MONTHLY LETTER: June/2012

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1 Dear Investors: There is still a low growth perspective for the global economic scenario for a prolonged period of time. In fact, since our last Report, there is increasing evidence on such meek growth rhythm. Throughout the second quarter, the deepening of the European crisis, the deceleration of China and the fear relative to the sustainability of the recovery seen in America s economy have translated into increased volatility and aversion to risk in the financial markets. Additionally, this picture also includes the drop in the commodities prices, moderation of international trade and losses in equity markets. Though recovery has materialized quite gradually in Brazil, activity is likely to accelerate in the next quarters as a result of the lagged effects of the monetary stimuli commenced in August The effects of the complexity that surround the international environment are added to the moderation of domestic activity witnessed in the second semester of 2011, which was greater than initially expected. In this context, the impact of the international scenario deterioration is transferred to the Brazilian economy via investors trust and foreign trade and investment flows, among other channels. On this matter, it is worth mentioning the delayed and cumulative impacts of the monetary policy actions implemented since August 2011, which will still take a while to fully manifest themselves over activity. We think that the government s policy mix will continue to be biased in the direction of further monetary easing, with fiscal policy still under control. Monetary easing would also be consistent with the government s desire. The rhythm of the trade sector is still intense its dynamic is closed to the labor market conditions. The Purchasing Managers Index (PMI-Services) relative to business activity hit points in June, when compared to 49.3 points in May, thus having once again accelerated. Without seasonal adjustment, the indicator registered 52.1 points in June, compared to points in May and June While signs of a slower pace of expansion can be identified in different segments, the bulk of the disappointment continues to come from manufacturing. Industrial production (IP) in May surprised on the downside and the prior releases were revised down. In the first five months of the year, IP declined 3.4%. Production in all main categories is now below the pre-crisis level, with overall IP 5.4% below the September 2011 level. Sentiment surveys suggest some adjustment in inventories towards the end of the quarter, with positive implications for a recovery in production ahead, but declining confidence levels doesn t support too much optimism. Government actions to boost specific segments (automobile, trucks, autobus, household appliances & furniture, machinery), in our view, should only have localized impact, and in some cases, just noticeable more towards the end of the year. The unemployment rate disclosed by the Monthly Employment Survey (PME) prepared by the Brazilian Geography and Statistics Institute (IBGE), and which takes into account Brazil s six main metropolitan areas, was of 5.8% in May Considering the data disclosed by the Central Bank, which are not subject to seasonal adjustment, the average unemployment rate was of 5.7% in the quarter ended in May, compared to 5.6% in the quarter ended in February, resulting from the 0.8% increase of employed persons and of 0.9% of the Economically Active Population (EAP). Labor market data are still strong and do not show signs of deceleration. Looking ahead, we continue to expect growth to gradually accelerate as some of the limitations we see on the short run ease moving forward consumer indebtedness and high delinquency rates, mainly allowing some recovery in credit expansion, in the case employment levels are not significantly harmed (our base case). In this sense, we still expect most of the economic sectors to benefit from it in some extent, implying improved performances in the end of 2012 and Inflation, measured according to the variation of the Broad Consumer Price Index (IPCA) in twelve months, has receded since 4Q11, having thus shifted from 7.31% in September 2011 to 4.92% in June In general, the core measurements calculated by the Central Bank have seen similar evolution as that of headline inflation. As we mentioned above, this scenario of a more gradual recovery has helped contain inflationary pressures. Some important prices which have been running above headline inflation on the last few years, helped by favorable demand conditions, are starting to show some ease, as services inflation and apparel prices, for instance. While still above the average, inflation on those segments has been surprising on the downside recently. As we said before, we see increasing risks of an even more benign scenario, with higher regulated price increases in 2012 potentially diminishing pressures for

2 On the fiscal front, while fiscal performance at the margin has weakened somewhat due to disappointment in the revenue stream, it is still compatible with achieving the primary fiscal target of 3.1% of GDP. Fiscal policy is more expansionary this year than last in 2011 expenses grew 3.4% in real terms, against 7.0% this year through May. Even so, this does not mean in our view that fiscal policy is helping the economy to grow. Tax revenues continue to grow above GDP (9% in real terms in 2011 and 5.7% year-to-date), intensifying the competitiveness problems faced by the industry, even under a much weaker currency. And on the investment side, performance has been very poor, preventing government capital expenditures from having a countercyclical role. Government s increased spending is happening mostly through higher transfers (pensions, social programs), particularly in 2012 after the large real increase in the minimum wage. This has contributed to sustain consumption at strong levels but it has not propelled growth as the industrial sector has continuously lost ground to imports. Such trend should moderate somewhat but not quickly reverse with the weaker BRL, reflecting structural issues (high tax burden end high energy costs, for instance). The government has announced this year several tax and expenditure measures that would prevent a more pronounced economic slowdown. We do not think that such measures will materially impact growth this year, even if they are important to keep some important sectors in the economy most importantly auto producers - from laying off workers. Also important is the government s reduction in the IPI tax for the auto sector, which led to a substantial increase of car sales in June (23.2% mom, 18.8% yoy). The dismal performance of public sector investment is related to the government s low efficiency to execute its projects. In our opinion, this is the result of: (i) problems related to environmental licenses, (ii) the very bureaucratic and time-consuming procurement process and (iii) allegations of irregularities resulting in stoppage of construction (as happened in 2011 and 2012). Trying to compensate the poor performance of public investment in infrastructure so far, the government announced the so-called PAC Equipamentos in June 27th. This program consists in increasing the budgeted expenditures for capital goods acquisition (as trucks, buses, tractors and others) by R$ 6.6 billion (equal to 0.15% of GDP), in order to stimulate the production of those items in 2H12. Purchasing such goods do not face the same lengthy process involved in infrastructure works. However, the impact of PAC- Equipamentos should not be verified entirely in 2012, given the procurement process and the production lags. Contrary to what would be desirable in the current stage of the economic cycle, public investments performance (excluding MCMV) has been contributing to the economic slowdown. Therefore, it is highly important that the government focus on finding solutions to accelerate capital spending in a true countercyclical way. In short, the most recent European decisions have dismissed the possibility of a banking crisis in the short term, but the lack of growth and shrinking trade still prevail in advanced economies and also affect the emerging economies. In what concerns its seriousness and consequences, the 2012 crisis is very similar to the 2009 crisis. The crisis affects primarily the industrial sector in most advanced and emerging economies, as can be seen in PMI, which in the past months has indicated the reduction of the activity. In Brazil, the government has a new macroeconomic matrix as well as a set of tax, monetary and exchange policies, whose purpose is to stimulate the economy by means of both short and long term measures. It is possible to summarize the grounds of said policy in the following five bullet points: 1. More efficient monetary policy, with lower interest rates and reduction of bank spreads; The government expects that by converging interest rates practiced in Brazil with international levels may result in (i) greater stimuli for the production of goods and services, (ii) greater liquidity in the production-related capital market assets (bonds and stocks), (iii) reduction of the tax deficit and government expenses with interest, (iv) indebtedness reduction and reduced family income impairment, and, finally, (v) inflation drop. 2. Fiscal solidity policy, including containment of expenses to fund and increase investments; Government debt has decreased in the past years; the government has made substantial changes to the social security system, which will result in significant long-term fiscal gains. 3. Tax structure reform, including tax simplification, debureaucratization and reduction; In the past months, the majority of the tax measures have been specific to the sectors that have been affected the most by the international crisis. The most commonly used measures include temporary tax reductions and unencumbering of payrolls; however, few measures have been implemented for the long term. 2

3 4. Stimuli to investment in and strengthening of the domestic market; 5. Industry-oriented stimuli. Education Sector: We believe that Brazil s education sector is undergoing a very special period. We have seen significant political will to increase access to education and recently implemented government programs have brought forth important results for the companies involved in the industry. In 2010, Brazil had 6.4 million university students and the target of the National Education Plan (PNE) was for this figure to be of 13 million by Circa 75% of the university students are enrolled in private schools and the ability of such institutions to cater to a greater number of students is essential for Brazil s educational targets to be reached. Brazil s politicians are fully aware of the country s educational deficit and addressing this issue is certainly a relevant objective. However, few advances were made in this area, in the past decades. Brazil is quite behind on this matter, when compared to other developing countries. Enrollment Rate: Higher Education Students (population aged years) PNE Target: 50% 35% In the PNE, the Brazilian government has set the goal of 50% in the Enrollment Rate by Enrollment Rate = (Higher Education Students/Total Population aged years). Source: Unesco. 3

4 Percentage of the Population with Higher Education Degree Brazil has increased only two percentage points (from 9% to 11%) in the number of Higher Education graduates, whereas South Korea has had an increase of 46 percentage points (from 12% to 58%) during the same period 2 Source: Education at a Glance 2010: OECD Indicators The difference between the current situation and the past scenario is not only the increased awareness of the issue, the government has taken concrete measures to address the deficit, which are going in the right direction and which represent important advances. We would like to specifically highlight the reformulation of the Student Loan Program (FIES). Though the program was implemented in 1999, its success was very limited. It was reformulated in 2010 and three main points were changed to render the loan more attractive for the students: 1) reduced interest rate, 2) increased credit period and 3) increased of the percentage of the monthly tuition that may be funded. 4

5 We believe this program is a turning point for the sector, and, in the next couple of years, the revenue of the universities will increase consistently for 1) there are people who would otherwise not pursue their studies, but who will be able to pay for private schools, 2) students will be able to choose courses with greater added value thanks to their increased purchasing power. We invest in the education sector via Krotoin. Below are the main reasons why we have chosen Kroton instead of the other investment options available in the sector: Competent management with background in the sector and solid alignment with the interest of minority shareholders. Board of directors comprised of shareholders with strong background in education and knowledge of the political issues involved in the sector Acknowledgment of the opportunity FIES represents for the sector and emphasis on adequately structuring the company to profit from such opportunity Diversified distance learning platform, the segment of higher education that has grown the most in Brazil. Well-organized company with solid control level and diversified management processes. Cash generation discipline and return on invested capital aimed at generating value throughout time. Attractive valuation even without working with aggressive premises. 5

6 Brasil Capital Equity Fund Monthly Net Performance (offshore fund in USD): RETURN TO DATE (% - left axis) & AUM (USD MM right axis) Equity Portfolio Performance Attribution by sector industry June YTD 6

7 Position of Equity Portfolio Daily Liquidity % Market Value % < BRL 1MM 3,2% < BRL 1 bi 1,9% BRL 1MM - BRL 10MM 31,3% BRL 1 bi - BRL 10 bi 71,5% > BRL 10 MM 65,5% > BRL 10 bi 26,6% Exposure % Long 128% Short -35% Net Exposure 93% * The data included herein are based on the June 29th, 2012 NAV; returns are net of management and performance fees. 7