Peña’s project

For many private equity investors, Mexico presents a potent brew. Economic growth looks likely to accelerate after decades of disappointment, there is a present dearth of private equity to pounce on the opportunities this generates, and there is a howling need for private investment in a large slice of the Mexican corporate sector because of underdeveloped banking and capital markets.

This combination of economic potential and patchy financing presents “a universe of opportunities” for private equity investors, says Miguel Olea, partner and regional head for Latin America at Abraaj Group, the growth markets-focused investment firm.

Many heads of state take office with airy promises to impose a slew of reforms to sort out the economy, but according to investors who follow political developments in the country closely, President Enrique Peña Nieto, the Institutional Revolutionary Party (PRI) politician who came to power last year, is actually making good on his pledges.

Peña Nieto’s success is one of the key factors enticing KKR, the US private equity group, into the Mexican market. It is the first reason for investing cited by Alexander Navab, the firm’s New York-based head of Americas Private Equity, interviewed shortly after a trip to the country to seek out opportunities – though KKR has not yet bought any Mexican businesses. “We are very impressed with the new president and his agenda”, he says. “The reforms he is putting in place are pretty extraordinary.”

Navab recalls: “A year or so ago everybody said they were good reforms but he’d never be able to get them done. However, many, many things have now been agreed to by both parties in Congress and turned into law.”

The reform with the highest profile internationally – the opening of the energy sector to foreign and private investment – was signed into law in August. Navab sees private equity opportunities arising from this, including investment in pipeline and other logistics companies.

Private equity investors also say that what is truly significant is not any individual reform, but the sheer breadth of the new government’s agenda for change. As well as the work done for the energy sector, they include telecoms deregulation and measures to prevent anti-competitive behaviour in all industries. KKR thinks the reforms could push Mexico’s long-term underlying growth rate from about 2.8 percent now to 4.5 percent in the future.

If economic and regulatory reforms do boost economic growth, private equity investors anticipate middle-class spending to rise significantly. This is not just a matter of income growth. Investors also expect them to run up more debts. Domestic credit – including corporate as well as household debt – is only 29 percent of GDP in Mexico, according to the World Bank, compared with 71 percent in Brazil and 198 percent in the US. However, experts expect bank lending to both business and households to rise, following changes to the banking laws that were enacted in January. These changes aim to increase the supply of credit by, among other things, making it easier to collect on loan guarantees in the case of non-payment.

It is, in fact, hard to have a conversation with a private equity investor about Mexico that isn’t peppered with references to the promise of the middle classes. “The area where we are most optimistic is in pretty much everything relating to the middle classes”, says Roberto Terrazas, managing director at Nexxus Capital, a private equity firm based in Santa Fe, Mexico. Its Nexxus VI Fund closed last year with commitments of $550 million. “The government’s reforms” – including, he notes specifically, the greater access to finance – “will create a large middle class with more purchasing power.”

Terrazas sees Price Travel – in which previous funds, Nexxus IV and Nexxus V, bought a 31 percent stake in 2012 – as a “middle class play”, offering trips such as a four-day stay in Cancún, the local resort town. By turning it into an ‘omni-channel’ company, with an online presence but also a suite of kiosks where middle-class customers unused to the web can receive help with booking online, Nexxus has managed to grow revenue by about 40 percent a year, he says.

Turning to the commercial opportunity for private equity that is growing out of the politically driven macro chances, Terrazas sees it as very attractive indeed, largely because there is “very little competition” for sponsors. As late as 2011, private equity activity in Mexico accounted for just 0.01 percent of gross domestic product. The total has risen since then: in 2013 funds raised for Mexican investment in private equity and venture capital reached $1.044 billion, more than triple the 2012 figure, according to the Latin American Private Equity and Venture Capital Association. However, the stock of private equity investment is still extremely low compared with many other emerging markets.

Terrazas notes that because of the lack of funding and therefore of competition, “we’ve been able to buy into good companies at around 6 to 7 times EBITDA” – below that of several other emerging markets, where purchase price multiples can reach double digits. He thinks that Mexico provides, therefore, a cheap way to tap into the broad global theme of the emerging market middle classes.

This estimate is echoed by Olea of Abraaj. He calculates that companies with a good track record in the mid-sized sector – companies with a book value between $5 million and $100 million – can be bought for 6 to 7.5 times EBITDA. He sees another reason for the benign pricing: these companies are subject to a shortage not just of private equity, but of funding in general. “Mid-caps do not have the same access to the banking system as in other economies”, he says. “The banks have been very slow in getting into the mid-cap market aggressively.” Partly for this reason, “the mid-caps are the sweet spot of the market”.

Mexican businesses in which Abraaj has invested include ARG, a leasing company, and RedIt, an IT services company. Both stakes were sold to Mexican trade buyers this year: ARG to leasing company Docuformas, and RedIt to IT provider KIO Networks.

Low valuations may not, however, last forever. Mexican private pension funds have gradually increased their private equity investment in the years following the 2009 removal of the regulations that barred them from putting money into private equity and other alternative asset classes. This base of local investors is attracting international investors, too, say people on the ground in Mexico City.

NO BARGAIN MARKET

In a virtuous circle, the growth of prestigious international investors is starting to bring in yet more local investors too. “New private equity firms are coming into the market every day”, says Olea, speaking with only a modicum of hyperbole. He estimates that the number of general partners active in the county has risen from seven or eight a half-decade ago to 15 to 20 now – with growth in both local and international partners.

However, if private equity investors continue to pour into the Mexican market – and banks start to provide stiffer competition with them in financing mid-sized companies – the same market fundamentals that are currently so appealing could start to disappear. As a potential new entrant, Navab of KKR is sceptical that stakes in good companies can still be bought for less than 7 times earnings.

“This is not a bargain market by any stretch”, he concludes. That may be the case precisely because huge international investors such as KKR are coming in.