Mexico is a nascent private equity (PE) market primed for strong growth. Yet it has been largely overlooked as an investment opportunity, even as private equity investors have flocked to establish positions in large emerging markets like India and China over the past 12 years.

In terms of funds raised and total deal value, Mexico has strained to keep up with activity in more popular markets, and PE penetration as a percentage of gross domestic product remains below levels in much of the developing world.

But the relatively low interest that investors have displayed masks the fact that PE investment in Mexico has grown substantially over the past 12 years. Since 2000, a total of $14.9 billion in capital has been committed to PE investments. And while the economic crisis severely crimped global PE activity, investment in Mexico has actually accelerated since 2008: The annual rate of fund-raising has increased nearly sixfold, to $2.9 billion, and the number of general partners active in the market more than doubled to 71 in 2012. Compounded annually, new fund-raising has grown 56% over the past four years vs. just 4% in Asia and 2% across the rest of the world (excluding Europe and North America).

Based on Bain & Company’s deep private equity experience in other emerging markets, our view is that Mexico is positioned for continued strong growth. The four key factors that affect PE penetration in a given market— economic foundation, deal flow, policy environment and commercial maturity—all suggest that Mexico is on a pronounced upward trajectory.

Although it continues to work through a number of regulatory and perception challenges, the market overall presents a fertile opportunity both for PE investors and the country itself. Experience has already shown that most Mexican companies backed by private equity investments have outperformed the market, growing revenues and adding jobs. And the injection of private capital can help accelerate Mexico’s economic growth overall.

Increasing PE activity in Mexico owes both to the country’s steady economic outlook and improving regulatory environment. One big catalyst was a rule change in 2009 that allowed domestic pension funds to invest up to 20% of their assets in private equity. Since then, they have played a key role, contributing a total of about $4 billion in fresh capital, half of it focused on the real estate sector. With reported total assets of $137 billion, according to the Emerging Markets Private Equity Association, these funds represent a large and growing pool of potential capital.

Outside investors have been attracted by the nation’s stability and growth potential. After years of economic volatility and turmoil in the 1990s, the Mexican economy has settled into a period of steady expansion. Public debt is low, inflation is tame at less than 4% and GDP is expected to keep growing annually in the 3% to 4% range, powered by strong exports and a growing domestic market. Demographic data suggests these trends will continue. Mexico’s labor force will increase by 10 million over the next 15 years, and middle-class households will almost double to approximately 18 million.

Mexico also has a number of structural advantages that enhance its position as a global trade partner, including a skilled, relatively low-cost labor pool and managerial talent that has a cultural affinity with the West. Geographically, it shares with the US one of the world’s most active borders and has both Atlantic and Pacific ports. It has forged 11 free trade agreements with 43 countries representing approximately 75% of global GDP and benefits from six preferential trade pacts.

Among investors, there is a perception that Mexico is dominated by a handful of very large companies, with a steep drop-off in size from there, raising concerns among some general partners that there aren’t enough targets worthy of investment. But a closer look at the nation’s industrial structure shows that there are 48,000 growth companies in the size range sought by private equity and venture funds. While the pool of medium- to largesized targets is limited to around 7,000, only about 50 of those have attracted PE investment so far, meaning there are ample opportunities to find suitable candidates. The country has also developed an extensive support ecosystem to incubate new and growing companies.

The increasing maturity of Mexico’s economy points to a number of expanding foundational industries that offer unique growth stories, including education, healthcare, financial services, housing and auto parts. Companies that have already gotten PE support provide encouraging results. Nine of them, including Homex, Credito Real and Sports World, have gone public on the Mexican Stock Exchange since 2004, and a sample of successful investments shows an average 41% increase in annual revenues over four years and a tripling in the number of jobs.

Developing PE to its full potential in Mexico, however, will require addressing some key challenges. From a policy perspective, the country has made great strides when it comes to ease of doing business, providing strong investor protection and creating valuable tax incentives. The government has forged a regulatory framework favoring investments, including the rules allowing pensions to invest more freely and an important new set of bankruptcy laws aimed at facilitating real restructuring.

Based on Bain’s interviews with investors, however, there is a widespread perception that some regulations and policies still need work or are not enforced consistently, leading to confusion and the potential loss of value. Troublesome outcomes in the bankruptcies of Bufete Industrial and Mexicana de Aviación, for instance, tarnished the positive image that the bankruptcy laws had garnered through other cases that had better results for investors. Another example: CKDs, the investment vehicles used by pension funds, are widely viewed as useful, but in need of continued refinement.

Our interviews also revealed that foreign investors and domestic entrepreneurs share a lack of awareness concerning how much potential there is in working together. Mexico is simply off the radar for many general partners who are not always fully alert to how much the regulatory environment has improved in recent years. On the company side, owners and entrepreneurs tend to be wary of giving up equity, reluctant to enter partnerships and ill-informed about the track records of potential PE investors and the value proposition they can offer.

Despite these challenges, however, PE in Mexico continues to grow rapidly. And given the broader forces encouraging investment, the pressure is to the upside. If Mexico can match China’s PE penetration as a percentage of GDP over the next 12 years, a reasonably attainable goal, annual fund-raising would almost triple to around $6 billion.

For Mexican policy makers, the value of encouraging that growth is clear. To increase long-term GDP growth to a level of 5% annually, the country will need at least $30 billion per year in additional private investment. A robust private equity market could be a substantial contributor to that total and help maintain the sort of virtuous cycle of investment and growth that leads to benefits for all participants in an expanding economy.

Mexico has already made it clear that it is open for business. For general and limited partners seeking growth opportunities in a less-crowded market, it is worth another look.

1. The current state of play: Rapid growth from a small base

• Private equity (PE) is still nascent in Mexico but has grown significantly since 2000, as investors have committed $14.9 billion in new capital.
• Encouraged by steady economic growth and favorable regulatory changes, annual fund-raising increased nearly sixfold between 2008 and 2012 as the number of active general partners more than doubled to 71.
• The recent PE growth rate in Mexico has outpaced that in the rest of the world, albeit from a small base, and investments have increased steadily despite the recent economic crisis.
• Government action permitting Mexican pension funds to invest has led to new commitments of $4 billion since 2009, mostly in real estate.
• Activity is concentrated: 23 general partners have committed 80% of the capital and have favored midsize growth companies.
• Four industry sectors have accounted for 60% of all investments: real estate, technology, telecom and media, financial services, and wholesale and retail trade.
• There have been many success stories, including nine PE-backed IPOs on the Mexican Stock Exchange since 2004.
• The benefits to local companies are clear: PE support has helped companies produce strong growth in both revenue and new jobs.
• Yet PE penetration remains well below those in other emerging markets. As a percentage of GDP, fund-raising in Mexico is approximately 58% of average fund-raising in Russia, 40% of the average in Chile or Brazil and 32% of that in China. Mexico’s total deal value is also a fraction of the values in those countries.

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2. The market: Primed for strong PE growth

• Based on Bain’s deep global experience, Mexico meets four key factors for private equity growth: a strong economic foundation, ample deal flow, an effective regulatory framework and growing commercial maturity.
• Mexico’s economy is stable, buttressed by steady GDP growth, low levels of public debt and tame inflation. Exports are booming, driven by an abundance of skilled, low-cost labor and preferential access to foreign markets, including the US.
• The domestic market is expanding steadily and will benefit over the next 15 years as the labor force grows by 10 million people and the middle class doubles to approximately 18 million households.
• Mexico’s growth and development present unique opportunities in several key industries: healthcare, financial services, automotive parts, housing and education.
• Mexican companies are predominantly small. But there are 48,000 in the size range sought by private equity and venture funds. Of the roughly 7,000 medium- to large-sized growth companies, PE funds have invested in only 50.
• From a policy and regulatory standpoint, the business environment in Mexico is rapidly improving. By most measures—from ease of doing business to taxation—it performs better than the BRIC countries: Brazil, Russia, India and China.

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3. Future trends: Opportunity tempered by key challenges

• Private equity investors still face several key challenges.
• Though regulatory policies, including a strong set of bankruptcy laws, are well founded, they are not always clearly enforced, leading to uncertainty. Several important fiscal reforms have been discussed but not yet implemented, further clouding decision making.
• Investors and companies face a communication gap. Foreign sources of capital are not always fully aware of the progress being made in Mexico, and local entrepreneurs remain wary of accepting outside investment.
• Conditions remain favorable for continued growth. If Mexico can boost its fund-raising to the level of China’s as a percentage of GDP—a modest goal—the annual total of capital available for PE investments would almost triple over the next 12 years to $5.9 billion.
• The increased private investment would have substantial benefits for the Mexican economy, helping boost GDP growth toward a 5% annual rate, increasing jobs and accelerating performance among the nation’s burgeoning set of entrepreneurial companies.

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Antonio Martinez Leal is a partner with Bain & Company. Pino del Sesto is a principal with the firm. Both are in the Private Equity practice of Bain’s Mexico City office.