China exits: Open to alternatives

Thanks to Shanghai Jin Jiang International's recent acquisition of budget hotel operator 7 Days Inn and Shenzhen Energy's purchase of China Hydroelectric, the total value of announced private equity trade sales in China this year has nearly doubled.

Jin Jiang is paying $1.3 billion for 7 Days Inn, with The Carlyle Group, Actis Capital, Sequoia Capital and GIC Private due most of the proceeds, while the $542.6 million China Hydroelectric deal represents a full exit for NewQuest Capital Partners and Tsing Capital. These are two prominent examples of a rising trend. According to AVCJ Research, a record 79 trade sales generated $5.2 billion in 2014. So far this year, there have been 45 deals worth $4.2 billion, exceeding the IPO and open market sale numbers on both counts.

This shift in the exit balance is largely a product of necessity. For all the relief that greeted the end of the embargo on new domestic share offerings in the domestic market in January 2014, IPOs have yet to recapture their previous highs. Moreover, approvals were paused again this summer in response to market turmoil. China's private equity exit problem has not gone away.

We were considering a Shanghai or Shenzhen listing for one of our companies. Unfortunately, the regulators decision to suspend new listings took that option off the table - Kyle Shaw

"Up until June, the Chinese stock market looked like a wonderful place to exit. So if you put together a plan and started spending money on lawyers and accountants, by August you would have been disappointed" says Kyle Shaw, managing director at Shaw Kwei & Partners. "We were considering a Shanghai or Shenzhen listing for one of our companies. Unfortunately, the regulators decision to suspend new listings took that option off the table."

Ups and downs

PE exits in 2014 were the fourth-highest on record, coming in at $12.9 billion, with shares sold at IPO accounting for $2.99 billion (although Alibaba Group and JD.com's offerings accounted for 80% of this). In total, the Shanghai and Shenzhen A-share markets, plus Chinext and the SME Board, saw 62 PE-backed offerings.

The wave of IPOs carried through to July of this year, with 75 more PE portfolio companies going public. It coincided with a 59% gain in the Shanghai Composite Index between January and mid-June - public market exits accounting for over half of total transaction value - and the announcement of a slew of capital markets-friendly reforms.

The Shanghai-Hong Kong Stock Connect scheme was unveiled, allowing mainland investors to trade Hong Kong-listed stocks, and vice versa. It boosted both markets. Meanwhile, China's much anticipated switch from an approval-based IPO system in to a market-oriented registration model for being foreshadowed by the National Equities Exchange and Quotation (NEEQ), or New Third Board, to great effect. Many of the 600 or so applicants in line for mainboard listings turned their attentions to the New Third Board instead.

However, in July macroeconomic concerns prompted a massive slump in the domestic markets, which in turn hit Hong Kong and other bourses. About half of the stocks listed in Shanghai and Shenzhen voluntarily halted trading. Then the plug was pulled on new offerings and there has been nothing since.

"There are some uncertainties about when these companies can list and they have to consider other exit channels. A Hong Kong IPO is one of the options. It's similar to the A-share market IPO suspension in 2012-2013. A lot of companies couldn't get listed in China so they came to Hong Kong. There are many Chinese applicants in the pipeline in Hong Kong and they want to list before the end of this year," says Paul Lau, a partner at KPMG China.

Nevertheless, Hong Kong is still a highly selective market in terms of size and sectors. So far this year, only 18 PE-backed Chinese companies have achieved listings in the city, compared to 37 last year, and 40 in 2010. The US market has also dried up with WoWo the only VC-backed Chinese company to complete an IPO. Within a few months it announced a take-private proposal.

The pick-up in trade sales has been helped by the acquisitive tendencies or listed Chinese companies. AVCJ Research has records 21 trade sales to A-share listed buyers in 2015, or 50% of the total. Last year, it was 59%, with a scattering of Hong Kong and US-listed Chinese companies making up the numbers. This represents a significant turnaround from the three years before that: in 2011, 2012 and 2013, mainland-listed companies were responsible for 16%, 15.8% and 18.9% of all China PE-backed trade sale exits.

The change mirrors a spike in overall M&A activity. Plenty of industries in China are ripe for consolidation and listed companies see acquisition as a means of opening up new avenues of growth. Chinese M&A reached a record $454.1 billion last year, with more than 5,200 deals announced. Domestic companies were responsible for 75% of transaction value, compared to 61% in 2013, according to Thomson Reuters. As of September, 4,000 deals had been announced in 2015 worth a collective $477 billion.

In addition to agreeing a deal for 7 Days, in last 12 months Shanghai Jin Jiang has snapped up properties in China and abroad. Notable acquisitions by state-owned group include Europe-based Louvre Hotels from US real estate investor Starwood Capital.

"The central government's reforms involve supporting outbound investments and acquisitions of businesses that can bring know-how and expertise to help improve the efficiency of the domestic market, things like precious engineering and finance services. They are streamlining regulatory approval process for domestic investors to make outbound acquisitions," says Rupert Chamberlain, another partner at KPMG.

Another example of a PE trade sale exit is Shanghai-listed Guangdong Yihua Timber Industry's agreement to buy an 18.21% stake in Meilele, an online-to-offline (O2O) furniture retailer. The company uses online traffic to drive customers to offline stores where they can look at the furniture and make purchases - a useful add-on for Yihua Timber's traditional wood manufacturing business.

"We like the buyer because it can help in other aspects of Meilele's business and that was why we just did a partial exit - we see more upside in combining Yihua's expertise with that of Meilele," says Choon Chung Tay, managing director at Vertex Ventures China. Lightspeed China and China Renaissance K2 Ventures also sold part of their stakes in the business.

Succession issues are another factor. Vanzo Communication Technology, a Chinese mobile handset maker backed by Spring Capital, was sold to Shanghai-listed Hubei Kaile Science & Technology in a deal worth $140 million. Vincent Chan, Spring Capital's CEO, notes that Hubei Kaile is not only wanted new intellectual property and customers, but was also keen to add new blood to its management team. "The founder of is about 60 and his kids don't want to take over the business. He saw in Vanzo's founder a 33-year-old who has the passion to run the business," he says.

However, not every trade sale to an A-share listed company makes sense. Clothing manufacturer Kaiser, for example, bought mobile games developer Youkia despite the absence any recognizable synergies between the two businesses. Industry participants observe that fashionable technology start-ups are popular targets for some listed companies because the presence of these new assets can shore up a dropping stock price.

For the sellers, trade sales can be less attractive because the exit multiples are lower than for IPOs. Neither are they guaranteed a pile of cash: many deals - particularly where an offshore investor is involved and approvals take longer - are predominantly structured as share swaps. The PE investor would then be subject to three year lock-up in the listed company.

Furthermore, share swaps seldom happen at equal valuations. If the listed company is trading at a price-to-earnings (P/E) multiple of 30-40x, the target company's shares are valued at 10-15x, Spring's Chan says. Should the target company fail to achieve three consecutive years of profitability there is an additional financial penalty.

"Managers should be looking at a variety of choices in their exit strategies," says Shaw Kwei's Shaw. "But when I am talking to a trade buyer or a listed company about selling, it would be better if the China market is doing well, because then I could tell them I have other alternatives. If they know the stock market is closed, that means I have less leverage in negotiating with them."

In reverse

For those unwilling to bet their fortunes on shifts in the regulatory mind-set, especially if they are sitting on substantial unrealized investments, there is another, higher risk option: a backdoor listing. There are several reasonably high-profile examples of companies opting to list domestically via reverse mergers. This involves a listed shell absorbing the privately-held asset and then issuing securities to the investors. "The popularity of reverse mergers is a symptom of investors needing a liquidity event," one GP says.

Outdoor advertising business Focus Media was taken-private in 2012 by a PE and management-led consortium in 2012 at a valuation of $3.5 billion. In May, Shenzhen-listed Jiangsu Hongda New Material said it would acquire the firm for RMB45.7 billion ($7.37 billion).

One month before the transaction was announced, a group of Focus Media's offshore shareholders, including Carlyle, FountainVest Partners, Fosun International, CITIC Capital Partners, China Everbright and Primavera Capital, made partial exits to 36 domestic institutional investors at a valuation of RMB45 billion. The move was to remove the "red chip" offshore listing structure and become an onshore-controlled entity. The investors are understood to have reaped a 3.8x return on the sale.

Giant Interactive, an online games developer that was also taken-private, in this instance by Baring Private Equity Asia and Hony Capital, is also being primed for a backdoor listing.

However, reverse mergers are harder to pull off than trade sales and include a higher degree of risk. Focus Media's plan to relist through Jiangsu Hongda was terminated as the chairman of the shell company resigned in response to a probe by authorities. A new shell had to be found. Hong Kong regulators have also made companies more difficult to list via reverse merger. For example, the reverse merger is treated like an IPO and therefore subject to all listing requirements.

In terms of secondary market appeal, Focus Media and Giant are large and cash generative. Smaller companies in less fashionable industries may find it more challenging to drum up interest.

Focus Media and Giant are also notable in that companies partnered with PE investors to privatize the businesses with a view to going public in China. As such, there is an alignment of interest in choosing this exit route, as there is with a standard IPO. This is not necessarily the case with a trade sale, where the founder may be reluctant to give up control.

As minority investor in a company, it is incredibly challenging to preserve that alignment of interest while maximizing exit options available. There are examples of founders looking to get out due to advancing age or a more complicated commercial environment, but they are the exception rather than the rule.

"The on-and-off scenario in the A-share market is always there and it is actually part of the uncertainty of emerging markets in general," says John Zhao, CEO of Hony Capital, "When you invest in China, understanding the uncertainties associated with the market is part of the deal."

Hony has been on the wrong side of a regulatory decision before, having structured most of its portfolio companies for onshore listings only to see the A-share market shut down in 2009-2010. As a result, the majority of investments in the firm's fifth US dollar fund and second renminbi fund have been structured offshore. Hony also adds a provision to its investment agreements stating that, even as a minority investor, if a domestic listing is less likely it can opt for a trade sale or an offshore IPO.

"When we do the due diligence, we don't negotiate how to make an exit. We negotiate how we can come together and have upfront discussions about growth strategies," Zhao adds. "We are also very direct in saying that we are a financial investor - we invest for a certain period of time and then they must support our business model and allow us to exit. When that is clear, we start to work together."

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• Topics
• Exits
• Greater China
• Expansion
• China
• Exit
• IPO
• Trade sale
• Hony Capital
• Shaw Kwei & Partners
• Growth capital
• Vertex Management (II)
• KPMG