Asia Awards: PE Deal of the Year – Tianhe Chemicals

Tianhe Chemicals had serious misgivings about doing business with private equity investors. About five years ago the Chinese specialty chemicals producer had a negative experience working with a small PE fund, not unusual for the pre-global financial crisis period of abundant liquidity when a number of hedge funds sought to enter the asset class.

"The company redeemed the fund, so they did the right thing, but the chairman formed a very cautious view towards working with private equity after that experience," says Homer Sun, chief investment officer at Morgan Stanley Private Equity Asia (MSPEA).

The chairman, Qi Wei, is responsible for establishing Tianhe's market leading positions in lubricant oil additives and specialty fluorochemicals, but remains largely focused on product development. He had brought in his brother, Xuan Wei, as a shareholder and CEO, and tasked him with sourcing the capital required to keep the Tianhe R&D machine running.

"Tianhe carefully conduted its own due diligence on the financing sources available, whether bank debt or private equity," says Sun. "This was the context for our discussions that lasted over many years with the company. My sense is that they talked to a lot of international and domestic GPs over that same timeframe."

When Sun met Xuan Wei in 2009 establishing trust was at the top of the agenda. Three years later, the private equity firm acquired a significant minority stake in Tianhe for $300 million, its largest investment to date.

Industry specialist

Tianhe was founded more than a decade ago in Jinzhou, in northeastern China's Liaoning province, where it has three manufacturing bases and more than 1,200 employees. The company's core business is lubricant oil additives, the highest value-added components of lube oil. The additives play an important chemical role in vehicle engine performance, minimizing friction, cleansing and facilitating heat dissipation.

Due to the technical barriers to entry, the global market for lubricant oil additives is dominated by four players: Lubrizol, Infineum, Afton Chemical and Chevron Oronite. Last year, Warren Buffett's Berkshire Hathaway bought Lubrizol for about $9.7 billion. Until recently, China imported about 60% of its additives because no domestic producer had the technical expertise to match the big four global firms. Tianhe is gradually changing that.

"China wants to reduce its reliance on imports in this area and having a domestic champion that has spent 20 years overcoming the technical barriers for the industry is a vital part of this strategy," Sun says. "Tianhe is not only the number one player in China but bigger than the next three players combined."

A longstanding relationship with China National Petroleum Corporation - the largest domestic petroleum refiner and owner of many of the gas stations through which lube oil is distributed - has helped Tianhe consolidate its position at home. MSPEA is now supporting the company as it moves overseas, faciltating new partnerships with global oil majors. Most of these companies don't have the capability to move upstream into additives, so they purchase lube oil components from third parties like Lubrizol.

The other arm to Tianhe's business, specialty fluorochemicals, is already highly export-oriented. The company entered the space about eight years ago with the assistance of a group of American scientists. The technical requirements are arguably more demanding than for lubricant oil additives - as a result, gross margins are far higher - and the global market is led by DuPont, Daikin, Asahi Glass and Clariant.

Uses of fluorochemicals range from ski jacket waterproofing to fire-fighting foams. "After the BP spill in the Gulf of Mexico, companies have been engineering more effective fire-fighting foams for oil spills, and speciality fluorochemicals enable foams to better glide over the surface of the water," says Sun. "Speciality fluorochemicals are used in a diverse array of niche, lower volume markets that each command very high values."

Private equity 2.0

Tianhe is already a well-established company, on course to record a net income in excess of $300 million for the current financial year. There are a number of standard improvements that can be made -corporate governance initiatives as well as financial forecasting capabilities that help the company plan production and capital expenditure - but the principal challenges are likely to come with scaling up and internationalizing the business.

Even so, Sun sees Tianhe as representing a different type of company to traditional private equity targets in China, and this speaks to a broader evolution of the market.

The first generation of private equity investment was characterized by companies that often stood out for their brands or distribution networks, run by entrepreneurs who tended to focus on short-term considerations. By contrast, the R&D capabilities that underpin Tianhe's value-add require long-dated and uncertain investment. Sun sees parallels with another MSPEA portfolio company, Sihuan Pharmaceuticals, where he says the board also places a premium on innovation.

"Once you start competing with Lubrizol or DuPont you are up against companies that have been doing this kind of R&D for decades. You are not going to compete in every product category, but in areas where there is strong domestic demand in China that can drive revenue and cash flow, expertise is emerging," Sun adds.

"The ‘Made in China' stereotype used to be a plastic toy from Dongguan; now we are seeing businesses creating significant technical barriers to entry and stepping onto the global stage."

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• Topics
• Expansion
• Greater China
• Industrials
• Morgan Stanley Private Equity Asia
• Growth capital
• Chemicals
• China
• AVCJ Awards