January 6, 2014
Interviewed by: David Snow
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Gen. Petraeus of KKR: Global Opportunities, Risks

General David Petraeus, the US Army four-star general and former Director of the CIA, and national security expert Vance Serchuk, explain why they partnered with KKR to create the KKR Global Institute. In a wide-ranging, exclusive interview with Privcap’s David Snow, they also discuss:
• The promising outlook for the North American economy, including Mexico
• Why tensions between China and Japan may spur economic progress
• Why emerging Europe is a bright spot for the EU
• The under-heralded progress of ‘reformist monarchies’ in the Middle East

This interview was shot in NYC in December 2013.

General David Petraeus, the US Army four-star general and former Director of the CIA, and national security expert Vance Serchuk, explain why they partnered with KKR to create the KKR Global Institute. In a wide-ranging, exclusive interview with Privcap’s David Snow, they also discuss:
• The promising outlook for the North American economy, including Mexico
• Why tensions between China and Japan may spur economic progress
• Why emerging Europe is a bright spot for the EU
• The under-heralded progress of ‘reformist monarchies’ in the Middle East

This interview was shot in NYC in December 2013.

The World of Opportunities and Risks
With General David Petraeus and Vance Serchuk of the KKR Global Institute

David Snow, Privcap:
Today we’re joined by Vance Serchuk and General David Petraeus
of the KKR Global Institute. Gentlemen, welcome to Privcap today. Thanks for being here. Why don’t we start with a question for you, General. Many people know your background – or at least they think they know your background – but I’d love to hear directly from you a bit about you and the path that led you to private equity in general and KKR in particular.

General David Petraeus, KKR:
Well, I think a fair number of folks know that I served in military for some 37 years, then did a stint as the director of the CIA. Not all would know that I did an academic phase earlier in life, did a PhD at Princeton in a combination of international relations and economics, and actually taught both of those subjects at West Point. I continued to follow that avocation in various respects including at the Agency and a fellowship at Georgetown at another juncture. I knew [KKR co-founder] Henry Kravis very well, knew [co-founder] George Roberts, had enormous respect for them.

Warren Buffett always says that you invest in leadership. The truth is, that’s what I did with KKR. I invested in those two great leaders, the co-founders that are still with the firm, and a team that is absolutely phenomenal. It’s really a team of all-stars and it’s a great privilege to be part of it. We’re having a lot of fun actually, working very hard to contribute to the investment process to ensure that the decisions that are made are informed by as much of the kind of research and insight that we can offer by experiences not just in the Mid-East but elsewhere around the world.

Snow: We’re going to hear a bit more about the Institute and also about your views on North America and elsewhere in the world, but first, Vance, can you tell us a bit about your background, how you were connected with the General and with KKR and the Institute.

Vance Serchuk, KKR:
So I, likewise, came to private equity by way of Washington D.C. I spent the last six years as the foreign policy advisor to Senator Joseph Lieberman. That was a job that meant working with various parts of the US government, working in close contact with foreign governments and travelling a lot around different parts of the world.

At the end of last year, I left the Senate along with Senator Lieberman. I spent the first six months of this year out in Asia with the Council on Foreign Relations and writing a monthly column with the Washington Post. And I was lucky enough to get a phone call one day from General Petraeus, from Dave, telling me about KKR and his plan to go there and asking me if I might be interested in pursuing that opportunity to become Executive Director. And so one thing led to another and here I am.

Snow: I’d love to hear a bit more about the institute. What is it? Who does it serve? What are the resources that you’ll bring to bear to accomplish what you need to accomplish?

Petraeus: What the institute tries to do, first and foremost, is to enable those who are making decisions to do so with as much insight – wisdom, if you will – good diligence as is absolutely possible. The Institute brings together three pillars. One was the existing global macroeconomic team headed by [KKR Head of Global Macro] Henry McVey, superstar in that field. Another is the environmental, social and governance as well as global public affairs element headed by Ken Mehlman. And then we’ve really added the third pillar and then worked hard to begin to integrate all of these, the third pillar being the geopolitical risk, the trends analysis, regional issues, those kinds of topics to then bring it all together, integrate and provide that as a package again to the cofounders, to the senior partners and so forth as they’re making decisions on big investments.

Snow: Vance, ultimately who are the clients of KKR Global Institute?

Serchuk: Well, in practice, David, we find ourselves working with several different lines of operation. We’re working very closely with KKR deal teams to evaluate prospective investments. We’re working very closely with some of our portfolio companies to develop their global growth strategies. We’re working closely with some of our investors. We always want to make ourselves available as a resource to them. And then, lastly, part of our mandate is to do what we call thought leadership – what are the global trends in macroeconomics and demographics and geopolitics, technology and energy that are going to shape the investment climate over the next five to ten years? As part of that long term view, also, what are the black swans, the events that we need to be cognizant of and think through that would have a transformational impact if they were to materialize.

Snow: Let’s start with North America. It sounds like you’re very bullish and it’s not just because you’re patriotic. It’s because you see fundamentals that are compelling. Can you talk a bit more on that?

Petraeus: It really started probably as much as two years ago at the Agency. You know, the Agency doesn’t just chase bad guys and recruit spies. It also does an enormous amount of analysis including in the energy and security area, various economic issues as to how the US fits in the global economy. And we did a great deal of that, especially as the various rounds of sanctions were being envisioned for Iran, asking predictions for what would happen to the oil prices and so on. And we started realizing the impact of the energy revolution.

Let’s remember that just three years or so ago people tossed around the term “peak oil,” i.e. we’ve peaked in our oil production. Well, as you know, last year alone we added another million barrels per day to US oil production. We’re now the largest natural gas producers in the world and we have an extraordinary comparative advantage when it comes to natural gas in that we’re paying maybe $3.70 or $3.80 per million BTUs. The Japanese are paying some $16.00, $17.00 for that same amount, China $10.00 to $12.00, Europe $9.00 to $12.00 depending on the deal with Russia.

So this is an extraordinary opportunity for the United States. It has a pipeline price when it comes to natural gas, not a global price the way Brent Crude does, and oil. And it will really have enormous ramifications. It already does. Any industry that uses natural gas as a raw material, any industry that needs cheap energy, is going to benefit substantially from this. And by the way, so are our partners in Mexico and Canada, having quite a lot of energy resources of their own already.

What this is going to do is provide much greater independence. I don’t know whether we get to self-sufficiency or not. There’s a variety of different forecasts for that. But regardless, we are going to be vastly more independent as an economy, as a region, as a continent. Keeping in mind the enormous integration that has taken place over the past 20 years of NAFTA, where now Canada – a relatively small country, certainly compared to say the 1.3 billion people of China, the number two economy in the world – Canada is our number one trading partner, goods crossing back and forth that border at a very high rate, and then Mexico, now our number two trading partner.

So as this evolves, you have a market of roughly 500 million people. The demographics are good compared certainly to those of say Japan, or China, which is facing a downturn, and many of our trading partners.

We have a number of other advantages: The manufacturing revolution, the IT revolution and the life-sciences revolutions are also endeavors in which the United States and North America at large are in the lead and so the prospects are quite good. There are issues certainly. Our country faces a number of challenges, among them the need for more infrastructure investment, the need to continue research and development, the need to address education shortfalls, keep the deficit to GDP ratio coming down rather than ultimately going up if we don’t deal with entitlements.

So there’s a variety of different issues that have to be confronted by the United States, and also, by the way, in our two leading trading partners. But comparatively speaking, looking at the world as a whole, the prospects are quite bright for North America.

Serchuk: Another dimension of it is demographics. And when you look at North America in comparison to the other major regional blocks, the other great powers, we have a comparative advantage in that our population, thanks to immigration in large part, is going to stay comparatively younger. One of the challenges that China has is – in the West most countries got rich before they got old. For the Chinese the danger is that they’re going to get old before they get rich. Because the average age in the United States is going to stay lower, that’s actually a huge advantage.

Another is geopolitics, which is that the United States is blessed by having these neighbors – two democracies, 500 million people taken together, no territorial disputes. This is another area where in comparison to China we’re really blessed. The bigger point here is – this is the sort of thing that the KKR Global Institute tries to get at. In addition to working with our deal teams, with our portfolio companies, with our investors, it’s what we call thought leadership. It’s trying to find the big ideas out there that are going to affect the way in which people are going to have to think about the world and the investment climate over the next five, ten, 15 years. What are the trends that are going to shape things just over the horizon? And we think that the North American decade is one of them.

Snow: What are your views on the future of Mexico? How bullish are you?

Petraeus: I think I’m a qualified optimist. The qualification obviously is a result of recognizing the rule-of-law challenges that exist. But if you look at what’s going on in Mexico with a growing middle class, with a real manufacturing boom taking place. . . keep in mind that Mexican labor is now only a bit more expensive than Chinese labor, after ten years of double-digit increases in the cost of labor in China. And you actually see on-shoring of manufacturing, not necessarily to the United States, but actually in many cases coming to Mexico. Some of that then will come back to the United States as well as again this manufacturing revolution, three dimensional printing, robotics, increased automation and so forth, reduces further the human labor and increases further therefore the productivity of those who are actually still in that field.

No question that Mexico’s got a variety of different challenges but there’s also no question that President Pena Nieto has really been taking them on quite head on. He’s now embarked on reform in the energy sector that is of enormous significance. They have enormous blessings in that area. But because of the way it has been structured and the state-owned enterprise aspect of it, if you will, the production has been falling rather than increasing. Their view clearly is that if you can get outside investment expertise and technology, that they can reverse that. I think that’s a very good bet. It will take some doing, clearly, to get that through. It’s a very tough issue politically for him and I have enormous respect for him and quite frankly, for the major opposition party that is working with him on this to enable them to take what I think is clearly the right step forward.

Snow: A very quick follow up question. It sounds like the security situation that gets a lot of attention in Mexico doesn’t figure prominently into your view of the country…

Petraeus: No, it does. And again, that’s the qualification. There clearly has to be an accelerated additional effort. This is a serious rule-of-law challenge. These are enormous enterprises. These aren’t just illegal narcotics gangs, they are criminal empires, if you will. And they work in other areas now than just the illegal narcotics arena. But having said that, again, you see this economic growth, you see the dynamism, you see the expansion of the middle class and you see efforts looking closely now at the initiatives in Monterrey State, a very important manufacturing hub, where they have quite good initiatives to tackle that rule-of-law issue and to reestablish what is necessary, again, for the economy to truly realize its full potential.

Serchuk: The big question, in addition, to security is to also remember the political reforms have made progress but they’re not done yet. And so this is another thing that we just have to watch very, very closely. And exactly what will the parameters of energy reform itself be? Still very much open to question. But all this goes back to the point that this is how politics ultimately is going to help drive a market outcome.

Petraeus: The kinds of understanding and insight that we think are hugely important to individuals making investment decisions. One final comment on Mexico is that I think few Americans realize that the net flow of people in the past year has actually been to Mexico, not from Mexico, and that’s quite a shift as well. And it’s really a result not only of the economic slowdown in the United States, but the economic growth in Mexico.

Snow: Really big question. I’m interested in your overview but the outlook for Europe. Clearly challenges, but a variegated set of challenges. What does your research tell you about the future of Europe?

Serchuk: Well, I think that we should look at Europe right now. We are seeing some signs of recovery, particularly on the periphery. We like Spain. Another story that we’re paying a lot of attention to is that Europe went through, in many respects, its economic near-death experience over the last several years, but it’s gotten through it and what’s so striking is that you can see the extraordinary, magnetic, attractive power of the European Union on the eastern periphery.

So just actually a few weeks ago we were in Serbia. KKR just did the largest-ever private equity deal in Serbia. And you know, the story in Serbia is one of really quite remarkable decisions and courageous decision on the part of political leadership there to confront difficult issues so that they can move forward towards the EU. So that’s fundamentally a good news story.

I think on the other side of it, something that we’re going to be watching very closely on the political side over the next several months, is European parliament elections. Centrist parties have been pretty badly damaged by the crisis and as a result you see the rise on the far left and the far right of rejectionist parties. And what impact that will have on the European narrative in the way in which investors look at Europe is something which is, I think, still very much open to question. By and large, you know, there are opportunities in Europe that we can, I think, identify. But it’s not out of the woods yet.

Snow: Let’s move to Asia. Clearly some tensions there right now. What is your analysis and, you know, how do you see the situation there?

Serchuk: The question that we’re often asked is, is there really a real risk for open conflict here. I think that the answer that we would give right now would be, cautiously, that we don’t think that it’s going to boil over.

What’s striking though is, in the case of Japan, a country which over the last few years from an economic perspective has done much better than we’ve come to expect over preceding decades. I think that part of our thesis is that it’s actually, in part, those tensions and the concern about China which has spurred a greater willingness to contemplate otherwise really, really unthinkable reforms. And so in a strange way those viewed political tensions, although they are a negative and a danger, could also have a positive upside, provided that they push the Japanese in the right direction towards trying to rebuild their economic strength.

Petraeus: And we’re watching Abenomics, obviously, very closely. The prime minister, we both spoke with him when he was here during the UN general assembly. We also just met with his ambassador and foreign minister and others. He has re-inflated that economy in an impressive way. Of course, he’s done it with the tools that are more easily wielded – fiscal stimulus and monetary easing. The challenges now are carrying through the meaningful reforms in the labor sector with the agriculture economy and then in various financial ways and doing that of course while still retaining the support of the people. But recognizing that – he has an opportunity that no other prime minister has had in recent decades, and there are several years without another election. And he controls both houses, albeit with a coalition for the upper house.

So that’s another country we’re watching closely. KKR did recently do a deal there as a matter of fact. We’re looking at others. There are opportunities there and we’re very keenly watching how this goes.

Snow: A final question for you regarding a very important part of the world and a part of the world that you know very well – the Middle East. Obviously a big place, different things happening in different places. But is there a key aspect of developments in the Middle East, wherever it is, that investors and people in general need to understand better, especially here in the West, where if they did understand it would give them a different outlook about the future of that region?

Petraeus: Well, clearly you have a number of countries that have gone through an Arab Spring and most of which now are less stable than they were, some much less stable as in the case of Syria where you have really a regional civil war being fought on that country’s territory.

Egypt – going through an evolution now, coming to grips with its constitution but facing some significant economic challenges. They’ve got to get the outside investment and the tourists back in there. Libya -confronting the militia that took down Khadafy but then didn’t demobilize. And then you do have Tunisia, which seems to have been able to grapple its way forward. The opposition and the parties in power are able to have dialogue and to meaningful move forward. So perhaps that’s an example of what right can look like.

But then you have what really should be termed the reformist monarchies. You have Saudi Arabia. You have Qatar, the UAE, Kuwait, even Bahrain, Jordan, even Morocco. And in each of these countries there have been far more reforms than I think most people recognize. You have to understand the culture. You have to understand the conflicting tensions in these countries to appreciate how much, say, King Abdullah in Saudi Arabia has really done in a state where there is a lot of conservative sentiment that does resist some of what he has implemented. And they are moving forward.

These countries are investing. They are building superb educational facilities. They are working very hard to diversify their economy so that within decades they are no longer completely dependent on the oil and natural gas exports. And these are very important trends.

Snow: Well, gentlemen, thank you so much for joining Privcap today. I hope I can have you both back to talk about what you see in the world in the future.

Petraeus: Our pleasure David, thank you.

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