AVCJ Awards 2016: Operational Value Add: China Hydroelectric

At first glance, the overall timeframe of NewQuest Capital Partners' turnaround of China Hydroelectric appears normal, even rapid by infrastructure standards. But the four-and-a-half-year arc from initial investment in April 2011 to full exit in September 2015 belies an uncommonly protracted struggle for control, especially in the context of an asset class typically characterized by efficient single-transaction buyouts.

The private equity firm acquired a 24% stake in the electricity provider as part of a portfolio of assets about a year after the company's New York Stock Exchange IPO. The plan was to help a stable, physical asset-driven business achieve its maximum potential through a significant but essentially passive minority position.

However, the stock failed to stabilize after a weak start, and by the time it fell from its launch price of $14.80 to as low as $0.62 in mid-2012, NewQuest had resolved to launch what would prove to be a three-year takeover and value-add process. As few things outside of low rainfall can cripple a hydroelectric business so suddenly and severely, the protracted nature of this corporate recovery was roundly attributed to the incumbent leadership.

"They were initially interacting with us, but over time, it was clear they weren't aligned with us," says Darren Massara, managing partner at NewQuest. "They had very little incentive to make changes and given the company was listed in the US, and domiciled in the Cayman Islands, where shareholders have very few legal rights, they felt they could run it the way they saw fit without being answerable to shareholders."

Going concern

China Hydro was set up in 2006 to acquire and operate small hydroelectric power projects, defubed as having a capacity of 50 megawatts or less. Over the course of three years it raised about $350 million through four rounds of private financing and then a further $100 million when it went public in January 2010.

The company's top management was well credentialed in the hydropower space and by mid-2012 it had helped establish a fleet of 26 power projects generating 548 megawatts across four provinces in China. But despite EBITDA reaching $42.8 million in the first half of 2012, up 107% year-on-year, nearly $700 million of value was wiped out by the share price plunge.

Meanwhile, high-profile fraud allegations against a number of US-listed Chinese companies were impacting valuations across the board, even for operators that were not under any suspicion such as China Hydro. This sentiment factor compounded the company's woes but was by no means the primary problem.

When auditors eventually issued the company a going concern qualification, shareholders attributed it to a liquidity shortfall created by the New York-based executives, which they said were paid almost five times the salary of counterparts in similar Chinese companies. By the end of 2012, the company had a working capital deficiency of some $81 million.

Value-add efforts on the part of NewQuest during this period included proposals to rationalize this bloated cost base and increase revenue without having to expand the plant fleet. The firm was denied a seat on the board and the recommendations went unheeded.

"In hindsight, it appears they were giving us lip service and mismanaging conflicts that existed with other businesses they operated," says Amit Gupta, COO at NewQuest. "For example, one major difference of opinion arose around the level of SG&A expenses. We wanted SG&A [selling, general and administrative expenses] to be closer to that of a 500 MW company ¬- which it was - rather than a 2-gigawatt company.

"As a result of issues like these, we were left with no option but to pursue a proxy contest in a public manner. In the end, we received overwhelming support from shareholders who understood what we were trying to do and believed in us."

The proxy fight, initiated in August 2012, mobilized a 40% shareholder consortium including Swiss Re, Tsing Capital and Aqua Resources as well as two family offices, Abrax and IWU International. This group claimed at the time to have invested approximately $170 million in the company since 2008.

The contest ultimately resulted in the replacement of almost the entire board by a combination of independent and investor-appointed directors. Gupta assumed the role of chairman. The shake-up dissolved a number of other shareholder concerns around senior management's involvement with other businesses and transparency issues related to a combined chairman-CEO position.

By this time, NewQuest was running China Hydro's day-to-day business, despite holding a minority stake. The firm then cemented this control with two secondary stake acquisitions made out of its first Asia fund, reaching a 54% holding one year later.

The share price had ticked up to as high as around $3.50 during this period, but many existing investors weary of the rollercoaster thus far were ready to cash out rather than abide a multi-year PE-style turnaround effort. NewQuest, therefore, was able to take the company private through a $79 million investment from its second fund, bringing the total investment size to $153 million.

In private hands

Once China Hydro was private, a new employee stock ownership plan for senior and middle management was rolled out, allowing senior management to invest into the company as a way of strengthening alignment of interests. The leadership changes were reinforced with a focus on introducing talent beyond the energy and infrastructure spheres. This included an emphasis on improving expertise in human resources policy framing, in-house legal capabilities, and offshore finance and corporate-level functions.

Privatization also allowed the firm to achieve its final value enhancement objectives, especially through the reining in of cost overruns. By 2011, general and administrative expenses were growing at 17% per annum and represented 32% of revenue.

Between 2011 and 2014, NewQuest was able to grow revenue by 62% and achieve a 113% increase in EBITDA. During the same period, a liquidity deficit of about $100 million was turned into a cash surplus, and by 2015, the company was making dividend payments. As of the first half of 2015, it posted revenue of $45 million, generating net profit of $12 million. This compares to revenue and profit of $89 million and $6 million for 2014 as a whole.

"This is a pretty simple brick-and-mortar business, so you don't have to spend a lot on things like marketing," says Gupta. "As a result, any excessive cost that can be cut without effecting the plant-level operations directly improves cash flows."

More specifically, cost cutting work included the elimination of listing expenses as well as a number of public and investor relations programs in the US. It also encompassed a major staff reduction and the nixing of a large Manhattan office rental in favor of cheaper headquarters in China. The company initially set up shop in Beijing but eventually settled in Shenzhen to realize further economies by improving proximity to an established operational footprint across the country's southeastern provinces.

"One of the expenses at the individual plant-level was that each of the plants had its own maintenance team," Gupta explains. "But the whole idea of aggregating these small power plants - which was the original operating plan - is to create economies of scale and use one maintenance team to mange all the plants in a certain area. We started implementing a lot of these small initiatives and they added up to meaningful numbers."

Value-add plans otherwise focused on a systemic de-leveraging and debt refinancing effort, which resulted in virtually all high-interest loans being extinguished by 2014. Between 2011 and 2014, net debt was down 32%, current liabilities were down 60% and cash holdings gained 525%. From 2012 to 2014, effective interest rates were reduced from 10% to 8% by repaying high-interest loans and replacing existing loans with lower interests. By mid-2015, the debt load had narrowed to $35.9 million from $270.2 million in 2012.

This was achieved in part by taking a more local tact. The heads of NewQuest's provincial financial teams were therefore encouraged to coax support from the smaller lenders in their respective areas through a message about the relative stability of cash flow generating businesses like hydro power plants.

"Our team was a little resistant at first because they had never done it before, but we engaged at the provincial level, speaking to the higher authorities at banks and explained that hydro was a pretty stable cash flow businesses," Gupta says. "That education program at the senior and branch levels worked. Our success was in large part due to tackling the problem from a different perspective and empowering our local people."

This work coincided with the resolution of legacy issues such as the striking of a settlement with a joint venture partner in a defunct development project. Environment, social and governance (ESG) compliance, meanwhile, was incorporated as a metric in the ongoing personnel evaluations of individual plant managers.
As a result, plant managers were assessed not only according to their ability to achieve efficient electrical output, but also for worker health and safety records. The program was expanded with the engagement of specialist advisory firm Pacific Risk Advisors and ultimately made a meaningful contribution to the company's marketability at the time of exit.

"In the end, the international and domestic Chinese bidders conducted their own ESG due diligence as part of the auction process and no issues were raised," Massara says. "For a heavy infrastructure business to not have any ESG concerns raised at the time of due diligence was an important milestone to reach given all the issue areas potential buyers must evaluate."

Time to exit

NewQuest exited China Hydro in December 2015 through a sale of a 100% stake to Shenzhen Energy for $495 million in equity value, post dividend recaps. The private equity firm controlled 93.7% of the company at the time and executed the deal alongside minority position sellers Tsing Capital, Junya Investment, Asia Pacific Energy Investment and various individual players.

For NewQuest's first fund, the investment generated a 3.7x net return over a 4.7-year period, resulting in an IRR of 41%. Fund II achieved a 2.7x net return over a period of 1.4 years, with an IRR of 102%.

Perhaps a more appropriate measure of the value creation, however, would be the improvement realized since NewQuest launched its proxy contest to remove the incumbent leadership. From this mark, the exit achieved a 9.9x return over 3.3 years, representing a 104% IRR and a 753% jump in equity value.

The most extraordinary aspect of the China Hydro story, however, is the notion that NewQuest achieved these improvements as a passive minority investor that became compelled only through extenuating circumstances to lead a prolonged and aggressive take-control process. Achievement of the coup is all the more interesting in light of China Hydro's low level of liquidity as a publicly traded company, with only 10 investors owning roughly 80% of the stock at the time.

Although such multi-transaction buyouts do have their place in the private equity secondaries playbook, the advantages of the approach are not related to value creation per se. Improving the bottom line under these conditions is an uphill climb, but with each small victory, stakeholders grow more confident about the viability of the long-term vision.

"Doing it incrementally may not be ideal because it takes longer and there is a lot more uncertainty, but if you see progress, it gives you further conviction in your thesis and empowers you to convince your investment committee and LPs that taking on additional risk is warranted - particularly given the control you have and the execution and performance you've been able to deliver to date," Massara says. "If you had to buy 100% on day-one with a significant check size, you could lose a lot more if the deal goes wrong."

Pictured: Darren Massara (right) of NewQuest Capital Partners receives the award from Alvarez & Marsal's Oliver Stratton

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• Topics
• Greater China
• Trade sale
• Buyouts
• Infrastructure
• Cleantech
• China
• NewQuest Capital Partners
• AVCJ Awards