Monster transactions in China have recently monopolised the private equity headlines. Is the opportunity worthy of the hype? Despite many risks, a combination of liberalisation and investor innovation is widening the scope of possible activity, giving investors new ways to tap China’s growth story.
Of the US$20 billion invested in Asian private equity transactions in 2005, US$5.75 billion was spent in the People’s Republic, and that inflow is weighted towards the leviathans.
Pioneering deals include Newbridge’s link-up with Shenzhen Development Bank and Carlyle Group’s purchase of an 85% stake in Xugong Group Construction Machinery for US$375 million. This Triassic era of adaptation was swiftly followed by a Jurassic period, featuring staggeringly large sauropod deals, such as Goldman Sachs paying US$1.8 billion for 6% of Industrial and Commercial Bank of China and Singapore’s Temasek’s paying US$1.4 billion for 5.1% of China Construction Bank.
Exits have been similarly monumental, notably 2005’s US$9 billion IPO by China Construction Bank. Coming soon is a US$10 billion float of ICBC. Three-quarters of incoming private equity allocations have gone into such growth-style deals.
The top predators in 2006 may be several new funds that have recently closed. Among these behemoths are CVC’s US$1.975 billion fund, a US$1.775 billion fund from CCMP and Newbridge’s US$1.5 billion fund.
Risk Versus Rewards
An important driver attracting investors to Chinese private equity funds is the access that it can give to dimensions of the economy that simply investing in the stock market cannot provide. Indeed, the A-share market has mostly declined as GDP growth rates have soared.
But are investors being rewarded for these deals? The giant bank investments involve significant risk. Paul Sheehan, bank researcher at AsianBanks in Hong Kong, says, “PRC banks are trading at 18x price earnings and at 2.4x price-to-book value. That is the highest in Asia. This would be reasonable if there was the prospect of profit growth, yet their return on assets of 0.66% is the lowest in the region. China Construction Bank’s share price rose 60% post IPO, but has fallen back.”
It is early days for China’s private equity market, with issues surrounding legal matters, accounting uniformity, due diligence and repatriation of profits. There has been progress, but from an extremely low starting point. Investors get so excited about the growth story that they sometimes sweep these issues under the carpet.
“We’re positive about the PRC, and the macro story is important and relevant, but ultimately private equity is a micro-business,” says Gary Lawrence, managing partner at Excelsior Capital Asia. “People have to get their heads round this and come to terms with the risks unique to a particular transaction.”
Accounting verification is tricky and audited accounts have to be restated with alarming regularity; and investors face outright fraud. “You see kickbacks from suppliers, board minutes doctored, systems and controls inadequate to prevent fraud; these virtually allow people to write cheques to themselves,” says Neill Poole, managing director and head of the regional dispute analysis and forensics practice at Alvarez & Marsal Asia in Hong Kong.
Beijing’s support for the market’s progress has been arbitrary, but investors note that the pre-execution phase of a private equity deal has started to shorten. This reflects an improved predictability around winning various approvals and licenses from municipal, provincial and national regulators and ministries.
However, there is a backlog of incomplete deals as a result of procrastinating by the State Administration for Foreign Exchange (Safe) prior to its clarification of the regulatory framework. Offshore private equity structures still need to be registered with Safe, which is an arm of the People’s Bank of China, though Safe no longer has an approval role.
As the deal pipeline fills, private equity firms are ramping up their deal teams, and bringing in senior managers to place on the boards of their acquisitions.
“Chinese companies gain new independent directors with corporate governance and global industry expertise, as well as access to our international network of business contacts,” explains Jamie Paton, managing director at 3i in Hong Kong. “In some cases, this can be quite a change to their management culture, but the Chinese management we work with are nothing if not pragmatic, and they know what it will take to grow their companies at an international level.”
That said, the logical reason Chinese entrepreneurs primarily want to ally with Western private equity firms is because of their wheelbarrows of cash. An important part of managers’ agendas is growing their company in a way that increases their wealth.
“The investor and Chinese entrepreneur may start out with very different agendas, but to align those agendas is essential. An investor has to understand on what their money is going to be spent, and for whose benefit,” says Neill Poole. “The entrepreneur has to be transparent.”
Innovation the Way to Go
But investors should also be wary of copycat PE transactions chasing the China dream. As more private equity players enter the market, they risk bidding up prices for a finite number of opportunities. Marginal deals are vulnerable to market volatility. But this also forces PE firms to widen their horizons and pioneer new ways to achieve internal rates of return of over 20%. Innovation is the business’s hallmark.
“There is a widening landscape of venture capital opportunities in China, such as consumer services on the internet, semiconductors and medical technology. Last year various operational models of US-style venture capital operations emerged in China,” says Gil Forer, global director at the venture capital advisory group of Ernst & Young.
Proliferating business models include joint funds between a foreign and a China-based fund, such as the US$250 million IDG-Accel China Growth Fund; strategic limited partners, as practiced by 3i-CDH, in which the local fund serves as a deal feeder and a local arm to the fund overseas; or the standalone China-based fund, such as Sequoia China Fund, run by Chinese partners and an indigenous investment team.
China is even beginning to see buyout strategies, which until now have been eschewed in favour of growth deals. But developments in regional capital markets make leveraged buyouts (LBOs) increasingly possible.
Brett King, partner at Paul, Hastings, Janofsky and Walker in Hong Kong, thinks there will be at least 10 LBOs of at least US$100 million each emerging from China over the next two years: “There’s not a large amount of leverage in offshore vehicles for PRC buyouts, leading to typical debt-to-equity ratios of 0.75x/1x, compared to 3x/5x in Korea, 3x/4.5x in Hong Kong and 5x/6x in Europe. Nevertheless, now that high-yield debt can be issued in all Asian jurisdictions, it makes leveraged buyouts far more attractive.”
A lot of infrastructure needs to be put in place before buyouts become common. Secured lending laws are still at a low level of sophistication, meaning that lenders cannot be granted a perfect charge over all assets of a buyout company. Also, where a security interest can be taken, the enforcement process is unclear or subject to government consents. Furthermore, Chinese companies are not allowed to guarantee the debts of those shareholders, and unlike other markets, the PE vehicle holding the debt must be incorporated offshore, isolated from the company with the assets.
More M&A exit opportunities may arise as the government continues its non-tradable share reform, which is seeing Beijing earmark ‘legal person’ and state-owned majority stakes in listed companies as tradable, and the government has waived portfolio quotas for foreign investors taking stakes of 10% or more in these companies.
Whether in the form of growth capital, buyouts or venture capital, private equity money will continue to flood China and suck capital inflows from its regional neighbours. So is there a bubble? Market players say no: given the gigantic scope of the virgin territory in China, there should be enough action for all, and continuing overseas listings by Chinese companies will widen the opportunities for exiting deals.
“In China, there is a lot of money chasing transactions, but there is an enormous number of entrepreneurs and companies searching for capital,” says Gary Coull, chairman of CLSA Capital Partners. “Prices are still reasonable in China, around 6x Ebitda, which is cheaper than Europe and a lot cheaper than Japan where you get nutty asking prices of 10x to 12x Ebitda.”
He also says that fears over dodgy mainland accounting can be overcome by carefully structured convertible debt instruments, via loans that convert to equity at a prearranged time following the private equity firm’s investment in a company. It seems that for every hurdle in the Chinese market, private equity investors have an equally creative solution.