Stacking the deck

A couple of news items caught my eye in the last couple months that, when taken together, paint an ominous situation looming in the world of Chinese private equity (PE).

The first is the creation of China’s largest renminbi-denominated fund to date, a US$1.3 billion blockbuster from the PE platform of state-backed financial conglomerate CITIC Group. The second is media coverage of the key role children of powerful government officials are playing in China’s PE industry.

I fear that this combination of state control and family nepotism will only serve to squeeze out foreign players, while at the same time lower the standards and future prospects for China’s burgeoning PE industry.

We have seen an explosion of new domestic renminbi funds, helped along by reforms such as allowing fund managers to raise capital from domestic investors and local governments, and a tightening of the screw on "round-trip" investments. It’s good that China is taking steps to foster the growth a vibrant domestic PE industry – but it doesn’t necessarily mean a level playing field for all concerned.

For foreign players, renminbi funds by their very nature have some key advantages over offshore funds, notably a streamlined approval process (especially for deals in industries where Beijing would like to exclude foreign ownership) and easier access to a domestic listing. Attempts to redress the balance by setting up foreign-controlled local currency funds are often thwarted by difficulties in obtaining licenses.

Flawed favoritism

While these factors clearly stack the deck in favor of the state-owned domestic PE funds, the news isn’t all good for them either.

One visible artifact of China’s one-party system is the rather obvious favoritism bestowed to the families of powerful government officials. Several of the most prominent domestic funds are headed by the children of some of China’s most prominent political leaders. Notwithstanding the competence of any of these specific cases, I have personally observed looseness in the management of domestic PE funds. This has resulted in a lack of discipline in sourcing and evaluating investment opportunities, and a rapid and unjustified escalation of valuation.

My firm – a boutique, family-run fund – was recently courting a private PRC company and, after careful analysis, we offered what we believed to be a fair valuation. The price was consistent with the valuation applied by the public markets for comparable Chinese companies trading on US exchanges (albeit at a discount to accommodate the company’s current private status). Just as we were issuing a term sheet, a domestic player met the chairman of the company for dinner and made an offer that was nearly double ours, justified by the current average valuation on China’s Growth Equities Market (GEM) – a whopping 69.1 times earnings – and cemented with a bottle of baijiu.

Needless to say, we declined to counter. I only hope that investor sells his stake before the GEM plummets back to earth.

Plagued by inefficiency

Another aspect of the state-run funds is that not all deals are executed based on merit alone. Decisions can be heavily influenced by politics, and often favor other state-owned firms. History has shown time and again that nepotism leads to inefficiency and misappropriation of capital. China is no exception, as evidenced by huge overcapacity in several industries even as GDP growth heads north of 10% for 2010.

The root of the problem lies in the structure of the country’s political system, where local governments are highly motivated to generate GDP growth regardless of the (lack of) economic viability of the projects they support. In most cases, funding and approval is bestowed upon the friends and relatives of local officials. The situation amounts to a potentially disastrous blend of the worst aspects of central planning and free markets.

As a foreign investor in China’s PE industry, this appears to be a lose-lose situation for everyone except those fortunate enough to have been born into the right family. In the short term, I fully expect that it will become increasingly difficult for foreign players to secure deals. In the long term, the development of a truly vibrant, efficient and effective PE industry, managed by experienced professionals, may be further away than we realize.