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September 1, 2016

INVESTOR LETTER

Saudi Arabia: The Challenges of National Transformation “It must be considered that there is nothing more difficult to carry out, nor more doubtful of success, nor more dangerous to handle, than to initiate a new order of things.”

― Niccolò Machiavelli, The Prince Saudi Arabia is at a crossroads in history. Lower oil prices have caused a gash in the Saudi exchequer, forcing an unprecedented transformation of the economy. While we do not see an imminent threat to the Kingdom’s formidable financial strength, the challenges ahead are significant and the remedies painful. The structural problem the Kingdom faces is that its economy is highly dependent on governmental spending. A bloated public sector that employs millions of Saudis needs to be fixed. Policymakers are counting on the private sector to reinvigorate the economy and create jobs. However, it is unclear to us how corporates will grow earnings when costs are rising and the discretionary spending of Saudi households is shrinking as the government reins in subsidies and spending. With each passing day, we believe that outcomes in Saudi Arabia are increasingly becoming binary: The Kingdom will either emerge as one of the largest emerging markets in the world or tailspin towards financial and political instability. The skeptics would argue (as they always have) that Saudi Arabia is doomed. They fail to recognize the resilience the Kingdom has shown throughout history in the face of seemingly insurmountable odds. They also underestimate the resolve of the Saudi establishment to finally succeed in diversifying the country away from oil. However, those who buy into the rhetoric of a grand vision without taking a sober look at the challenges of execution should heed the wisdom of Thomas Edison: "Vision without execution is hallucination." In our view, execution will depend on (a) reducing governmental expenditure (b) reforming labor markets and (c) providing transparency and accountability to attract global capital. Only when these critical areas are addressed will there be a future for the Kingdom away from oil. Mind the Gap

Oil revenue – Expenditure = Surplus (or Deficit)

The simple equation above has underpinned the Saudi economy since its inception. However, with oil in decline and a young a burgeoning population testing the limits of governmental hand-outs, this equation needs a revamp. Thankfully, an army of well-paid consultants have been laboring on a solution for quite a while. Finally, after multiple iterations, the Kingdom has a roadmap called the National Transformation Plan (NTP) and the man in charge of its execution is Mohammad bin Salman (MBS) – the Deputy Crown Prince. His aim is to change the above equation to the following by 2020:

Oil revenue + Non-oil revenue – Expenditure + Cuts in subsidies = 0

According to our analysis, this is an ambitious target if oil prices persist at $40. Here is why:

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September 1, 2016

INVESTOR LETTER

On average, Saudi Arabia exports approximately 2.5 billion barrels of oil a year. At $40 oil it generates revenues of $100B while its expenditure is $260B1. Non-oil revenues account for another $40B, which leaves a gap of almost $120B. In order to close this gap, the Kingdom needs to increase revenues while cutting expenditure. We did this exercise and saw that, despite increasing non-oil revenues by $25B2 and saving $19B3 through subsidy reform, the Kingdom would still fall short by roughly $80-85B or more than 13% of GDP.

Increasing non-oil revenues, rationalizing subsidies and increasing efficiencies are all incredibly important, but will not fill the wide gap created by the current rate of spending. It is true that the Kingdom has more than a trillion dollars of financial firepower to bridge shortfalls.4 However, a rapid depletion of cash without a viable path to closing the fiscal gap will make creditors nervous and derail a structural recovery. Already we are beginning to see interbank rates spiking as government bank borrowing drains local liquidity.

1 2015 actual Expenditure; SAMA 2 New Non-Oil Revenue = $25B: (Value-added Tax = $9B + Fuel Mix Change = $8B + Sin Tax = $3B + Remittance Tax = $2B + White Land Tax = $2B + Pilgrim Tax = $1B); One Market estimates. 3 Expenditure Reform = $19B: (Public Wage Savings = $6B; Diesel Reform = $4B; Electricity Reform = $4B; Gasoline Reform = $3B; Water Reform = $1B); Assumes $19B for cost of implementing NTP; National Transformation Plan 2020; One Market estimates. 4 Assumes $555B in current reserves and $600B+ in borrowing capacity (i.e. 100% of GDP)

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September 1, 2016

INVESTOR LETTER

To sustain investor confidence and constrain speculative attacks on the currency,5 we believe the government needs to balance its fiscal budget before reserves fall below $400B (60% of GDP) and debt levels increase above 40% debt/GDP. This gives policymakers a cushion of $500B, or approximately 6-years at current burn.6 The Kingdom can stretch this timeline by selling assets (such as a stake in Saudi Aramco), but buying time will not fix the structural problem of reducing the dependence of the private sector on governmental spending. For economic diversification to succeed, the private sector must stand on its own two feet. This is easier said than done. Our analysis shows that private sector GDP is highly correlated to government spending. If the government simultaneously cuts spending, reduces subsidies and increases labor costs for the private sector,7 it will create a significant drag on the economy. Moreover, it will extinguish investor confidence in the Kingdom’s economic transformation.

Self-inflicted wounds The two culprits bleeding the Saudi treasury are: (a) Defense and (b) Salaries, wages and allowances for government employees. Together, these account for a staggering 75% of the entire Saudi budget.8 Defense Spending Saudi Arabia is the 3rd largest spender on defense globally and has the highest military expenditure per capita.

5 We think the Saudis are committed to maintaining the peg and have enough financial firepower to withstand speculative activity by hedge funds. For an alternative view, read PointState's Schreiber Says Saudi Riyal Peg Massively Overvalued; Bloomberg. 6 Assumes oil price stays at $40; One Market estimates 7 By forcing firms to higher Saudis at higher wages through ‘Saudization’ 8 NTP 2020; SAMA; One Market estimates

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Stockholm International Peace Research, 2015

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September 1, 2016

INVESTOR LETTER

By reducing the defense budget by 50%, the government can halve its fiscal gap by saving more than $40B a year. The procurement process for arming the military is highly inefficient and opaque. The money goes to foreign defense contractors and very little of it (if any) trickles down to the domestic economy. MBS himself wonders why, despite being the third largest military spender, Saudi Arabia does not have a local military industry?9 The paradox that confounds outside observers is that while championing greater fiscal prudence, MBS is the chief architect of the costly war in Yemen – an 18-month conflict that is causing immense human suffering and damaging the image of Saudi Arabia globally. As a student of the great Chinese general and military strategist, Sun Tzu10, the young Prince should perhaps consider his teacher’s advice:

The supreme art of war is to subdue the enemy without fighting.

Sun Tzu, Art of War History is littered with examples of Saudi foreign policy mistakes leading to an increased feeling of insecurity and the need for protection. While the threat of Iran’s ayatollahs is ever looming, the Saudis also have themselves to blame. They have consistently picked the wrong friends, spent lavishly on them and been forced to pay even higher to get rid of them.11 A recent example: a payment of $681 million was transferred from the Saudis to the personal account of the Malaysian prime minister, Najib Tun Razzak, who along with his cronies is under investigation by the US Justice Department and other global law enforcement agencies for embezzling $3.5B from Malaysia’s state fund. Watching the Saudis doll out a “genuine donation”12 to a corrupt leader 6,300 km away from Riyadh is perplexing. It would be unfair to blame the Saudis for spending frivolously on fickle friends without acknowledging the immense contribution the country makes to humanitarian causes. Saudi Arabia is the world’s largest donor of humanitarian assistance outside the Western states.13 The Kingdom spends 3.7% of its GDP for development and humanitarian aid, far higher than the UN target of 0.7% of GDP for development assistance and four times the average achieved by OECD members.14 Tragically, these efforts of goodwill and compassion lay wasted in the hearts of those who bear the brunt of the Kingdom’s policy mistakes.

9 Defense News, April 25, 2016 10 The $2 Trillion Project to Get Saudi Arabia’s Economy Off Oil: Eight unprecedented hours with “Mr. Everything,” Prince Mohammed bin Salman. Bloomberg 11 Exhibit A is Saddam Hussain – a friend when fighting against Iran and a foe thereafter. Exhibit B is Ali Abdullah Saleh – a trusted friend in 1970s and now aligned with Houthis against the Saudis. Others dictators that received Saudi support include Idi Amin (Uganda), Gaafar al-Nimeiry (Sudan), Hosni Mubarak (Egypt), Zia-ul-Haq (Pakistan), Zine El Abidine (Morocco), Abdel Fatteh el-Sisi (Egypt), 12 Saudi Arabia says money sent to Malaysian PM was a 'genuine donation'; The Guardian 13 Saudi Arabia as a Humanitarian Donor: High Potential, Little Institutionalization; Global Public Policy Institute 14 Ibid, Pg. 5

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September 1, 2016

INVESTOR LETTER

Central Government Wage Bill Almost half of the total annual expenditure by the government is spent on salaries, wages and allowances.15

Of the 5 million Saudis in the national workforce, two-third work for the government. Conversely, 97% of the expats work for the private sector. The government blames the private sector for not hiring more Saudis. It derides local businesses for enjoying a free ride with zero corporate taxes, cheap foreign labor, heavy subsidies and meaty public contracts. However, an objective analysis shows a different story. Despite criticism of the private sector, we think government has inadvertently created the problem it is now trying to solve. By spending too much too quickly, it has crowded out the private sector by never allowing it to fully mature. As a nation that rose from a barren desert to become the world’s largest oil producer in a few short decades, Saudi Arabia prioritized speed over the need to indigenize its industry. As the government spent its oil revenues to modernize the nation, it was far simpler and quicker to buy than to build with private businesses acting as the middleman. Flush with increasing oil revenues, the Saudi government had no need to tax the private sector.16 Reciprocally, without taxation, there were no calls for representation and the system worked. Inevitably, this convenient arrangement severely distorted the labor markets. The private sector brought in cheap foreign labor while Saudis, enjoying better living standards, demanded higher wages. Faced with a growing population, the government acquiesced to employ an ever increasing number of Saudis while paying them a substantially higher wage than the private sector.17 Today, the government employs 3.3 million Saudis costing $130B whereas the private sector employs 7.9 million workers with a wage bill 37% lower at $95B.18 The average monthly wage of a Saudi public sector employee is almost 50% higher than that of a Saudi compatriot in the private sector and 75% higher than that of an expat.19 This has created a severe disincentive to work for the private sector. The participation rate of women in the labor force is only 18% versus 45% in G20 countries.20 McKinsey estimates that raising it to 40% could increase GDP by $17 billion per annum, add $58bn in revenues to Saudi companies and significantly increase productivity, engagement and innovation.21

15 NTP 2020; We based our calculation on 3.3 million Saudi workers employed in government at an average monthly wage of $3,250 16 Other than zakat or charity tax at 2.5% 17 Central Department of Statistics, Saudi Arabia; One Market estimates 18 1.6 million Saudis and 6.5 million expats = 7.9 million; Central Department of Statistics, Saudi Arabia; One Market estimates 19 Central Department of Statistics and Information, Ministry of Economy and Planning; Ministry of Labor; Ministry of Health; McKinsey Global Institute analysis; One Market estimates 20 Ibid 21 Why Should Women Drive in Saudi Arabia? Here’s Another Reason: the Economy.; Elliot Hannon

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September 1, 2016

INVESTOR LETTER

Policy incongruences and lack of engagement with the private sector is creating higher frustration and frictional costs. Here are a few examples: 1. Expulsion of expats: 88% of all expats work for salaries below the minimum wage.22 They perform the jobs

that Saudis refuse to do (e.g. construction, housekeeping, etc). Expelling these workers will not lead to Saudis filling their jobs. On the contrary, it will result in higher costs for local businesses, higher costs for government and significant delays in project execution.

2. Non-payment to laborers: Thousands of foreign workers continue to work without pay for months as the government withholds payments to contractors.23 Authorities may want to send a message to local businesses that the gravy train has stopped, but such actions cause immense suffering to the workers (and their families back home) gravely damaging the Kingdom’s reputation as a good paymaster.

3. Business unfriendly labor laws: Businesses often complain that it is extremely difficult to fire a Saudi employee.24 This creates abysmal rates of labor productivity leading to cheating on Saudization quotas (where companies pay Saudis to stay home while hiring expats to do the work).

4. Separate work-areas for men and women: To avoid ‘co-mingling of sexes’ companies are required to provide separate work areas for women and men. This disproportionately impacts small and medium enterprises (SME) and discourages the hiring of women.25

5. Generous handouts: Saudi royals are known to show their benevolence towards their subjects but this creates a headache for the private sector. For example, on ascension to the throne last year, King Salman gave away $30B as a ‘gift’ to public sector employees.26 Each time a handout is given, the private sector is burdened to match the amount. Businesses that do not, face the ire of their Saudi employees.

6. Gender discrimination: The Kingdom has made a genuine effort to promote gender equality in the workforce (including ratifying a number of UN conventions on discrimination).27 However, the question of how women can come to work if they’re not allowed to drive remains unanswered? Such contradictions should no longer have any excuse in a modern Saudi Arabia.

22 Central Department of Statistics and Information, Ministry of Economy and Planning; Ministry of Labor; Ministry of Health; McKinsey Global Institute analysis; One Market estimates 23 Most of the workers can’t leave even if they wanted to as their employers hold their passports. 24 The Ministry of Labor has amended some laws but enforcement remains in question 25 Interestingly, the same policy is not implemented at the offices of Saudi Aramco where young, educated men and women work together in a professional environment. 26 Similarly, King Abdullah gave $130B in 2011 post the Arab Spring. 27 Saudi Arabia is a signatory to The Convention on the Elimination of all Forms of Discrimination Against Women (CEDAW) – an international treaty adopted in 1979 by the United Nations General Assembly.

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September 1, 2016

INVESTOR LETTER

Reforming the labor market: More carrots, less sticks We believe that the first step to reform the labor markets is to significantly reduce the number of Saudis employed on the government’s payroll. This is important for three reasons (a) to cut the public sector wage bill (b) to increase the participation of Saudis in the private sector (c) to send a strong message that the government is serious about changing the culture of entitlement. 12% of the total expat private sector workforce or approximately 750,000 expats get paid higher than the minimum wage for Saudis.28 These expats work in Finance, Real Estate, Utilities, Communications, Travel & Hospitality, Business Service, Mining and Oil and Gas sectors – jobs that Saudis are willing to take as long as the salaries are comparable to reserve wages in the public sector. If these 750,000 expat workers in the private sector are replaced by the same number of Saudis from the public sector, the government could save approximately $30B a year and reduce its payroll by more than 20%.29 Assuming the transferred workers take no cut in salary, the net increase in labor cost to the private sector would be $14B (4.3% of non-oil GDP). To avoid a drag on the private sector, a wage rebate for employing Saudis could be given until labor productivity gains are achieved through better workforce training. However, we think this idea can be taken further: We propose that the government pay any company in the GCC that is willing to hire a Saudi government employee a direct wage rebate of $19,500 per year per worker. For each worker hired by a private company, the government would save 50% or $19,500 on average despite the cost of a rebate. By offering this incentive across the GCC, the government would allow a much larger pool of companies to compete for the subsidy opening more work opportunities for Saudis.30 For a million employees, this could translate into nearly $40B in annual savings.

28 General Authority of Statistics, Saudi Arabia; One Market estimates 29 An expat earning above minimum wage in Saudi gets paid approx. 50% less than a Saudi in the public sector. 30 We calculated that in Dubai 30 job categories out of 38 (79%) paid a higher average wages than the Saudi public sector

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AVERAGE MONTHLY SALARY OF EXPATRIATE EMPLOYEES IN THE GULF ($000s)

% Wage rebate offered by Saudi Gov.to GCC employer ($19.5K per year)

Average Wage for Saudi Public Sector Employee

Gulf Business: GCC 2015 Salary Survey

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September 1, 2016

INVESTOR LETTER

The above chart shows the average monthly salary for expats across the Gulf countries ex-Saudi (i.e. Bahrain, Kuwait, Oman, Qatar and UAE). For each of the professions shown, the average monthly wage is higher than that of a Saudi government employee. By giving a fixed rebate to an employer, the Saudi government could make hiring Saudis highly attractive especially for professions towards the right-hand-side of the chart.

The benefits of converting Saudi public employees into well paid ‘expat workers’ go far beyond the billions in savings to the government. First, they would gain valuable exposure and develop ‘on the job skills’ outside the Saudi public sector. Second, it would allow the government to more accurately target resources to train new entrants and unemployed workers for the domestic workforce. Third, the private sector and government could keep project costs lower by hiring cheaper foreign labor for jobs Saudis are unwilling to do. Fourth, the government would receive ‘reverse remittances’ as Saudis send a portion of their income back home. Lastly, it would create a more flexible labor market, mobility across national boundaries and faster transference of skills enriching the entire ecosystem.31 Despite a surplus of national labor and growing unemployment in the region, GCC countries are still importing expatriates. Merely, 0.2% of GCC nationals are migrant workers within the region (compared with 3% in the EU) even though the region is far more homogeneous in terms of language, culture and living standards.32 Expats are often cheaper and better skilled, but with a little help from the government through an attractive subsidy for companies willing to hire Saudis, the ‘skill gap’ could be closed at least for the professions we’ve highlighted above. We believe that creative solutions are possible that entail more carrots than sticks for the private sector. However, the starting point has to be for the government to reduce its own workforce. Leading from the front will encourage others to follow.

31 Expat workers are restricted by their work visas from switching jobs from one employer to another. This limits the transference of skills the expats can impart to locals while keeping wages lower. 32 Strength in unity: Making the GCC the sixth largest economy in the world; E&Y, (Pg. 14)

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September 1, 2016

INVESTOR LETTER

Transparency, Accountability and Consistency To those accustomed to the glacial pace of change in the Kingdom, the recent reforms are undoubtedly audacious. While we are circumspect about the challenges Saudi Arabia faces, we also acknowledge the efforts that have been made so far. There is no blueprint that defines the complexity of transforming a nation. The good news is that the country’s leadership has selected a talented, dedicated and experienced group of individuals to spearhead change. But to convince skeptics, policymakers must show that actions speak louder than words. Will the boldness of vison be converted into the bravery of action? Will the rule of law apply equally or will the privileged have exemption? Will long-term objectives succumb to the desire for short-term solutions? These are some of the questions that remain on our mind. For decades, the Kingdom could afford to ignore foreign capital and its own private sector. Now it needs to woo both for an economic transformation. Good corporate governance will be crucial to attract interest from foreign investors and the ultimate litmus test will be the IPO of Saudi Aramco. Our experience has shown that government related entities (GREs) in Saudi are the least open to provide information.33 Frankly, they’ve had no need to as foreigners represent only a tiny fraction of their ownership structure. This attitude will now have to change as Saudi Arabia comes under the intense spotlight of global markets. Moreover, board directorships in GREs – provided as perks for government employees – should now be open to foreign participants. This will encourage more activism, innovation and better governance. Today, of the ten largest public listed companies in Saudi, only one has an independent foreign board member.34 After years of delay, the Capital Market Authority (CMA) has finally started to address the concerns of foreign investors to access the Saudi public markets. Attracting foreign capital will be crucial, not only for initiating change in the economy, but also for improving the corporate culture. However, unless governmental expenditure is reduced, labor markets are reformed and a ‘top-down’ culture of transparency, accountability and consistency is encouraged, merely opening the market to outsiders will not have the desired effect. Perhaps the path ahead could become easier if oil rises. Yet an old Arabic proverb forewarns:

Winds do not blow as the ships wish.

Sincerely,

Arshad Ashraf

33 Publicly traded businesses from the private sector do a far better job in providing disclosure to investors. 34 Bloomberg

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September 1, 2016

INVESTOR LETTER

Riyadh, 1937 Riyadh Today

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September 1, 2016

INVESTOR LETTER

IMPORTANT DISCLOSURES Confidentiality. This document is confidential. It is being provided to you on the condition that it not be forwarded, copied or otherwise distributed without the prior written consent of One Market Capital, L.P. (“One Market”). No Offer or Solicitation. The only purpose of this document is to provide general market and economic commentary as well as general background information on One Market and the investment strategies it intends to follow for its investment funds and other accounts (collectively, the “Funds”). The information in this presentation is for informational purposes only and is not an offer to sell or the solicitation of any offer to buy securities. Any such offer will be made after you have received the applicable Fund’s Offering Circular or Private Offering Memorandum (as applicable, the “Offering Document”) and have had the opportunity to discuss all matters concerning any prospective investment that you desire with One Market. No Duty to Update. Neither One Market nor any of its affiliates assumes any duty to update any information in this document for subsequent changes of any kind. For example, the investment objectives, methods and limitations summarized herein represent One Market’s current intentions. Nevertheless, depending on conditions and trends in securities markets and the MENA economies generally, One Market may pursue any objectives, employ any techniques or purchase any type of security that it considers appropriate and in the best interests of the Funds. The descriptions herein, including the descriptions of One Market’s investment strategy, are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in a Fund. Forward Looking Statements. This document may contain forward-looking statements based on One Market’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors. No Representation as to Accuracy of Information. No representation is made as to the accuracy or completeness of any statement, assumption, estimate or projection or with respect to any other materials in this document. Certain information contained herein has been provided by, or obtained from, third party sources. While One Market believes that such sources are reliable, it cannot guarantee the accuracy of any such information and does not represent that such information is accurate or complete. References. References to “us” or “we” means One Market.