Brazil's youngest billionaire after selling BTG Pactual's predecessor to UBS AG.
Over the past six years, he committed around $10 billion from the bank's and clients' money to land, company stakes, property and infrastructure projects. In ramping up exposure to Latin America's largest economy, Esteves pursued a philosophy of sharing risk with clients at a time of widespread confidence that Brazil was finally coming of age.
Now that strategy, encapsulated in his definition of BTG Pactual as "an investment bank that invests," is being turned on its head as the bank becomes a forced seller as Brazil's commodities-fueled economy hits the skids.
"The mood was different back then and BTG Pactual and many rivals took bets on an ever-growing Brazil," said Claudio Furtado, a finance professor at Fundação Getulio Vargas in São Paulo. "Even Esteves, a brilliant banker, couldn't have foreseen everything going bad at once."
Brazil's economy shrank 4.5 percent on an annual basis in the third quarter, the steepest plunge in almost two decades. Urban unemployment is running at a six-year high. Industrial output and retail sales have fallen for more than a year.
As Brazil's fortunes declined, the prospects of some of BTG Pactual's investments soured. Now the bank's efforts to exit those investments could further cloud Brazil's economic outlook.
One senior government official, who asked for anonymity, said BTG Pactual's downsizing, while not numerically significant for the $1.5 trillion economy, risks hurting confidence at a delicate time. Many investors agree.
"This aggravates a situation that was already tough," said Jankiel Santos, chief economist at Haitong Securities do Brasil.
While BTG Pactual will take longer to offload some of the bank's problematic investments, potential bidders are circling its most prized assets, including debt collection firm Recovery do Brasil SA, parking lot operator Estapar Participações SA, and card payment processor Stone Pagamentos SA, sources said.
BTG Pactual is even looking to unwind what had seemed the safest of bets, the $1.3 billion acquisition of Swiss private bank BSI Ltd earlier this year, although at a steep 20 percent discount to what it paid for the Lugano, Switzerland-based bank just months ago.
Since Esteves' arrest, BTG Pactual has raised about 15 billion reais to shore up cash and stem client withdrawals and restricted access to funding.
The most notable was the sale of a 12 percent stake in hospital chain Rede D'Or São Luiz SA to Singapore's GIC Pte Ltd, which will bring in about 2.4 billion reais. Rede D'Or returned almost 11 times the amount originally invested - by far, BTG Pactual's most profitable investment ever.
On Thursday, BTG Pactual expects to raise at least 444 million reais by partially exiting commercial real estate company BR Properties SA, the sources added.
Last week, the bank said in a securities filing that several companies have expressed interest in BR Properties, Recovery and gym chain BodyTech as well as in co-investments like Leader.
Sources close to the situation said the Gouvêa family wants to take control of Leader back from BTG Pactual and clients, although at a large discount to the 1 billion reais they paid for their 70 percent stake. The family declined to comment.
A standoff between the Gouvêas and the bank had worsened even before Esteves' arrest, as the family accused the BTG Pactual-backed management at Leader of adopting a failed strategy and firing key staff. The Gouvêas have blocked capital injection plans, despite accelerating losses due to the failure to revamp the company, one of the sources said.
With 1 billion reais in debt and almost no operating earnings, Leader needs 800 million reais to return to profitability, another source said.
A much-needed capital injection into BR Pharma, as Brazil's third-largest pharmacy chain is known, also looks less likely now, another source said. Shares of BR Pharma have plunged the most among BTG Pactual-backed companies as investors questioned the feasibility of a capital plan - half of it to be subscribed by BTG Pactual and partners - chiefly aimed at cutting debt.
Of all BTG Pactual's investments, the most painful is Sete Brasil.
Hailed by President Dilma Rousseff as the cornerstone of her industrial policies, Sete Brasil was Esteves' boldest deal - a green field project to supply as many as 28 rigs for Petrobras once valued at $80 billion.
Sete Brasil's collapse would be devastating not only for banks and pension funds that backed the project, but for dozens of shipbuilders and manufacturers supplying the company. More than 800,000 jobs could be destroyed, said a source involved in the company's turnaround plan.
Executives at Petrobras oppose terms of the Sete Brasil contract, and have remained at loggerheads with BTG Pactual and lenders over the issue for months. Sete Brasil, however, cannot wait any longer.
Both Petrobras and state development bank BNDES abandoned the project as the corruption probe swelled, leaving Sete Brasil moribund. BNDES reneged on prior commitments to refinance $3.8 billion in debt, forcing BTG Pactual to write off the value of the investment, a source added. Petrobras declined to comment.
While conceding that Sete Brasil had flaws, Esteves told Reuters in April that, in proprietary investments, "you win and you lose all the time. We've done well many times, but we did stupid things too." ($1 = 3.7819 Brazilian reais)
Additional reporting by Luciana Bruno, Flavia Bohone and Patrícia Duarte in São Paulo; Editing by Carmel Crimmins and Matthew Lewis