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* Agrees to sell Pactual to BTG Investments to reduce risk
* To sell Pactual for $2.5 bln, same price it paid in 2006
* Sale raises UBS Tier 1 capital by 1.3 bln Sfr
* Shares slump 4.5 percent (Adds foreign banks in Brazil, details on BTG and Esteves)
By Katie Reid
ZURICH, April 20 (Reuters) - UBS AG UBSN.VX(UBS.N) agreed to sell its Brazilian business back to its original owners for about $2.5 billion, boosting its capital despite a small loss, and potentially reducing the need for a capital hike.
UBS, one of the European banks hit hardest by the credit crisis, said the sale was part of a strategy to reduce its risk profile and strengthen its balance sheet.
The deal for Banco Pactual is the biggest sign yet of foreign banks pulling out of Latin America's largest economy because of problems they are facing at home. It also marks the return of Andre Esteves, a 41-year-old banking wunderkind who sold Pactual to UBS for $2.5 billion three years ago, to the forefront of Brazil's financial world.
Activist investor and former UBS chief executive Luqman Arnold called last year for UBS to sell the highly profitable Brazilian investment bank as part of a series of demands centered on refocusing the bank on wealth management.
The Swiss bank is struggling to return to profitability and rebuild its brand after massive investments in risky U.S. assets forced it to write down billions and accept government backing.
Arnold, who said last month he was still trying to recover his 2.8 percent stake in UBS from the administrators of collapsed bank Lehman Brothers, has also called for the sale of UBS's Australasian business and its huge asset management unit.
"The transaction highlights the downsizing and re-alignment activity UBS is firmly showing," said Kepler Capital Markets analyst Mathias Bueeler. "There may be more transactions like this to follow."
UBS said the sale, which it hopes to close in mid-2009, will result in a small loss. The bank will give more details when it reports first-quarter results on May 5.
UBS shares were down 4.5 percent at 13.35 Swiss francs at 14:56 GMT, compared with a 5.9 percent slump in DJ Stoxx European banking index .SX7P.
Last week, the bank said it would post a first-quarter loss of nearly 2 billion Swiss francs ($1.73 billion), mainly due to writedowns and outflows at its prized wealth management unit and announced plans to cut another 11 percent of its staff.
Esteves, a former global head of fixed income, currencies and commodities for UBS, founded BTG after stepping down as chairman and CEO of UBS' Latin America unit in June 2008.
The new bank, to be called BTG Pactual, plans to expand its business beyond Brazil once the takeover is approved by the central bank, Esteves said in a statement.
"BTG is celebrating the reunion with its former partners, who have been managing Banco UBS Pactual, in the certainty of consolidating and expanding the global operations of the new BTG Pactual group," he said.
BTG, with more than 100 employees in Sao Paulo, Rio de Janeiro, New York, London and Hong Kong, has about $1.5 billion in assets under management. The firm said UBS Pactual had 14 billion reais ($6.25 billion) in assets and manages about 57 billion reais for clients.
New UBS Chief Executive Oswald Gruebel, the former Credit Suisse CSGN.VX boss UBS brought out of retirement in February to try to end the bank's woes, said last week he would take steps to protect and strengthen UBS' capital base.
UBS said on Monday the sale of Pactual will strengthen its Tier 1 ratio, a measure of financial strength, by approximately 60 basis points. The bank's Tier 1 ratio fell to 10 percent at the end of March, from 11 percent at the end of 2008.
UBS said the deal would increase its Tier 1 capital by 1.3 billion Swiss francs, decrease risk weighted assets by 3 billion francs, and reduce total assets by 6.3 billion francs.
Vontobel analyst Teresa Nielsen said the sale would release a large amount of goodwill which was the reason for the big fall in risk weighted assets and the Tier 1 capital increase.
"Hence, we believe it ensures there will be no need for a capital increase," she said.
The founding partners of BTG, headed by Esteves, built up Pactual into one of the most successful Brazilian investment banks before selling out to UBS in 2006.
There had been speculation in the last year that Esteves, made one of the wealthiest people in Brazil by the Pactual sale, might want to buy back the bank, Brazil's seventh largest asset manager and one of the leading underwriters of stock issues in Latin America's largest economy. ($1=1.155 Swiss Franc / $1=2.239 reais) (Additional reporting by Elzio Barreto in Sao Paulo, editing by Dave Zimmerman) (Reporting by Katie Reid, writing by Emma Thomasson, editing by Jon Loades-Carter)