InsIghts Global Macro Trends

OctOber 2011

Phase III: The Last Stage of a Bumpy Journey

The bear run that began in 2000 has played out like a triptych, with the third and final act now upon us that will, in our view, be marked by uncertain fiscal sustainability, shorter economic expansions and heightened capital-markets volatility. We believe this third actwhich we dub Phase IIIwill require more opportunistic approaches to asset allocation and introduce a host of possibilities for such approaches.

KKR global MacRo & asset allocatIon teaM henRy h. McVey Head of Global Macro & Asset Allocation +1 (212) 519.1628 henry.mcvey@kkr.com DaVID R. McnellIs +1 (212) 519.1629 david.mcnellis@kkr.com FRances b. lIM +1 (212) 519.1630 frances.lim@kkr.com Rebecca J. RaMsey +1 (212) 519.1631 rebecca.ramsey@kkr.com

Introduction
a physicist and nobel Prize laureate by the name of niels bohr once said that prediction is very difficultespecially if it is about the future. no doubt, there is a lot of truth to bohrs cynical quip: forecasting is somewhat of a necessary evil in the investment business, given that decision processes about capital allocation require that we almost always make todays decisions about tomorrow. but there are several things investors can do to improve their chances of success. We focus on three. First, we try to counter the uncertainties inherent in making predictions through consistency of process, meaning that we tend to look at the same data series month-in and month-outrather than simply jump from one data point to the next just because it may support our existing thesis. second, we attempt to marry our top-down approach with bottom-up checks and balances by working closely with KKrs in-house industry experts, senior advisers, portfolio companies and key business relationships. this part of the process helps not only to keep existing ideas accurate and up-to-date, but also to generate new ones. third, we try to develop high-level proprietary insights by leveraging KKrs global franchise to our advantage. collectively, KKrs private-equity portfolio companies generate in excess of $200 billion in annual revenues, employ over 900,000 people globally and operate in 14 different industries. this informs our thinking, which we also hope will, in turn, be useful to our portfolio companies and our investors.

MaIn oFFIce Kohlberg Kravis roberts & co. l.P. 9 West 57th street suite 4200 new York, new York 10019 + 1 (212) 750-8300
coMPany locatIons Usa new York, san Francisco, Washington, d.c., Menlo Park, houston eURoPe london, Paris asIa hong Kong, beijing, dubai, tokyo, Mumbai, seoul aUstRalIa sydney 2011 Kohlberg Kravis roberts & co. l.P. all rights reserved.

KKR

InsIghts: global Macro trends

so what do we see from our perch these days? In this paper we comment about what tomorrow might look like and make a number of observations and recommendations.
1. We Have Entered an Investment Period 1 (Phase III) That Will Require a More Opportunistic Approach. our big-picture belief is that we have entered the third and final phase of a debt-driven deleveraging cycle that actually began in 2000. Phase I of the great debt Unwinding began at the turn of the century and was related to excessive valuations and corporate deleveraging, with examples ranging from the enron and Worldcom debacles to tyco. Phase II came in 2007 and originated in excess housing-related leverage on both Wall street and Main street, embroiling such firms as bear stearns, lehman brothers, and countrywide. Phase III, which is already upon us, is inextricably linked to the mountainous levels of sovereign debt that we now see straining developed economies like those of europe and the United states. during Phase III we expect shorter economic expansions (3040 consecutive months, as opposed to 100 or more consecutive months of expansion witnessed in the 1990s and early 2000s) and heightened volatility in the capital markets (an s&P 500 index value in the range of 1050 1350 is not inconceivable). We therefore believe Phase III will require a more opportunistic approach to asset allocation. 2. We Believe Economic Growth Should 2 Continue to Slow in 2012. We foresee a contraction of earnings among s&P 500 companies in 2012, in contrast with a consensus forecast that calls for earnings growth of up to 14%. earnings of energy and financial-services companieswhich, according to the forecasting consensus, are expected to account for 48% of 2012 incremental earnings growthappear at risk the most. We actually anticipate negative growth in these two sectors next year. From a gdP perspective, we think that 1.25% growth in the U.s. is a reasonable target for 2012. our estimates for international growth also suggest a slowdown, though these estimates do vary by region. 3. Which Will Keep Many Indices in 3 Flux. Until recently, we have been in an earnings-driven bull market, one that is, to no surprise, unlikely to consistently resume its upward trajectory until readings by the Institute for supply Management (IsM) and overall earnings revisions turn positive again. Moreover, we believe that two international macro headwindsa shortage of bank capital in europe and stickier-than-expected inflation in chinacould continue elevating risk premiums in the near term. 4. After a Decade of De-Rating, Long4 term Value Has Finally Been Created in Equities. From almost any vantage point we consider, equities now qualify as good long-term investments. We do not make this statement lightly, as we have just endured a decade of dismal returns in public equities. but thats exactly our point: yes, there will be ongoing volatility in stocks in the near term, but we are approaching valuation levels at which one can finally make a bullish case for the long-term potential of stocks.

operation twist further confirms our view that long-term U.s. rates are likely to stay lower for some time. More important, though, is that we see significant change in the global fixed income marketplace. specifically, in the short run, we think the term risk-free will become more closely associated with corporate-relatedrather than sovereign-relatedindebtedness, and therefore we perceive significant opportunity to generate outsized returns in the bank loan, high-yield, and mezzanine markets. additionally, we are positive on special-situation and distressed-related investing. 7. Currencies Have Become a Key Dif7 ferentiator. In light of the global imbalances that already exist, we believe that national economies are bifurcating into two groups: those which have the flexibility to raise rates and sustain stronger currencies (the haves), and those which do not have such flexibility (the have-nots). additionally, currencies are becoming critical to total return calculations. In 2010, for example, currency translation accounted for a full 33% of

The last decade or so has seen a movement of debt from corporations, to U.S. financial institutions, to governmental entities
5. Inflation Should Remain in Check, But 5 the Environment Will Reward Companies With Pricing Power. In line with past deleveraging cycles, we believe there appears to be a greater near-term risk of deflation rather than inflation. however, structural consumption growth among emerging markets informs our base case that the status quo will continue in 2012, with U.s. headline inflation of about 2% and producer price inputs of 3% or more. If we are right, the ability to build and maintain pricing power should be a distinguishing feature of almost any corporate marketplace globally in the coming quarters. 6. Spicier Fixed Income Could Emerge 6 as the Asset Class of Choice in 2012. the total return on emerging-market equities. 8. Allocations to Commodities Should Be 8 Done with a Fresh Perspective. We feel that now is the time to think more critically and unconventionally about commodity allocations. correlations between traditional commodity indices and most other asset classesequities in particularare now near historic highs; roll costs can be expensive; and volatility is outsized. thus, we recommend focusing on non-traditional allocation strategies to gain commodity exposure. and with interest rates so low, our research shows that real estate should perform on par with commodities as an effective inflation hedge.

KKR

InsIghts: global Macro trends

Phase III: Here and Now

as americans embraced the dawn of a new century, aol was acquiring time Warner in a $350 billion transaction, britney spears was the diva of pop, dVds were just gaining popularity, the s&P 500 traded at 1527 and approximately 25.7 times expected earnings, and 10-year bond yields were at 6.19%. Fast forward to early-october of 2011, and French, belgian, and luxembourg governments are acquiring distressed bank dexia in a 4 billion transaction, Justin beiber is the new king of pop, iPads are all the rage, the s&P 500 is trading at 1160 and just 10.5 times expected earnings, and 10-year bond yields are at approximately 1.80%. While then and now seem worlds apart, there are actually some notable similarities. an obvious one is that Vladimir Putin is again aiming to be the President of russia. another back-to-the-future moment is that we face yet another major debt overhang, with one critical difference: whereas the 2000 overhang came from the corporate sector, the current one is largely government-incurred. as Exhibit 1 shows, the last decade or so has seen a movement of debt from corporations (Phase I) to U.s. financial institutions (Phase II) to governmental entities (Phase III).

exhIbIt 1

The Three Phases of This Debt Overhang: From Corporates to Wall Street to Sovereigns
35 Phase I
Corporate Leverage Wall Street Government

Phase II

Phase III

120 100

Corporate and Wall Street Leverage

30 25 20

Government Leverage %

80 60

15 10 5 0 2000 2007 2011 40 20 0

corporate leverage = s&P 500 ex-Financials net debt-as-a-%-ofassets; Wall street leverage = average assets-to-equity for goldman sachs and Morgan stanley; government leverage = United states: general government gross debt % of gross domestic Product (gdP). source: IMF Weo, Factset, s&P. as at september 30, 2011.

exhIbIt 2

Expect Shorter and More Volatile Economic Cycles When Government Debt Load is Higher
Duration of Economic Expansion (months)
140 120
100 80 60 40 20 0 0 20 40 60 80 100 120 140 1954-1957 1949-1953 2009-Current 1958-1960 1945-1948

R = 0.5253

Without more robust corporate-led hiring and investment, the U.S. faces the prospect of relying on an overly levered government or overreaching consumption to heal the current economic malaise

U.S. Government Debt % GDP

economic expansions from 1900 to 2011; debt to gross domestic Product (gdP) is at the start of the expansion. source: nber, bea, Us treasury, KKr. as at september 30, 2011.

KKR

InsIghts: global Macro trends

as we attempt to figure out where we might be headed, we think it makes sense to look back and gain some perspective. We subscribe to the conclusions of a study conducted by carmen reinhart and Kenneth rogoff on debt cycles and deleveraging1. their findings show that economies are seldom successful at cutting expenses and debt levels at the same time. In fact, they examined a group of 22 countries that tried to do just thateliminate their debt overhang while still growing their economiesover a 30-year period (19702000). What they found was that just one country of those 22 was actually successful in doing so: the small african nation of swaziland. We will not diminish swazilands achievement in 1985, but their success is probably not directly applicable to economies the size of United states and europe at this point in the cycle.
exhIbIt 3

exhIbIt 4

The Typical Aftermath of Secular Bear Markets Imply Wide Trading Ranges for Many Years
Rebound Rally +71%, 17 Months Trading Range, 52% Wide, 5.6 Years Long

Bear Market -57%, 30 Months

Next Correction -25%, 13 Mths

Debt Loads Affect Equity Valuations Too

Gross Government Debt % GDP Versus Forward P/E 15x 14x 13x
Forward NTM P/E
Indonesia New Zealand Mexico

chart represents the typical secular bear market based on Morgan stanley research sample of 19 such bear markets. data as of 9/19/1929 to 3/25/2010. source: Morgan stanley research.

12x 11x 10x 9x 8x 7x 6x 5x 0 50 100 150

Greece China Spain United Kingdom France Italy India United States

exhIbIt 5

Post-Crash Performance Characterized by a Wide Trading Range

Post-Crash Performance for the Following Decade 40% 30%
200
Average Up Year Average Down Year Index Performance for the Decade

32% 13%

30% 20% 2.2% -8% -18% -30% 1991-2000

Japan Nikkei

20% 10% 0% -10% -20% -30%

-25% 1931-1940
Dow Jones

22%

2011E Gross Government Debt % GDP

0.5% -2.2% -5.3% -15%

gdP = gross domestic Product; P/e = Price to earnings ratio; e = estimate. source: IMF Weo, Factset. ntM = next 12 Months. as at september 30, 2011.

-27% 2002-Current* 2009-Current*

Nasdaq BKX Bank Index

history shows that debt overhangs tend to lead to shorter and sharper economic cycles than what we have experienced during much of the last 20 years. as Exhibit 2 shows, in Phase III we would expect the median period of economic expansion to trend back closer to 3040 consecutive months, in contrast with the much longer expansion periods of 75 months or more that the U.s. enjoyed during the 1980s, 1990s and 2000s. We saw similar economic patterns play out in the U.s. from 1945 to 1960, when government debt began consistently exceeding 60%. a Phase III environment also means that both europe and the U.s. are likely to face increased political unrest and social discord as they try to stimulate growth and reduce debt at the same time.

-40%

1991-2000
Taiwan Taiex

* current through october 4, 2011. source: bloomberg.

In keeping with more erratic economic trends, we also believe strongly that investors should expect wider trading patterns amid heightened volatility. as Exhibits 4 and 5 show, significant bear market swoons (a la 2008) follow a typical pattern of busts, booms and then range trading. We believe that we are now in the hangover phase, which is often characterized by volatile market behavior. the good news is that, with the recent sell-off, the s&P 500 has now largely fulfilled the next correction phase. Whats required, though, is more time for the correction cycle to run its course, since the declines experienced during apriloctober of 2011 spanned just six months, versus an average historical correction period of 13 months.

1 reihnhart, rogoff, this time is different: a Panoramic View of eight centuries of Financial crises, april 2008
KKR InsIghts: global Macro trends

In broad view, the environment that we are forecasting has significant implications for almost anyone who allocates capital. demand for hedging features will almost certainly continue to increase in the foreseeable future, while the ability to thoughtfully consider the timing of capital deployments and realizations becomes increasingly critical to sustaining superior long-term returns in a Phase III environment. It also means that investments that can return capital throughout the investment cycle would likely better serve investors, since annual capital appreciation is no longer a foregone conclusion. bottom line: while there is significant opportunity to create value in todays markets, we are deeply convinced that investors should assume a more opportunistic mindset in the near-term. how do we emerge from this current period of stagnation? there is no surefire remedy, but we do see two potential catalysts to economic growth. First, we know that corporate america and its regional equivalents in europe, asia, and latin america must be the drivers of growth and investment in the global economy. Unlike governments and consumers in developed markets, corporations are flush with cash, have low debt balances, and are experiencing rising productivity. In order to achieve strong growth, governments worldwideparticularly the U.s.need to step back and promote a business-friendly and less uncertain regulatory environment that could allow for corporations to have confidence and more predictability to begin hiring and deploy the cash on their balance sheets. Without more robust corporate-led hiring and investment, the U.s. faces the prospect of relying on an overly levered government (manifest in governments debt as a percentage of gdP at 98.0%) or overreaching consumption (which, as a percentage of gdP, stands at 71.1%) to heal the current economic malaise (Exhibits 6 and 7).

exhIbIt 6

Government Cant Be the Driver of Growth

CBO Gross Federal Debt % GDP Based on Baseline Budget Projections 110% 100% 90% 80% 70% 60% 50% 40% 30% 20%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2013, 103% 2012, 102%

gdP = gross domestic Product. source: congressional budget office. data from 1960-2013.

exhIbIt 7

Nor Can the Consumer

140% 120% 100% 80% 60% 40% 20% 1952 1962 1972 1982 1992 2002 Household Debt % Personal Income Household Debt % Disposable Personal Income

Unlike governments and consumers in developed markets, corporations are flush with cash, have low debt balances, and are experiencing rising productivity. In order to achieve strong growth, governments worldwide need to step back and promote a businessfriendly and less uncertain regulatory environment that could allow for corporations to have confidence and more predictability to begin hiring and deploy the cash on their balance sheets
6
KKR InsIghts: global Macro trends

source: Federal reserve. through 2Q2011.

rebalancing is also the key to global economic growth: the world would benefit from an increase in chinese consumption as a percentage of chinas gdP and a trimming of american consumption as a share of U.s. gdP (Exhibit 8). Passing the baton of consumption from the U.s. to china is paramount not only for generating absolute global economic growthbut also for correcting much of the lopsidedness that has resulted in significant surpluses and deficits throughout the world. as Exhibit 9 already indicates, chinese reserves have burgeoned to near record highs even as U.s. unemployment and indebtedness continue to hover at outsized levels.
exhIbIt 8

Economic Growth Will Continue to Slow in 2012

according to our research methodology, we believe corporate earnings growth will reside in negative territory during 2012 versus a consensus forecast of up nearly 14%. Importantly, we come to almost the same conclusion even if the european crisis subsides in short order. driving this view is our 7-factor model, which we use to predict s&P 500 earnings growth. this model now suggests an earnings decline of around 12% next year (Exhibit 11), driven largely by the lack of a rebound in home prices. our fundamental research, however, points to a slightly better outcome, with earnings down about 5%. average aggregate ePs growth tends to fall about 30% or more during a typical garden-variety recession, but neither our quantitative modeling nor our fundamental analysis suggest a decline of that magnitude this time. Why? because it would be hard for housing-related activity to plummet precipitously from current levels (Exhibit 10). all told, we think a gdP estimate of positive 1.25% for 2012 is a reasonable target for the type of corporate earnings environment we envision next year.
exhIbIt 10

China And the U.S. Need to Rebalance Their Economies

2010 GDP Components as a % of Total 80% 60% 40% 20% 0% Consumption Investment Government Exports* 33% 12% 13% 21% 71% China 48% 27% 13% US

U.S. Housing Transaction Volumes Remain Weak

120% 100% 80% 60% 40% 20% 0% -20% -40% -60%
1980 1981 1983 1984 1986 1987 1989

Housing Starts Y/Y% US New 1-Family Houses Sold Y/Y%

*exports are on a gross basis and as a result, total gdP will exceed 100%. gdP = gross domestic Product. source: china national bureau of statistics, bureau of economic analysis.

exhIbIt 9

1992

1994

1995

1991

1997

1999

2000

2002

2003

2005

2006

2008

3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0

Total Reserves Minus Gold in US$m China US Japan Russia

source: bloomberg. through august 1, 2011.

exhIbIt 11

Our Analysis Shows Slower than Expected Growth in 2012

S&P 500 EPS Growth: 12-Month Leading Indicator 40% 20% Jun-11a 22.6% Dec-11e 9.3% Dec-12e -11.5% Actual Predicted (3mo MA)
2000 2003 2006 2009 2012 1982 1991 1994 1985 1988 1997

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

sources: IMF, bloomberg. as at september 20, 2011.

0% -20% -40%

the earnings growth leading Indicator (eglI) is a statistical synthesis of seven important leading indicators to s&P 500 earnings Per share. henry McVey and team developed the model in early 2006. a = actual; e = estimated. as of september 23, 2011. source: KKr, bloomberg.

2010

China Reserves Now at Outsized Levels

KKR

InsIghts: global Macro trends

For those inclined to a bottom-up perspective, we would make the following two points. Within the U.s., consensus estimates assume that nearly 50% of the incremental growth in earnings is likely to come from financials and energy (Exhibit 12). given weak trading volumes, deteriorating credit and lower oil prices, these forecasts seem too optimistic to us. second, as Exhibit 13 shows, 37% of total global growth is supposed to come from asia (with china being the largest contributor) at a time when central banks are still striving to dampen domestic inflation. this, too, is a forecast that merits attention.
exhIbIt 12

48% of 2012 Consensus EPS Growth From Financials & Energy Appears Aggressive
2012E EPS Y/Y consUMer dIscretIonarY consUMer staPles energY FInancIals health care IndUstrIals InFo tech MaterIals telecoM serVIces UtIlItIes s&P 500 13.6% 10.2% 10.9% 32.0% 4.9% 15.2% 11.2% 16.3% 9.1% -5.0% 13.6% COnTRIBuTIOn TO 2012 EARnInGS GROWTH 9.1% 7.1% 12.1% 35.5% 4.7% 11.1% 15.8% 4.4% 1.6% -1.3%

ePs = earnings Per share; e = Mean consensus estimate. source: Factset, s&P. data as at september 21, 2011.

exhIbIt 13

2012 Global Growth Is A Bet On Asia ex-Japan

2011E nOMInAL GDP 2012E nOMInAL GDP 2012-2011 nOMInAL GDP 2012 nOMInAL GDP GROWTH COnTRIBuTIOn TO 2012 WORLD GDP GROWTH 12% 7% 9% 7% 37% 7% 17% 5%

Us JaPan eUro area other eUroPe asIa lataM eMea other adVanced econoMIes World

15,065 5,855 13,355 4,605 13,296 5,630 8,356 3,850 70,012

15,495 6,126 13,681 4,862 14,666 5,895 8,981 4,036 73,741

431 270 326 257 1,370 265 625 186 3,730

2.9% 4.6% 2.4% 5.6% 10.3% 4.7% 7.5% 4.8% 5.3%

gdP = gross domestic Product; e = IMF estimate. nominal gdP in Us$ billions. source: IMF World economic outlook september 27, 2011, KKr.

KKR

InsIghts: global Macro trends

Equity Valuations Are Reasonable, but Global Imbalances Are Likely to Keep The Risk Premium High In The Near Term
When we shifted our focus from researching financial-services companies to macro and portfolio strategies in 2003, we began examining the anatomy of bull markets, and what we found was that there are really two types of bulls: earnings-driven and valuationdriven. the former benefit from more growth in earnings (versus falling interest rates), generate less overall total return than their valuation-driven brethren, and usually end in a recession. one can see the varying characteristics of each in Exhibit 15. For those who keep tabs, we have beenat least until recentlyin an earningsdriven bull market. however, as Exhibit 14 highlights, earnings revisions are now negative, a pattern that will likely need to reverse to sustain an upward advancement in stocks.
exhIbIt 14

exhIbIt 15

Anatomy of a Bull Market

s&P 500 PerForMance annUalIzed PrIce PerForMance annUalIzed P/e exPansIon annUalIzed real earnIngs groWth annUalIzed cPI InFlatIon annUalIzed In dIVIdend YIeld, basIs PoInts length (Years) aVerage bUll 36.6% P/e led 43.8% earnIngs led 24.9%

26.2%

39.6%

4.5%

6.0%

1.0%

14.2%

3.2%

2.1%

4.8%

-72

-106

-17

S&P 500 Performance Tends to Follow Earnings Revisions

S&P 500 EPS Revisions S&P 500 Index Performance Y/Y% 80% 60% 40% 20% 0% (20%) (40%) (60%) (80%) 2000 2001 2002 2003 2005 2006 2004 2007 2010 2008 2009 2011

2.0

1.6

2.6

P/e = Price-earnings ratio; cPI = consumer Price Index. based on cycles between 1928 and 2007, and defined as bull markets that end between two months after to 12 months prior to the start of a recession. source: s&P, bls, Federal reserve, Factset, stock Market data Used in Irrational exuberance by robert J. shiller.

note: earnings Per share (ePs) revisions are calculated as: number of Upward revisions to estimates minus number of downward revisions to estimates divided by total number of estimates. source: Factset, s&P. data as at october 5, 2011.

Consumption in emerging markets is overtaking developed markets, and we see no reason for this trajectory to change course

KKR

InsIghts: global Macro trends

also supporting our view that equities lack a near-term catalyst are recent reports by the Institute for supply Management (IsM). the IsM Manufacturing index hit 51.6 in september versus a peak of 61.4 in February this year, and it is now potentially showing signs of contraction. In past cycles, equities tended to struggle when the IsM indicators decelerated toward or below 50. Using Exhibits 16 and 17 as roadmaps, we now believe that we are transitioning from deceleration to contraction.
exhIbIt 16

alongside slowing growth in the U.s., we see two other macro issues that are worthy of investor attention in the near-term:

Sticky Inflation In EM Is Keeping Central Bankers from Stimulating Growth

despite the recent downdraft, we remain strong believers in emerging-market growth and return potential. as seen in Exhibit 18, consumption in emerging markets is overtaking developed markets, and we see no reason for this trajectory to change course. however, we do worry that cyclical inflation in countries like china and India could remain higher than what governments and central banks desire in the near term. and we should not forget that inflation can be difficult to control in emerging economies because it is much more tightly linked to volatile commodity inputs. In china, for example, food accounts for 30% of the consumer price index (cPI), with pork accounting for nearly half of the total. In the U.s., by comparison, total food costs are less than 15% of the overall cPI calculation (Exhibit 19).
exhIbIt 18

We Are in the Later Stages of the ISM Cycle

Expansion
Shift of focus from P/E growth to earnings growth

Deceleration
Earnings growth coupled with multiple compression

Recovery
Multiple expansion

ISM = 50

Contraction
Market correction

EM Consumption is Now Surpassing DM Consumption

source: KKr
Household Consumption Expenditure $B US ex Health Care Emerging Markets 8,332 7,185 5,106 8,509

exhIbIt 17

Headline ISM Cycles: Average Change P/E and EPS Growth

Average Change P/E and EPS Growth 12.34 3.74 5.71 11.11 11.58

2005
-6.92 -10.35
Trough to 50 50 to Peak Peak to 50 50 to Trough Trough to 50 50 to Peak Peak to 50 50 to Trough

2010e

-5.70

eM = emerging Markets; dM = developed Markets; e = estimate. data as at september 9, 2009. source: Morgan stanley research.

exhIbIt 19

% Change in P/E

Annualized EPS

P/e = Price earnings ratio; ePs = earnings Per share. headline IsM cycles from 1949 to 2011. source: Institute for supply Management, s&P, Factset, bloomberg, KKr.

Different Inflation Drivers in Different Economies

45 40 35 30 25 20 15 10 5 0 Key Components of CPI Food Housing 30.3 18.9 41.5

Weight in CPI Index (%)

14.8

China

US

cPI = consumer Price Index. source: ceIc, bls. china weights as at august 2011, Us weights as at February 2011.

10

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InsIghts: global Macro trends

exhIbIt 20

exhIbIt 22

Money Supply Growth at Near-Low Levels in China

50% 40% 30% 20% 10% 0%
Jan-05 Jan-00 Jan-04 Jan-06 Jan-01 Jan-07 Jan-02 Jan-08 Jan-09 Jan-03 Jan-10 Jan-12 Jan-11

5-Year Sovereign CDS Spreads

US$ 6000 5000 4000 3000 2000 1000 0 Portugal Ireland Italy Greece Spain

China M1 Money Supply Y/Y%

data as at august 31, 2011. source: the Peoples bank of china, bloomberg.

exhIbIt 21

2007

2008

2009

2010

2011

China Cant Promote Growth Until Inflation Dissipates

% 40 35 30 25 20 15 10 5 0
Jan-97 Oct-97 Jul-98 Jan-00 Oct-00 Jul-01 Jul-04 Apr-08 Jul-10 Apr-99 Jan-03 Oct-03 Apr-05 Jan-06 Oct-06 Jul-07 Apr-02 Jan-09 Oct-09 Apr-11

cds = credit default swaps. source: bloomberg. data as at september 28, 2011.

China Financial Institutions Loan Growth Y/Y% (LA) China CPI Y/Y % (RA) ?

10 8 6 4 2

exhIbIt 23

2011E Nominal GDP Growth Minus 10-Year Government Bond Yield, Basis Points
22 -298 -271 88 173 243 300

-740 -1292

0 -2 -4 -2737 Greece Portugal Ireland Italy Spain France Netherlands Germany Belgium Austria

la = left axis; ra = right axis; cPI = consumer Price Index. source: bloomberg. data as at august 31, 2011.

e=IMF estimate. gdP = gross domestic Product. source: IMF Weo, bloomberg. data as at september 27, 2011.

the cPI in china is currently running at 6.1%, down from 6.5% in July, but still above a target of 5% for the year. Why this matters so much is that central bankers in china cant promote growth strategies until inflation trends begin to dissipate.In the interim, governments are being forced to reduce the money supplyand subsequently loan growthin an effort to curb inflation, but so far, inflation trends have remained persistently high (Exhibits 20 and 21). at the moment, our base case is that china will shift toward a neutral policy stance sometime in 2012, but we do not believe it will move toward a loose monetary policy the way it did after 2008. What were implying is that china cannot act as a growth engine during a time of global growth deceleration until inflation subsides meaningfully.

Within equities, we focus on areas of extreme undervaluation and secular growth to capture value during Phase III

KKR

InsIghts: global Macro trends

11

The European Debt Crisis: Banks Need More Capital

We arent exactly certain what american author henry Miller was referring to when he said that chaos is the score upon which reality is written, but his comment certainly befits what were seeing in europe these days. Fiscal austerity, working hand-in-hand with fits and starts of debt reduction, is increasingly straining the confederation of nations that define the european Union. In our humble opinion, the european debt crisis has emerged as the single biggest macro concern in the marketplace. naturally, it is also eerily consistent with our Phase III worldview about government debt as the achilles heel of global growth (Exhibits 22 and 23). at this point, we think that a european recession could already be underway, and thus expect continued relative underperformance in the near-term. Further, we do think there is a potential roadmap for dousing the firestorm created by the sovereign debt crisis, and we cannot overstate the need of european banks for more capital. according to Morgan stanley, 205 european banks that its analysts track have a combined $23.7 trillion in assets supported by just $1 trillion in equity capital. that is just too high a ratio of assets-toequity, particularly when one considers what happened to the U.s. financial system in 2008 when leverage was at similar levels. our belief is that a capital injection into european banks is desperately needed and may need to come from local governments and/or the european Financial stability Facility (eFsF). We would also like to see the eFsF work with the private sector to lever up, buy bonds in the open markets and become the first lien in the event of losses. Ultimately, we maintain that certain asset pricesgreek debt in particularmust be marked down to more realistic levels, while others need to be ring-fenced and protected (Exhibit 24). this plan of action would hardly be a panacea for what ails europe, but we feel it should provide enough near-term stability to soothe the panic gripping the region.
exhIbIt 24

exhIbIt 25

Stocks Getting Structurally Cheaper

25x 20x 15x 10x 5x 0x 2000 2007
Year end traIlIng P/e

Year End Trailing P/E (LA) Year End 10 Year US Treasury Yield (RA)

6 5 4 3 2 1 0

Current
Year end 10 Year Us treasUrY YIeld (%) 5.11 4.02 1.98

2000 2007 cUrrent

23.5 17.4 12.6

la = left axis; ra = right axis; P/e = Price-earnings ratio. current as at september 27, 2011. source: Factset, bloomberg.

Greek Financial Services System Under Stress

% 25 20 15 10 5 0 -5 -10 -15
Jan-02 Aug-02 Mar-03 Oct-03 May-04 Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jan-09 Aug-09 Mar-10 Oct-10 Jun-08 May-11

Greece Deposits Households and Businesses Y/Y Bank of Greece Intra-Eurosystem Liabilities B

B 120 100 80 60 40 20 0

source: bank of greece. through July 31, 2011.

If the 1930s were a period of extreme deflation and the 1970s were a period of extreme inflation, we think that the next few years could fall somewhere in the middle

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Long-term Value in Equities Is Finally Emerging

While the aforementioned macro issues represent important considerations, we believe we are finally at the lower end of the trading range we envision for Phase III. Using the s&P 500 as a proxy, we would recommend aggressively acquiring stocks below an index level of 1050, and, as we discuss later, we think 1250 would be a reasonable level for todays fair value of stocks (Exhibit 25). We do not make this statement lightly, as we have just endured a decade of dismal returns in public equities. but our point is that we are finally returning to a time of stocks for the long run, a term originally coined by Wharton professor Jeremy siegel in 1994. there are several factors shaping this view. First, as Exhibit 26 shows, the 10-year rolling return for stocks through the third quarter of 2011 was 2.8%, 780 basis points below average, and essentially on par with the 1930s. anyone who believes in mean-reversion investing has to consider the current starting point for equities at least somewhat attractive. second, the dividend yield on stocks is now finally on par with 10-year government debt yields (Exhibit 27). and third, price-to-earnings multiples are so low that we are finally poised for a period of sustained multiple stability and potential expansion, in contrast with the 50% or higher contraction we have experienced since 2000.
exhIbIt 26

exhIbIt 27

Stocks Yielding as Much as Bonds

18 16 14 12 10 8 6 4 2 0
1900 1910 1920 1930 1940 1950 1960 1970 1990 2000 2010 1980

S&P 500 Dividend Yield

US 10 Yr Yield

as of september 30, 2011. source: Factset, s&P, Federal reserve, stock Market data Used in Irrational exuberance by robert J. shiller.

10-Year Rolling Average for Stock Returns is Now at Historically Low Levels
25% 20% 15% 10% 5% 0% -5% -10%
1941 1936 1946 1951 1956

our analytics show that we are at price-to-earnings level at which it has paid to bet on stocks for solid long-term returns. Exhibit 28 indicates that the annualized return for buying stocks with a trailing price-to-earnings (P/e) ratio of 1214 times, which is where we are currently trading, is 8.9% on a 1-year basis, 6.7% on a 3-year basis, 6.2% on a 5-year basis, and 7.4% on a 10-year basis. thats the good news. the unfortunate news is that the catalyst for a significant and sustained upward revision in sovereign-credit ratings that would lead to outsized equity returns needs to stem from notable improvements in government leverage ratios and gdP growth trends. as we showed earlier in this report (Exhibit 3), equity valuations are heavily influenced by sovereign debt loads. In addition, the level of sustainable gdP affects valuation levels too. one can see this relationship in Exhibit 35. regrettably, we see no signs of near-term change in these two factors as current government spending trends in most developed markets are still headed upward, which is likely to keep growth below trend in the near-term. If and when they are corrected, however, we believe that these events could serve as the turning point for a major sustained P/e-driven bull market in equity valuations.

Historic S&P500 10-Year Rolling Average Annualized Returns

S&P 500 10 Yr Return Average

1966 1976 1986 1996 2001 2006 2011 1961 1971 1981 1991

as of october 4, 2011. source: Factset, s&P, stock Market data Used in Irrational exuberance by robert J. shiller.

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13

In 2012, we think that the s&P 500, which we use as a proxy for global markets, should earn approximately a 13% return on equity (roe). based on historical comparisons, that level of return on equity should equate to a price-to-book valuation of around 2 times (Exhibit 29). Using a $625 billion year-end 2011 estimate for s&P 500 book value, we assess a fair value estimate of around 1250 for the s&P 500.
exhIbIt 28

Stock Returns: Entry and Exit Points Matter

sUbseQUent aVerage annUalIzed s&P 500 PrIce retUrns (%) s&P 500 P/e entrY leVel <8 8-10 10-12 12-14 14-16 16-18 18-20 20-22 22-24 >24 1 Yr 13.6 8.3 12.3 8.9 11.4 3.3 3.5 2.4 -4.8 -3.3 2 Yr 10.6 10.9 12.9 8.8 7.3 1.8 3.4 5.8 4.2 -2.5 3 Yr 8.5 12.3 11.5 6.7 6.5 2.3 3.5 7.4 7.2 -2.9 5 Yr 10.2 12.0 8.0 6.2 6.8 3.1 4.0 8.2 2.4 -0.7 10 Yr 11.1 9.0 8.3 7.4 6.5 2.6 3.1 6.2 2.0 -1.2

Within equities, our recommendation is to focus on areas of extreme undervaluation in order to capture the maximum value in such a volatile asset class. by our measures, germany looks categorically cheap (Exhibit 30) and the U.s. looks attractive (Exhibit 31), as do certain emerging markets (Exhibit 32). our comparative stock-versus-bond model, which screens for overbought or oversold conditions in the momentum of stock prices relative to bond prices, has indicated that either stocks are oversold or that bonds are overbought in the U.s.but in fact, we think both are true (Exhibit 33).
exhIbIt 30

Germany Is Cheap
35x 30x 25x 20x 15x 10x 5x
1986 1990 1992 1993 1995 1996 2001 2002 2004 2005 2007 2008 2010 1987 1989 1998 1999 2011

Germany Forward P/E

+1 Avg -1

P/e = Price-earnings ratio. data from 1913 to september 2011. data as at september 30, 2011. source: bloomberg, Factset, s&P, stock Market data Used in Irrational exuberance by robert J. shiller.

P/e = Price-earnings ratio. source: Factset. as at september 30, 2011.

exhIbIt 29

exhIbIt 31

Our Analysis Suggests Modest Near Term Upside to Stocks

6 5 4 3 2 1 0 4%
PrIce-to booK s&P 500 For bVPs oF $625 * P/B S&P 500 ROE vs. P/B

Valuation of US Stocks Looks Reasonable Again

35 30 25 20 15 Avg -1 S&P 500 Trailing P/E

R = 56%

2012e

10 5

1900

1920

1930

1910

1940

1950

1960

1970

1980

1990

2000

6%

8%

10%
1.8x 1125

12%

14%
2.0x 1250

16%

18%

20%
2.2x 1375

P/e = Price-earnings ratio. as of september 30, 2011. source: Factset, s&P, stock Market data Used in Irrational exuberance by robert J. shiller.

roe = return on equity; P/b = Price-to-book; bVPs = book Value Per share; e= KKr estimate. through september 23, 2011. source: s&P, Factset, ned davis. excluding outlier periods around 1950 and 1980. *KKr estimated bVPs at year end 2011.

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2010

ROE

exhIbIt 32

exhIbIt 34

Certain EM Countries Beginning to Screen Attractively and Trade Below Historical Averages
18x 16x 14x 12x 10x 8x 6x
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

Valuation: Little Premium for Growth

60 50 S&P 500 Valuation Spread Between Highest and Lowest Quintile P/E FY1

Emerging Market Equities Forward Price - Earnings Ratio

+1 Avg 1

40 30 20 10 0 Jan-90 Jan-98 Jan-02 Jan-08 Jan-92 Jan-96 Jan-06 Jan-10 Jan-94 Jan-00 Jan-04 Jan-12 14.3 14x 12x 11.4 13.0 10.7 >5

Average

as at september 2011. Using s&P/citigroup bMI emerging Markets Index for emerging market equities. source: bloomberg, s&P.

exhIbIt 33

P/e = Price earnings ratio. source: Factset, s&P. as at october 5, 2011.

Near Term, Stocks are Oversold, Bonds are Overbought

Stocks Versus Bond Indicator 3 2
1

exhIbIt 35

+2

GDP Environment Matters for Valuation

20x 18x 16x Median S&P 500 Normalized Price-to-Earnings for Various Growth Environments 17.9 16.7 16.0

0 -1 -2 -3 -4
-2
Sep-74
Nov-81 Nov-87 Jan -08 Aug-98 Mar-01 Sep-11 -1.5

Sep-02

Feb-09

Jan-00

Jan-05

Jan-80

Jan-85

Jan-90

Jan-95

Jan-70

Jan-75

Jan-10

10x 8x

Proprietary stock/bond Momentum Indicator. source: Factset. data as at september 28, 2011. source: Factset.

<0

0-1

1-2

2-3

3-4

4-5

5-Year US Real GDP Annualized Growth Rate %

We are also predisposed to focus on companies experiencing secular growth for several reasons. For starters, in the slow-growth environment we envision for Phase III, we believe that strong topline earnings growth will be rare. additionally, U.s. investors are currently paying little premium for the outsized growth relative to the market (Exhibit 34). this narrowing of valuations is the exact opposite of what investors saw during the late 1990s and early 2000s, a period when investors were willing to pay almost any price for equities experiencing solid long-term-growth. We believe a similar story holds true outside the U.s. as well.

normalized Price-to-earnings valuation ratio = Price divided by average of past 5 years ePs. study from 1900 to 2011. source: bea, historical statistics of the United states, Factset, s&P, bloomberg, stock Market data Used in Irrational exuberance by robert J. shiller.

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15

Inflation Outlook: Still Greater Downside Risks, but Focus on the Pricing Power in the Interim
given the twin forces of deleveraging and excess monetary stimulus, one could make equally strong cases for inflation and deflation. however, as we describe below, we maintain our outlook for moderate inflation with downside risks. We tackle the inflation/deflation debate from two perspectives: capacity utilization and the monetary environment. Exhibit 36 illustrates that excess capacity in the U.s. remains high, which is conducive to low or negative inflation. Moreover, the correlation between laborforce growth and inflation is high, suggesting further downward pressure on consumer prices (Exhibit 37). In accordance with this view, one should consider that real income growth, which was a major factor in the inflationary spiral of the 1970s, has been stagnant for over 20 years: U.s. median household income was $49,445 in 2010, essentially unchanged from $49,076 in 1989 (in 2010 dollar terms).
exhIbIt 36

From a monetary standpoint, we believe we are on the cusp of a major deleveraging cycle. barring any major currency devaluation, deleveraging is almost always disinflationary and often deflationary. given that total U.s. debt as a percentage of gdP is at a record 336% as of June 2011 versus a historical average of 280% over the past 20 years and a prior peak of 299% in 1932 (Exhibit 38), we argue that debt levels must come down. Unless things play out differently this time, economic growth trends and asset valuations should be negatively impacted. also, the amount of debt required to generate a dollar of gdP appears to be at unsustainably high levels (Exhibit 39).
exhIbIt 38

The Elephant in the Room: US Debt % of GDP

350% 300% 250% 200% 150% 100% 50% 0% 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Dec-32, 299%

US Debt % GDP
Financials Government GSE Corporates Households

Mar -10, 349%

Excess Capacity
US Capacity Utilization % of Total Capacity 90 85 80 75 70 65 1971 1983 1991 1995 1999 1967 1975 1979 1987 2003 2007 2011

gdP = gross domestic Product; gse = government sponsored enterprises. data through 2Q2011. source: bea, Federal reserve, Morgan stanley research and the statistical history of the United states by ben Wattenberg.

exhIbIt 39

Now, More Than Ever, it Takes Money to Make Money

US Economy: Incremental Dollars of Debt Per Incremental Dollar of GDP 5.6

through august 31, 2011. source: Federal reserve, nber, bloomberg. shaded areas indicate recessions.

exhIbIt 37

Slowing Employment Growth Implies Lower Inflation

3.0 2.5 2.0 1.5 1.0 0.5
1958 1961 1964 1968 1971 1974 1978 1981 1984 1988 1991 1994 1998 2001 2004 2008 2011

2.9 1.4 1.5 1.7

3.1

Labor Force Growth (LA) Long term Inflation (RA)

10 9 8 7 6 5 4 3 2 1 0

1950's

1960's

1970's

1980's

1990's

2000's

gdP = gross domestic Product. 2000s = 1999 to 2009. source: bea, Federal reserve, bloomberg.

la = left axis; ra = right axis. long term inflation and labor force growth represented as 10-yr annualized growth. source: bureau of labor statistics. through august 31, 2011.

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those concerned about inflation rising out of control tend to believe that a greater money supply (known in economics as M1, which includes currency and bank reserves) automatically translates into rising prices. however, we also think investors should consider that an increase in M1 (which the Fed has been boosting via its asset purchase programs) does not necessarily translate into more money in circulation (also known as M2, or the broader money base) if the money multiplier is short-circuited by lack of consumer and business confidence. In addition, as Exhibit 40 shows, even rapid M2 growthto the extent it materializesdoes not automatically translate into runaway inflation. to date, monetary and fiscal stimuli as a percentage of gdP has exceeded 30% this cycle, nearly 4 times what the government spent during the great depression. however, they have not yet translated into significant loan growth or asset price increases. on the contrary: banks have continued to shrink their private-sector loan books while expanding their holdings of low-yielding U.s. government debt.
exhIbIt 40

another consideration in the inflation debate is to understand what actually constitutes inflation in the U.s. and why we think inflation would likely not rear its head. at the moment, nearly 31% of the U.s. inflation index comprises direct housing inputs (ex-heating, etc.). the main driver of the U.s. consumer Price Index (cPI) index is whats known as an owners equivalent rent: the amount a homeowner would pay to rentor earn from rentinga home in a competitive market. since the rental market is being bolstered by waning interest in home ownership, we could see inflation creeping in through higher rent prices, though it is hard to imagine well have runaway inflation amid sluggish wage growth and challenging economic conditions. by comparison, food constitutes approximately 14% of the overall U.s. cPI composite, compared to 30% or more in emerging economies like china. In order for our concerns about inflationary pressures to rise, we would need to witness some combination of the following four phenomena: 1. a decline in banks treasury holdings in favor of private-market 1 loans, which is a bullish indicator for economic and wage growth (Exhibit 41 confirms this has not yet happened); 2. an increase in loan growth that is commensurate with the 2 money supply (Exhibit 42 indicates this is only happening at a very slow clip); 3. a diminishment of excess factory and labor capacity (whereas 3 to date, unemployment is unacceptably high and capacity utilization remains well below average); and 4. a collapse in the dollar, which could usher in a period of run4 away inflation (although to date, we do not share this prognosis, since the pound, euro, and yen all face similarif not worse monetary and fiscal headwinds than the U.s.)

Little Relationship Between M2 Growth and Year-Over-Year Inflation

16% 14% 12% US CPI yy (%) 10% 8% 6% 4% 2% 0% -2% -4% 0% 2% 4% 6% 8% 10% 12% 14% 16% US M2 Money Supply Growth yy (%) R = 0.0277

cPI = consumer Price Index. data from January 1960 to august 2011. source: bls, Federal reserve.

exhIbIt 41

Banks are Extending More Credit to The US Government, But Not the Private Sector
30% 25% 20% 15% 10% 5% 0% -5%
1910 1920 1930 1940 1980 1990 2000 2010 1900 1950 1960 1970 2011

Domestically-Chartered Commercial Bank Assets

Loans and Leases, Y/Y% Treasury and Agency Securities, Y/Y %

-10%

data as at september 14, 2011. source: Federal reserve.

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InsIghts: global Macro trends

17

exhIbIt 42

M1 Up, But Bank Credit Growth Remains Weak

25% 20% 15% 10% 5% 0% -5%
Jan-00 Aug-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Apr-05 Nov-05 Jun-06 Jan-07 Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 Feb-11 Sep-11

US Bank Credit Growth Y/Y% US Money Supply M1 Growth Y/Y%

tute (ecrI) Future Inflation gauge (FIg) has proved quite effective over time. currently it suggests that core inflation will remain low over the next few years, in the 1.52.0% range (Exhibit 44). We acknowledge some upside risk to inflation over the near-term as the recent surge in corporate earnings growth circulates back into the economy (Exhibit 45). Yet we think the effect will be transitory, since we expect growth to slow meaningfully next year.
exhIbIt 44

ECRI US Future Inflation Gauge Points to Core CPI in the 1.5-2.0% Range
US Core CPI Y/Y% (LA) 3.0 2.5 2.0 ECRI FIG (RA, Leading 18 months) 130 120 110 100 1.5 1.0 0.5 Aug-00 Jan-06 Nov-03 Dec-04 Mar-08 Jul-99 Sep-01 Feb-07 Apr-09 May-10 Oct-02 Jun-11 Jul-12 40% 30% 20% 10% 0% 1.5 1.0 0.5 Jul-99 Nov-01 Jan-03 May-05 Sep-07 Nov-08 Mar-11 Sep-00 Mar-04 Jul-06 Jan-10 May-12 Jul-13 -10% -20% -30% -40% 90 80 70

-10%

source: Federal reserve. through august 30, 2011.

exhIbIt 43

Falling Margins Likely to Pressure Earnings Growth Amid Rising Input Costs
60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40%
1980 1981 1983 1985 1987 1989 1991 1992 1994 1996 1998 2000 2002 2003 2005 2007 2009 2011 2013

S&P 500 EPS Y/Y (LA) CPI y/y minus PPI Y/Y shifted forward by two years (RA)

12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8%

la = left axis; ra = right axis; cPI = consumer Price Index; ecrI FIg = economic cycle research Institute Future Inflation gauge. data from July 31, 1999 thru august 31, 2011. source: ecrI, bureau of labor statistics, bloomberg.

exhIbIt 45

Corporate Earnings Growth Leads Inflation

US Core CPI YoY% (LA) S&P 500 EPS Y/Y% (RA, Leading 18 months) 3.0 2.5 2.0

la = left axis; ra = right axis; ePs = earnings Per share; cPI = consumer Price Index; PPI = Producer Price Index. shaded areas indicate periods of Us recessions. source: s&P, bloomberg, Factset. as at october 10, 2011.

What do we think inflation might look like in the near future? If the 1930s were a period of extreme deflation and the 1970s were a period of extreme inflation, we think that the next few years could fall somewhere in the middle. With the rise in consumption throughout emerging-market economies, we could see continued upward pressure on producer prices as demand for commodities continues to rise. at the same time, cheap labor and excess capacity could curb consumer prices and compress corporate margins. already, the spread between the cPI and PPI in the U.s. is at record lows. (Exhibit 43). With knowledge and background in macroeconomics, we attempted to forecast inflation but found that 1) it is difficult to do so well; and 2) our forecasts would likely prove no better than what forecasts already exist. In particular, the economic cycle research Insti-

la = left axis; ra = right axis; cPI = consumer Price Index; ePs = earnings Per share. dashed line indicates KKr forecast. data from July 31, 1999 thru June 30, 2014 (estimated). source: s&P, Factset, bloomberg.

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Spicier Fixed Income Could Emerge as the Asset Class of Choice in 2012
our school of thought is that rates are likely to stay lower for some time in many of the worlds largest markets, including U.s. treasuries (Exhibit 47). this view, which we have long held, comports with our outlook for low inflation (see previous section entitled Inflation outlook: still greater downside risks, but Focus on the Pricing Power in the Interim). also, given the need to stimulate improvement in the housing market, we expect government-related intervention to focus on holding down long-term interest rates at historically low levels. In europe, by comparison, we think that some of the more levered countries are likely to face ongoing funding difficulties. supporting our thinking is that debt loads and gdP projections for 2012 are still too high across the region. countries like spain and Italy are at high risk and must either grow and/or reduce debt levels to avoid the fate of some of their weaker brethren. as Exhibit 47 shows, both countries are now dangerously close to the 6% funding threshold that has tipped over countries like greece, Ireland, and Portugal toward much more difficult macro-economic environments.

exhIbIt 46

Government Debt No Longer Looks Risk Free

% 300 250 200 150 100 50 0 United States Euro Area United Kingdom Japan 2005 2012E Gross Government Debt % GDP

gdP = gross domestic Product; e = IMF Weo estimate. source: IMF Weo. as at september 22, 2011.

exhIbIt 47

At Some Point, Deficits Do Matter

10 Year Yield (%) 25 20 15 Portugal 10 5 0 Ireland Spain UK US Italy Germany Sweden Switzerland -15 -10 -5 0 5 10 15 Norway

Greece

We believe rates are likely to stay lower for some time in many of the worlds largest markets, including U.S. Treasuries

2010 General Government Net Lending/(Borrowing) % GDP

Yellow line represents 6% funding threshold. gdP = gross domestic Product. source: IMF Weo, bloomberg. as at september 30, 2011.

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InsIghts: global Macro trends

19

In the near term, we think that the concept of risk-free will become increasingly associated with corporaterather than sovereignindebtedness, a notion backed by the fact that corporations appear to be in sound financial shape, having significantly delevered after the 20012002 downturn, while governments in europe and north america have continued to lever up. one can see the magnitude of the different leverage trajectories in Exhibit 48.
exhIbIt 48

consistent with our thesis of Phase IIIand with our view that we are likely to endure a modest recession at worst in 2012we also think that there is significant investment opportunity in the corporate fixed income market, including bank loans, debt, high yield debt and mezzanine debt. We also hold that distressed and specialsituation investors should have plenty of possibilities to consider as banks, governments, and select corporates delever during Phase III. Underpinning our favorable outlook for fixed income are a host of factors. First, the discount between what investors can earn on certain parts of the corporate capital structure relative to the riskfree rate and to equities seems too high, in our opinion. If we look at the current risk-free rate of about 2% and the equity risk premium of 4%, then the implied total return on stocks is around 6% or so. but an investor can earn 9-13% returns in certain parts of the fixed income markets, potentially with less volatility (Exhibit 51). In other words, we think the illiquidity premium associated with some of the spicier fixed income products doesnt really need to be 300800 basis points over equities and 7001100 over the risk free rate. second, as Exhibit 49 highlights, the discount rate and return assumptions that most pension-plan sponsors use is now so low in absolute terms that it affords them a lot of downside protection in loans, high yield, and mezzanine debt, even if there is some erosion of capital through defaults.

Government and Corporate Balance Sheets Have Headed in Different Directions

S&P 500 ex-Financials Net Debt-as-a-%-of-Assets (LA) United States: General Government Gross Debt % of GDP (RA) 28 26 24 22 20 18 16 14 12 10 2000 2002 2006 2004 2008 2010 1990 1992 1988 1994 1996 1998 100 90 80 70 60 50 40

la = left axis; ra = right axis; gdP = gross domestic Product. source: IMF World economic outlook, Factset, s&P. data as at december 31, 2010.

exhIbIt 49

Average Expected Returns and Discount Rate Suggest There is Opportunity in Non-Traditional Fixed Income
S&P 500 Pension Discount Rate (%) S&P 500 Pension Expected Return Rate (%) 10 9 8.0 8 7 6 5 4 2000 2007 2010 7.4 6.1 5.3 7.7 9.2

We think there are noteworthy investment opportunities in the corporate fixed income market, including bank loans, high yield debt and mezzanine debt

data as at september 30, 2011. source: standard and Poors.

20

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third, many of the above-mentioned asset classes return a significant amount of capital to investors each year in the form of coupons or repayments, which is critical to supporting annual cash spending ratios and commitments at this point in the cycle.
exhIbIt 50

Banks Will Need to Shed Assets

ECB Lending to Commercial Banks (% of Banks Assets) 25 20 15 10 5 0
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

Within the currency market, we have a fairly simple thesis. as Exhibit 53 shows, the world is bifurcating into haves (i.e., countries with the ability to raise short-term rates and attract capital) and have-nots (countries trapped by low rates, weak economies and outsized entitlements). of course, we would aspire to more stakes in the havesand some of our long-term favorites include the singapore dollar, Mexican peso, and chinese yuan.
exhIbIt 52

Currency Impact on Emerging Market Equity Returns From a US Investor Perspective

Italy Spain Portugal Greece Ireland 35% 30% 25% 20% 15% 10% 5% 13% 19% 16% Percentage of Returns from Currency Movement

33% 26%

ecb = european central bank. source: ecb data through July 31, 2011.

exhIbIt 51

0%

Corporate Market Appears to Offer Better Yields and Potentially Less Risk
Yield (%) as at 9/30/2011 9.7 6.7 5.2 3.5 1.9 1.9 2.3 10.8 13.0

2006

2007

2008

2009

2010

currency Impact = (MscI eM gross Usd returns - MscI eM gross local returns) / MscI eM gross local returns. source: MscI, bloomberg. through dec 31, 2010.

exhIbIt 53

Haves Versus Have Nots

Policy Rate (%) BRL IDR
6.75 5.75 4.75 4.50 3.25 12.00

Germany Govt Bond 10 Year

United EMU Corp US Govt Bond 10 Kingdom Bond 10+ Govt Bond Year AAA Year 10 Year

Moody's BAA Corp Bond

U.S. Bank Loans

Global High Yield

Emerging Mezzanine* Market Corp High Yield

TRY AUD PLN KRW EUR

1.50 0.50 0.25 0.10

Have's

* = KKr estimated. data as at september 30, 2011. source: Factset, KKr.

Currencies Have Emerged As an Important Differentiator

In addition to sovereign bond yields, currencies too have emerged as an important release valve, often identifying, and in some cases altering, many of the global imbalances we see in the world today. If we are right (and we believe we are), then investors need to better incorporate currencies into their global-macro and assetallocation strategies. one needs to look no further than Exhibit 52 to find that the currency effect on total return can be as much as one third of the entire total return in some years.

GBP USD JPY

Have Not's

brl = brazilian real; trY = turkish lira; Idr = Indonesian rupiah; aUd = australian dollar; Pln = Polish zloty; KrW = south Korean won; eUr = euro; gbP = british pound; Usd = Us dollar; JPY = Japanese yen. data as at september 20, 2011. source: bloomberg.

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Within the cohort of have-nots, we believe that the dollar is poised to regain some of its losses in the short-term, as evidenced by the fact that many developed-market economies are now beginning to exhibit similar economic weaknesses as the U.s. Further, regions like europe are now considering cutting rates after pledging to raise rates just months earlier. that said, while a bounce-back may be in order, the U.s. dollar faces major structural headwinds in a Phase III environment. Its government suffers from both fiscal and trade deficits, and its central bank has been among the most aggressive in terms of its commitment to bailouts and quantitative easing policies. additionally, as sovereign funds and central banks in emerging markets diversify away from the dollar, it is likely to face ongoing pressure.
exhIbIt 54

thoughtfully constructed portfolio, were inclined to a 57% allocation as more appropriate, rather than the 10% or more that some investors espouse. In addition, we recommend focusing on non-traditional allocation strategies to gain commodity exposure, including greater ownership of physical assets in place of futures.
exhIbIt 55

Commodities are Now Increasingly Correlated to Equity Markets, Especially EM Equities

80% 60% 40% 20% 0% -20% -40% -60%
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-10 Jan-11 Jan-12

Rolling 60-month Correlation with Commodities

US Equities US Bonds EM Equities

Correlation of Asset Classes with Inflation

30% 20% 10% 0% -10% -20% -30% -40% -50% -60% Stocks Bonds Commodity Futures

Inflation

Change Expected Inflation

Unexpected Inflation

as at september 30, 2011. source: bloomberg, using s&P 500 for Us equities, barcap Us agg for Us bonds, s&P gscI for commodities and s&P emerging Markets index for eM equities.

Inflation: Y/Y% consumer Price Index (cPI); expected inflation: t-bill rate as proxy; Unexpected inflation: Inflation - expected inflation. For additional information regarding the chart and basis for the data shown, please refer to Page 19 table 6 within Facts and Fantasies about commodity Futures. data is quarterly from July 1959 through 2004. source: gorton & rouwenhorst, Facts and Fantasies about commodity Futures draft: February 28, 2005.

exhIbIt 56

Inflation Hedging Power of Real Estate is Strong in a Low Rate Environment

Correlation Between Real Estate Indexes and Inflation Rate Y/Y Change in Various Yield Environments 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 0-4% -0.20 4-8% Initial US 10yr Yield -0.14 >8% 0.11 NCREIF Property Index 0.68 0.78 0.35 Equity REITS (TR)

Commodities Should Be Approached With a Fresh Perspective

Most asset allocators we know continue to want to increase their exposure to real assets, commodities in particular. their chief concern is the desire to increase their exposure to inflation hedges, given the surge in global money supply. though we do not see an immediate concern for significant inflationary pressures, there is no question that commodities greatest strength is their role as an inflation hedge. as shown in exhibit 54, the correlation of commodities with inflation as well as changes in inflation is positive; by comparison, stocks and bonds typically have a negative correlation with inflation and changes in inflation expectations. separately, commodities can also act as an important diversifier, particularly during periods of heightened geopolitical tension. nonetheless, commodities do have their drawbacks, including their performance during periods of economic weakness. their correlation in times of market stress tends to rise from essentially zero with a traditional 60/40 (stock/bond) portfolio to more than 40%. they have also become increasingly correlated with other asset classes, including most equities (Exhibit 55), and negative roll down costs can be a major headwind when the asset class is in contango. therefore, while we do agree that commodities are an important part of any

Inflation rates measured by Us consumer Price Index (cPI). data from december 31, 1978 to december 31, 2009. Past performance is no guarantee of future results. source: bloomberg, MsIM.

another point to consider is that real estate can also act as an important inflation hedge, assuming we are correct that rates are likely to remain low in the U.s. for the foreseeable future. one can see its strong correlation to inflation in a 04% interest rate environment (Exhibit 56). Ironically, if deflation does not settle in, the ability for real estate owners to raise rents amid low financings costs would be attractive.

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Conclusion
our macro view boils down to one key imperative: make volatility your friend, because it wont be going away anytime soon. Phase III is the third and final phase of this extended deleveraging cycle, and it means that investors will have the opportunity in the next few years to make highly lucrative investments owing to opportunistic circumstances as well as structural shifts. In a series of upcoming papers, we will examine more closely specific asset classes and their expected returns. For now, we recommend exploiting weaknesses in equities in order to tactically establish long positions in german, U.s. and emergingmarket equities. We still favor an overweight position in fixed income and currently believe that the bank-loan, high-yield, and mezzanine areas all represent good to extremely compelling value. near-term, we favor tactical long positions in the dollar and short positions in the euro. Within commodities, we recommend non-traditional investments that are not afflicted by the adverse correlation factors we previously discussed. looking ahead, we think that the recapitalization of european banksif done properlycould equate, at a minimum, to a 5% upswing in global equity valuations overall. less U.s. government intervention will also, by our perspective, contribute positively to market performance, while falling inflation in china remains a key variable on which to focus.

Real estate can also act as an important inflation hedge, assuming we are correct that rates are likely to remain low in the U.S. for the foreseeable future

Finally, we expect recent weaknesses in commodities to alleviate some inflation concerns, and we expect deleveraging to gain momentum. thus, we remain comfortable in our assumption that deflationary risks overshadow the possibility of inflation in 2012.

Important Information the views expressed in this presentation are the personal views of henry McVey of Kohlberg Kravis roberts & co. l.P. (together with its affiliates, KKr) and do not necessarily reflect the views of KKr itself. the views expressed reflect the current views of Mr. McVey as of the date hereof and neither Mr. McVey nor KKr undertakes to advise you of any changes in the views expressed herein. In addition, the views expressed do not necessarily reflect the opinions of any investment professional at KKr, and may not be reflected in the strategies and products that KKr offers. this presentation has been prepared solely for informational purposes. the information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. charts and graphs provided herein are for illustrative purposes only. the information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither KKr nor Mr. McVey guarantees the accuracy, adequacy or completeness of such information. nothing contained

herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. there can be no assurance that an investment strategy will be successful. historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. this presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. the information in this presentation may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. there is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. the information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Perfor-

mance of all cited indices is calculated on a total return basis with dividends reinvested. the indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments. neither KKr nor Mr. McVey assumes any duty to, nor undertakes to update forward looking statements. no representation or warranty, express or implied, is made or given by or on behalf of KKr, Mr. McVey or any other person as to the accuracy and completeness or fairness of the information contained in this presentation and no responsibility or liability is accepted for any such information. by accepting this presentation, recipient acknowledges its understanding and acceptance of the foregoing statement. the MscI sourced information in this document is the exclusive property of MscI Inc. (MscI). MscI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MscI data contained herein. the MscI data may not be further redistributed or used as a basis for other indices or any securities or financial products. this report is not approved, reviewed or produced by MscI.

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