July 28, 2014
Interviewed by: David Snow
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KKR: Why Investors Should Consider Mexico

Mexico’s widespread economic and political reforms, favorable demographics, and proximity to the U.S. are positives for private equity firms investing in the country, say KKR’s Henry McVey and KKR Global Institute’s Vance Serchuk. However, security risks remain and investors must acknowledge that it is a long-term investment play.

Mexico’s widespread economic and political reforms, favorable demographics, and proximity to the U.S. are positives for private equity firms investing in the country, say KKR’s Henry McVey and KKR Global Institute’s Vance Serchuk. However, security risks remain and investors must acknowledge that it is a long-term investment play.

Why Investors Should Consider Mexico

With Henry McVey of KKR and Vance Serchuk of KKR Global Institute

David Snow, Privcap:

Today we’re joined by Vance Serchuk, executive director of the KKR Global Institute, and Henry McVey, member and head of global macro and asset allocation for KKR. Gentlemen, welcome to Privcap. Thanks for being here.

Vance Serchuk, KKR Global Institute:

Great to be here.

Snow: You have worked together on an important new paper on Mexico and your views on Mexico as an investment destination.

Henry, talk in general about the various sectors of the Mexican economy that you find interesting as an investment possibility.

Henry McVey, KKR:

Great. Within Mexico, we see a couple of interesting things. First, on the real estate side, prices are extraordinarily cheap in terms of commercial rents, so there is a mad rush towards Brazil—São Paulo, in particular. Whereas in areas like Mexico City, sometimes rents are one-third to half. Second, as financial services reform takes place, we think credit will start to flow more in Mexico. Unlike most other emerging markets we look at where there was somewhat of a credit binge between 2000 and 2010, Mexico has been dominated by five banks with 80% market share. As the reforms take hold and you start to see legislation that changes that, that should drive great credit penetration, which will affect consumer spending as well as corporate spending in small to medium-sized businesses. Then, I would focus on the consumer. You’ve got great demographics that should continue to shine. Then, what Vance and I try to highlight in the paper is that energy reform is a key milestone, and that it would include everything from services and energy to pipelines, to partnering with Pemex, the national champion there. A lot will take place, but it will be over a multi-year period, so quite a bit of opportunity from a sector perspective.

Snow: What is unique about the Mexican opportunity that maybe stands in contrast to some other emerging markets?

McVey: With Mexico, you have to look through a different investment lens to capture what the opportunity is. This is a country with a lot of internal demand already; almost 70% of the GDP is consumption. Contrast that with China, where it’s 36%. If you look at GDP per capita, it’s $11,000—that’s much more than most of the emerging markets. Other emerging markets, particularly in Asia and Africa, and it’s almost 80% urbanized. So, from a macro standpoint, this is wildly different from other things we see in the emerging-market opportunity set. The other thing that’s important to highlight is that Mexico is much more liked to America as well as just North America. So, we view it almost as the anti-China. As a firm, we’ve got a distinct thesis that the China manufacturing boom that dominated the 2000 to 2010 period is starting to slow, and we’re looking for other ways to play where we think we’re going to see incremental growth, either through manufacturing or emerging market growth. And, without question, Mexico is clearly in that strike zone.

Snow: Vance, can you paint a picture of what’s going on in Mexico politically? What are some of the reforms taking place? What is driving that progress?

Serchuk: This is one reason, David, that Mexico is so interesting: since President Peña Nieto came to office in July 2012, he’s been able to engineer a series of historic structural reforms through something called the Pact from Mexico. What we’ve seen are essentially three major political parties in Mexico coming together on a united program of changes in areas like energy, telecomm, fiscal, and governance, though each of these parties represents a different part of the political spectrum moving forward. When you think about the world overall, there are not many countries now in either the emerging space or the developed space where you see leadership with the political capital, the political will, and the vision to push through tough structural reforms.

Snow: Let’s go back to the manufacturing play. Talk about how changes in China and Mexico’s proximity to the U.S. spell a manufacturing opportunity in Mexico.

McVey: First, if you think about wages, wages in China have been growing nominally somewhere between 9% and 11% per year. Wages in Mexico have been growing at less than the rate of inflation, so you’ve had a wild delta where China has exploded to the upside, while Mexico has been very flat.

Given its proximity to the U.S., Mexico is important. Though, if you look at manufacturing, you have to drill down, because there are a couple of things to know. One: auto’s growth is exploded; exports out of Mexico to the U.S. have quadrupled in the manufacturing sector, and, overall, 87% of Mexico’s manufacturing goes to the U.S. That’s the good news. The bad news is that outside of key areas like autos, there haven’t been the productivity gains you need. So, it’s important that Mexico has low-cost wage labor, but ultimately, over time, they’ve got to increase productivity.

Snow: Does private equity play to the investment opportunity in Mexico? Are there opportunities there to put private capital to work?

McVey: One thing that’s most unique about Mexico is that it’s dominated by somewhat of a monopolistic or oligopolistic, top-down view for most of the industries. Because of these reforms that Vance talked about, you’re starting to see some real change or you should see some real change where the mid-capitalization stocks will actually start to grow and perform better. Since the president came in, the mid-cap stocks have actually outperformed the large-cap stocks by 50%. Since 2012, that’s a huge number.

The opportunity to partner with good or great companies and good managements in strategically important sectors to help accelerate this reform is key. And those companies ultimately will come public and will provide an opportunity for people to participate in Mexico.

We both want to reiterate, though, this is a long-term play. You’re not buying Mexico for the next six months. This is a three to five to seven-year play. You have to know where you want to participate. It’s important to have local expertise and it’s important to be with the right people. Ultimately, the private equity business there will continue to grow, and it’s important that, in private equity, you can target where you see the key changes, whether it’s in energy reform, parts of consumption, parts of manufacturing, or logistics, or pipes—not just buying a broad-base market.

Serchuk: This is an extended period where we’ll have to see how these reforms play out and what their impact will be. The good news, with respect to the reforms, is that they built up a good head of momentum. The flip side, though, is that the test now falls on implementation and execution, so a number of the reforms still have to get through Congress—so-called implement legislation, energy legislation first among them, but others as well. Then, the next part is how effective the Mexican government will be in being able to carry out on a day-to-day basis the new institutions, new regulatory structures, and new laws it wants to put into place.

Snow: Vance, can you talk about the perceptions of risk in Mexico around the violence taking place in the country? To what extent is that preventing more investment in the country?

Serchuk: There is a certain schizophrenic quality in the way people talk and think about Mexico. A few years ago, newspaper headlines read that Mexico was going to be the next Afghanistan, that it was on the way to being a failed state. Now, you hear the flipside, with a great deal of bullishness about Mexico. The key is, you have to understand Mexico for what it is—its own complicated society. Security is a serious issue.

In some respects, security has gotten a bit better, particularly in the last year. Murder rates have gone down. But, we see another phenomenon, which is an increase in kidnapping. What’s really at stake here is that rule in law and institutions in Mexico remains weak. That means courts, police, and prisons. And, while these structural reforms the Peña Nieto government has pushed forward in a variety of other areas are really transformational, we have not yet seen the kind of comprehensive strategy that’s really credible with respect to this big challenge.

This is going to be a drag on growth going forward. For investors, it also means you’ve got to take this into consideration and really be granular in your analysis of how you might be exposed to these kinds of risks.

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