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Cablegate: A Look at Mexico's Nascent Private Equity Industry

VZCZCXRO6374
PP RUEHCD RUEHGD RUEHHO RUEHMC RUEHNG RUEHNL RUEHRD RUEHRS RUEHTM
DE RUEHME #4451/01 2331505
ZNR UUUUU ZZH
P 211505Z AUG 07
FM AMEMBASSY MEXICO
TO RUEHC/SECSTATE WASHDC PRIORITY 8491
INFO RUEHXC/ALL US CONSULATES IN MEXICO COLLECTIVE
RHEHNSC/NSC WASHDC
RHMFIUU/CDR USSOUTHCOM MIAMI FL
RHMFIUU/CDR USNORTHCOM
RUEHC/DEPT OF LABOR WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC

UNCLAS SECTION 01 OF 04 MEXICO 004451

SIPDIS

SENSITIVE
SIPDIS

STATE FOR A/S SHANNON
STATE FOR WHA/MEX, WHA/EPSC, EB/IFD/OMA, AND DRL/AWH
STATE FOR EB/ESC MCMANUS AND IZZO
USDOC FOR 4320/ITA/MAC/WH/ONAFTA/GERI WORD
TREASURY FOR IA (ALICE FAIBISHENKO)
DOE FOR INTERNATIONAL AFFAIRS KDEUTSCH AND ALOCKWOOD
NSC FOR RICHARD MILES, DAN FISK
STATE PASS TO USTR (EISSENSTAT/MELLE)
STATE PASS TO FEDERAL RESERVE (CARLOS ARTETA)

E.O. 12958: N/A
TAGS: ECON EFIN PINR PGOV MX
SUBJECT: A LOOK AT MEXICO'S NASCENT PRIVATE EQUITY INDUSTRY

------------------------
Summary and Introduction
------------------------

1. (U) A strong private equity (PE) and venture capital (VC)
industry has long been seen as an important vehicle for
economic growth, the development of small- and medium-sized
businesses, and job creation. Recent reforms measures and
relative political and macroeconomic stability have made
Mexico a more attractive market for PE groups. The amount of
funds PE/VC firms raised in Mexico increased from
approximately $347 million in 2004 to more than $1 billion in
2006, according to the Mexican Private Equity Association
(AMEXCAP). That said, most funds focus on companies in their
growth stage -- leaving a funding gap for start-ups and early
stage companies. Additional measures are needed to
strengthen and grow the PE/VC industry. In particular, work
is needed to build Mexico's cadre of entrepreneurs, improve
laws and regulations that affect PE/VC investments, encourage
effective and knowledge management teams, increase the
availability of exits, improve rule of law, and promote
judicial, labor, educational, and bankruptcy reform. End
Summary.

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--------------------------------
Positive Momentum Is Underway...
--------------------------------

2. (U) Mexico in recent years has enacted significant reforms
to reduce legal impediments to PE/VC investment and to
enhance transparency and disclosure. The Securities Market
Law -- which went into effect last year -- significantly
improved corporate governance and minority shareholder rights
through the creation of a special corporate category called
an Investment Promotion Corporation (SAPI). A company that
registers as a SAPI can avoid some of the requirements of
publicly traded companies for three years in return for
adopting the "Best Practices of Corporate Governance" code
and giving more power to minority shareholders. In 2006,
Mexico established a new fiscally transparent trust structure
known as the FICAP to allow venture funds to incorporate
locally. High management fees charged by banks and brokerage
houses that administer the trust and some lingering concerns
about FICAP's corporate governance structure have greatly
limited their use, but the creation of this domestic tax
pass-through vehicle was an important step nonetheless.
(Comment: PE/VC funds pooling resources from several
investors incorporate using corporate forms considered as tax
pass-throughs, in which tax is applied directly to the
investors rather than the fund. End Comment.)

3. (U) These reforms, together with relative political and
macroeconomic stability in Mexico, have generated growth of
domestic and foreign-owned PE funds focused within Mexico's
borders. Mexico has approximately 40 active funds, the
majority of which are subsidiaries of foreign companies. The
amount of funds PE/VC firms raised in Mexico increased from
approximately $347 million in 2004 to more than $1 billion in
2006, according to the Mexican Private Equity Association
(AMEXCAP), and there is optimism that deal flow will continue
to increase over the next few years. That said, most funds
focus on companies in their growth stage -- leaving a funding
gap for start-ups and early stage companies (i.e. there is
very little VC in Mexico). According to a 2006 AMEXCAP and
Deloitte survey, the industrial sectors that receive the
largest investment from PE funds are real estate, consumer
products, and manufacturing, and most investments are in
Mexico City, Monterrey, and Guadalajara.

--------------------------------------------- ---
... But Investment Environment Holds Back Growth
--------------------------------------------- ---

4. (SBU) While the accomplishments discussed above are
significant, Mexico must address the following obstacles to

MEXICO 00004451 002 OF 004


strengthen and grow its PE/VC industry.

Lack of Investment Culture
--------------------------

5. (SBU) The lack of an investment culture is routinely cited
as one of the top factors hindering the development of
Mexico's PE/VC industry. Mexico's history with PE/VC is
limited, and knowledge about the financing and benefits of
PE/VC is still wanting. Hortensia Contreras, the Director of
Investment Capital at Nacional Financiera (strictly protect),
told econoff that progress in fostering a venture oriented
entrepreneurial culture has been slow because many companies
in Mexico are family-owned, and risk-averse owners do not see
the need for PE. Carlyle Mexico's Andres Obregon (strictly
protect) added that it is not just the entrepreneurs, but
also their accountants and advisors who are unfamiliar with
the PE/VC model.

6. (SBU) Contreras told econoffs that Nacional Financiera
(Nafin) is working with Mexican universities to "catch the
next generation." She noted how many universities (e.g.
UNAM) produce excellent academics and researchers, but not
entrepreneurs. Obregon echoed Contreras' comments about the
importance of working with universities to build a culture
that fosters PE/VC and entrepreneurship. He noted how the
major VC funds in the U.S. are located in areas with a high
concentration of top-ranked universities (e.g. California and
Massachusetts). He highlighted the need to improve public
education in Mexico, noting that PE does not affect
education, but education affects PE through entrepreneurship
and innovation.

Lack of Legal Assurances
------------------------

7. (SBU) The legal uncertainty associated with Mexican
judicial processes is a another impediment to PE/VC. The
judicial system is generally considered to be slow and
unreliable. According to Joaquin Avila, the Managing
Director of Carlyle Mexico (strictly protect), judicial
corruption is also a problem.

Local Regulations and Laws
--------------------------

8. (U) Additional measures to improve laws and regulations
affecting PE/VC are needed. For example, while the FICAP
allows companies to incorporate in Mexico, the new trust
mechanism's high costs and inefficient structure have
resulted in it hardly being used. At the same time,
incorporating abroad remains prohibitively expensive for
smaller funds. Currently, Mexico does not recognize U.S.
partnerships and limited liability companies as fiscally
transparent for tax purposes. This prompts many fund
sponsors to incorporate in Canada, which is considered a tax
pass-through. According to a local consulting company,
Mexico does not recognize funds incorporated in the U.S. as
tax pass-throughs because of a lack of understanding about
U.S. partnerships, pass-through entities, and disregarded
vehicles. Some argue that if investment vehicles are
considered a tax pass-through under their host country law,
the Mexican government should recognize them as pass-through
entities as well.

9. (SBU) Contreras told econoff that the problem of minority
rights of shareholders was solved with the new Securities
Market Law, but Obregon noted that there was still a tendency
to focus on getting a "51% slice" of the company, and not on
the "size of the pie." A 2007 report from the Latin American
Venture Capital Association (LACVA) noted that there are some
concerns that the prevalence of family and other ties will
dilute minority shareholder voices.

10. (U) Many investors have argued that Mexico should

MEXICO 00004451 003 OF 004


increase tax incentives for PE/VC investing. Some say that
such incentives should favor only positive investment
outcomes and not reward losses.

11. (U) Some investors have called for Mexico to lift
restrictions imposed on institutional investors for putting
money in this industry, noting that pension funds are an
important source of U.S. venture funds. The President of
AMEXCAP earlier this month said publicly that allowing
pension funds to invest in PE would not only help workers
retire with a dignified pension but it would also finance a
productive activity.

Ineffective Management Teams
----------------------------

12. (SBU) According to KPMG's 6th annual Latin American
private equity survey, one of the primary causes for deal
failure involving PE transactions in Latin America is
ineffective management teams. Contreras told econoff that a
key to a fund's success in Mexico is high involvement of the
fund managers in their investments. She added that funds are
trying to create more local management teams to ensure
understanding of the Mexican culture, political, business,
and legal environment.

Need for Exit Strategies
------------------------

13. (SBU) A vibrant VC industry requires not only investors
willing to fund the deals, but also plausible exit strategies
for those investors. Contreras told econoff that exits are
still a problem because most companies are still too small to
do an initial public offering (IPO). She said the government
created a private non-regulated middle market company to
help, but that Mexico must do more to develop strategies that
facilitate exits.

Need for Structural Reforms
---------------------------

14. (SBU) Avila told econoffs that economic reforms that
improve Mexico's business climate are needed to strengthen
the PE/VC industry. He specifically mentioned the need to
improve rule of law and for labor and bankruptcy reform.

----------------------------------------
The Government's Role in Promoting PE/VC
----------------------------------------

15. (SBU) The Mexican government -- with the support of
several leading Mexican government financial institutions,
including Nafin, Bancomext, Banobras, and Focir --
consolidated its investment into a fund of funds to more
efficiently disburse public investment into private
sector-run PE/VC funds. This "Fund of Funds" (Corporacion
Mexicana de Inversiones, CMIC) started operating in August
2006. Contreras told econoff that Nafin now invests only
into this fund, and that it has about $200 million committed.
Seven new funds have been approved for $100 million and 12
funds, worth $1.5 billion, are being evaluated.

16. (SBU) Obregon told econoff that the government should do
more to develop the PE/VC industry in Mexico, but he added
that the scope of what the government could do is somewhat
limited. He said that Mexico needs people who are willing
"to go out there and pound the pavement" looking for deals --
something that will only happen if the person will directly
benefit from his/her work. In the context of fostering
PE/VC, Obregon said that it would be useful to bring
experienced venture capitalists to Mexico from the U.S. on a
regular basis.

-------
Comment

MEXICO 00004451 004 OF 004


-------

17. (U) Many Mexican officials and economists understand the
benefits of having a vibrant PE and VC industry. Mexico is
an increasingly attractive market for PE investment, but
progress on reforms is needed if this industry is to grow
enough to translate into the desired impact on jobs and
economic competitiveness. In this context, the importance of
improving Mexico's educational system cannot be understated.
Advancements in this area are needed to give the country's
youth the skills they need to further contribute to Mexico's
body of research and development, take advantage of
opportunities from NAFTA and globalization, and reduce
widespread poverty.


Visit Mexico City's Classified Web Site at
http://www.state.sgov.gov/p/wha/mexicocity and the North American
Partnership Blog at http://www.intelink.gov/communities/state/nap /
BASSETT

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