More than just money

It is 10pm in a remote part of Shanxi province and a computer screen flickers to life – the chairman of a local hydropower company has got mail. The message is from the Hong Kong office of a private equity firm that has invested in the hydropower company. Its contents are fairly mundane: An inquiry about the latest power output figures.

This is an issue that could have been addressed during office hours, but that’s not the point. The PE firm is testing the chairman – finding out how closely he keeps tabs on the company he founded.

“The best way to find out how committed they are is to send an email at 10pm and see how long it takes for them to respond,” said Shelly Singhal, CEO of Crestpac, an Asia-focused alternative investment group which has 40% of its private equity pool invested in China.

Singhal went on to describe one instance in which a company chairman failed this test. The firm in question made rollers for laser printers and plastic components for iPhones. As a business model, it had potential and the chairman was likeable. It wasn’t long, though, before the Crestpac people realized they had misjudged the man in charge. They agitated for change at the top but none came.

“We were able to work out a mutually satisfactory solution – which involved us leaving,” said Singhal. “Once broken, relationships don’t really get back together. You have to spend time with [the entrepreneurs] and make sure you both look at the world in the same way.”

For private equity investors, a lack of confidence in the management of a target company can be a deal breaker. This is particularly true in China’s less mature private sector, where the entrepreneur who got the ball rolling is still at the helm and in possession of a majority stake.

According to Chris Gradel, managing partner and co-founder of Pacific Alliance Group, pricing aside, poor management is the main reason why he would walk away from a transaction.

These sentiments are echoed by X.D. Yang, managing director of The Carlyle Group’s Asia Partners fund, which currently has US$2.55 billion under management in the region. Asked to name what appears on this checklist when examining a potential deal, Yang highlighted three areas: The existing management and whether he can work with them; the nature of the industry and the target firm’s market position, and what the target firm wants from the investment.

“The personality factor is very important,” Yang said. “We generally agree on a set of actions or goals for the company and we make sure they welcome our input. We want to invest in companies where we think we can add value to the business through our global platform.”

International exposure
Access to international markets and management expertise is the big selling point for foreign private equity firms in China. A Chinese company that produces medical devices, for example, might see a potential business opportunity in bringing on board a foreign investor that owns a chain of hospitals in Europe.

Honghua is China’s largest manufacturer of onshore drilling equipment. Overseas sales account for 80% of its total business. The Sichuan-based outfit opted for Carlyle as an investor largely based on the company’s reputation. In late 2006, Carlyle took a 7% stake in Honghua for US$22 million, a spokesman for the Chinese firm said. Then in March, Honghua raised US$410 million through a share offering in Hong Kong. Carlyle still owns about 5% in the company.

“We wanted an international financing platform because we always knew we would list overseas,” the Honghua spokesman said. “Carlyle is a well-known PE investor and Honghua wants to create an image of itself as an influential multinational company.”

The Honghua story is shared by other Chinese companies planning to tap foreign markets. Shanghai Anxin, a producer of solid-wood floors, has received US$30 million in investment from Carlyle since 2006 and used the funds to set up a joint venture, A&W Woods, which then acquired assets from its parent. Risecomm Microelectronics manufactures semiconductors that can be used to control power lines, and counts SAIF among its investors. Both firms said they took foreign money with an overseas listing in mind.

“We think a foreign fund will help us to go public after several rounds of funding,” said Jian Gu, chief technology officer at Shenzhen-based Risecomm. “But we don’t want to go public in the Chinese market and that’s why we reject a lot of investment from within China.”

Companies have different requirements and that will lead them to different private equity investors. The common ground is the sectors they target. The consumer segment is regularly flagged up as a play on rising Chinese incomes. Pacific Alliance focuses almost exclusively on this area with investments in Goodbaby, a children’s products manufacturer, and Jiadeli Supermarket, among others.

There is also considerable interest in alternative energy and the environment. This is unsurprising, as such investments are very much in keeping with current government policy. Carlyle has stakes in recycling and biodiesel companies while Pacific Alliance is backer of wind turbine maker Goldwind Science.

“China’s economy is becoming more diversified and this creates new opportunities, particularly for environment-related businesses and alternative energy,” Carlyle’s Yang said.

The X factor
Competition to invest in these high-growth sectors is intensifying. Foreign money is vying with emerging domestic funds for deals that occupy a relatively narrow area also popular with venture capitalists. Foreign funds must do more than just wave their international credentials to stand out from the crowd.

“The lack of opportunities for large-scale buyouts, together with the sheer volume of dollars chasing these deals, means that people are looking for ways to invest in which they bring more than just money,” said Stephen Scott, managing director of Alvarez & Marsal Asia, a group that specializes in improving underperforming assets acquired by PE firms.

Scott believes the focus should be on “operational investing,” (see “Check-up time: Taking a close look”) which involves identifying areas in which the target firm can eradicate inefficiencies and unlock value. In this way, a fund can illustrate exactly where and how it can make a difference.

This value-added element becomes very important when the target is a state-owned enterprise (SOE) or if one of the selling parties is government-controlled. Restructuring SOEs is the biggest opportunity for foreign private equity players in China, according to Seung Chong, a partner at law firm White & Case. But transferring state assets to private – and particularly foreign – ownership can be tricky.

The most visible recent example of this was Carlyle’s proposed US$375 million acquisition of an 85% stake in Xugong, a construction equipment manufacturer owned by the city government of Xuzhou in Jiangsu province. It led to the launch of a nationalistic internet campaign by the head of Xugong’s rival, Sany Heavy Industry, who said he would pay a premium to keep Xugong in Chinese hands.

Suddenly the deal was at the heart of a political debate about foreign investment and regulators held back on approving it. Carlyle offered to reduce the size of its stake, but the deal, first tabled three years ago, appears to be locked in stasis.

“You always run into obstacles when the [target] company is very large,” said Carlyle’s Yang. “Private equity is still relatively new in China and it’s a process of educating people.”

Third party expertise
Despite the trouble over Xugong, Carlyle can still claim one of China’s largest ever PE investments – and it was in a state-run company. In December 2005, it paid US$410 million for 24.9% of Shanghai-based China Pacific Insurance, the country’s third-largest life insurer. In order to ensure its investment came with a value-added element, Carlyle brought in US insurer Prudential Financial as a minority investor tasked with passing industry expertise to China Pacific.

“This was a way for Prudential Financial to gain a toehold investment in China,” said Yang. “They can be involved but do not have to commit a lot of capital or human resources. It was a good situation for them, us, and China Pacific.”

Market watchers expect to see more of this kind of transaction, not least because of China’s desire to mine international expertise to boost domestic industry. However, this model only works when target companies value foreign strategic investors over purely financial ones. Beijing’s recent moves to promote outbound investment and corporate expansion suggest that priorities may be changing.

The largest foreign PE investment in China last year was Blackstone’s US$600 million purchase of a 20% stake in state-run chemical firm China National Bluestar. It was also Blackstone’s first deal in China since it sold a US$3 billion holding to the country’s sovereign wealth fund.

Two months later, Blackstone teamed up with Bluestar’s parent, China National Chemical, in a US$2.6 billion bid for Nufarm, the Australian agricultural chemicals maker. China National had the money and the strategic objective; Blackstone had the investment savvy. Although the deal fell through, it could mark the beginning of a growing trend for Chinese-led international acquisitions.

“There has been a lot of talk about how investment in China is difficult, the regulatory environment too complicated and the deals too small, too few and too expensive,” said Scott of Alvarez & Marsal. “Now there is more talk of investment with China rather than in China.”