China value-add: Empty promises?

By the time Harvard Business School published its case study of Kunwu Jiuding Capital in December 2011, the investment model being celebrated was already fading.

Within four years of its launch, the private equity firm had amassed $1 billion in funds and 260 employees, having turned itself into a PE factory "where investment activities were carried out in a way similar to large-scale industrial production." Jiuding's approach focused on getting a company to IPO quickly and leveraging exit multiples available on domestic bourses; and then repeating the process several dozen times over. With IRRs running to 500% or more, an army of copycats emerged as renminbi fundraising jumped 60% year-on-year to $30.1 billion in 2012.

But the average price-to-earnings ratio for ChiNext-listed companies had slipped below 40 by the end of 2011, compared to 129 two years earlier; SME board ratios were also sliding. Already denied the multiples to which they were accustomed, nearly a year later these pre-IPO investors were denied any listings at all as China's securities regulator froze approvals.

The Harvard Business School case study noted that concerns had been raised about the sustainability of the quick-fire approach, given that some of these GPs appeared to lack the skills and experience to operate in normalized conditions. "The short-term mentality creates volatility," Vincent Huang, a partner at Pantheon, told AVCJ in October 2011. "A lot of these GPs don't have real value to add and so they won't be in the market for the long run."

Systemic problems

Subsequent events have elevated the debate into one of existential proportions for pre-IPO growth capital firms. Listings will return but it is unclear whether they will reach their previous heights: the markets may be more selective and the valuations more muted.

There is also a sense that GPs have been found out lacking a Plan B; renminbi fundraising dropped to $5.1 billion in the second half of 2012. The trend is reflected on the US dollar side as the slowdown in Hong Kong listings over the course of the year left funds with ever decreasing certainty over portfolio exits. If GPs - big or small - face holding a company for longer than expected, what are they going to do with it?

"We value control and we can take advantage of the M&A markets if we have it. We also like the IPO markets here but any investment where we aren't a controlling shareholder, we can't set down the timetable for exit," says H. Chin Chou, CEO of Morgan Stanley Private Equity Asia. "We ask ourselves, ‘Do we like holding this investment for five years because there is no IPO? At some point the IPO market will come back but until then you have to be very comfortable holding it."

Prospective LPs also have to be comfortable with a private equity firm's ability to develop portfolio companies for longer than originally planned. GP selection naturally gravitates towards how managers add value in situations where they may or may not have overall control.

"GPs are becoming more serious and thoughtful about operating talent," says Oliver Stratton, co-head of Asia at Alvarez &Marsal, which works with PE firms on portfolio improvement. "Much of it is driven by LPs. They are more demanding in terms of what funds are doing in Asia. Ten years ago only the top global firms focused on value-add. Most others were more hands-off and planning for a quick flip."

The problem with assessing the viability of approaches to operational value-add is that they differ markedly. Numbers alone don't suffice.

Bain Capital has approximately 30 people addressing China investments and then a regional operating team of 15, of which half are in China. CVC Capital Partners has three dedicated operations professionals as part of a 15-strong China operation. As for TPG, half of its 60 investment professionals across Asia are in China and then there is a team of 18 regional operating professionals, led by three partners.

The Carlyle Group has three senior operating executives in Asia supporting 60 investment professionals who cover China across its buyout and growth funds. Capstone, KKR's operating division, employs 16 people in Asia, of which 11 are based in Greater China, working alongside about 20 investment professionals.

These stats are deceptive for three reasons: many investment professionals play an active role on the operations side; value-add comes not only from permanent staff but also networks of industry experts who are called upon as required; and firms with a global footprint bring in people from other offices to work on China deals.

In this respect, the operational development of the domestic firms is perhaps more instructive. Hony Capital, which has more than $6 billion under management, has at least 65 investment professionals across three offices. A 30-person in-house consulting unit that was introduced around 2007 to provide operational value-add.

CDH Investments, Hony's closest counterpart among the domestic firms in terms of longevity and funds under management, started out 10 years ago with six partners but now has 45, of which a dozen are deal leaders. The operating team is seven-strong, and includes an executive who previously served as a division manager at the China Securities Regulatory Commission (CSRC) can tell companies how they can expedite the listing process. There are also two former CEOs, one former CFO, as well as the ex-head of human resources at a multinational.

Although CDH's operating team was set up with a long-term view to completing more buyouts, it is also designed to accommodate situations where the PE firm can't issue top-down instructions. "The two CEO-types come in, speak the language of the CEO and have a real input into the thinking," says Shangzhi Wu, CDH's chairman and managing partner. "As a minority investor the most important thing is having experience and commanding the respect of those controlling the company."

Issues of control

Control is indeed a key differentiator in operational value-add and it influences the extent and nature of China-focused PE firms' hiring policies. CITIC Capital Partners has been buyout-focused since its inception and defines control not in terms of percentage ownership but by the ability to appoint a CEO. Brian Doyle, the firm's managing partner, argues the value creation process can only be driven once the investor has sent in people to run a company, as opposed to advising it.

Operating professionals account for approximately one third of CITIC's total headcount of 34 and its second China fund, raised in 2009, has a corpus of $925 million. This vehicle and its predecessor have made about a dozen investments between them - a number that sits in stark contrast to the 50 or more un-exited portfolio companies on the books of many growth capital firms that may operate funds of at least $200 million with a similar number of investment professionals.

Lunar Capital has been involved with control deals since inception and has beefed up operational capabilities to meet the challenge of acquiring more businesses. Of its 35-member team, half are operations people - a relatively large number by industry standards for its most recent fund of $200 million.

Derek Sulger, Lunar's managing partner, admits this intensive approach is exacerbated when targeting smaller companies. Global firms have bigger funds and so tend to make larger investments. There is a scale challenge as the portfolio company might have a national or international footprint but the higher the revenue base the greater the chances that there will be some semblance of professional management. A smaller operator is likely to require a more fundamental kind of help.

As a result, Lunar claims there is a high degree of integration between portfolio companies and its various internal teams. The idea is that companies work with the mothership much like the subsidiaries of a conglomerate. Portfolio company CFOs, for example, report to the mother ship much like the subsidiaries of a conglomerate, working with Lunar staff who scrutinize budgets, approve payments and actively manage finances.

Although he accepts that investment professionals are often entrepreneurial by nature and can become highly operationally engaged, Sulger's view is that many growth firms who designate limited resources to portfolio work simply aren't doing it properly. "The five deal guys are running around and they find a problem they have to deal with and give it to one guy who doesn't really fit in the organization, and call him an operations guy. It's an afterthought."

There is no small amount of skepticism in certain quarters of the market about the ability of operating professionals to fulfill their roles. According to Peter Fuhrman, chairman and founder of specialist investment bank China First Capital, a key difference between private equity firms in China and the best-performing of their Western counterparts is that very few senior executives have operating backgrounds. The identikit executive went to university in China, got an MBA in the US and then entered private equity via a stint in investment banking.

"If by ‘adding value' they mean helping pretty-up a balance sheet, yes, they have the background and skill set to do this," Fuhrman says. "But to help improve manufacturing efficiency, devise an effective marketing plan, build strategic partnerships, improve product quality or logistics, in all these areas most PEs in China, as compared with the US, have little to no experience."

This view is echoed, to a degree, by C.V. Ramachandran, Asia president at AlixPartners, which specializes in portfolio company turnarounds. He estimates there are probably no more than 10-15 PE firms globally that have truly strong internal operational capabilities. The limiting factor is resources: even those with the requisite capabilities find it hard to cover all industries, functions and geographies. He doesn't expect them to take on the costs of being able to address all issues in all portfolio companies.

Jim Dubow, co-head of Asia at Alvarez & Marsal, offers a similar assessment. In 2008, he was brought in by Standard Chartered IL&FS Asia Infrastructure Growth Fund - a joint venture between Standard Chartered Private Equity (SCPE) and IL&FS Investment Managers - and Farallon Capital Management following the acquisition of Chinese power producer Meiya Power. Having served one year as interim CFO, Dubow then took on the job full-time for four more years during which period Meiya was sold to China Guangdong Nuclear Power.

Neither SCPE nor Farallon had a dedicated operating partner for the project but there was regular engagement and a point man who made site visits. While the PE executives tended to come from an investment banking background, they had made previous investments in the sector and two used to work for another power company. As a result, they operated more like board members, contributing to the decision-making process but lacking the bandwidth to execute strategies.

It was left to Dubow to bring down Meiya's overhead costs, diversify the business portfolio, refinance the balance sheet and improve corporate governance standards. "What we do is industry-agnostic but very different from what an investment banker would do," he adds. "It's a bottom-up approach and we look at every group, customers and operations as well as financials, and establish how we can improve performance."

The presence of in-house operating teams doesn't preclude the use of outsourced help. Indeed, both Alvarez &Marsal and AlixPartners claim to generate a sizeable amount of business from such firms, because operations and transformation are more likely to appear in investment theses.

At the same time, a lack of control doesn't necessarily mean a lack of operational influence. KKR's policy in Asia is that Capstone comes in at the invitation of management, not as a result of investor decree. The PE firm never held a majority position in China Modern Dairy but Julian Wolhardt, KKR's regional leader for China, is chairman and non-executive director at the company and Capstone spent 16 months helping improve efficiency and productivity.

Similarly, TPG's status as a minority investor in Chinese sportswear company Li Ning didn't stop the appointment of Jin-Goon Kim, a partner at the PE firm, as vice chairman. Kim has yet to replicate the turnaround he led at shoe retailer Daphne but his presence is a clear indication of operational involvement.

In this sense, a private equity firm's attitude towards operational value-add is a product of internal culture, having a desire to know what is going on beneath the surface and a willingness to act on it. This is the question that China's growth capital firms must now answer: Do they have the mindset and resources to behave like owners rather than just multiples arbitragers?

The long game

A longer-term consideration is specialization and whether a sector-agnostic strategy still holds for firms that aren't blessed with large resources but are having to devote more time and domain expertise to portfolio companies. While specialization may have been dismissed in the past for fear that it would constrict the deal pipeline, pragmatism appears to be prevailing.

These trends are already present in certain GPs, on a national and regional level. Lunar is consumer-focused and has built up substantial exposure to beverages and babywear in particular; Hao Capital is concentrated on healthcare, followed by consumer and light industrial. Unitas Capital, a regional buyout player, does only industrial and consumer-retail deals, with four of its eight partners previously holding operational roles in these fields.

Chris Lerner, who heads up the Shanghai practice for placement agent Eaton Partners, says that sector specialization is becoming more common. He notes that the trend is more prevalent in the renminbi space because domestic LPs, particularly corporates and state-owned enterprises, are more comfortable dealing with specific industries.

International LPs are more wary about a higher concentration of risk, but they are certainly those attracted to the extra return potential often advertised by such funds. Domain expertise, in terms of sourcing and exits as well as value-add, can make a difference.

"China is such a large economy that the natural evolution is there will be more room for specialist funds," Lerner says. "At the same time, in a challenging fundraising environment, we see more GPs trying to differentiate themselves and specialization is part of that story."

This brings the debate back to what is behind the renewed focus on value-add. If a PE firm's position is reactive - hiring more operating partners because that is what is required to market the next fund - can it really claim that portfolio development is part of its DNA?

No it can't, says Fuhrman of China First Capital. "We're at a point where exits have ceased, and LPs are growing increasingly restless and concerned about perceived passivity among GPs. So, the GPs trot the argument they will now switch from waiting for the IPO proceeds to roll in to rolling up their sleeves and improving operations at portfolio companies."

If LPs are willing to buy into the story and growth capital firms endure under a modified mandate, it remains to be seen whether promises are kept and GPs accept operational value-add as a fundamental part of private equity rather than a means to an end. A maturing investment environment, potentially offering more control deals where investors can't hide from problems as minority participants, will help shape progress.

"Private equity is about investing in companies where there are challenges you think you can solve. This isn't something where you can just flip a switch and start, you have to build the right culture," says Lunar's Sulger. "It's easy to buy a hotdog and eat it. Operational involvement is like getting to know the recipe and watching the hot dogs being made in the factory - it takes a much stronger stomach, but you are more likely to know what you ate. "

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• Topics
• GPs
• Greater China
• Investments
• Expansion
• Buyouts
• Portfolio management
• GPs
• China
• Operating partners
• buyout
• Growth capital
• Lunar Capital Management
• CDH Investments Management
• CITIC Capital Partners
• KKR
• Hony Capital