China is of huge interest to global private equity players looking for the next Microsoft. Last year, China attracted US$1.3bn in venture capital funds, up 28% from 2003. But recent data suggests that private equity is being scared off by recent State Administration of Foreign Exchange (SAFE) rules requiring foreign and domestic interests to obtain approval before setting up offshore vehicles, those entities used by private equity houses to exit their China investments. Nonetheless, capital is still flowing in.
The Carlyle Group, one of the world's largest private equity firms with about US$30bn under management, opened its third office in China in July.
Wayne Tsou oversees Carlyle's US$330m Asia growth funds of which about 60% is invested in China. He talked with the CHINA ECONOMIC REVIEW about the opportunities and the downsides of investing in China's private sector. Excerpts from the conversation:
Q: The SAFE rules issued earlier this year have made it tougher to move assets offshore. How have they affected deal flow in the private equity industry in general and yours in particular?
A: The government wanted to serve two purposes. One is to regulate some of the illegal offshore asset transfers, particularly the state-owned assets, and the other is to prevent individuals from transferring their assets offshore to avoid paying tax. But when SAFE issued the regulation, they didn't think about how it would affect the VC industry. It was not targeted at our industry at all, but it affected our industry because historically and because of the regulatory environment in China, we've had to structure deals offshore when we do investments in which we split the domestic entity, moving all the shareholding offshore, in order to enforce our legal rights. So the regulation…would require this kind of transaction to be registered. They didn't say we can't do it; it's just that we have to seek approval from…them. Now, for all of our transactions, we have to go through a number of regulatory approvals anyway, but this just adds one extra step. So because of this, there's some uncertainty, and the industry as a whole has seen a lot of delays in closing deals because that particular branch of government doesn't understand the industry very well. They tend to put [the transactions] on hold or they may not approve some of them, so there has been some impact in the last year on these kind of structuring. But obviously not all our structuring are like this, so some transactions are still able to go through. The industry as a whole has been lobbying the government to clarify this issue and to make them understand our industry and what we do…In the meantime, for my business, we're seeing some delay in our deals; we're structuring around them, or patiently waiting for the [rules] clarification to come, so it's not a big impact mid-term or long-term.
Q: There appears to be too much capital and not enough deals. Is that your experience? When will the balance be restored?
A: The imbalance is not across the board. The imbalance is only in a few sectors the herd has been focused on. China is very diverse in terms of sectors, diverse in terms of geography. The sectors outside of the ones most people care about right now still have very good valuation. The geographies beyond the three or four cities in China that most people focus on are still undiscovered. The imbalance within those sectors that you're probably referring to, I think they will just play themselves out. If it keeps on being in a bubble state, then over time, the returns will come down and people will gradually pull out. It's just a supply and demand issue.
Q: What is the risk profile of China's private equity investments versus the rate of return?
A: So far, in general, it hasn't completely proven out that the returns justify the higher risks. I think increasingly, that's getting better. More and more Chinese companies have gone public either on the NASDAQ or in Hong Kong. The proof is coming. The risks stem from the inefficient allocation of capital and the amount of cheap capital available. In a way, the high valuations translate inversely into cheaper capital. So whenever you have too much cheap capital in the economy, you create an inefficient allocation of capital. So, that's the biggest thing. The manifestation is basically irrational competition using the cheap capital which destroys the profit margin of businesses. In China, it's difficult for companies to grow beyond a certain scale profitably, so that's one very big operational risk. The second risk – or maybe this should be the first risk – is the people issue. It's very difficult to judge whether you're backing a group of people who are capable, have integrity, transparent – all these things. The third risk comes from the capital market environment, which is highly immature versus a country like India, which has a mature domestic capital market, very transparent, very liquid. China virtually has no capital market that's relevant to the VC industry…so your exit is very much more limited. So, there's a huge risk there as well.
Q: Explain how China's weak corporate governance affects the investment climate or your decisions.
A: I think there are two categories when you talk about this topic. If you look at the state-owned sectors that are privatizing and restructuring, then you have much more of a problem because these were obviously run by the state before, so they're much below the standard of corporate governance internationally. But if you look at the private sector, which is what the Carlyle Growth Fund is almost exclusively focused on, then the private sector actually draws from both the best within China, which has been learning from the West – including the best practices – and also the best talent returning to China from western markets. If you focus on the cream of the crop among the Chinese private entrepreneurs – which is what we do – the corporate governance is not that far, I would say, behind similar stage private companies in the West. The room for improvement lies in financial management and financial control, but these are exactly the areas where local entrepreneurs and professional VCs like ourselves complement each other.
Q: Can you talk about the talent running the private sector?
A: We're primarily looking at local indigenous entrepreneurs. I think the reverse brain drain is good for the environment, but in terms of who's controlling the power of growth of the private sector in China, it's the indigenous entrepreneur. The returnees, when they come back, there's no way they can really understand everything. They have to relearn -and some never relearn – the local market environment, how to tap markets and customers. They can only create the environment for certain practices which help the entrepreneur. But the drivers, the people who are really creating value, are the local entrepreneurs who may not speak any English, who may never have been outside China. But they're learning very fast from the returnees. They're surrounding themselves with the returnees who have worked with multinationals.
Q: In what sectors are we seeing the most overvalued companies?
A: Anything online, in Internet content-related, mobile content-related and anything that's semiconductor-related.
Q: What's Carlyle's China strategy?
A: The strategy is we're taking a very broad-based approach. We're not taking a specialized, sector approach because China is growing; it's flexible, it's fluid. A lot of things are still emerging, so you cannot really say I'm only going to look at a particular sector. The strategy is to seek out people, rather than some specific product or service in a sector. The third strategy is to become very localized. All of my team members, including myself, are PRC natives who consider China as our home …so we can find and work with the local people. The fourth is, look for significant-sized deals, rather than early stage, very small investment. We aim to put more substantial capital to work per investment and look for proven businesses rather than very early, concept-stage start-ups.
Q: Any sectors that pop out right now?
A: The high growth areas are tech, media, telecom. Outside of these tech-related industries, there's healthcare, traditional manufacturing as well as all kinds of consumer services.
Q: What are the private equity opportunities in China?
A: It's mostly a domestic market opportunity, meaning that for private equity, or at least for Carlyle, we're primarily looking at local companies selling to local companies that have a local customer base. A lot of times, it's a domestic market play, even if the end product is exported, be it a TV or handset. The value chain, the supply chain today is in China already, so you're selling to a local base. I'm not doing the technology transfer between West and East. We're betting on the local economy, rather than going for an export play.
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