Q&A: Ascendent Capital's Liang Meng and Kevin Zhang

Q: What led to the creation of Ascendent in 2011?

MENG: Chinese private equity has changed significantly since 2004-2005. At that time there were fewer players, and therefore investment banks were key to introducing and brokering deals. However, most international banks didn't really have much in terms of advisory, as they were mostly focused on IPOs.

My M&A team at J.P. Morgan served as sell-side advisors for some of the earliest PE deals. When I moved on to D.E. Shaw in 2007 to start and lead the firm's Greater China investment business, it was a similar approach.

We helped companies think about their issues and opportunities, and then provided capital in combination with advice and solutions. Kevin and I first met when we were both advising CNOOC on the attempted acquisition of Unocal in 2005 - he was at Goldman on the capital markets side and I was on the M&A side. Between 2007 and 2011, we co-invested around $600 million in China PE deals, so we knew each other's style. Spinning out from D.E. Shaw in 2011, I decided to partner with him.

Q: And the advisory approach still prevails?

MENG: Today's environment is even more uncertain than a few years ago, so the combination of capital and advice is very powerful. Our strategy is all about having a lot of influence, thinking about what companies want to do and in a lot of cases helping them do it.

ZHANG: The market is maturing and entrepreneurs are becoming more sophisticated. They are more open to interesting transactions that they wouldn't have been open to 10 years ago. And then the Chinese economy is slowing. If a company is growing at 40%, all it needs is the cheapest cost of capital; there is not much interested in other opportunities. But as growth slows, even industry leaders must deal with challenges such as rising costs, increasing capital intensity and consolidation. At this juncture, if you show them not only capital but also opportunities such as M&A that offer synergistic combinations and change the competitive landscape, it is very interesting to them.

Q: So you would describe your strategy as different to conventional private equity?

ZHANG: Chinese private equity has seen its good days when everyone was making money, driven mostly by beta plays - GDP growth and multiple expansion. In a slower growth environment and with a lot of dry powder chasing those opportunities, you really have to deliver alpha. Our objective is to deliver attractive risk-adjusted returns. We do that by generating our own ideas and advising Chinese companies on how to accelerate growth. Through that process we develop a trusting relationship with entrepreneurs, which means we get in at reasonable valuations and can structure deals not only towards meeting a company's capital needs but optimizing our risk-return profile. We stay very involved post-investment, actively managing the portfolio.

MENG: Our approach also differs from conventional private equity because we look at things from a credit angle and an equity angle. We protect our downside using structured mechanisms but without sacrificing too much of the equity upside. Everyone talks about downside protection but how many of them have really gone through the exercise of loan-to-value, credit, analytics, asset and equity pledges, and enforcements? We are one of few with knowledge and experience in this area.

Q: What are the challenges involved with downside protection in China?

MENG: Downside protection could be as simple as a put option, but then you have to ask if it's really protected. Is your counterpart a special purpose vehicle or a person? Is there a personal guarantee next to it and, if so, does the person have sufficient assets? Is the enforcement mechanism strong enough. We take precautionary measures to protect equity pledges - we get pre-signed instruments of transfer with full power-of-attorney allowing us to date and effect the transfer upon a default. But in most cases we have known the company for a long time through the advisory angle. We understand them, we know they are creditworthy, and we are comfortable working with them. A lot of conversations run along the lines of us saying, "Let's develop this idea together and we will put in money to show we believe in the idea. If things go well, we get some equity upside. If things go really badly, just treat it as a loan and return the money plus some interest."

Q: So you wouldn't use protection mechanisms such as ratcheting?

MENG: We don't like those situations because there is a misalignment of interest - some founders might fudge the accounts rather than face losing 30% of their equity. We do it the other way around. We tell the founder that we think the business is capable of 10-15% growth, and our valuation reflects this assumption. But if we together manage to achieve higher growth we will return equity to him. Downside protection is not a zero-sum game.

There is often some kind of trade-off, incentives to get them to return cash sooner rather than later. For example, we might own 40% of a company with a 2x put option after four years and a preferred dividend stream that guarantees us a certain payout until we have covered 1x cost. If capital can be returned earlier we don't mind reducing the 40% ownership to 37.5%. It is less challenging when interests are aligned and you are giving them money not just to pursue organic growth but do something strategic to maximize shareholder value.

Q: What sort of strategic benefits have you achieved with your portfolio companies?

ZHANG: We have been involved in one take-private of a Chinese company on the Korean Stock Exchange. It is a complicated process and few people have done it before - our deal was announced last May and completed in October and it wasn't until last week that the remaining minority shareholders finally exited. We invested $54 million in the form of a convertible bond with a 4% coupon and an 18% put option. Our entry valuation is very competitive. But from the entrepreneur's perspective, he owned 45% and post-privatization his stake has risen to 70% without putting in any additional capital. We have invested and also helped the company make some small acquisitions to enter new areas. We have been working with a bank on an offshore syndicated loan that will extend financing from one-and-a-half years to three years, lowering the risk. And we are in the process of bringing in one of the company's largest customers as a strategic investor.

Q: Most private equity firms emphasize the operational side of value creation...

ZHANG: We work with industry leaders and established companies. A food packaging business doesn't need us to come in and explain how to make a metal can at lower cost. But they might need us to advise on how the company can reposition itself as a multi-product food and beverage packaging company. They might have identified an acquisition target and need help on the transaction, or they might want us to look at their capital structure, not only to lower financing costs but also to match assets and liabilities in order to reduce potential risks. We want to add value in areas where companies most need support and right now it is not operations.

Q: Doesn't your strategy - building relationships with the possibility of investing later - limit the number of deals you can look at?

MENG: We can probably do no more than two or three deals each year, but that's okay. When we launched Fund I we said there would be 7-9 investments in total with a $30-70 million sweet spot. Three years on, we have made five investments and are currently working on a sixth. If you see us doing one deal a month then we have deviated from our strategy. The deals will probably become larger in size but overall number won't increase much. And you won't see us opening four offices in China either. It doesn't make any sense. We don't need a lot of people but it is an advice- and intelligence-intensive strategy - there is a lot of dialogue with companies.

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