Private equity in China: Enemy of the state?

Certain employees at state-owned Harbin Pharmaceuticals enjoy one of the most luxurious working places in the world. As illustrated by a series of photographs that went viral last year, the headquarters of Harbin subsidiary Sixth Pharmaceutical is every bit the 18th century Rococo masterpiece. Modeled on the Palace of Versailles, the interiors feature engraved wood paneling with gold foil inlays, carvings of angels and crystal ceiling lamps. Then there are the mod-cons: a swimming pool, gymnasiums and pool rooms.

The building - yet another example of state sector managers' tendency towards excess as a means of discounting economic returns - was erected several years before CITIC Capital and Warburg Pincus invested into Harbin Pharmaceuticals in 2005. They are currently trying to pass it on to the local government for use as a museum while the general manager who ordered its construction was ushered into retirement three years ago. This was no easy process: Sixth Pharmaceutical was built in his self-image just as much as the headquarters.

"It shows how perverse the state-owned enterprise (SOE) system can be," Yichen Zhang, CEO of CITIC Capital, tells AVCJ. "In China, you cannot easily separate people from assets and you often must wait to take action in order to minimize the potential disruption. Not respecting this rule is to ask for trouble."

State sector reform has preoccupied the Chinese government for 30 years and the slow pace of change means it is likely to remain an issue for 30 more. Taking over underperforming, inefficient assets and turning them around represents a massive opportunity for private equity investors, not least because there is so much low-hanging fruit. However, few industry participants have the connections, operational expertise and diplomatic skills to make these deals work.

History lessons

The entrenched systems and hierarchies within SOEs that are so difficult to budge date back to the early days of China's reforms in 1980s. Rather than rollout a market economy overnight, the government focused on expanding output and boosting productivity through a "dual-track system," under which SOEs were allowed to exceed their sales quotas and private enterprise was given license to operate in areas unoccupied by the state.

The system succeeded, but it was imbalanced. While the private sector thrived, SOEs saw their initial expansion undone by deflation in the 1990s and many started to lose money. Privatization was seen as the antidote. "The number of SOEs declined dramatically from 61,300 in 1999 to only 20,300 in 2010," says Gao Xu, chief economist of China Everbright Securities. "In terms of assets, the ratio of SOEs to total industrial enterprises also dropped to 40% from 70% in the same period."

This has narrowed the gap, but not removed it. In 2010, the average return on assets for Chinese SOEs was about 6% compared to 12% for private enterprises. Chronic managerial problems within SOEs are routinely blamed for the gulf in performance. A key issue is that the people tasked with running these companies receive little in the way of financial incentives to ensure they do well.

Often political appointees, these managers don't see the world in terms of economies of scale and market metrics. In many cases, priority is given to personal and political interests, such as expanding fixed investment regardless of cost in order to build a power base or pursuing short-term growth spurts to meet local government jobs or tax targets.

"From a market perspective, a final perverse incentive is that local officials do not stay around to face the consequences of these short-term behaviors," says Matt Fish, managing director of New Pacific Consulting. "Indeed, these actors encourage quick-fix SOE investment strategies precisely to achieve rapid promotion to new positions in different locations."

Reform-minded

Harbin Pharmaceuticals was a case in point. Sixth Pharmaceuticals' headquarters aside, when CITIC Capital and Warburg Pincus invested, the company was spending four times its annual net income on television commercials and investing in a portfolio of 100-plus products, many of which didn't make any money at all.

Most damaging of all, each subsidiary maintained its own finances, which meant that profit-making businesses were receiving low interest returns on bank deposits while loss-making units paid heavy premiums to borrow money.
Centralizing Harbin Pharmaceuticals' financial structure meant facing down resistance from managers desperate to hold on to power. When the change was finally completed in 2009, it turned out the company had a net cash position of RMB4 billion. Since CITIC Capital and Warburg Pincus first invested, Harbin Pharmaceuticals' profit has increased six-fold.

"You need to be sensitive and patient enough to move gradually because if you change everything on day one, everybody turns against you," says CITIC Capital's Zhang. "What you need is a right incentive system so that when these managers give up some of their power, they get some other benefits in return."

First movers

CITIC Capital was among the first Chinese private equity firms to pursue SOE deals. Hony Capital has also emerged as a prime mover in the space. It began investing in SOEs in 2003 and they currently account for half of its 65 portfolio companies. These deals - which are often buyouts and therefore command bigger ticket sizes than typical growth equity transactions - have delivered an average IRR as good as the firm's investments in private enterprises, John Zhao, Hony's CEO, tells AVCJ.

"When we find people who want to hold on to the power and don't know how to run the company, we don't touch them," he says. "We help capable managers who understand the harmfulness of being a SOE and sometimes we are able to get controlling stakes; China Glass and CSPC Pharmaceutical Group are examples."

Hony invested in China Glass - then known as Jiangsu Glass Group - in 2004, took it public in Hong Kong a year later, and then supported an acquisition spree of other state-owned glass assets in order to expand market share and build up economies of scale. With a view to repeating this success, in 2007, the private equity firm backed Jushi Group, a subsidiary of China Fiberglass Group, and subsequently took a significant stake in China Yaohua Glass Group.

"Most SOEs in this space see the need to strengthen and we see the opportunity," Zhao adds. "Local governments typically do not have a sophisticated mindset concerning the consolidation of the industry; they just like us invest into their region. We use successful companies such as China Glass as a platform to consolidate the whole industry."

Exclusive access

Alongside CITIC Capital and Hony, CCB International, China Everbright and New Horizon are among the more active players chasing SOE deals. Each has strong government connections, either through state-backed parent companies or ties to powerful agencies and quasi-state institutions. Hony, part of Legend Holdings, is itself controlled by the Chinese Academy of Science while CITIC Capital is owned by China Investment Corporation (CIC) and CITIC Group Corporation, the country's largest conglomerate. The names are sufficiently revered in SOE circles to open doors.

"We are always in an exclusive position with local governments because the CITIC brand itself is already enough to push away many players when we bid for these potential deals," says CITIC Capital's Zhang. "In the case of CITIC buying it, local government can defend the underlying rationale easily because of our close connections with them."

On the contrary, other private equity firms, which don't enter negotiations with the blessing of local authorities, face all kinds of obstacles, from arranging regulatory approvals to securing alignment with company management. According to one China-focused foreign GP, it's not worth the effort - especially when private enterprises account for 70% of GDP and 80% of the labor force. "The decision makers are government officials and often they have no incentive to sell the business at a cheap price," the GP adds. "You start working on a deal and it may or may not happen."

The Carlyle Group's attempted buyout of Xugong, a state-owned construction equipment manufacturer, in 2005, is the most notorious example of a deal gone wrong. The private equity firm agreed to buy 85% of Xugong for $375 million in what would have been the biggest control transaction by a foreign player in China. It prompted unease that the Jiangsu provincial authorities were selling a strategic asset to a foreign investor, and Sany Heavy Industry, which was itself keen on buying Xugong, stoked these fears. No regulatory approval was forthcoming and Carlyle ended up quietly abandoning the acquisition three years later.

In the case of Harbin Pharmaceuticals, CITIC Capital originated the deal and negotiated with the local government. US-based Warburg Pincus was invited to participate as a co-investor because it was able to commit additional capital and offered pharma sector expertise.

However, even local players must work their way through considerable amounts of red tape and, more importantly, pay close attention to the way political winds are blowing. An inevitable consequence of the 1990s SOE privatization drive was the concern that entrepreneurs had been handed state assets on the cheap. In the early 2000s, Beijing took regulatory action to prevent these assets being spirited overseas and local and national agencies have become mindful about who they sell to and at what price.

For example, the State-owned Assets Supervision and Administration Commission (SASAC), which is responsible for overseeing SOEs controlled by the central government, has introduced a minimum purchase price for private sector investors. The net asset value of the company, rather than its future income projections, is often one of the key criteria, and this is a potential turn-off for private equity.

"A company with very large assets and very low earnings would probably be very expensive under this method and so we would probably get rid of the deal," says Johannes Schoeter, founding partner of China New Enterprise Investment (CNEI). "You need to make sure despite of those rules, you are still able to get an attractive valuation."

The vast majority of CNEI's capital has been earmarked for private enterprises. One SOE investment is expected to close soon, but it has been in the works for two years because the seller must balance political and economic considerations.

Good timing

In this way, gauging a local government-related entity's appetite to sell a state asset, and the best time to do it, is a vital and time-consuming process. It can take many months create an alignment of interest between the various stakeholders, with management and government agencies having to be convinced one-by-one.

Lunar Capital is in a similar position with a large enterprise in a remote northern Chinese province. It has been looking at the asset for more than three years, building up relationships with management, but sometimes delaying a decision, as opposed to forcing one, is the best course of action. Patience is paramount. "We have setup an operating framework and mindset that allows us to cultivate a deal for three years and execute in five, but how long are domestic private equity firms willing to wait?" asks Derek Sulger, Lunar's managing partner.

On top of all this, financial and legal due diligence of state-owned assets can be protracted and painful. A manager who puts personal and political objectives before commercial considerations is liable to supply unreliable financial records, either as a result of incompetence or willful obfuscation. After investing in one SOE and conducting full due diligence, CITIC Capital discovered that the management was far more corrupt and less cooperative than it could possibly have imagined. In these situations, the only viable solution is to ask local governments for exit or restructuring support, and take a financial hit on the way out.

Even when an SOE is profit-making, exits are not always easy. A private equity investor might hold a controlling stake, but the timing of an IPO - the most popular form of exit as it enables the PE player to exit and gives other stakeholders the opportunity to remain - is largely up to the state-related interests. The onus is on finding a solution that is politically acceptable, and this means secondary and trade sales are often unfeasible.

"For certain SOE assets, trade sales would be possible but they are mostly to domestic players," Zhang adds. "I am sure some multinational companies are interested in buying attractive Chinese state-owned assets, but the regulatory challenges would be huge."

Game change: A new era of SOE investments

Not all Chinese state-owned enterprises (SOEs) are financial black holes. Some, notably those operating in industries where they are part of an oligopoly, generate enormous profits. China Mobile, for example, is the largest of China's three telecom providers and the number one mobile phone operator globally, with annual revenue of RMB528 billion ($83.4 billion) in 2011.

By carving out dominant positions in key areas - such as energy, electricity supply and tobacco, as well as telecom - SOEs accounted for just 9.6% of loss-making companies in China in 2010 compared to over 50% in the late 1990s. Publicly listed by still controlled by state interests, there is neither the will nor the incentive for the likes of China Mobile or PetroChina to change the status quo.

"I think the golden age of privatizing SOEs has gone and many of the remaining ones are considered as commanding highs of the national economy, and are highly profitable given their monopoly status," says Gao Xu, chief economist of China Everbright Securities.

Although the number of SOEs has declined drastically, John Zhao, CEO of Hony Capital, argues that opportunities within the space are increasingly interesting. The objective is not to control and restructure these firms, but to assist them in overseas M&A, which requires sophisticated strategies and financial knowledge.

Hony-backed Zoomlion's acquisition of Italy's Compagnia Italiana Forme Acciaio SpA in 2008 and CITIC Private Equity's participation in Sany Heavy Industry's purchase of German pump manufacturer Putzmeister in February are examples of this. Zhao expects more to follow.

"The landscape of SOE investments has changed," he says. "In the early 2000s, we invested to help SOEs achieve better efficiency, and now some of them come to us with the aim of becoming global leaders through offshore M&A."

Hony first invested in Zoomlion in 2006, when it had RMB3 billion in revenue and RMB300 million in profit. Six years on - following the overseas acquisition, which was also supported by Goldman Sachs and Mandarin Capital Partners - Zoomlion's revenue and profit have grown 16-fold and 23-fold, respectively. It has become the fifth-largest construction machinery manufacturer globally.

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• Topics
• Greater China
• Investments
• Hony Capital
• CITIC Capital