Mexico: Different Investment Lens Required

Volume 4.4 • May 2014 Mexico: Different Investment Lens Required

By Henry H. McVey, Head of Global Macro & Asset Allocation And Vance Serchuk, Executive Director of the KKR Global Institute Mexico: Different Investment Lens Required Given both the breadth and depth of a new reform agenda, we think Mexico is approaching an inflection point that offers the opportunity to invest in both the equity and debt of companies that can finally take advantage of a more level playing field as the prior regime of monopolistic pricing in several key industries KKR Global Macro & Asset Allocation Team is disrupted. Importantly, investing in Mexico requires that an investor look through a different emerging Henry H. McVey Head of Global Macro & market lens. Specifically, Mexico is not a pure-play Asset Allocation urbanization story nor is it a low GDP-per-capita story +1 (212) 519.1628 [email protected] that has the potential to double overnight. Also, unlike many of the Asian countries that we visit, Mexico’s David R. McNellis +1 (212) 519.1629 fortunes may actually be non-correlated, or potentially [email protected] even inversely linked to China’s success. Rather, with Frances B. Lim 87% of its exports destined for the United States +1 (212) 519.1630 [email protected] and the government committed to expanding trade agreements with both Asia-Pacific and Latin American Rebecca J. Ramsey +1 (212) 519.1631 peers, Mexico is much more of an open economy [email protected] investment story than many of the other emerging Jaime Villa markets countries many investors know. +1 (212) 401.0379 [email protected]

Special thanks to Vance Serchuk, Executive Director of the KKR Global Institute, who co-authored this report and provides valuable geopolitical advice to the KKR Global Macro & Asset Allocation Team on an ongoing basis. “ Always bear in mind that your Main Office own resolution to succeed is more Kohlberg Kravis Roberts & Co. L.P. important than any other. 9 West 57th Street Suite 4200 ” New York, New York 10019 Abraham Lincoln + 1 (212) 750-8300 16th President of the United States COMPANY Locations Americas New York, San Francisco, Washington, D.C., Menlo Park, Houston, Louisville, São Paulo, Calgary Europe London, Paris, Dublin, Madrid Asia Hong Kong, Beijing, Singapore, Dubai, Riyadh, Tokyo, Mumbai, Seoul Australia Sydney

© 2014 Kohlberg Kravis Roberts & Co. L.P. A2ll Rights RKKReserved. Insights: Global Macro Trends As someone who has been married to a Houston, Texas native for it – Mexico cannot achieve the efficiencies in other areas of almost 14 years, it should come as no surprise to folks that I have its economy, including manufacturing, exports, logistics, and spent a considerable amount of time enjoying the many compelling electricity that it so desperately needs. cultural aspects of Mexico. In fact, I spent my honeymoon in Cabo San Lucas on the west coast of the country in 2000, and in recent • To date, though, Mexico remains a “show me” story. For start- years my family, often using Houston as a jumping-off point, has ers, Mexico’s productivity growth has been running, on aver- explored various destinations throughout Mexico. age, at only half that of Brazil, 1/8 of India, and 1/16 of China since 19906. More recently, GDP growth has been lackluster, However, over the past few months my trips to Mexico have been consumer confidence is down, and unemployment is rising more frequent—but less family-oriented. Specifically, with President again. Our bottom line: The current administration should deliver Enrique Peña Nieto’s “resolution to succeed” in delivering broad- not only on its long-term reform agenda to improve productivity based reforms across energy, financial services and telecommuni- but also on its tactical mandates, including infrastructure spending cations gaining momentum, my colleague Vance Serchuk, the Execu- and public works, to boost growth during this transition period. tive Director of the KKR Global Institute, and I have visited Mexico several times to try to better understand what we now believe is an • As the reform agenda gains momentum, we believe strongly inflection point in the country’s political and economic history. that asset allocators would benefit more from owning small- and mid-cap Mexican equities versus higher profile large- Importantly, beyond the robust contacts we now enjoy through the capitalization stocks. Already, since July 2012, which coincides KKR Global Institute on the geopolitical and macro side, KKR also with the election of Peña Nieto, the Mexico IMC 30 Index, Mex- has a notable footprint In Mexico though its private equity effort ico’s mid-cap index, has outperformed the large-capitalization as well as its 10 portfolio companies, which employ nearly 12,000 index (Mexican Bolsa IPC Index) and the MSCI Mexico by 46% people across Mexico. and 44%, respectively7. Separately, we also think that private credit and non-bank financing represent notable opportunities, So what are our big-picture thoughts on Mexico and how should particularly given 80%+ concentration of the banking sector investors position their portfolios? See below for details: by just seven or eight financial institutions that cater largely to mega-cap and multinational corporations8. • Simply stated, Mexico requires a different investment playbook than that of many of its emerging market peers. Already, • Though we are positive, the Mexico story still has several key consumption is a robust 69% of GDP1, GDP-per-capita is high geopolitical and macro risks. In particular, weakness in rule at around $11,0002, and urbanization stands at almost 80%3. of law institutions—and the associated problems of criminal- Mexico is also an extremely open, services-based economy, ity, violence and corruption—still acts as a significant drag on with major bilateral trade agreements with more than 40 coun- GDP. All told, Grupo de Economistas y Asociados estimates that tries. Finally, with 87% of its exports going to the U.S. and the annual GDP would be 600 basis points higher if money spent by country poised to benefit from growing access to cheap U.S. the government on national security went to households to boost natural gas, Mexico is more closely linked to North American private consumption9. Finally, while the reform agenda of Presi- growth – not China’s GDP trajectory4. dent Peña Nieto is well defined and credible, Mexican history is littered with reform stories that stumbled in implementation. • With small current account and fiscal deficits, Mexico has been a good emerging markets (EM) investment story since Our bottom line: Given both the breadth and depth of the current the Great Recession. However, as we describe below in more reform agenda, we think Mexico is approaching an inflection point detail, we think Mexico has the potential to be a great one if it that offers the opportunity to invest in both the equity and debt of executes on the structural reform agenda put forth by Presi- companies that can finally take advantage of a more level play- dent Peña Nieto. All told, potential GDP growth could increase ing field as the prior regime of monopolistic pricing in several key to approximately 4.5% from 2.8%, we believe. industries is disrupted. If we are right, then Mexico’s equity market capitalization as a percentage of GDP could increase notably from • Contrary to press reports of late, Mexico is not just a pure-play its current level of just 40% of GDP (Exhibit 1). From a sector energy reform story. To be sure, energy reform is an important perspective, we are bullish on real estate, financial services, energy piece of the macro puzzle (e.g., current receipts from PEMEX services, infrastructure, healthcare, and logistics. account for fully one-third of tax revenues5), but a comprehensive overhaul of the sector is crucial because – without

6 data as at January 31, 2013. Source: OECD. 1 data as at February 21, 2014. Source: Instituto Nacional de Estadística Geografía e Informática, Haver Analytics. 7 data as at April 30, 2014. Source: Bloomberg. 2 data as at April 13, 2014. Source: World Bank, IMF, Haver Analytics. 8 data as at December 31, 2013. Source: J.P. Morgan estimates, Central Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras 3 Ibid.1. (Chile),Superintendencia Financiera de Colombia, Comision Nacional 4 data as at December 31, 2013. Source: Instituto Nacional de Estadística Bancaria y de Valores (Mexico), and Superintendencia de Banca, Seguros, Y Geografía e Informática, Haver Analytics. AFP (Peru). 5 http://www.ri.pemex.com/files/content/Pemex_Outlook_I_120906%20 9 data as at April 11, 2014. Source: Global Source Partners, “Mexico: Outlook %28New%20Investors%29_ri.pdf and Challenges Ahead.”

KKR Insights: Global Macro Trends 3 Exhibit 1 Exhibit 3 The Potential for Better Equity Representation Relative to We Expect Mid-Capitalization To Narrow the Gap With GDP in Mexico Is Now Significant Their Larger Peers…

130% Stock Market Capitalization as a % GDP Average Company Market Cap 8,000 110% 96% 7,000 $6,684

68% 6,000 58% $5,013 48% 5,000 45% 41% 40% 32% 31% 4,000

3,000

o $1,980 e y ea sia azil 2,000 xi c o r frica India Chile u s ur k China B r A R T M e

Colombia 1,000 Indonesia South K South 0 Data as at April 18, 2014. Source: Bloomberg. IMC30 MEXBOL MSCI Mexico Data as at April 30, 2014. Source: Bloomberg, MSCI, Factset.

Exhibit 2 Mexican Mid-Cap Stocks Have Outperformed Large-Cap Exhibit 4 Stocks by a Wide Margin Since the Election of Peña Nieto ..Driven By Valuation Convergence and Stronger Growth in July 2012 of Mid-Cap Stocks Relative Performance of Mexican Mid-Cap vs. Large-Cap Stocks NTM P/E By Sector Indexed: July 2012 = 100 IMC30 MSCI Mexico MEXBOL 30 IMC30 MEXBOL MSCI Mexico 25 150 20 140 15 130 10 120 5 110 -

100 etionar y 90 Staples r Materials Financials Industrials Consume r Health Ca r Disc r 80 omunications Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 ele c Consume Data as at April 30, 2014. Source: Bloomberg, MSCI. T Data as at April 30, 2014. Source: Bloomberg, MSCI, Factset.

For investors who run hedged or market neutral portfolios, we also think that there is significant opportunity. Specifically, while we “ expect mid-cap stocks to outperform, we expect many of the large- capitalization stocks to underperform as reforms gain momentum. Mexico requires a different On the fixed income side, we favor shorter-duration local bonds, investment playbook than and we suggest investors begin to gain exposure to the limited supply of local corporate bonds, financial services in particular. that of many of its emerging Importantly, unlike many other EM countries we follow, we do not market peers. think that currency hedging would be required on either the fixed income or equity side. “

4 KKR Insights: Global Macro Trends Mexico Since NAFTA Exhibit 6

“Deserve your dream.” Octavio Paz (Mexican writer, poet and diplo- Mexico Suffered A Major Crisis Of Confidence In 1994… mat, 1914-1998) MXN Currency 8.00 While Mexico – like its global peers – enjoyed some healthy eco- 9-Mar-95 7.50 nomic and stock market gains during the 1991-1993 period, 1994 7.45 7.00 30-Jan-95 was quite the opposite. Specifically, the negative effects of high 6.35 debt loads, weak government finances, big deficits and a suspect 6.50 currency all caught up with the Mexican economy and its inves- 6.00 27-Dec-94 tor base. During the course of 1994, Mexican stocks fell 72% on 5.50 5.70 average, while short-dated interest rates increased from 9.5% in 5.00 February 1994 to 41.7% in February 1995, causing massive losses 4.50 for fixed income investors10. 4.00 19-Dec-94 3.50 In the end the Mexican peso depreciated almost 40%, falling to 3.46 5.70 pesos against the US dollar from 3.46 in a week’s time during 3.00 4 4 9 9 95 95 December 1994. Thereafter, it weakened further to 7.91 by year-end 95 -

11 v - 1995 . The United States was ultimately forced to intervene, provid- eb - Oct - Ap r- 95 Jan - F Ma r- 95 N o Dec -9 4 May ing $50 billion in loan guarantees to Mexico under the direction of Data as at December 31, 1995. Source: Bloomberg. then-President Bill Clinton and Treasury Secretary Robert Rubin.

Exhibit 5 Exhibit 7 Mexico Enjoys Both Geographic and Economic Diversity …Leading to a Decline in Inflation and Sparking a Secular Bull Market in Fixed Income Interest Rates Decomposed Between Inflation and Growth 40%

35% Inflation 30% Potential Growth

25% Short Term Rate 20%

15%

10%

0% 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Data as December 31, 2013. Source: Organization for Economic Source: U.S. Department of State, Getty Images. Cooperation & Development, Haver Analytics.

As the country transitioned out of the Tequila Crisis in 1994/1995 But the fiscal restraint and industry concentration also stifled and into NAFTA, the Mexican government implemented a series of productivity. As Exhibits 8 shows, Mexico’s productivity has been deliberate policies that rewarded stability, including smaller fiscal running significantly below its peers for quite some time. Sepa- imbalances in the public sector, less private sector leverage and rately, there has also been too little spending on fixed investment, more industry concentration. Not surprisingly, against this macro which has been running at just around 20% of GDP versus 40%+ in backdrop, bond investors were rewarded more than equity inves- China12. So, while favorable demographics have been growth sup- tors as the risk premium associated with fixed income investments portive, the Mexican economy has clearly been undershooting its in Mexico declined precipitously during this period (Exhibits 6 and 7). potential, particularly in terms of GDP-per-capita growth.

10 data as at December 31, 1994 and February 28, 1995. Source: Bloomberg. 12 data as at December 31, 2013. Source: Instituto Nacional de Estadística 11 data as at December 31, 1994. Source: Bloomberg. Geografía e Informática, China National Bureau of Statistics, Haver Analytics.

KKR Insights: Global Macro Trends 5 Exhibit 8 Exhibit 10 Low Productivity Has Hurt Mexico’s Growth Industry Concentrations Created Economic Stability, but Decomposition of Annualized GDP Growth Have Also Dented Innovation and Productivity 1990-2013 Mexican IPC Index: Stock Market Cap Concentration 8.9% Labor Force Growth Productivity Growth 5 Largest Stocks Next 5 Largest Remaining Stocks 0.8% 100 6.2% 90 20 29 28 26 24 26 27 27 28 25 25 25 80 4.8% 4.9% 2.2% 70 19 20 18 19 18 18 21 22 3.4% 60 18 20 20 20 2.7% 2.2% 2.6% 2.4% 2.9% 50 40 2.9% 1.7% 0.8% 30 58 60 2.1% 52 52 54 55 55 53 52 58 54 53 20 1.1% 1.6% 2.0% 2.8% 4.0% 8.1% 0.5% 0.5% 10 Mexico Colombia Brazil US Peru Chile India China 0 7 3 9 6 4 2 011 ent 012 010 0 0 0 0 005 008 0 r 0 2 2 2 Data as at 4Q13. Source: Conference Board Total Economy Data Base, r 2 2 2 2 2 2 2 2

McKinsey. Cu Data as at March 31, 2014. Source: FactSet.

Exhibit 9 GDP-per-Hour Worked Suggests Mexico Still Has a Long Exhibit 11 Way to Go on the Productivity Front Industrial Electricity Prices Are a Good Proxy for Mexico’s Structural Inefficiencies 90 Units of GDP-Per-Hour Worked (U.S.$) 80 Electricity Prices for Industry U.S. $ MWh 70 126.0 Mexico U.S. 60 121.5 50 115.3 114.7

40 102.1 104.0 30

20 86.2 10

0 L R R S N A A 68.3 68.1 67.9 68.2 67.0 68.1 O SP CD O U S IRL I T P J P K E FRA TUR

RU S 63.9 A GBR DEU N O CAN U MEX SWE OE Data as at January 31, 2013. Source: Organization for Economic Cooperation & Development (OECD). 2007 2008 2009 2010 2011 2012 2013 Data as at April 8, 2014. Source: OECD. “ Looking ahead however, there are several reasons we believe Because of its low-cost labor that Mexico could now enjoy a fundamentally different position in force, the country is making the global economy. First, while several deficit-heavy emerging markets are now being tarred with acronyms like the Fragile Five13, considerable progress in Mexico is emerging as somewhat of a safe haven, given its small fiscal imbalances and its independent central bank. Second, the key export sectors like auto country is now in the “sweet spot” of its demography: The median manufacturing. 13 In 2013, Morgan Stanley declared the Brazilian real, the Indonesian rupiah, “ the South African rand, the Indian rupee, and the Turkish lira as the “Fragile Five,” or the troubled emerging market currencies under the most pressure against the U.S. dollar.

6 KKR Insights: Global Macro Trends age stands at just 27 years14. Third, because of its low-cost labor Exhibit 14 force, the country is making considerable progress in key export sectors like auto manufacturing. All told, total trade including both Wages Are Now More Competitive With China exports and imports reached a sizeable 65%15 of GDP in 2013. As Manufacturing Wages (US$ per hour) 3.5 a result, the country’s economy has become more industrialized (Exhibits 12 and 13). China Mexico 3.0 Exhibit 12

Trade Is Helping Mexico Become More Industrialized… 2.5 2013 Mexico GDP By Major Industry Category 1994 2013 2.0

70% Industry has 61.5% 59.6% 1.5 60% become a more important sector 50% of the economy 1.0 40% 32.7% 29.5% Agriculture has 30% become a smaller Taxes have 0.5 20% share of GDP generally declined 2002 2004 2006 2008 2010 2012 4.5% 4.6% 10% 3.8% 3.9% Data as at December 31, 2013. Source: ILO, INEGI, CEIC, Morgan Stanley 0% Research. Agriculture Industry Services Taxes on and Livestock Products

Data as at December 31, 2013. Source: Instituto Nacional de Estadística Exhibit 15 Geografía e Informática, Haver Analytics. Mexico’s Working Age Population Will Peak In 2042, Twenty-Eight Years After China’s Exhibit 13 Working Age Population Indexed: 1990 = 100

…And Is Also a Substantial Driver of the Services Sector Mexico Brazil China Mexico GDP: Trade Services as a % of Services 180 Chile Peru 2048 29% 160 2042 27% 2033 140 2026 25% 120 2014 23% 100 21% 80 19%

17% 60 0 0 0 35 45 30 25 2 40 015 010 0 055 0 0 0 0 005 050 0 000 1995 19 9 2 2 2 2 2 2 2 20 6 2 2 2 2 15% 2 7 7 9 6 6 4 2 11 12 10 9

9 Data as at July 12, 2013. Source: United Nations, Haver Analytics. 95 0 - 0 - 0 Sep - Jun - Dec - Sep-01 Jun - Ma r-9 4 Dec - Ma r- 99 Sep - Jun-05 Ma r Dec- 0 Ma r Jun-00 Sep- 0 Dec- Data as at February 21, 2014. Source: Instituto Brasileiro de Geografia Fourth, unlike many other EM stories, Mexico’s fortunes are not tied e Estatística, Instituto Nacional de Estadística Geografía e Informática, to a slowing Chinese economy. Rather, Mexico actually benefits Haver Analytics. from a close relationship with the United States. Indeed, twenty years since NAFTA, the U.S. and Mexican economies have become deeply interwoven with the establishment of regional supply chains. In fact, U.S.-Mexican trade crossed the $500 billion mark last year, cementing Mexico’s role as the United States’ third largest trading partner16. 14 data as at July 9, 2013. Source: United Nations World Population Prospects, Haver Analytics. 16 office of the United States Trade Representative http://www.ustr.gov/ 15 see Shannon O’Neil, “Mexico Makes It,” Foreign Affairs, March/April 2013. countries-regions/americas/mexico

KKR Insights: Global Macro Trends 7 Exhibit 16 Structural Reforms Could Have a Meaningful Impact on GDP by Some Estimates Possible Structural Reforms Affect on GDP Growth, (%)

4.4 - 4.9% +1.0% +0. 3%

+0. 5% 2.5 - 3.0% +0.1%

Natural GDP Growth Labor Reform Telecom Reform Energy Reform Financial Reform New Natural GDP Rate Growth Rate (2019)

Data as at April 11, 2014. Source: Grupo de Economistas y Asociados, Instituto Nacional de Estadística Geografía e Informática, Banxico and SHCP.

But more important than the aforementioned macro tailwinds at this Exhibit 17 point in its economic history is the potential for the current reform agenda to accelerate structural growth in Mexico. All told, potential Private Credit in Mexico Is Quite Low… GDP growth could improve to 4.4-4.9% from 2.8%, we believe, by 2012 Domestic Credit to Private Sector by 2019. One can see the building blocks of this potential accelera- Banks as a % GDP tion in Exhibit 16. If this view is right, then productivity – and hence GDP-per-capita – should finally start to reaccelerate back towards U.S. 184 levels commensurate with the country’s underlying potential. In ad- Japan 177 dition, as corporate competition is encouraged, the country’s market Korea 148 capitalization as a percentage of GDP could appreciate meaning- China 134 fully. Singapore 121 Malaysia 118 However, to ensure that it takes full advantage of its potential, Vietnam 95 Mexico should use the reforms as catalysts to not only break down Brazil 68 current industry rigidities but also to improve participation, pro- Turkey 54 ductivity, and profitability outside its mega-cap sector to include a India 51 wider swath of companies across more industries. The opportunity Indonesia 35 for improvement certainly appears sizeable, we believe. Just con- Philippines 33 sider that electricity prices for industry use were, on average, a full Mexico 28 17 78% higher in Mexico versus in the United States . Data as at July 4, 2013. Source: World Bank, Haver Analytics.

In addition, the government should work harder to open and grow credit channels back towards more normalized levels. Without question, this initiative may require a major overhaul of a clubby banking system that currently seems content to only lend to the highest quality credits.

“ If there is a ‘swing factor’ in the Mexico macro story, we think it starts and ends with the government. “ 17 data as at December 31, 2013. Source: OECD.

8 KKR Insights: Global Macro Trends Exhibit 18 as “the perfect dictatorship”—it has since developed into a genuine multiparty democracy with a strong civil society and independent …Which Is Consistent With the View That Overall Credit institutions including a well-respected Supreme Court, and a Penetration in Mexico Is Subdued legislature in which no faction controls a majority of seats. Mexico: Credit as a % of GDP The key question now is how successfully the 2013 reforms are brought into effect. This involves at least two distinct challenges. The first and most immediate is the need to adopt secondary legislation in the Mexican Congress. Unlike the constitutional changes of 28.5 2013, passage of these bills will not require parliamentary su- permajorities. Rather, a simple majority will ultimately be achiev- 43.6 able for the ruling party, the Partido Revolucionario Institucional (PRI). However, the situation remains fluid, so we will need to watch closely what the proposed bills actually put in place as the 9.9 devil will be in the details. 5.2 Exhibit 19 Consumer Mortgage % Corporate Credit % GDP Credit % GDP GDP Credit % GDP The Structural Reform Agenda Is Impressive, Particularly Data as at December 31, 2013. Source: Instituto Nacional de Estadística When Compared to What Was Accomplished During the Geografía e Informática, Haver Analytics. Previous 18 Years

Selected Structural Reforms Beyond more broad-based lending, we think that development of a deeper corporate bond market should also be a priority. To date 1993-2011 2012-2013 though, the Mexican fixed income market has remained largely a fo- rum for primarily sovereign credits. Finally, the government should NAFTA (1994) Labor deliver on more and better energy production, which we think is a Banxico’s Autonomy (1995) Educational prerequisite to many of the other aforementioned reform initiatives. Private Pension Reform (1997) Telecom

Key Themes/GDP Analysis Balanced Budget Reform Fiscal (2006) In the following section we drill down on some of the key macro and geopolitical trends in Mexico. In so doing, we break down the Energy various components of the Mexican economy, including private and Financial government consumption, exports, and fixed investments. Finally, we close with some thoughts on Mexican financial services as well Economic Competition as on criminality and rule of law, which we view as important risk Data as at March 31, 2014. Source: Global Source Partners. factors for investors to consider.

“It’s the Government, Stupid”

If there is a “swing factor” in the Mexico macro story, we think it starts and ends with the government. The succession of reforms adopted in Mexico since early 2013 is unprecedented in its scope and breadth—and certainly the most sweeping since the passage of NAFTA twenty years ago. While the constitutional changes end- ing the state monopoly on investment in the energy sector have “ naturally captured the greatest international attention, it has been We think Mexico is approaching accompanied by a series of other historic measures, including over- hauls in telecommunications, fiscal affairs, education, labor mar- an inflection point that offers the kets and electoral rules. What paved the way to passage of these opportunity to invest in both the measures was the Pact for Mexico (“Pacto por Mexico”), a grand bargain-like agreement orchestrated in late 2012 by then-President- equity and debt of companies elect Peña Nieto and his team, and endorsed by the three major Mexican political parties. that can finally take advantage of a more level playing field. The 2013 reforms build upon a foundation of broader economic and political changes in Mexico since NAFTA came into effect in 1994. “ Whereas in the early 1990s, Mexico was still a one-party state— famously described by Peruvian Nobel Laureate Mario Vargas Llosa

KKR Insights: Global Macro Trends 9 Exhibit 20 There is also risk that political momentum behind the reforms could stall. In particular, Peña Nieto could face internal pressure within PEMEX’s Output Per Employee Is Well Below Its Foreign the PRI as 2015 congressional elections approach. As with Prime Counterparts Minister Abe and the Liberal Democratic Party (LDP) in Japan, we Barrels of Oil Produced have the paradox in Mexico of a long-ruling party that is back in per Employee per Day (2012) power after a spell in the political wilderness, with a reform-minded chief executive who is taking on entrenched, growth-sapping inter- Statoil est groups, which also happen to be the historic base of his own Ecopetrol party. There is also likely to be mainstream resistance in Mexico, including legal challenges and protests, which could delay reform ExxonMobil implementations that lack decisive public support. BP For foreign investors, the most important litmus test over the coming Shell months will be the trajectory of energy sector reform: If Mexico can Petrobras get this right, it will unlock the door for other sources of growth and renewal; conversely, if it stumbles on energy, all other efforts may PEMEX prove for naught.

0 20 40 60 80 We remain optimistic here. Despite concern about the delay of im- Data as at August 10, 2013 for 2012. Source: The Economist, CIDAC plementing secondary legislation, we are confident market-friendly Mexico, Statoil, Ecopetrol, Exxon Mobil, BP, Shell, Petrobras, Pemex laws will pass Congress in the coming months, Our base case is annual reports. that it occurs during a special congressional session this summer, or in the worst case scenario, in the autumn. The second challenge is institutional, as the Mexican government is now planning to establish or beef up its regulations, procedures Parallel to the legislative activity is the “Round Zero” lease alloca- and regulatory bodies. In the case of energy reform for instance, tion, under which it will be determined how much of PEMEX’s the National Hydrocarbon Commission is expected to be reconsti- current acreage it is allowed to keep. PEMEX has proposed to tuted, while a new Energy Regulatory Commission is anticipated retain 83% of its proven and probable oil reserves, and 31% of its as well. Without question, attracting the necessary talent to these prospective resources18. Mexico’s Energy Ministry (SENER) has new bodies (e.g., engineers and geologists) may prove challenging until mid-September to determine if the company has the fiscal and and time-consuming at a time when international companies are technical ability to develop these fields. Following the completion also increasing their staffing needs in Mexico. Mexico also lacks of Round Zero, the deal making between PEMEX and international four-year undergraduate degree programs in oil engineering and energy companies will begin, as will a secondary process under local university-level expertise in this field. However, our contacts which new acreage—including deepwater and shale opportunities— in Mexico indicate that, given the changing nature of the energy are opened to auction. opportunity set, there is an effort underway to recruit Venezuelan teachers to remedy PEMEX being the sole training mechanism in 18 march 25, 2014, “Pemex presents wish list to energy ministry,” Financial the oil services and engineering fields in Mexico. Times.

Exhibit 21 PEMEX Oil Production Has Been Plagued by Inefficiencies, Resulting In Reduced Production PEMEX Oil Poduction by Fields, Thousands of Barrels per Day 4000 Cantarell Ku-Maloob-Zaap Other 3500

3000

2500

2000

1500

1000

500

0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Pemex, OECD Economic Surveys Mexico 2013.

10 KKR Insights: Global Macro Trends Given the availability of low-cost U.S.-produced shale gas from just Exhibit 23 across the border in Texas as well as the security challenges surround- ing the geography of Mexico’s own shale gas, we think that—at least in Mexico Is Behind Many of its Peers On Government the short to medium term—energy reform is going to be more focused Spending on oil, particularly using foreign partnerships and new technologies to 2013 Government Consumption as a % of GDP yield greater efficiencies at mature fields.

The bottom line here, we think, is that the reform agenda—includ- 19.4% ing energy reform—still faces significant political and operational 16.6% obstacles to implementation. As such, we think investor expectations need to be kept in check about the pace of delivery. It will 13.5% not happen overnight, and there will certainly be continued bumps 11.1% 11.3% along the way. But that shouldn’t obscure what we see as the far bigger story, which is that Mexico is one of very few countries in 7.7% the world today—either emerging or developed—where smart, effective political leadership is successfully pushing through historic, market-friendly structural change that could meaningfully boost the country’s equity market capitalization over the next five to seven years. Indonesia Mexico India China Colombia Brazil Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia Beyond the reform agenda, however, there is still a lot of day-to-day e Estatística, Departamento Administrativo Nacional de Estadísticas, work that needs to be done by this government. In particular, we Instituto Nacional de Estadística Geografía e Informática, Central feel strongly the government should be more effective in pushing Statistical Organization, India Badan Pusat Statistik, China National Bureau of Statistics, Haver Analytics. through the necessary spending required to reignite GDP, pay sup- pliers in the private markets and encourage both consumer and corporate innovation/risk-taking. This was clearly not the case in 2013 as GDP reached a meager 1.2%, which is actually even below the In the early parts of this year the government has begun to spend country’s population growth of 2.0%19. Corporate executives, un- again. In fact, according to the latest public statistics, the govern- nerved by erratic spending patterns of the government early in the ment was running a 62 billion deficit (pesos) as of 1Q2014, versus a year, retrenched in the second half of the year. At the same time, 40 billion surplus at the same time year ago20. Meanwhile, based on consumer confidence tumbled as the fall-out from higher taxes was our research, business activity in the U.S. appears to be reacceler- not fully understood by the country’s middle class (Exhibit 24). ating in April/May, which should also help to start to pull economic activity in Mexico forward. Exhibit 22 We Believe That More Government Spending Is Necessary to Drive Growth in the Economy Mexico Government Consumption as a % of GDP, 1994-2013

Dec-95 15% 14% “ 14% Overall, we think that investors 13% 12% Dec-14 can take some comfort in the 11% 11% fact that the government has the 10% capacity to spend quite a bit 9% more and not affect its standing 8% 6 3 9 4 7 6 2 8 7 11 13 12 9 99 9 0 - in the global markets. -01 - 0 Ma r Jun - Sep - Ma r- 9 Ma r Jun - Jun- 0 Sep - Dec -9 4 Dec - Ma r Jun- 0 Sep- 0 Dec- 0 Sep-08 Dec- “ Data as at December 31, 2013. Source: Instituto Nacional de Estadística Geografía e Informática.

19 data as at July 9, 2013. Source: United Nations World Population Prospects, 20 Data as at March 31, 2014. Source: Secretaria de Hacienda y Credito Publico, Haver Analytics. Bloomberg.

KKR Insights: Global Macro Trends 11 Exhibit 24 Overall, we think that investors can take some comfort in the fact that the government has the capacity to spend quite a bit more and Consumer Confidence Has Begun to Rebound In Recent not affect its standing in the global markets. As Exhibit 26 shows, Weeks… even with increased outlays in 2014, Mexico’s fiscal deficit is likely 115 Mexico: Consumer Sentiment (Monthly,%) to remain under control. The country’s debt to GDP also remains modest at 46%, well below Brazil, India and the United States. 110 Exhibit 26 105

100 The Fiscal Gap Is Expected to Peak This Year Fiscal Balance Revenue (R) 95 Expenditures (R) 90 4 % GDP % GDP 30 85 28 2 80 26 24 0 Apr-11 Oct-13 Apr-01 Feb-12 Jun-10 Oct-03

Dec-12 22 Oct-08 Feb-07 Apr-06 Jun-05 Feb-02 Dec-07 Dec-02 Aug-09 Aug-04 20 Data as at April 30, 2014. Source: INEGI, Haver Analytics. -2 18

-4 16 Exhibit 25 2014 14 -4.1 …Because the Government Has Finally Started Spending -6 12 Again 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 Data as at March 28, 2014. Source: IMF, Haver Analytics. Planned Public Spending in Mexico Annual Nominal Growth 22% 17% Exhibit 27 Government Leverage Remains Modest 9% 9% 9% 7% 2013 General Government Gross Debt as a % of GDP

Japan 243

U.S. 105

Singapore 104 -7% India 67 2008 2009 2010 2011 2012 2013 2014E E=estimate. Data as at December 31, 2013. Source: Interacciones and Brazil 66 SHOP. Malaysia 58

Vietnam 55

Mexico 46

Philippines 38 “ Korea 37 There is potential for the current Turkey 36 Indonesia 26

reform agenda to accelerate China 22 structural growth in Mexico. Data as at April 8, 2014. Source: IMF, Haver Analytics. “

12 KKR Insights: Global Macro Trends Exhibit 28 and the military and federal government21. Moreover, of those that do pay taxes, both the personal income rate and the VAT appear Mexico’s Strong Fundamentals Are Reflected in Credit too low relative to other countries. Exhibits 30 and 31 provide some Ratings and Pricing perspective on Mexico’s low tax burden. This imbalance in the 300 composition of the labor force has placed a large burden on select individuals and corporations, including PEMEX, that ultimately end Russia up being responsible for paying the taxes of the entire nation. 250 India Exhibit 30 200 Turkey

ead South Africa Indonesia The Personal Income Tax Rate in Mexico Appears Too

S Sp r Low… 150 Brazil

C D 2014 Highest Rates of Personal Income Tax

ea r Italy 100 Colombia 5 Y Spain Sweden 57 Denmark 56 Mexico Poland Spain 52 50 South Korea Netherlands 52 Japan 51 Portugal 48 0 A+ A- BBB+ BBB BBB- BB+ Israel 48 Ireland 48 S&P Rating Norway 47 Data as at April 28, 2014. Source: Bloomberg, S&P Ratings, KKR Global U.K. 45 Macro & Asset Allocation analysis. Germany 45 France 45 China 45 Australia 45 Exhibit 29 Italy 43 Greece 42 Low Inflation and a Strong Currency Already Make South Africa 40 Mexico a More Attractive Destination for Foreign Capital Chile 40 Than Many of Its Global Peers U.S. 40 Turkey 35 Decomposition of Emerging Market Country Risk Premium Korea 35 Argentina 35 16.0% Inflation & Currency Risk Venezuela 34 India 34 Country Credit Risk 14.0% Colombia 33 Poland 32 8.4% 8.1% 12.0% 8.4% 9.0% Peru 30 Mexico 30 10.0% Indonesia 30 7.2% Canada 29 8.0% Brazil 28 Czech Rep 22 6.0% Singapore 20 Hungary 16 4.0% Russia 13 1.4% 5.5% 4.6% 5.1% 2.0% 4.1% Data as of 2014. Source: KPMG International. http://www.kpmg.com/ 2.1% 2.3% Global/en/services/Tax/tax-tools-and-resources/Pages/individual- 0.0% income-tax-rates-table.aspx Mexico Brazil South India Russia Indonesia Africa Data as at March 31, 2014. Source: JPMorgan, Bloomberg, KKR Global Macro & Asset Allocation analysis.

Separately, the government should also do more to reduce the share of the sizeable and highly unproductive informal economy. All told, the Mexican labor force is composed of approximately 50 million workers, of which we think only a third are formal workers who pay taxes. The remaining two-thirds of the Mexican work force are evenly split between the informal sector of the economy

21 data as at 2013. Source: OECD. http://www.oecd.org/mexico/OECD- SocietyAtaGlance2014-Highlights-Mexico.pdf

KKR Insights: Global Macro Trends 13 Exhibit 31 position that is expected to improve modestly over time22. Probably more important to the investment community however, is that Mexi- …As Does the VAT, Especially When Considering the Size can consumers now spend north of $700 billion annually, ranking of the Informal Sector them #7 worldwide in absolute dollars consumed. One can see this 2014 Indirect Tax Rate / VAT in Exhibit 33. Besides its large and growing population base, what else is interesting about Mexico is that consumption is already a Hungary 27 sizeable part of GDP. Indeed, as Exhibits 32 and 33 illustrate, Mexico Sweden 25 Norway 25 is at the high end of its emerging market peers in this respect. Denmark 25 China 25 Exhibit 32 Finland 24 Portugal 23 Mexico’s GDP Composition Is Heavily Weighted Towards Poland 23 Consumption Ireland 23 Greece 23 2013 GDP Composition Italy 22 Netherlands 21 69 Mexico Brazil China Czech Rep 21 62 Belgium 21 Argentina 21 U.K. 20 48 Austria 20 France 20 36 Germany 19 32 Chile 19 29 Brazil 19 22 22 Turkey 18 18 Spain 18 12 13 13 Russia 18 3 Israel 18 Mexico 16 Colombia 16 -1 -2 New Zealand 15 Venezuela 12 Consumption Government Investment Net Exports Exports Korea 10 Data as at February 21, 2014. Source: Instituto Brasileiro de Geografia Australia 10 e Estatística, China National Bureau of Statistics, Instituto Nacional de Switzerland 8 Estadística Geografía e Informática, Haver Analytics. U.S. 8 Japan 5 Canada 5 Data as of 2014. Source: KPMG International. http://www.kpmg.com/ Global/en/services/Tax/tax-tools-and-resources/Pages/indirect-tax- rates-table.aspx “ Longer-term, this approach to tax collection is unsustainable if Mexico is to modernize. Given this view, we believe strongly that The good news is that we think the one of this government’s legacies should be to reengineer its tax system so that it not only generates more revenue but can also country’s proximity to the United facilitate spending more on key initiatives like healthcare, education, States, its flexible currency, and infrastructure and technology. No doubt, this task will not be easy. However, as we have seen in other emerging market countries that its competitive wages should all have expanded their tax base and/or reduced subsidies, the benefits act as distinguishing features as to the countries’ growth trajectories and societal development are often immense. China’s role as “manufacturer” to the world diminishes further. Not the Typical EM Consumption Story

Officially known as the United Mexican States, Mexico now boasts “ a population of around 115-125 million citizens (Exhibit 33). As such, the country ranks #11 in terms of total country population, a

22 Data as at 2012. Source: United Nations World Population Prospects, Haver Analytics.

14 KKR Insights: Global Macro Trends Exhibit 33 Exhibit 35 Mexican Consumption Outpaces Many Of Its More Mexico Private Consumption Outpaces Its EM Peers Populous Peers 2013 Private Consumption as a % of GDP

Private Consumption 69% Consumption Per Capita Population 61% 62% Country US$ Trillions US’ 000 millions 58% 58%

1 U.S. 11.1 35.1 318

2 Japan 3.2 25.5 127 36%

3 China 3.0 2.2 1377

4 Brazil 1.3 6.7 199

5 India 1.1 0.9 1237

6 Russia 1.0 7.1 143 China Indonesia India Colombia Brazil Mexico

7 Mexico 0.8 6.4 121 Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia e Estatística, Departamento Administrativo Nacional de Estadísticas, 8 Indonesia 0.5 1.9 247 Instituto Nacional de Estadística Geografía e Informática, Central Statistical Organization, India, Badan Pusat Statistik, China National 9 Pakistan 0.2 1.0 179 Bureau of Statistics, Haver Analytics.

10 Nigeria 0.1 0.7 160 Mexico’s consumption economy is likely to remain robust in the Data as at 2012. Source: United Nations World Population Prospects, coming years as the country enjoys some of the most favorable World Bank, Haver Analytics. demographic tailwinds in the emerging markets. According to the International Labor Organization, Mexico’s economically active population will grow by 20% from 2010 to 2020, compared to just Exhibit 34 2.9% for China23. Moreover, Mexico’s working age population will not peak until 2042, 28 years after China (Exhibit 15). Also, as Growth In Private Consumption Has Consistently Exhibit 37 shows, Mexico’s consumers are largely already based in Remained Strong urban centers, suggesting that the opportunity is to upsell to con- Mexico Private Consumption as sumers as GDP-per-capita hopefully reaccelerates. If our analysis is correct, then the consumer story is quite different than that of a 70% a % of GDP, 1994-2013 country like China, which has been more of a direct play on con- 68% sumers consistently migrating from rural settings to urban areas. 66%

64%

62% 60% “ 58% As financial services reform gains 56% momentum, we think that any 54% 7 9 8 6 6 4 2 13 12 10 9 9 0 0

- increase in lending off such a low -08 - 0 -00 r ug - ug-01 ug - ug- 0 ug-05 Ap r A Dec - Ap r- 9 A Ap r Ap r A Dec - Dec -9 4 Ap Dec- Dec- A A base could likely be beneficial for Data as at December 31, 2013. Source: Instituto Nacional de Estadística Geografía e Informática, Haver Analytics. overall valuations and transaction volumes in the real estate sector. “

23 Data as at December 2011. Source: OECD.

KKR Insights: Global Macro Trends 15 Exhibit 36 Exhibit 38 Mexico’s Working Age Population Offers a Sharp Mexico’s Private Credit Growth Has Lagged Badly Contrast to China Relative to Its Peers Working-age Population (2010A to 2035E, % change) Credit of the Private Sector as a % of GDP 120% Brazil Chile Colombia India 36.5% 100% Mexico US Mexico 26.4% 80% Brazil 14.3% 60% USA 8.7% 40% UK 3.7% 20% Spain -2.2% 0% 7 3 9 6 4 China -6.3% 2 011 012 001 010 010 0 0 0 0 005 005 008 0 0 000 000 2 2 2 2 2 2 2 2 2 2 2 2 2 2 Japan -19.0% 2 2 Data as at April 8, 2014. Source: IMF, Haver Analytics, CEIC, EMED, Note: Working-age population is aged 15 to 65 years old. Source: UN Emerging Advisors. Population Division (2011) and the Economist Intelligence Unit.

But not all the news is good news on the consumption front. In Exhibit 37 particular, because productivity growth has not been as strong at a time when Mexico is consistently adding significant numbers to Growth in GDP-per-capita Has Yet to Catch Up With its workforce, its GDP-per-capita is not growing as fast as many of Urbanization its global peers. So while the country has enjoyed its “demographic dividend” on the consumption front, there has not been the same Urbanization Versus Per Capita GDP 60,000 level of a multiplier effect that we have seen in other EM countries Singapore when GDP-per-capita increases too. U.S. 50,000 United Arab Exhibit 39

S$) Emirates 40,000 Real GDP Growth Has Not Translated Into Real GDP-per- Israel capita Growth… -Capita ( U 30,000 e r 25% Greece Korea 20,000 Russia 000 20% 012 GDP- P Russia 2

China vs. 2 10,000 Turkey Brazil Mexico China 013 Indonesia India 15%

0 GR 2 20 40 60 80 100 Indonesia 2012 Urban Population % Total Population (%) S$ C A Brazil India Data as at April 13, 2014. Source: World Bank, IMF, Haver Analytics. 10% Turkey -Capita U

e r 5% Another key feature of the Mexican economy is that total con- Mexico sumer leverage, including both bank and non-bank lending, is low GDP- P U.S. at around 25% of GDP (Exhibit 38). This capacity is significant 0% because it means that current consumption trends are likely to 0% 2% 4% 6% 8% 10% 12% be maintained or potentially even accelerate as the government’s Real GDP CAGR 2013 vs. 2000 (%) financial services reform takes hold over the next few years. By comparison, other Latin American countries have seen their con- Data as at April 8, 2014. Source: IMFWEO. sumer debt surge in recent years, which has been a major – though potentially unsustainable – contributor to GDP growth. One can see the magnitude of the differential in Exhibit 38.

16 KKR Insights: Global Macro Trends Exhibit 40 Exhibit 42 …As GDP Has Been Dampened by the Lack of Unit Labor Costs For Mexico Have Risen at a Much Productivity Growth Slower Pace Than For China Productivity Growth, CAGR, 1990-2013 (%) Unit Labor Costs 2005 = 100 8.1% 200 Mexico China

180

160 4.0%

2.8% 140 2.0% 1.6% 1.1% 120 0.5% 0.5% 100

Data as at 4Q13. Source: Conference Board Total Economy Data Base, McKinsey. Data as at May 6, 2014. Source: OECD Economic Outlook Database, Haver.

The major culprit is the lack of real wage growth, which has been stagnant for years. In fact, as Exhibits 41 and 42 show, Mexico has So against this backdrop of strong population growth but more really only maintained competiveness by restraining wages, not tepid growth in both salaries and GDP-per-capita, where are the key improving productivity and/or innovation, since the Great Reces- areas for investment linked to consumption? Our thoughts are as sion. While this approach represents one potential way to maintain follows. First, we expect wellness, beauty, and healthcare to remain economic relevance, it is one that has neither high barriers to entry important areas of long-term secular growth. At the moment, pri- nor creates long-term competitive advantages, in our view. vate healthcare accounts for about 50% of total healthcare spending, but we expect this segment of the market to grow much more Exhibit 41 sharply in the coming years24. Key to our thinking is that, as Exhibit Real Salary Growth Has Remained Largely Unchanged 43 underscores, Mexico still appears to be significantly underrep- resented in overall healthcare spending. However, a recent survey Since 2007 undertaken by the World Bank estimates that 25% of Mexicans with Real Salary Growth y/y public insurance already have some form of private insurance, a percentage we think will grow meaningfully in the years ahead. 2000-2007 CAGR = 3.14% Second, we think that the financial services industry has the potential to be a big winner. Specifically, we think firms that can provide 10.00% deeper and broader penetration of basic financial services products 8.00% 2007-2014 CAGR = -0.12% to a growing base of consumers are likely to perform quite well. 6.00% Key areas on which to focus include auto insurance, life insurance, 4.00% and private credit in fast-growing consumer-related industries. 2.00% Also, the payments arena should continue to be an area of particu- 0.00% lar growth within Mexico. -2.00% -4.00% -6.00% -8.00% “ 7 3 9 6 4 2 11 13 12 10 99 0 0 0 We think that the financial Dec - Dec - Dec - Dec - Dec-01 Dec - Dec- 0 Dec- 0 Dec- 0 Dec- Dec-05 Dec-08 Dec- Dec- Dec-00 Data as at March 31, 2014. Source: INEGI, Haver Analytics. services industry has the potential to be a big winner. “

24 Source: OECD Reviews of Health Systems – Mexico, published July 2005.

KKR Insights: Global Macro Trends 17 Exhibit 43 country’s pupil-to-teacher ratio is quite high at 29.9:1 in secondary education; in primary education it declines just marginally to 28:126. We Believe Health Care Will Increasingly Become a Interestingly though, Mexico currently spends more than any other Focus of the Middle Class In Mexico country tracked by the OECD on teacher compensation. One can see 2012 Health Expenditure per Capita (US$'000) this in Exhibit 44. Finally, we believe that consumer “value” plays will likely perform well if we are right that wage growth will remain U.S. 8.9 more contained than in other EM countries. To be sure, aspirational Japan 4.8 U.K. 3.6 brands can perform too, but Mexico’s limited annual salary in- Italy 3.0 creases mean that a different approach is required to invest behind Spain 2.8 consumption stories in Mexico than in places like China and Brazil. Chile 1.1 Brazil 1.1 Exports Represent the Crown Jewels in the Mexican GDP Story Argentina 1.0 Russia 0.9 There are certainly many compelling features to the Mexican econ- Turkey 0.7 omy, but its export businesses are the country’s economic crown Mexico 0.6 jewels, in our view. All told, they now account for almost 35% of its Venezuela 0.6 Colombia 0.5 economy (Exhibit 45), compared to just 12% in the United States. China 0.3 Besides its dominance in Latin America, a key part of Mexico’s Philippines 0.1 export success has been the country’s ability to effectively leverage Indonesia 0.1 its proximity to the U.S. Vietnam 0.1 India 0.1 Within its export sector, manufacturing has accounted for over Data as at April 13, 2014. Source: World Development Indicators, Haver 80% of total exports since 2000. Petroleum, agriculture and mining Analytics. account for the rest as one can see in Exhibit 46. Importantly, as Exhibit 45 shows, Mexico’s export economy is not only large but it is also gaining GDP share. In 2013, for example, Mexican exports Exhibit 44 reached 31.5% of GDP, versus 12.5% for Brazil, 24.4% for China, and 24.7% for India27. Mexico Ranks Number One by the OECD in Teachers’ Salaries and Compensation Expenditures Exhibit 45 Mexico and OECD Average of Teacher's Salaries and Exports Have Been Rising Steadily Since 1994 Compensation of All Staff as % of Education Budget 2010 Mexico Exports as a % of GDP, 1994-2013 Mexico OECD Average 93.3% 35% 83.1% 78.2% 30%

62.0% 25%

20%

15%

10% 6 3 4 4 8 7 7 6 11 12 10 13 99 9 9 9 - - 0 eb - ug - ug - eb - ug- 0 eb- 0 Ap r F Jun - A Ap r- 9 Oct- 0 F Dec-01 Jun - Oct-00 F Ap r Dec - A Dec-08 A Jun-05

Teacher's Salaries Compensation of Staff (all Data as at 4Q2013. Source: Instituto Nacional de Estadística Geografía e together Informática, Haver Analytics. Data as at 2010. Source: Mexico Education at a Glance 2013: OECD Indicators.

Third, given that Peña Nieto has made educational reform one of his primary pillars, we see education and related services as a potentially attractive area for investment. According to the OECD, the time 15-29 year old Mexicans spend in formal education ranks 26 Data as at 2013: Source: OECD: Education at a Glance 2013 Mexico. among the lowest in the world – a full two years below the OECD 27 Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia e average and just barely above Brazil and Turkey25. Meanwhile, the Estatística, Instituto Nacional de Estadística Geografía e Informática, Central Statistical Organization, India, China National Bureau of Statistics, Haver 25 Data as at 2013: Source: OECD: Education at a Glance 2013 Mexico. Analytics.

18 KKR Insights: Global Macro Trends Exhibit 46 Exhibit 47 Exports Are Dominated by Manufacturing From 2007-2012, Wages in China Increased 13%, While Breakdown of Exports, % Mexico Recorded No Growth Average From 2000-2013 Minimum Wages Per Month in US$

China Philippines Indonesia Agriculture, Mining, 2.9% 0.7% Vietnam Mexico 250

Petroleum, 200 13.3%

150

100

Manufacturing, 50 83.2%

0 2007 2008 2009 2010 2011 2012 Data as at December 31, 2013. Source: Instituto Nacional de Estadística Data as at June 1, 2012. Source: World Bank Doing Business Geografía e Informática. Employment Data.

How did it gain such momentum? Well, after a serious setback fol- Exhibit 48 lowing China’s inclusion in the WTO around the turn of the century, Mexico has worked hard to reassert itself as a viable manufacturer. It’s Easier to Do Business in Mexico Than in China Several things have gone its way. First, productivity in the auto Ease of Doing Business Index manufacturing sector has improved nicely, which has become the flagship of the country’s export economy. In fact, auto exports from Mexico China 108 Mexico to the U.S. more than quadrupled from 1993 to 2013, and 99 96 the country is expected to topple Japan as the #2 auto exporter to 93 90 91 egulations 28

R 83 the U.S. this year . Second, as China’s wages have increased, the 78 79 spread between labor costs is now virtually non-existent, as one can see in Exhibit 47. As part of this drive to maintain competitive- riendl y 62 56 ness, Mexico has also embraced favorable immigration policies with s F 53 51 53 neighboring countries. This approach has helped to keep domestic 43 42 41 35 wage growth in check as multinational companies look to relocate manufacturing away from China and back towards regional hubs.

Third, as Exhibit 48 below shows, the ease of doing business in 1=Most Busine s Mexico is improving, particularly as the trend towards regional “near sourcing” has gained the upper hand versus global outsourcing. 05 06 07 08 09 10 11 12 13 Data as at November 7, 2013. Source: World Bank, Haver Analytics. “ Importantly, Mexico’s export economy has not had to deal with some of the currency headwinds that other regions of the world, Europe in particular, have confronted in recent quarters. “

28 Data as at January 31, 2014. Source: ISH Automotive, Bloomberg.

KKR Insights: Global Macro Trends 19 From a destination perspective, we now estimate that around 87% Exhibit 50 of Mexico’s exports go to the U.S. One can see this in Exhibit 49. So while many emerging market countries like Brazil and Indone- …With Manufacturing and Intermediate Goods the sia are linked to China, Mexico is more closely akin to a U.S. “back Largest Exports On a Percentage Basis door” play. Mexico is also working hard to become even more of a Mexico: Exports by Commodity (%) Latin America influence. Last year for example, Mexico formed the Pacific Alliance with Colombia, Chile and Peru—a highly ambitious free trade and regulatory framework that we expect will expand to Consumer include others over time. Goods 11% Capital Beyond increased trade with its continental neighbors, Mexico also Goods has been extremely aggressive in signing free trade agreements Manufacturing 13% outside the Western Hemisphere, including ones with the EU, Japan 40% and Israel. All told, Mexico has trade agreements (FTAs) with over 40 countries, which is actually more FTAs than the U.S. and China Intermediate have combined. In addition, Mexico is a member of the 12-nation Goods Trans-Pacific Partnership (TPP), under negotiation now, which we 26% think has the potential to accelerate Mexico’s commercial linkages with the economies of the Asia-Pacific region. Mining 1%

Exhibit 49 Agriculture 2% Petroleum 7% Mexico Is Highly Levered to the U.S… Data as at December 31, 2013. Source: Instituto Nacional de Estadística Mexico: Exports by Country Geografía e Informática, Haver Analytics.

But outside of the auto industry, productivity is not as strong. One can see this in Exhibit 51, which shows that – outside of Transpor- Central America tation & Equipment (which is largely cars), Primary Metals, and 2% Miscellaneous – Mexico has actually been losing a reasonable share South America 4% of U.S.-destined exports to Chinese manufacturers. Moreover, many U.S. of its market gains have actually come at the expense of Canada, 87% Europe Japan and the United Kingdom, not other low-cost competitors like 7% China. Other 0% “ What we see as the far bigger Data as at December 31, 2013. Source: Instituto Nacional de Estadística story is that Mexico is one Geografía e Informática, Haver Analytics. of very few countries in the world today—either emerging or developed—where smart, effective political leadership is successfully pushing through historic, market-friendly structural change that could meaningfully boost the country’s equity market capitalization over the next five to seven years. “

20 KKR Insights: Global Macro Trends Exhibit 51 Market Share of U.S. Manufacturing Imports (NAICS Categories): Mexico vs China

% of Total Mex Exp US Mkt Share Gain US Mkt Share Gain Gain of Mkt Share to US US Mkt Share (2013) (2000-2008) (2009-2013) vs China

Mexico China Mexico China Mexico China 2000-2008 2009-2013

Transportation and Equipment 28.2% 23.6% 4.1% 0.4% 2.1% 6.6% 0.9% -1.7% 5.7%

Computer and Electronic 18.8% 14.6% 45.7% 1.5% 26.1% 0.0% 9.5% -24.6% -9.6%

Electrical Equipment 7.6% 23.7% 39.4% -1.0% 12.4% 0.4% 4.5% -13.4% -4.1%

Machinery 5.6% 10.7% 17.0% 2.5% 7.9% 2.8% 3.3% -5.3% -0.5%

Primary Metals 3.9% 11.5% 4.8% 2.0% 8.2% 4.1% -6.2% -6.2% 10.3%

Miscellaneous 2.6% 6.5% 34.7% 1.0% 9.0% 0.9% -5.6% -8.0% 6.4%

Fabricated Metals 2.5% 11.1% 30.9% -2.0% 16.3% 1.0% 1.6% -18.3% -0.5%

Food 2.3% 11.7% 7.2% 2.6% 4.9% 3.0% -0.6% -2.3% 3.7%

Chemicals 1.9% 2.7% 8.6% -0.6% 4.6% 0.3% 1.7% -5.2% -1.4%

Plastics and Rubber Products 1.5% 8.8% 34.1% 0.8% 16.1% 1.6% 2.9% -15.3% -1.3%

Apparel 1.4% 4.5% 39.0% -8.1% 21.2% -0.8% 4.6% -29.2% -5.4%

Beverage and Tobacco 1.2% 16.1% 0.3% 0.3% 0.0% 1.3% 0.1% 0.3% 1.2%

Petroleum and Coal 1.0% 3.1% 0.3% 2.2% -0.5% -1.8% 0.0% 2.7% -1.8%

Nonmetallic Minerals 0.9% 12.5% 33.2% 1.6% 12.8% 0.8% 3.8% -11.2% -3.0%

Leather and Allied Products 0.8% 5.4% 65.5% -1.3% 16.2% 0.4% -4.2% -17.5% 4.7%

Furniture and Related 0.7% 6.3% 57.8% -2.1% 27.2% 2.0% 0.6% -29.3% 1.4%

Paper 0.4% 5.1% 15.9% 1.3% 8.9% 1.6% 3.6% -7.5% -2.0%

Textile Product Mills 0.3% 4.1% 52.4% -5.7% 25.1% -0.3% 3.2% -30.8% -3.5%

Textile Mills 0.2% 6.8% 26.7% -0.8% 13.2% -0.1% 7.7% -14.0% -7.7%

Printing and Related Activities 0.2% 8.8% 46.3% 0.6% 21.0% 1.6% 8.6% -20.4% -7.0%

Wood Products 0.1% 1.2% 22.6% -0.5% 15.0% 0.0% 1.7% -15.5% -1.7%

Total Manufacturing 81.9% 12.3% 23.9% -0.8% 11.4% 2.2% 2.6% -12.2% -0.4%

Total manufacturing 53.7% 9.9% 28.3% -0.6% 12.6% 1.0% 3.5% -13.2% -2.5% ex-Transportation

Source: Could China Steal Mexico’s Manufacturing Thunder, USCB, UBS, April 3, 2014.

While we think that wage costs (which typically make up around tively inexpensive U.S. gas and electricity—has such broad-reach- 18-20% of overall manufacturing production costs) are competi- ing implications. tive, Mexico is significantly disadvantaged in other areas. Indeed, as Exhibit 52 shows, Mexico has not enjoyed much success in areas where energy intensity is high. This dichotomy is one of the key reasons why we think that the indigenous energy reform—but just as importantly, the potential for growing access to compara-

KKR Insights: Global Macro Trends 21 Exhibit 52 Exhibit 53 High-Energy-Intensive Sectors Could Increase KKR GMAA Decomposition of Estimated USD-MXN Competitiveness With Energy Reform Long-Term Fair Value of the Mexican Peso Is Driven by Mexico's Manufacturing Output (3mma SA, 2008=100) Inflation and Growth Differentials 14.00 13.39 High energy intensity 150 0.68 Low energy Intensity 13.50 13.00 140 0.01 13.00 130 12.50 0.31 +24% 120 12.00 110 11.50 100 11.00

90 e r wth Spot o ential ential G r 5-years Inflation Forward fe r fe r

80 Fair Value Di f Di f Capital GDP 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 aluation/ P V Data as at January 31, 2014. Source: DataStream, Morgan Stanley Data as at April 8, 2014. Source: IMF, KKR Global Macro & Asset Research. Allocation analysis, Haver Analytics.

Importantly, Mexico’s export economy has not had to deal with Exhibit 54 some of the currency headwinds that other regions of the world, Europe in particular, have confronted in recent quarters. In fact, the Valuation Relative to Per Capita GDP Growth Is Fair Mexican peso is one of the few currencies not to trade back through 50 R² = 0.7773 its 2007 levels, despite relatively strong economic fundamentals.

To be sure, we expect foreign direct investment (FDI) to increase SD 30

meaningfully over the next few years. However, even with this w) U tailwind, the local currency will likely remain “in play,” as one local 10 Parit y e/(Bel o described his currency outlook to me. On the one hand, the central e r v w bank wants the currency strong enough to dampen any increase o (10)

in inflation expectations. On the other hand, a weak currency can ch. P at times provide a much needed boost to its fast growing export (30)

at Pu r Mexic o

industries. Given such strong nationalist sentiment among locals aluation, % Ab o towards Mexico knocking off some of its Asian competitors in the (50) FX V export arena, this viewpoint has been strongly communicated to the government and central bank by business leaders throughout the (70) country. Importantly, when Agustin Carstens, who has served as 0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 Governor of the Bank of Mexico since 2010, thinks about monetary 2014 GDP-Per-Capita, $US policy, he starts from a position of strength. Key to our thinking is Data as at April 8, 2014. Source: IMF, KKR Global Macro & Asset that the country has not had to use any form of quantitative easing Allocation analysis, Haver Analytics. (QE) post the financial crisis to help stabilize over-indebtedness in any sector of the economy. In addition, Mexico’s international liquid- ity position is quite strong as net reserves (i.e., total reserves minus Looking ahead, we believe that the government should work hard gold) are now larger than both the U.S. and the lion’s share of its to extend its strength in autos to other export sectors, including Latin American peers. aerospace and pharmaceuticals. The good news is that we think the country’s proximity to the United States, its flexible currency, and its competitive wages should all act as distinguishing features as China’s role as “manufacturer” to the world diminishes further. Moreover, if Peña Nieto is successful in his energy reform and as new pipeline infrastructure increases Mexican access to cheap U.S. gas, we think the potential for a greater number of strong export sectors could increase meaningfully, which would be bullish for growth and the country’s fiscal deficit.

22 KKR Insights: Global Macro Trends More Investment/Infrastructure Needed to Boost Long-Term GDP Exhibit 57 Growth Investment per Capita Is Quite Low

As folks who travel to emerging markets quite frequently, Vance $10,000 Investment Per Capita US$ and I sometimes use the travel time from the airport to the ho- 1980 1990 2000 2013 tel as a proxy for fixed investment and infrastructure woes. Sao $9,000 Paulo and Jakarta often take the prize for the longest commutes, $8,000 but Mexico City can sometimes be a problem too. This compari- 2000-2013 CAGR 1% son should not come as a huge surprise, as Mexico has generally $7,000 underinvested in infrastructure for years. In fact, as one can see in Exhibit 55, Mexico’s investment spending is barely above Brazil, but $6,000 below Indonesia, Colombia and China. 2000-2013 $5,000 CAGR 19% 2000-2013 Exhibit 55 $4,000 CAGR 2000-2013 9% Investment In Mexico Lags Demand… $3,000 2000-2013 CAGR CAGR 2% 16% 2013 Investment as a % of GDP 47.8% $2,000 2000-2013 CAGR $1,000 13% 32.7% $0 27.6% 24.9% India Indonesia China Mexico Brazil U.S. 20.4% 21.5% Data as at April 8, 2014. Source: IMF WEO estimates for the year 2013.

Exhibit 58 Brazil Mexico Indonesia Colombia India China The New Administration Has Proposed a 71% Increase in Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia Infrastructure Investment e Estatística, Departamento Administrativo Nacional de Estadísticas, Instituto Nacional de Estadística Geografía e Informática, Central Statistical Organization, India, Badan Pusat Statistik, China National National Infrastructure Plan, Investment Breakdown Comparison, US$ Bureau of Statistics, Haver Analytics. 2007-2012 2014-2018 % Growth

Exhibit 56 Infrastructure $73.7 $101.5 38%

…This Is Particularly True In Infrastructure Spending Energy $159.8 $299.8 88%

Infrastructure Spending as a % of GDP Water $20.5 $32.1 57% 12% Indonesia Mexico India China Total Comparable $253.9 $433.4 71% 10%

8% Health $5.6

6% Housing $143.1

4% Tourism $13.9

2% Total Investment $596.1

0% Data as at April 30, 2014. Source: Barclays, Office of the President of 2005 2006 2007 2008 2009 2010 2011 Mexico. Data as at 2011. Source: CEIC, V Informa de Gobierno, Morgan Stanley Research. So our bottom line is that increased public spending on investment and infrastructure is hugely critical to Mexico achieving its potential Given its sizeable and growing population, Mexico’s investment per as a nation. Importantly, investment and infrastructure is needed capita also remains low – too low, in our view. One can see this in across Mexico’s major industries and regions to avoid some of Exhibit 57. While this approach does help to keep the fiscal deficit in the slow growth/higher inflation environments that we have seen check, it is a direct detriment to both long-term growth and productivi- unfold in Brazil and India in recent years from inadequate levels of ty. Moreover, as the exhibit also shows, growth in investment per capita investment. is now badly lagging many of its emerging market peers since 2000.

KKR Insights: Global Macro Trends 23 If there is good news, it is that Peña Nieto seems to have embraced Exhibit 59 this critique, announcing recently an ambitious target of 7.75 trillion pesos (approximately $596 billion) in infrastructure spending over Mexico Has the Lowest Share of Bank Credit as a % of the next five years—versus the $340 billion plan put forward by his GDP in Latin America administration just a year ago. According to Finance Minister Luis Credit Origination From Traditional Banks as a % of GDP Videgaray, six of every ten pesos for these projects will come from Mortgage Loans % GDP federal and state budgets, with the balance from the private sector. 78.7 As Exhibit 58 shows, this total would not only be significantly more Commercial Loans % GDP than the previous administration of Felipe Calderon but also would Individual Loans % GDP help to narrow some of the investment deficit Mexico now faces 53.1 Total Loans % GDP relative to some of its other emerging market peers. To be sure, not all this spending will take place overnight, but the increases Peña 35.2 Nieto is proposing are now sizeable enough to actually make a dif- 29.4 ference, we believe. 15.1 Financial Services: Plumbing in Need of Repair

Lending. While not a formal component of GDP, we think any thor- ough country analysis should have some overview of the banking Chile Brazil Colombia Peru Mexico sector. Indeed, if the credit is either too stagnant or not being al- Data as at December 31, 2013. Source: J.P. Morgan estimates, Central located properly, then the economic “plumbing” required to sustain Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras growth is likely broken. In the case of Mexico, our view is that the (Chile),Superintendencia Financiera de Colombia, Comision Nacional plumbing is working, but it certainly would benefit from some re- Bancaria y de Valores (Mexico), and Superintendencia de Banca, pair. Specifically, it needs to be larger and more efficient, which we Seguros, Y AFP (Peru). view as a tremendous opportunity for investors.

At its most basic level, credit penetration in Mexico is remarkably Exhibit 60 low, particularly on the consumer side. In fact, as Exhibit 59 shows, total credit originated by private banks is only 15.1% of GDP, the Non-Banks Dominate the Credit Origination Process lowest among the major Latin American economies. Not surpris- Credit as % of GDP By Type of Originator ingly limited access to traditional bank lending for households and 60 small- and medium-sized businesses (SME’s) has been a structural Dec-95 Bank Non-Bank 52.7 headwind to GDP growth. 50 Dec-13 43.6 40 Mar-06 27.5 30 28.5

10 15.1

0 95 97 99 01 03 05 07 09 11 13 “ Data as at December 31, 2013. Source: Banco de Mexico.

Because of its low-cost labor A quick review of the banking sector explains why credit penetra- force, the country is making tion is strikingly low. Consider the following. After a history of frequent crises that led first to nationalization of the banks in the considerable progress in 1980s and then privatization of the banks in the early 1990s, the key export sectors like auto sector ultimately found stability when NAFTA opened it to foreign investment. But with this stability came significant concentration. manufacturing. All told, the top five banks in Mexico (four of which are owned by foreigners) account for 73% of bank loans; moreover, they dominate “ bank intermediation for large companies and multi-nationals based in Mexico (Exhibit 62).

24 KKR Insights: Global Macro Trends Exhibit 61 Exhibit 63 Interest Rates Charged for Consumer and Business Credit Mexican Banks Are Amongst the Most Profitable in Latin by Non-Banks Are Quite High America … 2013 Return On Equity Minus Policy Rate (%) Type of Loan Average Annual Interest Rate 17.0 Small Business Loans 28%-32%

Used Car Loans 24%-30%

Durable Goods Loans 40%-50% 11.9 11.0 Payroll Loans 50%-65% 9.6 Microcredit 90%-110%

Data as at November 12, 2013. Source: Crédito Real. 5.8

Concentration in the banking sector is not uncommon in Latin America. But what is unique to Mexico is that 60% of bank loans are originated by the Mexican subsidiaries of large foreign banks. In essence, lending decisions are not being made in Mexico City, but Peru Mexico Chile Colombia Brazil instead in Madrid, London and New York. Besides this lack of con- nectivity to the local economy, there have been few incentives for Data as at December 31, 2013. Source: J.P. Morgan estimates, Central Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras change, given the high level of profitability of Mexican banks. One (Chile),Superintendencia Financiera de Colombia, Comision Nacional can see this in Exhibit 62 and 63. Bancaria y de Valores (Mexico), and Superintendencia de Banca, Seguros, Y AFP (Peru). On the plus side, we think that the reform package being implemented by Peña Nieto will encourage increased competition in the banking sector, which should ultimately drive down the high level of Exhibit 64 interest rates to households and SME’s (Exhibit 64). We are particularly encouraged by the proposed laws aimed at improving the legal ….Despite Having the Lowest Leverage framework to allow for a streamlined bankruptcy process. We also 2013 Loan-to-Deposit Ratio (%) believe that allowing the development banks to play a larger role in lending will help increase credit creation. However, these are broad 143.6 and ambitious goals which will likely take years – not months – to materialize. 113.5 101.3 Exhibit 62 97.6 95.6 Banking Sector Concentration Is Not Unusual in Latin America, But Foreigners Own Most of the Mexican Banking Sector % Foreign Ownership Top 5 Bank Loan Market Share

87 80 76 73 72 72 Brazil Chile Peru Colombia Mexico Data as at December 31, 2013. Source: J.P. Morgan estimates, Central 40 Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras (Chile),Superintendencia Financiera de Colombia, Comision Nacional 20 20 Bancaria y de Valores (Mexico), and Superintendencia de Banca, Seguros, Y AFP (Peru). 0 Peru Chile Mexico Colombia Brazil

Data as at December 31, 2013. Source: J.P. Morgan estimates, Central Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras (Chile),Superintendencia Financiera de Colombia, Comision Nacional Bancaria y de Valores (Mexico), and Superintendencia de Banca, Seguros, Y AFP (Peru).

KKR Insights: Global Macro Trends 25 Exhibit 65 Exhibit 66 The Costs of Financing Appear Excessive In Many Instances A+/A Office Rents in Mexico Are Significantly Below Peer Mexico: 2013 Average Annual Interest Rates (%) Cities… Average Class A/A+ Office Asking Rent 31.0 80 70 26.0 60

30 11.0 20 5.8 USD Per Square Meter, Monthly 10

0 , , o o, es, azil azil xi c Cit y gota, Chile B r B r Ai r o o Cit y Consumer Credit Card Mortgage Commercial Rio de M e B Buenos Panama Panama Janei r xi c Colombia Loan Santiago, Argentina e Sao Paulo, M Data as at December 31, 2013. Source: J.P. Morgan estimates, Comision Nacional Bancaria y de Valores (Mexico). Data as at December 31, 2013. Source: CBRE.

Exhibit 67 So our bottom line is that given the low level of credit penetration and rigid structure of the existing banking system, there are cur- …While Retail Asking Rents Appear Particularly Attractive rently ample opportunities for both local and foreign non-banking Average Retail Asking Rent ($/sq. meter per month) entities to provide the financing necessary to fund what we believe could be a much faster growing and more innovative SME sector 250 over the next few years. In doing so, not only would these non- banks help to play a critical role in the evolution of the Mexican 200 corporate landscape, they would also be in a position to earn attrac- 150 tive returns with a lower risk profile than may be available in other parts of the emerging markets. 100

Real Estate. Beyond bank lending and other forms of financing, we also 50 think that real estate is an essential part of the Mexican financial services landscape. Interestingly though, unlike other EM countries that 0 have benefitted mightily from low rates and access to global capital, Brazil Colombia Peru Chile Mexico Panama commercial and retail real estate prices in many of Mexico’s major cit- Data as at December 31, 2013. Source: CBRE ies, Mexico City in particular, are amongst the lowest in Latin America.

We believe there are two primary reasons behind the low prices. In the past the Mexican real estate market was limited to develop- First and foremost, insecurity has been a longstanding concern in ers and sophisticated private investors. However in 2011, the Fibra the region, and in many instances, multinationals have – until re- (REIT) market was created in order to provide access to the real cently – based their Latin American hubs out of Brazil, not Mexico. estate market in a liquid vehicle for income-oriented investors such Second, some of the largest sectors of the economy have been as local pension funds (Afores). The Fibra structure also provides closed to foreign investment, which has kept pricing more local. foreign investors access to the Mexican real estate sector.

However, as we look ahead, we believe that both these trends are Similar to U.S. REITS, Mexican Fibras are pass-through entities now subsiding and that given the low rents, high-end retail and of- which distribute most of their earnings in the form of dividends. fice space in Mexico City is particularly attractive. Indeed, as Exhibit The universe of Fibras is relatively small (and growing), but still 66 shows, asking rents for A+/A office space are among the lowest offers diversity to investors looking to gain exposure to the asset in Latin America at approximately $25 per square foot. As foreign class. Most Fibras specialize in different sub-sectors of the real firms in the energy, telecom and financial sectors enter Mexico on estate market such as industrial, retail and commercial. the back of a more level playing field, we believe rent prices will likely converge over time towards other major Latin American cit- So against this macro backdrop, we think that commercial real ies. As Exhibit 67 shows, we think that retail properties are particu- estate provides an interesting way to participate in not only the larly attractive at current valuations. compelling local demographics but also the increased interest in

26 KKR Insights: Global Macro Trends Mexico by foreign corporations looking to benefit from a more level the north to the center and the south. In addition, we fear the calm playing field. Moreover, as financial services reform gains momen- in some places may be more illusory than real. Several Mexican tum, we think that any increase in lending off such a low base could geopolitical analysts with whom we spoke suspect the reduction likely be beneficial for overall valuations and transaction volumes in in violence in some areas does not signify the defeat of the cartels the real estate sector. there, but rather the domination of the area by a single criminal network and its tacit agreement not to wage open war. Perhaps Criminality and Rule of Law—Mexico’s Achilles Heel? most worrisome for investors should be the significant growth of kidnapping—which has quadrupled since 200732— and of extortion, Beyond the obvious risk of reform implementation highlighted even as the number of murders may be decreasing. earlier in this essay, we think that Mexico’s rule of law challenges should be considered by all investors. Ultimately, Mexico’s criminality and security problems are insepa- rable from its under-resourced rule of law institutions—courts, In recent years, the scope of Mexico’s violence and criminality police and prisons. There is no quick or easy solution for this. problem has seized headlines. Last year there were approximately While there have been pockets of improvement, what is ultimately 50 percent more homicides in Mexico than in the U.S., despite less required is massive, long-term investment in these perennially than half the population. All told, Mexico now accounts for ap- under-resourced bodies. Although there are signs that some in the proximately half of all homicides in the OECD29. There are as many government grasp the scope of the problem and are pushing in the murders in Mexico in a week as in Spain in a year, and only two right direction, including passage of the long-delayed penal code countries in the world have more homicides in absolute terms— this spring, we do not yet see a comprehensive national strategy Brazil and India30. Unsurprisingly, on survey after survey, Mexicans commensurate with the challenge. indicate that public safety is their number one concern. Although inherently difficult to quantify, Mexico’s violence carries a Although often portrayed in the U.S. as the outgrowth of a narcot- heavy economic cost. INEGI, the country’s national statistics office, ics/illegal drug problem, Mexico’s violence is better understood as estimates that direct material losses from violence are $16.6 billion the consequence of the country’s weak rule of law institutions and per year, approximately 1.3% of GDP33. But indirect costs—in lost the rise of resilient, adaptive, entrepreneurial criminal networks. productivity, investment and misdirected resources—are clearly far Although these networks have historically derived much of their higher; last year, for instance, Mexico’s health minister estimated revenue from the production and shipment of narcotics, they have violent crime cost between 8-15% in annual economic output34. increasingly diversified into other illicit, lucrative activities as well. According to Mexican officials, for instance, the top source of Does this mean that high hopes for Mexico are misplaced? Ulti- income for the Knights Templar cartel in Michoacan has shifted to mately we don’t think so. Although violence and weak rule of law illegal mining (particularly iron ore), logging, and the extortion of in Mexico will remain a significant drag on growth and could cast a local agribusiness31. cloud over Peña Nieto’s reform accomplishments, we think the risk of the country being overwhelmed by these problems is exagger- While the presidency of Peña Nieto’s predecessor, Felipe Calderon ated. became defined by its bloody and ultimately indecisive struggle with the cartels, Peña Nieto entered office inclined to deemphasize an overt security agenda, focusing instead on the governance and economic reforms described above. The government believes that its new low-key approach has yielded dividends as evidenced by an apparent nationwide reduction in intentional homicides in 2013. In addition, since January 2014, Mexican security forces have moved forcefully to restore security in Michoacan, where conditions badly deteriorated last year, and successfully carried out a succession of “ operations that have resulted in the killing or capture of high-level cartel leaders. Mexico has maintained competiveness by restraining Despite some high profile successes, however, we are less bullish. While security has improved significantly in some parts of wages, not improving the country (e.g., Ciudad Juarez and Monterrey)—it has remained productivity and/or innovation. constant or deteriorated elsewhere, including not only Michoacan and neighboring Guerrero on the Pacific coast, but also Tamaulipas and Mexico State. What we appear to be seeing is, to some extent, “ a redistribution of violence—from urban to rural areas, and from

29 Data as at 2013. Source: OECD Better Life Index. 32 “Mexico’s Drug War Leads to Kidnappings, Vigilante Violence,” Time Magazine, January 17, 2014. 30 Ibid.29. 33 Data as at 2013. Source: INEGI, KKR KGI Research. 31 http://america.aljazeera.com/watch/shows/fault-lines/multimedia/ timeline/2014/5/timeline-the-riseofvigilantisminmichoacainmexico.html 34 Ibid.33.

KKR Insights: Global Macro Trends 27 Conclusion: Mexico Likely to Be a More Important Part of Any Latin American Strategy

In targeting an overweight position in small- to mid-capitalization equities, private credit, and private equity in Mexico, we are making a statement that—beyond the country’s compelling demographics— Mexico’s reforms will make a difference over the next five to seven years. We are also wagering that the reform agenda extends beyond energy to include other sectors, so that there is a real possibility of the productivity improvement we think this country desperately needs to reach its potential. If we are right, the benefits to the capital markets that investors may enjoy by a true leveling of the competitive playing field would be quite significant. “ Importantly, investing in Mexico requires that an investor look So against this macro backdrop, through a different emerging market lens. Specifically, Mexico is we think that commercial real not a pure-play urbanization story nor is it a low GDP-per-capita story that has the potential to double overnight. Also, unlike many estate provides an interesting of the Asian countries that we visit, Mexico’s fortunes may actually be non-correlated, or potentially even inversely linked to China’s way to participate in not success. only the compelling local

Rather, with 87% of its exports destined for the United States and demographics but also the the government committed to expanding trade agreements with both increased interest in Mexico Asia-Pacific and Latin American peers, Mexico is much more of an open economy investment story than many of the other emerging by foreign corporations looking markets countries many investors know. to benefit from a more level To be sure, there are obvious risks to investing in Mexico, including playing field. corruption and criminality. Also, similar to what we see in Indonesia and Philippines, valuations in the public markets can at times feel “ rich, so point of entry does matter. Finally, as we have documented throughout this piece, productivity outside the auto sector is still quite weak.

Our conclusion: Mexico’s macro tailwinds, coupled with the potential that the current historic reform agenda provides, warrant investor attention. Importantly, this country has a credible central bank with strong policies, and its government is moving towards more openness, not less, which distinguishes it from almost every other emerging market country we visit. Also, there is no credit overhang that should impede growth or monetary/fiscal policy. Over time, we believe, this backdrop should reward investors who too appreciate that Mexico is an emerging market opportunity that is best ad- dressed through a more innovative macro-focused lens.

28 KKR Insights: Global Macro Trends KKR Insights: Global Macro Trends 29 30 KKR Insights: Global Macro Trends Important Information This publication has been prepared solely for infor- concerning financial market trends, is based on current mational purposes. The information contained herein market conditions, which will fluctuate and may be The views expressed in this publication are the is only as current as of the date indicated, and may be superseded by subsequent market events or for other personal views of Henry McVey and Vance Serchuk superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated of Kohlberg Kravis Roberts & Co. L.P. (together with reasons. Charts and graphs provided herein are for on a total return basis with dividends reinvested. The its affiliates, “KKR”) and do not necessarily reflect the illustrative purposes only. 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