China private equity shooting for world No.1?

In fact, its significance as a private equity venue has already run ahead of its overall economic growth, as it became the largest investment and fundraising market by value in the region long before it overtook Japan as the world’s second largest economy by nominal GDP in 2Q10. However, even though the Chinese economy may be on track to surpass the US within 20 years, according to Goldman Sachs and the World Bank, what kind of private equity market is developing there? And will it have anything like the characteristics familiar from Western prototypes?

China PE by numbers

China’s private equity market has rebounded after the GFC in almost every significant metric: funds raised, investments and IPOs. Fundraising to date in 2010 is up 90% according to AVCJ Research figures, reaching $8.56 billion. The RMB portion of the funds raised is up 186%, for an RMB total of $5.88 billion.

Obviously, compared with the total of $100 billion raised in the US in 2009 for PE, China still has a long way to go. However, in a country home to financial institutions that are still evolving, and where few of the types of LPs that participate in private equity elsewhere in the world are able to invest, the money yet to come into private equity is significant. The recent decision by the China Insurance Regulatory Commission to allow domestic insurers to invest up to RMB226 billion ($33.2 billion) into private equity, and predictions that the PRC private equity market could grow to surpass the US in value do not seem so extreme.

Actual activity may also be running ahead of visible numbers. “There is a lot of activity below the radar screen, particularly in the RMB area, which goes unreported,” says Johannes Schoeter, Founding Partner of China New Enterprise Investment (CNEI). “I would not be surprised if the total numbers were larger [than those reported].”

In investments too, China not only leads the region, but post-GFC is beginning to compare favorably with Western markets. The PRC saw over $14 billion of USD and RMB private equity investment to date in 2010; almost three times as much as the $5.2 billion invested in the second most active market, India. This compares with $33 billion invested in the US over the whole of 2009. RMB funds have a significant and growing share of this total: $5.53 billion in deals, versus $8.61 billion of USD-denominated investments to date in 2010.

“Foreign exchange controls, business ownership characteristics and the evolving regulatory landscape make navigating the private equity market here unique in its own way,” concedes Meng Ann Lim, Partner and head of the China team at Actis. But, with the USD total alone also well ahead of the region’s other market totals, it is clear that offshore investors as well as domestic firms are finding ample opportunities to tap into the China story.

Part of the trigger for this, as David Patrick Eich, Senior Partner at Kirkland & Ellis, remarks, is that “the law changed in March,” triggering the explosion of private equity funds. But this was only one move in a series of still-incomplete regulatory initiatives needed to build a full private equity base. However, not only is the process already under way: many international and local players alike are participating even while many grey areas remain.

Finally, on the exit side, private equity is also delivering returns to investors, particularly through IPOs. While the post-GFC appetite of international trade buyers left trade sale exits subdued in 2010, IPOs with a private equity component produced almost $22 billion of value in 3Q10 alone.

Drivers behind the growth

The official Chinese view of the function of private equity in the country can be deduced from the theme of this year’s Shanghai International Private Equity Forum: “China’s Economic Transformation and Private Equity.”

Given the importance of official approval and industrial policy in Chinese business, it is unsurprising that many of the more significant private equity investments to date have tended to address China’s industrial priorities. For instance, KKR’s $112 million investment in 2008 into Tianrui Cement targeted a very fragmented sector of the PRC economy in need of consolidation. The same GP’s investment in milk supplier Ma Anshan Modern Farming Co. coincided with PRC priorities to improve safety and efficiency in the foods business, which have spurred similar investments by the Carlyle Group, Hopu Investment, and Morgan Stanley Private Equity.

Private equity’s preference for investing in consumer propositions may even be an advantage, given what Lim describes as “China’s mounting need to rebalance its economy” away from export-driven production to domestic consumption. John Zhao, founding CEO at Hony Capital, confirms that “there’s a lot of restructuring opportunities..” But the divergence in goals and priorities carries a significant risk of upsetting the development of Chinese private equity. As Ed Greene, founding chairman of Diamond Dragon Advisors remarks, “if there is a bubble to be burst in China, it is the common misperception of the role of private equity in an economy.”

Schoeter also has a somewhat skeptical take on the priorities driving the “mushrooming” of private equity firms in China. “Once the government creates a certain buzzword and a new note to follow, many people do,” he observes. “The word right now which is being promoted is innovation … PE is perceived to be part of innovation. It is an innovative financing form and it also fosters innovation. It is politically very correct.”

Therefore, he believes, many stakeholders, especially government-connected entities in the provinces, are looking to receive even more than the usual quota of “political brownie points” by allocating resources to private equity. For most province-backed, state-connected vehicles, Schoeter argues, “returns are less important than financing local development.” Such funds also have a problem of definition. “You and I would not strictly call them PE funds: they are more like local development funds.” As Zhao says, “in China, the whole concept is new,” and still far more fluid than typical in the West.

However, others feel that China’s broader financial markets are maturing effectively enough to support truly value-driven private equity investing. “One can see the rapid development of a robust capital markets structure emerging in China to complement consumption and asset appreciation,” notes Greene..

Finally, as Zhao notes, “there is so much unmet demand” for private equity, and capital financing in general, in China. Despite the imposing size of the economy even as it stands, the need for both development-oriented capital and new asset classes for domestic capital to invest in, is unlikely to be fulfilled any time soon.

Quality issue in Chinese PE

The issue of priorities is closely related to the recurrent question of performance among private equity firms in China. The questions around this come down to two major issues: technical considerations of maturity, experience, capabilities; but more critically, the consequences of a fundamental difference of opinion in the function or purpose of Chinese private equity.

“I think there is still a process of understanding and learning,” said Jim Coulter, founding partner of TPG Capital, on the occasion of the launch of his firm’s new RMB funds in Shanghai and Chongqing, but he also remarked on how fast local private equity managers, investors and regulators are building their knowledge base. “Their level of understanding is so much higher than it was five years ago.”

Greene points out issues with the criteria RMB funds are using to evaluate deals. “Today the RMB manager is rated by how much money they have raised. This is false success when the ultimate measure is return driven by investment and operating acumen.” Although the PRC has ample deal flow, Schoeter confirms, he is also concerned by the approach of many domestic funds. “They do not see much risk… and believe that things often will turn out just as presented. They are willing to pay higher prices as a result.”

Actis’s Lim addresses the question of control and influence over an investee company’s destiny. “To this day, people remain skeptical about majority ownership opportunities in China. We acknowledge these are still relatively rare, but we see the opportunity set expanding.” He continues, “I see a need to expand the definition of ‘control’. This is particularly imperative given that foreign investor rights are not necessarily always enforceable in China. What is more important is the ability to influence investees.”

Private equity investors’ ability to add value may also still be a problem. “Although management styles are increasingly mimicking those of developed markets, there remains a very opportunistic element in private equity investing within China,” observes Lim.

Performance challenges may also attend international firms partnering with domestic institutions to launch their own RMB platform. “The argument you hear from many fund managers is that this is their way of creating a deep contact network,” Schoeter explains. “We believe that’s a double-edged sword. The local entity usually has no idea what quality of deals you’re looking for. If you turn down your local partner all the time, your prestigious network may turn into a negative asset.”

Despite his concerns, Schoeter asserts that “the scene is maturing and we believe there will be a lot of progress going forward. I have no doubt that the future is onshore.” And, Greene adds, “we will lose the distinction of onshore and offshore structures for investing in China, and money will flow freely in and out of their capital markets. It will be done with Chinese characteristics, but it is destined to get done.” 

Eich feels, “you’ve only seen the tip of the iceberg.” And In Coulter’s concluding words, “the issue of this market is the market growing up, and I think that is occurring as the fund market is growing.” 

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• Topics
• Greater China
• Performance
• Renminbi fund
• Funds
• CNEI
• Johannes Schoeter
• Meng Ann Lim
• Actis Capital
• TPG Capital
• Doug Coulter