China M&A funds: Double team

Aier Group, China's largest privately-owned chain of eye-care hospitals, is on the acquisition trail - but it needs help. In the space of two weeks, the company formed two M&A funds in partnership with private equity firms. Aier provides capital, the GPs do the deals - and hopefully other investors come along for the ride.

As Zhijun Wu, secretary to the Aier board, points out, the two funds serve very different purposes. A $32 million M&A vehicle launched in conjunction with China Orient Asset Management is a platform for consolidating the ophthalmology industry. Aier put in 10% of the capital and the fund is nearly fully deployed.

In the second fund Aier is one of three anchor investors, alongside gaming company Ourpalm and public relations agency BlueFocus Communication, with each contributing 10% of the $160 million corpus. Launched by Huatia United Securities, an investment arm of Huatai Securities, the vehicle targets industries, including tech, media and telecom (TMT), retail, medical services and pharmaceuticals.

Finally - and not officially tied to the company - Aier's controlling shareholders and CEO together provided $160 million to set up the Zhongrong Aier Healthcare Fund, managed by Zhongrong International Trust. It covers almost every part of the healthcare sector.

Aier clearly doesn't want to miss out on any M&A chances in its supply chain. "We used to build our network and now we have 50 hospitals. But if we continue to scale up this way it will be too slow," says Zhijun Wu, secretary to the board of directors in Aier. "It's the right time to acquire other industry players because ophthalmology is a highly-fragmented segment in China."

Plenty of other others agree. In the first half this year, at least 28 Chinese listed companies set up M&A funds that between them are seeking to raise more than RMB16 billion ($3 billion). From new energy to culture and entertainment, they see these vehicles as a means of achieving order in chaotic industries. There is even a fund targeting stationery shop consolidation.

The GP partners are usually independent PE firms or the direct investment arms of brokerages. Shenzhen Capital Group, for example, has set up media and entertainment industry M&A funds in association with three different parties - Hong Kong-listed Wisdom Group as well as BlueFocus and LeTV, both of which trade in Shenzhen. "We have seen an explosion of non-state-owned enterprises having IPOs. These companies become very acquisitive," Chris Burch, adviser to the PE firm's CEO, told the AVCJ China Forum last month, by way of explanation.

Through the GP's deal sourcing and execution expertise, the corporate hopes to tap inorganic expansion opportunities that allow it to preserve its market leader status. Is this a realistic objective or are these funds merely an indulgence?

Policy play

The Chinese government has been championing industry consolidation initiatives since 2010. Last year, Beijing once again released policy guidance for the consolidation of nine key sectors: automotive, steel, cement, shipbuilding, electrolytic aluminum, rare earths, electronics and information, pharmaceuticals and agriculture.

What these sectors have in common is overcapacity. And the combination of low barriers to entry, excess supply and rock-bottom prices exposes overdrawn companies once economic growth begins to slow.

Cleantech is a classic example of a sector in need of a shakeout to trim away the weaker players. Solar panel manufacturers have been particularly affected and for many it comes down to a choice between being bought out and being wiped out. Industry giant Suntech Power filed for bankruptcy last year and was saved by a local government bailout.

"The solar energy industry has been distressed. We feel that the industry is going to consolidate," says James Liu, CEO of Sailing Capital. "Meanwhile, we expect that there will be more reliance on the renewable energy in the future, especially in China. The demand of renewable energy will increase."

Looking to capitalize on the trade-off between short-term distress and long-term fundamentals, Sailing teamed up with Yingli Green Energy Holding, China's largest solar-panel maker, to form a RMB1 billion ($160 million) fund. Yingli will contribute about 51% of the total capital, with the rest coming from Shanghai Sailing Capital Investment Fund. The vehicle will invest in ground-mounted and rooftop-installed solar-power projects, helping Yingli's transition from a solar cell manufacturer into a broader renewable energy solutions provider.

"There are many new energy companies are queuing up to get access to the capital markets. We see it as an opportunity to invest in them and sell them to Yingli in the future," Liu adds.

Overcapacity is not the only driver of consolidation. The government has announced a range of healthcare reforms in recent years with a view to boosting service quality and private sector involvement. For example, under the 12th Five-Year Plan, which covers 2011-2015, the private hospital share of total beds is expected to increase from 10% to 20%. This explains why Aier and others are keen to get involved.

Furthermore, the China Securities Regulatory Commission (CSRC) is drafting rules to make it easier for listed companies to do M&A deals. They will no longer need regulatory approval when buying, selling or swapping assets, provided deals do not involve reverse takeovers. The CSRC has also encouraged private equity firms to set up M&A funds or other types of industry-focused funds to restructure listed companies.

"We don't' know have an investment team to do M&A deals but both Huatai and Orient Asset Management have a lot of experience in this," says Aier's Wu. "The GPs will follow Aier's standards - in areas such as financial reporting - when restructuring target companies. In China, almost all ophthalmology clinics are small businesses set up by specialist doctors."

Strategic shift

One of the reasons Aier has no in-house M&A unit is that outsourcing the function to GPs is cheaper and less risky. The Yingli-Sailing is an exception because the corporate is committing over half the total capital and will work with the GP in managing the fund. In most cases, the corporate accounts for 10-20% of the corpus and sees its involvement as a way of learning about acquisitions and building up an M&A network.

Partnership funds also benefit private equity firms. According to AVCJ Research, 22 renminbi-denominated funds received commitments of $3.8 billion in the first half of 2014. Fundraising has fallen dramatically from the 2011 peak of $28.1 billion with just $14.4 billion entering funds in 2013. The high net worth individuals (HNWIs) who backed local managers fled as IPO exit multiples dropped and new listings slowed to a crawl before the CSRC imposed suspended them altogether in order to clean up the market.

Renminbi managers must diversify to stay in business and M&A funds are one way of doing it. Pertinently, there is the expectation that corporate serving as anchor LP represents a guaranteed trade sale exit channel. This may also be a selling point with third-party investors.

"The main differentiator between this type of M&A fund and traditional ones is the PE firm can almost always secure an exit, selling the portfolios to the listed corporate after certain period of holding," says Roger Liu, China and Hong Kong private equity deals leader at PwC.

In this context, the PE firm is subordinating itself to the listed company, acquiring target firms that meet its strategic needs. There will be areas in which the company wants to boost its exposure, for example vertically integrating upstream and downstream assets within the same industry. In this context, the corporate LP is likely to play an active role in deal sourcing - effectively identifying the competitor it wants to buy and asking the GP to negotiate a deal.

However, this strategy is contingent on the PE partner actually achieving control of the target business. "It's difficult to ask founders to give up their business to the PE funds in China," says Xudong Qiao, head of research in Shenzhen Capital Group. "So what GPs often do is to invest through minority stakes and then try to persuade business owner to sell to the listed company."

Even if the PE firm is able to execute a buyout strategy from the outset, managing companies as a controlling investor is alien to many Chinese investors. Having emerged in a minority growth capital environment, they are not familiar with the restructuring, quality control, consolidation and brand awareness that come naturally to Western buyout players. They may struggle if required to replace company management.

"The most challenging part is post-investment integration work after investing," says Yangchun Yi, a partner at Hejun Consulting, which recently launched an $80 million fund with Shenzhen-listed stationery manufacturer Comix Stationery. "Apart from finding the best projects for the listed company, we have to manage an investee's business culture and try to integrate resources with the listed company, making sure it will be a smooth transition."

The Hejun-Comix fund's objective is to sell assets to Comix after a five-year holding period.

Conflicts of interest

While on one level guaranteed exits might appeal to third-party investors, there is also the risk that they will be left disenfranchised by M&A funds. An investment that is in the best strategic interests of the corporate sponsor might not be in the commercial interests of HNWIs who just want to make money. Similarly, the corporate often has right of first refusal on portfolio companies - so what happens if another buyer is willing to pay more for the business?

"Whether it is fundraising, investment or exits, those funds seems to have a lot of conflicts of interest," says Jenny Zeng, managing partner at fund-of-funds Magic Stone Alternative Investment. "If they want to raise capital from third-party investors, there must be a high level of information disclosure as to the nature of the GP-LP relationship."

Shenzhen Capital Group's Qiao adds that the key point of conflict will be whether a company is exited via IPO or trade sale. "It will depend on the level of influence corporates have on board decisions. And sometimes that depends on their capital commitment in the fund," he says.

Over time, Chinese companies will develop their own M&A capabilities and they may no longer require the support of a GP partner. By this point the GPs may also have gleaned enough from the relationship to introduce their own sector-specific value creation strategies. However, in the short term, it is difficult to see how M&A funds can meet their consolidation objective when run by inexperienced managers with little hope or idea of how to take full ownership.

"From pre-IPO strategy to M&A funds, we don't see a fundamental change in domestic PE managers. They still act as investment bankers, finding potential projects and then exiting through sales to listed firms," says Sun Dayi, managing director at Jade Investment. "Many GPs will fade away because they can't sustain their business during this transition, but it's a positive development for the market. It pushes GPs to review their fundamental skills."

SIDEBAR: State secrets - SOE restructuring

Restructuring state-owned enterprises (SOEs) has been on the Chinese government's to-do list for years. Progress tends to come in fits and starts, depending on the prevailing policy winds. Right now it appears the winds are blowing in favor of change as the private sector is encouraged to get involved and help improve operational efficiency in these companies. Pillar industries singled out for reform include autos, equipment manufacturing, iron and steel.

Last week, the State-owned Asset Supervision and Administration Commission (SASAC) - which is responsible for China's largest SOEs - selected six SOE parent groups to serve as pilot projects for private investment. Pharmaceutical distributor Sinopharm and cement-to-engineering business CNBM will be the first to undergo restructuring.

Momentum is picking up at both central and local levels, Steven Sun, head of China equity strategy at HSBC, said in a recent research report. However, industry participants are generally skeptical about words turning into deeds, noting that reforms take years to implement.

CITIC Capital Partners and Hony Capital were among the first Chinese private equity firms to pursue SOE restructuring deals. Hony has been involved in 31 such transactions, committing around RMB14 billion ($2.25 billion) over the past 10 years.

Arguably the private equity firm's most successful SOE restructuring is Jiangsu Glass Group, which used the proceeds of a Hong Kong IPO to support an acquisition spree of other state-owned glass assets in order to expand market share and build up economies of scale. Hony's most recent SOE investment was hotel chain Shanghai Jin Jiang International, in which it acquired a 12.43% stake for RMB3.04 billion.

"First we want to improve the governance and management systems, so the company becomes more competitive and market-driven. Then we will help the management team acquire other properties domestically and internationally," says John Zhao, Hony's CEO. "We are going to see acquisitions and consolidation that make the company bigger, better and more efficient."

In addition to SOE restructuring, Zhao sees consolidation opportunities in the healthcare sector. "Healthcare is one of segment to combine incremental and consolidation. We're looking at investing in hospitals, leveraging our skills to improve management and introducing industry best practices to provide high levels of care," he adds.

Last month, the State Council said it would relax limits on foreign investment in joint-venture hospitals as part of efforts to deepen healthcare reform. There are also plans to increase the number of medical service providers from Hong Kong, Macau and Taiwan able to set up private hospitals in China, and allow other qualified foreign investors to open wholly-owned medical centers in areas such as the Shanghai Free Trade Zone.

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• Topics
• Buyouts
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