Allure of private equity market grows

Outsiders still rule the roost, but Chinese funds are beginning to have a bigger sway

China's fast maturing private equity market is attracting a huge amount of investment from Western private equity firms, whose exit strategies are also shifting from routes dominated by initial public offerings to a more diversified range.

Competition from fast growing domestic Chinese private equity funds has also made foreign private equity firms increasingly focus on their strategy on winning desirable deals, drawing on their global expertise to help acquisition targets achieve growth.

Globally renowned private equity firms like Bain Capital, the Carlyle Group and Blackrock have significantly invested in China's private equity market over the past decade, and have dominated Chinese private equity until very recent years, when Chinese private equity firms grew.

As a testimony to the Chinese private equity market's vitality, the private equity unit of Edmond de Rothschild Group, one of Europe's oldest financial institutions, has raised a second fund to invest in China's healthcare, consumer and clean technology companies. Its first fund to invest in China was set up in 2009.

"As a developing country, China is still growing fast despite the moderate slowdown in recent years," says Jonathan Zhu, managing director of Bain Capital Asia.

"New business is being created every day, which stimulates demand for capital in both debt and equity."

Zhu says he recently visited a high-tech industrial park in Xi'an that hosts 30,000 high-tech companies, and every year another 5,000 or so arrive. "This demonstrates the vitality of China's economy," Zhu says.

One significant development in China's private equity market is the growing emphasis on trade sales, rather than IPO as exit options. The long IPO waiting time of up to three years in Shanghai and Shenzhen's exchanges have pushed private equity firms to look for opportunities where they sell their investment to a strategic investor.

The emphasis on trade sales rather than IPOs has recently gained favor, especially among China's smaller private equity firms that have historically sought listings for portfolio companies.

While IPOs of Chinese companies have increased after last year's slowdown, there are still concerns about general partners betting on one exit strategy. Chinese firms are now seeking other exit paths to ensure returns.

Edmond de Rothschild Group's exits include the sale of Chinese food distribution company Sinodis to Bongrain SA of France, a cheese and dairy specialty business; and baby care business Shanghai Elsker for Mother & Baby Co Ltd to Johnson & Johnson.

Gong Jie, a partner in the Hong Kong office of global private equity firm Pantheon, says: "There are more trade sales now as a result of drivers that include domestic buyers alongside well-financed foreign buyers, industry consolidation, and business owners' greater willingness to sell majority stakes in their firms as a way of managing succession."

Pantheon manages more than $32 billion (27 billion euros) globally and was the first private equity fund investor to set up a local presence in Asia, opening the Hong Kong office more than 20 years ago.

Jenny Liu, a partner in the law firm Squire Patton Boggs, says trade sales have become a trend over the past five years. The reasons include less favorable valuations for Chinese firms on foreign stock exchanges and the much healthier balance that now exists between the two exit options in China's private equity market.

In recent years the Chinese private equity market has become much more competitive because of the emergence of Chinese domestic private equity funds and the growth of large Chinese firms that compete with private equity firms to make acquisitions for high-growth targets, Liu says.

Cash rich Internet firms such as Baidu, Alibaba and Tencent have made many acquisitions of smaller firms believing that great strategic synergy can be achieved, she says.

This competition has made funds more focused in selecting for opportunities in certain industries, and more professional in devising investment strategies, Liu says.

Benjamin Kroymann, another partner in Squire Patton Boggs, says it is now much less common for foreign firms to take Chinese firms they have bought to overseas stock exchanges. This follows the wave of delisting of Chinese firms on US stock exchanges in recent years.

Shares in Sino-Forest, a Chinese forestry group listed in Toronto, fell 90 percent in 2011 after Muddy Waters, a research firm founded by short-seller Carson Block, accused the company of overstating its sales and the value of its forest land.

Almost $500 million was wiped from the value of the company, which is owned by a $37 billion hedge fund run by billionaire John Paulson.

Longtop, a Chinese software company, also delisted from Nasdaq in August the same year after its auditor, Deloitte, accused it of "very serious defects" with its accounting.

Those two were among 29 Chinese companies delisted from US bourses in a short time in 2011, with a combined paper loss of $5.7 billion. Another 48 companies had trading in their shares suspended, or received suspension warnings from the US Securities and Exchange Commission.

"Overseas IPO has become more difficult as an exit option for Chinese companies because we've had issues, and skepticism from investors have kept valuation for Chinese companies on overseas stock exchanges low," Kroymann says.

Guy Hands, chairman and chief investment officer of Terra Firma, a private equity firm founded as a spinoff of Nomura Bank in 2002, says trade exit is favored more by foreign private equity firms than domestic ones.

"Chinese firms still target pre-IPO opportunities, looking for fundamentally strong companies that desperately need capital injection.

"Comparatively, European private equity firms need to have the expertise and tools to more patiently guide portfolio companies to achieve operational excellence, creating value rather than simply finding it," Hands says.

"Helped by the IPO slowdown and industry consolidation waves, the Chinese market is experiencing a remarkable boom in mergers and acquisitions activities. There are now more regulatory requirements on listing procedure reforms which may fundamentally change the private equity industry in China in the short term," Hands says.

Even though Terra Firma has no investment in China, it has an office in the country and is looking for opportunities to invest in the Chinese market when the time is ripe, he says.

David Rubenstein, co-founder and co-CEO of the Carlyle Group, says trade sale is the preferred option for his team, because strategic buyers usually pay the highest prices.

"In Asia and China, our exits have been probably selling more to strategic buyer and financial buyer. IPO is not a big deal to us. People get excited with IPOs. Sometimes stocks go up. But stocks can't always go up. Sometimes they go down, too," he says.

Zhu says China's private equity market is set to grow much further, because the penetration rate of private equity is still low compared with what prevails in developed economies. The total private equity investment as a percentage of GDP is about two percent in the US, one percent in Europe, but only less than 0.5 percent in China, Zhu says.

"The private equity sector in China is still small. There are great opportunities for both Chinese and international investors. Some people think the competition between domestic and foreign private equity firms is becoming stronger, but I think the strong demand for capital has ample room for everyone."

Zhu's optimism is shared by Gong, who adds that private equity firms are well positioned to drive increased professionalism within Chinese businesses. "There is also a shake-up in the local private equity landscape, which has seen competition reduce and valuations become more attractive."

As China continues to develop, our investment strategy has also evolved over time, Zhu says.

"When we first came to China in 2006, we thought there would be almost no chance to acquire majority stakes in Chinese companies, but now we do a lot of it.

"Our own scale of investment has also increased a lot. When we first started in China we would typically invest $30 million to $50 million per project, but now we invest around $100 million to $200 million per project. Having a controlling stake is one of the reasons for such an increase."

Bain Capital has invested in seven companies since 2010, of which six are majority investments.

"One reason that we chose to be a majority investor is that we are confident about the companies on which we have done due diligence and that we have selected carefully," Zhu says.

"Second, we have the resources to help companies to restructure, so as to improve their management practices and help them realize their ambition."

Zhu says bidding for projects in China is not about paying the highest price, but the deep understanding of the target company, skills and experiences that can help the company grow, and the alignment of interest with the management team are key for private equity investors to secure deals.

"We must understand what the companies' expectations are, we must be able to offer the right skill sets and resources to help their business grow and effectively communicate with management teams," he says.

When accessing investment opportunities, Zhu says, his team always has to understand the ambition and goal of the company, assess whether the management team can lead and deliver, and also where Bain Capital can help and add value in achieving the company's goals.

One recent investment Bain Capital made in China was an 80 percent stake in Lionbridge Financial Leasing (China) Co Ltd, a financial leasing company focusing on the country's SMEs.

"We know the management team well, and we have convincing plans on how to help them achieve their goals, which was instrumental in helping us secure the investment opportunity," Zhu says.

Global private equity firms have dominated China's private equity market for most of the past decade. Newbridge Capital LLC, which became the Asia unit of TPG Capital in the 2000s, was the first foreign investor to control a Chinese bank.

Carlyle, which started in China in 1998, bought a 20 percent stake in China Pacific Insurance Group Co between 2005 and 2007, its biggest purchase in China.

But this trend is changing, as Chinese domestic private equity firms grow. In 2006 the government of Tianjin set up Bohai Industrial Investment Fund Management Co. This was the first government-backed domestic private equity fund, with 20 billion yuan ($2.6 billion) under management in December 2006.

Hony Capital, sponsored by state-backed Legend Holdings Ltd, has raised $6.8 billion since it was founded in 2003. Citic Private Equity Funds Management Co, the investment arm of state-owned Citic Group, China's largest conglomerate, has raised 9 billion yuan since it was set up in June 2008 with plans to raise the same amount for a second fund.

Domestic private-equity funds such as those of CDB, Hony, and Citic are seen as direct competitors to more established and well-known overseas funds such as those of TPG Capital and Carlyle Group.

"I think 2009 is the turning point that divides the Chinese private equity industry into pre and post," Liu says. "Until then the private equity market was dominated by US dollar denominated funds, and since 2009 there has been an explosion of renminbi funds."

Most of the renminbi private equity funds are raised by Chinese private equity firms, although increasingly Western private equity firms such as Morgan Stanley are raising renminbi funds to invest in China.

Liu says renminbi funds would be more liquid in terms of accessing the capital, and these funds typically dominate certain fields of investment. An example is the clean technology industry, where the exit option is more commonly domestic IPO rather than foreign IPO.

In recent years both domestic and foreign firms private equity firms have grown in China, and one noticeable trend has been the growth of smaller funds in the industry, Liu says.

"There are now more funds, and the opportunities have shifted in terms of how they select opportunities."

cecily.liu@chinadaily.com.cn

(China Daily Africa Weekly 01/09/2015 page16)