It is fitting that in China’s still youthful private equity market (PE) the breakthrough transaction involved a manufacturer of children’s products. The year was 2006 and Goodbaby Group – China’s largest producer of baby strollers – was subject to a leveraged buyout (LBO) by the private equity arm of Hong Kong-based investor Pacific Alliance Group.
The foreign LBO – a sophisticated financing technique in which the acquisition is backed by loans secured against the assets of the target company – had finally landed in China. The country had crawled into the private equity arena; now it was starting to walk.
Or at least this was the plan. Two years on, there has been no real successor to the Goodbaby deal. Although China continues its gradual acceptance of new financial initiatives, private equity remains dominated by conventional deals that are relatively small by global standards.
“I am somewhat surprised it’s the only transaction of its kind,” said Chris Gradel, managing partner and co-founder of Pacific Alliance.
“I think the main barrier is the lack of companies you can buy a controlling stake in. Most private companies are founded by entrepreneurs who have majority control and don’t want to sell up. With state-owned enterprises (SOEs), the government generally doesn’t want to give foreigners the equity.”
In fact, Pacific Alliance’s bragging rights could be contested by LBO purists. Foreign exchange controls prevent the use of assets in China to guarantee a loan made outside of China, while domestic banks are generally unwilling to lend money for such deals. This meant Pacific Alliance had to find its leverage offshore.
When the company came into the picture, Goodbaby had already been privatized by its management and restructured as an offshore investment vehicle and an onshore wholly foreign-owned enterprise (WFOE). Pacific Alliance bought the offshore vehicle for US$122.5 million, with Taiwan’s Fubon Bank providing US$55 million of this in debt.
The leverage was small compared to the proportions seen elsewhere because the bank had no direct claim on Goodbaby’s China-based assets, just on the offshore vehicle that owned them.
“Fubon was comfortable with the various covenants saying what we could and could not do – they were happy we weren’t just going to disappear into the night,” said Gradel. “But there was a gap between the onshore and offshore parts.”
In this respect, the Goodbaby deal – which took three months to complete because of the government approvals that were required on top of this financial handiwork – is a reminder that China’s private equity is still very much a work in progress.
But deals are still being done. New international players are turning up in their droves, spurred by China’s strong private sector growth.
“Private equity is increasingly perceived and accepted as an important alternative to raising funds – it allows firms to diversify their investor base, especially in turbulent capital markets,” said X.D. Yang, who runs The Carlyle Group’s Asia buyout fund. “The PE funds are getting larger and their number is increasing by the day.”
Local funds, local currency
Beijing is also putting in place legal structures that enable foreign funds to operate as yuan-denominated onshore entities as opposed to making investments in US dollars through an offshore holding company (see “A legal bind: Waiting to go local”).
Although the system has yet to be fully tried and tested, there is already considerable interest. Terry Teng, director of International Financing Services in Tianjin, which acts as a bridge between private equity firms and the Chinese government, said that 90% of the 40 or so funds registered with the China Private Equity Association are yuan-denominated and operated through joint ventures. One prominent early mover was Fang Fenglei, the man behind Goldman Sachs’s brokerage joint venture in China. Fang is said to have enlisted backing from Goldman Sachs and Temasek, the Singapore state investment arm, to form the US$2 billion Hopu Fund. He will also set up a yuan-denominated fund in collaboration with Suzhou Ventures Group.
This easing in the regulatory environment is taking place alongside a concerted effort to develop domestic private equity firms. The move is pioneered by the Bohai Industrial Investment Fund (see “Tianjin: A PE breeding ground”).
The Bohai Fund is joined by large SOEs, which have become major players through strategic investments in non-competing companies. Meanwhile, domestic financial institutions have lobbied the government to take things further.
Last September, China International Capital Corp and CITIC Securities became the first domestic brokerages to receive private equity licenses. China Life proposed in March that insurers be allowed to diversify into private equity.
Below the radar
Then there is a rising numbers of informal private equity funds set up by small groups of wealthy individuals.
“Close friends provide the money. They trust me so all I have to do is give them a call,” was how one Shanghai-based deal-maker, who specializes in buying stakes in firms and guiding them to initial public offerings (IPOs), explained it to CHINA ECONOMIC REVIEW.
These “clubs” traditionally operate more like hedge funds, investing in listed securities, but there is a growing appetite for direct equity investment. Unlike the Western private equity model, these funds operate on a deal-by-deal basis and are not committed to investing a certain amount within a specified time frame.
“A lot of company owners in China have become cash-rich and so an industry has emerged to take care of these people with money,” added Maurice Hoo, a partner in the Asia private equity group at law firm Paul Hastings.
The additional capital provided through the expansion of existing sources and the introduction of new ones has created a much more competitive – and more expensive – market for all concerned.
The aforementioned Shanghai-based deal-maker, who asked not to be named, recalled striking a deal with the founder of a silicon company under which he agreed to list the firm at six times its book value. The founder phoned back a day later to say that another private equity firm had come calling and offered to secure a valuation of 12 times book value.
“It was a blue sea and now it’s a red sea,” the deal-maker reflected. “Three years ago nobody did this kind of thing but now everyone wants to get involved.”
Shelly Singhal, CEO of Crestpac, an Asia-focused alternative investment group which currently has 40% of its private equity pool invested in China, has also noticed the growing pressure, particularly in major cities.
“Companies used to have two or three private equity firms come talk to them,” Singhal said. “Now it’s more like 30.”
Talk of tougher deal-making conditions appears to be borne out by the numbers. According to the Asian Venture Capital Journal (AVCJ), new funds raised for investment in China came to US$10.55 billion last year, up 93.6% on 2006. The average growth for Asia as a whole was 23.4%. However, new investments rose by just 3% to US$10.62 billion compared to 33.3% region-wide.
“Most of the PE firms raised a lot of money in 2006 but they did not invest much last year,” said Andy Xie, an independent economist who also participates in small-scale PE investments through his offshore firm Rosetta Stone Capital.
It could be argued that the competitive environment is exacerbated by the limited scope of deals on offer.
A total of US$84.32 billion in private equity money exchanged hands in Asia last year, the AVCJ claims. Buyouts accounted for US$39.84 billion, or 47.3% of this. Growth capital and private investment in public equity each took about 20% with 3.2% for pre-IPO investment.
In China the balance is very different. Buyouts made up just US$802.8 million, or 7.1% of the total pot. The lion’s share of the market was taken by growth capital and pre-IPO investment, on 41.1% and 20.5% respectively.
The prevalence of later-stage, pre-IPO investments make it difficult to establish where the venture capitalists’ territory ends and that of the private equity players begins. “In the US, for example, it’s pretty clear what a PE [firm] does and what a VC does,” said Andrew Qian, managing director at investment advisory firm New Access Capital. “But in China there is a phenomenon called growth capital.”
The growth capital craze is turning the archetypal venture and private equity models on their heads.
Breaking new ground
Venture capitalists are making bigger and later-state investments in China than they do in the US, pursuing companies that usually already have cash flow. This is happening partly because the trend for VCs in China has been to invest outside their tech sector comfort zone. Non-tech firms, like a home-shopping network or a renewable energy concern usually need more money than a web start-up.
“Everybody used to focus on TMT (technology, media and telecom); today, everybody would like to emphasize that they focus on non-TMT plays, such as cleantech, consumer-related,” Qian said. “For these kinds of non-TMT deals, [the investments] tend to be bigger in size.”
There is also the greed factor. On top of the routine management fees, VCs earn a “carry fee” – typically 20% – when they cash out. The bigger the exit, the bigger the carry fee – which means there is a strong incentive to make large bets. Later-stage investments are less risky and VCs can recoup their money more quickly.
“Growth capital gives investors [good returns] with much more certainty, so they are considered the low-hanging fruit,” said Tina Ju, a founding partner at venture firm Kleiner Perkins Caulfield and Byers in China.
Private equity funds, meanwhile, are behaving more passively than they do elsewhere. Denied the opportunity to participate in many buyouts due to government restrictions or the paucity of private entrepreneurs willing to give up their majority stakes, the PE players are driven into smaller, earlier-stage investments.
The big question is whether the market is sustainable at current price levels.
Martin Haemmig, who lectures on global venture capital trends, analyzed the investment returns on VC-backed firms that went public in China, the US, Europe and Israel. He divided the companies’ valuations before stock began trading by the amount of venture capital invested, coming up with an “exit ratio.” The companies were ranked by their exit ratios in quartiles.
Haemmig found that Chinese firms in the bottom quartile provided better rates of return than top-quartile companies in the US from 2004 to 2007. Meanwhile, top-quartile Chinese firms provided the best rate of return globally, giving VCs 30-60 times what they had originally invested.
Market conditions have deteriorated since Haemmig made his calculations and this will affect future valuations. However, he notes that, even if Chinese companies’ exit ratios were halved in future, they would still outperform investments made in other countries.
The difficult present
In the current climate, the danger is that private equity firms’ profligacy will come back to haunt them. They have raised huge amounts of money on the back of bullish growth projections and are committed to spending it within a certain time frame. Under pressure to find deals in a pricey market, fund managers may be forced to settle for lower returns.
“[The funds] raise too much money and overpay for the deals they make – it happens every 10 years and people are still surprised by it,” said Singhal of Crestpac. “They decide to deploy US$200 million but end up getting US$1 billion. The disciplined thing to do is say you just want US$200 million but this never happens.”
The Asia head of a global top 10 private equity firm, who asked to remain anonymous, was even more damning of the market as it stands, branding investors “fashion victims” for getting swept up by a gold-rush mentality.
“Some people have started to look at private equity guys as masters of the universe and they are not,” he said.
Although scathing in his assessment of short-term perceptions, this executive – like his counterparts – still regards China as fertile ground for private equity. The recent correction in the public markets is expected to have a knock-on effect on private equity, but this will not dampen the sense of opportunity in a country that still has far to go in terms of diversifying its sources of corporate funding.
“Domestic companies require vast amounts of capital to support their growth, and I don’t think private equity will have nearly enough money to satisfy these needs,” said Carlyle’s Yang. “The challenge for private equity is examining investment proposals in a disciplined way. We turn down a lot of opportunities very, very early.”