What is private equity? In the West, the term probably evokes companies like Bain Capital (and these days, Mitt Romney) buying and attempting to revive failing businesses. But in China, private equity has a radically different role and popular understanding, argues Yong Kwek Ping, the author of “Private Equity in China: Challenges and Opportunities.”
Yong launched one of China’s first private equity (PE) funds in 2001. Since then, his firm has provided growth capital for a range of Chinese businesses, including gold mines, dairy farms and gas stations. Yong spoke with China Economic Review about how China’s political and economic environment has shaped the industry.
How is PE different in China than elsewhere?
The entire concept of private equity is different in China. Private equity in China is about growth capital, whereas Western-style private equity is generally about buyouts that take a publicly-listed company private. There are traditionally five stages in private equity: fundraising, deal sourcing, due diligence and structuring, portfolio management and finally exit. All of these stages are different. For example, China has a very different business culture, and that affects the due diligence process.
What are the major challenges for PE firms?
One specific challenge is the concept of private equity. Private equity is a new industry in China, and many people do not understand it. The reason is that the popular Chinese translation of private equity is simu guben touzi jijin [私募股投基金, “private shareholder investment fund”], so people confuse it with hedge funds or mutual funds. They have the impression that the industry requires insider information, but that’s not true.
What about opportunities?
The seven strategic emerging industries that the government endorsed in the 12th Five Year Plan will be very good opportunities for PE investment – for example, high-end equipment manufacturing, advanced materials and energy – especially midstream and downstream parts of the value chain. The government seems to realize the role private equity can playing in helping to develop these sectors. We’ve put a pretty big bet on shale gas for the next five to 10 years. We think that’s good target because it will be a solution to the energy security issue in China. We also see more opportunities inland, in central and western China. There’s way too much competition in areas like Guangdong and Shanghai, and that’s driving valuations up. But inland, the valuation is still pretty low, and there are a lot of hidden companies that require funding and expertise. Finally, the Chinese PE market is still developing, so we expect to see more majority-stake investments and leveraged buyouts in the future in China, like you do in the West.
What are the biggest reasons PE firms fail here?
The most common reason is probably insufficient due diligence on potential investments. We say PE firms here have to go “beyond the checklist.” It’s not only about ticking off “Are the financial statements good?” “Is there good conflict management?” and so on. You have to go beyond that. Another reason could be guanxi [personal relationships]. During the due diligence or portfolio processes there might be an aspect of giving face to the company. For example, you got to know a company through a certain manager. But even though he’s not performing very well, you don’t fire him, because that’s how you got to know the company.
Is guanxi essential for successful investment?
Guanxi is important, but it doesn’t make or break an investment. You need guanxi to source the deal. If you are able to find a wider choice in companies to invest in, that gives your deal a greater chance of success. But it’s not the end-all or be-all, because it’s only one part of the process. If you are able to find a deal, but you have no expertise in how to manage it properly, your investment still might fail.
What effect does the National Security Review have?
The NSR is actually pretty good because it makes the process of investment clearer. It allows you to know how the government reviews and approves investments. We can’t invest in defense, for example, and we can’t invest in upstream oil and gas. The rules are pretty clear. But one thing you have to know as a PE firm is that competitors within the industry can initiate an NSR on you. Let’s say the government approves your plan to invest in China’s largest confectionary company. An industry association could initiate an NSR against you, even though the government has already approved your investment.
What opportunities do RMB-denominated funds offer?
Renminbi funds can be more flexible in their investment strategies, and they have wider boundaries for their investments, meaning they can invest in more sectors than US dollar funds can. The second advantage is that firms can exit an RMB investment via an IPO on a Chinese stock exchange, so that could potentially increase the exit valuation for the investment. But the entire renminbi fund concept is really new, so we have to wait and see how it develops. For example, we don’t yet know whether there will be a difference in how the government views foreign-owned and locally-owned yuan funds.
We’ve seen the Chinese government take steps to restrict companies from transferring some of their assets offshore, though for example variable interest entity (VIE) structures. Are PE firms now more cautious about Chinese firms with overseas assets?
PE firms want as little risk as possible. They want to know that no bad surprises will pop up during the investment period, which could be 3-5 years. You have to make sure the company you’re investing in doesn’t have anything hidden in the closet, which is why the due diligence process is important. The second thing is that all of these potential risks are caused because of how you draw up the contract, so you can make sure all of these potential risks are covered. We wouldn’t say that any company with offshore assets is bad, because that’s not true, but you have to really look at the company to make sure there aren’t any surprises.