China buyouts: Responsible owners

McDonald’s responded to the need for a digital marketing push by drawing up plans for a single global app. This wasn’t enough for the China team: they wanted an entirely local app and – aware that 45% of McDonald’s purchases in the country are made using electronic payment – they needed it sooner than the date planned for the global roll-out. 

A deal was duly reached with Tencent Holdings, owner of the WeChat Pay system, and within six weeks McDonald’s China had an app-based customer loyalty program in action. As of December 2017, it was serving about four million users. The initiative was driven by a unit of CITIC Group, CITIC Capital, and The Carlyle Group, which had taken majority ownership of the McDonald’s business in mainland China and Hong Kong earlier in the year. The parent company retained 20%, received an immediate $1.66 billion in cash, and secured a royalty payments agreement.

Situations like these are becoming increasingly common in China. Multinationals that once saw the country as central to their expansion plans are grappling with a difficult operating environment. Keeping pace in a market that now leads the world in digitization is just one issue. Whether it is intensifying competition or ineffective on-the-ground management, for many China is a problem rather than a growth engine. As a result, they are inclined to let a local partner take control.

This notion of assistance is a common theme among the different strands that make up the emerging China buyout opportunity: the corporate that needs help cracking the China market; the aging founder who lacks an heir; the founder who accepts that third-party input is required to drive business growth; and the state-owned enterprise (SOE) on the road to reform. While help is clearly needed, can PE provide it?

“What concerns me is that everyone is talking about buyouts but not everyone has done them before,” says Pamela Fung, an executive director at Morgan Stanley Alternative Investment Partners. “In the best-case scenario you buy a controlling stake, retain the existing management team to run the company, and everything goes according to plan. But if that doesn’t work, what is your plan B? Do you have back-up management or someone on your team who can be CEO or CFO? Unless you’ve done 10 or so of these deals, it’s hard to preempt what might happen.”

Spoiled for choice

Questions have been asked for several years as to whether China-focused private equity firms – many of which were founded by individuals with an investment banking background – can transition from growth capital to control-oriented transactions. As these deals become more readily available from a wider variety of sources, they now have opportunities to provide answers. 

CITIC Capital, for example, was among the first to set out its stall as a buyout specialist, but deal flow has been fitful and episodic rather than transformative. Indeed, the corporate carve-out angle is a relatively new one, with four transactions coming in the past 15 months. In addition to McDonald’s, CITIC Capital has acquired Ansell’s sexual health division, English language training provider Wall Street English, and Euromoney Institutional Investor’s financial information database unit.

Asked about the appeal of carve-outs, Eric Xin, a senior managing director at CITIC Capital, says: “The management team is motivated, a lot of bureaucracy can be removed, and improvements can be made through localization. In addition, valuations are not totally price-driven, it is more attractive than buying from another PE firm. When a multinational is struggling with its China business it wants a partner.”

The private equity firm’s initial steps in the buyout space involved SOE deals. It then established an international fund that served as the minority partner to US-based GPs on buyouts of companies with a China element to their business. Privatizations came next, chiefly involving US-listed Chinese companies with founders that thought they could achieve higher valuations on domestic bourses.

In this respect, the CITIC Capital experience reflects that of the wider market. The number of buyouts involving China-based companies hit 30 for the first time in 2012 as US take-privates began to gain traction, led by Focus Media. Come 2015, as it became clear that Focus Media would indeed end up listing domestically, more than 30 public-to-private deals were announced, although not all these closed. In most cases, PE investors collaborated with the company founder who rolled over his equity into the acquisition vehicle and retained control post-privatization.

Transactions of this nature propelled China buyout investment to nearly $25 billion in 2015, and while their popularity has since faded, overall activity has not. AVCJ Research has records of 57 China control deals in 2016 and 43 in 2017. Investment came to $34.6 billion and $24.7 billion, respectively.

There is a new breed of China take-private involving bigger check sizes, businesses that do not sit on US bourses, and control accruing to the PE investors. The top two buyouts announced in 2017 were: a privatization of Singapore-listed Global Logistic Properties, which followed a strategic review instigated by major shareholder GIC Private; and the acquisition of Hong Kong-listed Belle International, a part succession-planning deal as the founder cashed out.

However, arguably the most striking development is a change in the definition of a China buyout. Of 100 deals announced in 2016 and 2017, 39 were acquisitions of overseas businesses in which Chinese PE firms participated as lead investor or as a junior member of a consortium. That is more than the overseas total for the previous four years combined. 

The middle market

Where a private equity firm features in this deal matrix is in part a function of size. Large-cap GPs claim they are seeing more opportunities within China, particularly around succession planning and founders that want to professionalize their businesses with a view to being globally competitive. That said, it is no coincidence that China managers with funds of $1.5 billion and above have all ventured overseas in search of control transactions involving companies with underrealized China potential.

To K.C. Kung, who left MBK Partners to launch middle-market private equity firm Nexus Point, the sweet spot is deals below $150 million in equity value, where there is less intermediation and plenty of demand for assistance. A typical example is an entrepreneur who as recently as five years ago was riding along on topline growth of 30-40%, but who has been caught by the moderation in China’s economic expansion and is also under cost pressure due to rising wages and stricter regulation.

“For a lot of companies, the bottom line isn’t growing much anymore, so they must expand EBITDA margins by creating value,” says Kung. “The reality is many entrepreneurs don’t know how to do that; they haven’t grown up in an environment where they had to worry about operational improvement. As a result, more of them are open to discussing a buyout. They recognize that by giving up control they gain a lot in terms of value creation.”

Succession planning is often part of this process. In professionalizing management, the founder gives up his day-to-day duties as CEO and moves to an executive chairman role. Managing the transition can be precarious. “We’ve seen situations where PE firms have acquired 100% but the founder is still involved or has a subtle influence over the company, and management ends up retaliating against the new owner,” says Morgan Stanley’s Fung, adding that this is one of the reasons why the China buyout thesis is still not proven.

Most GPs advocate keeping the founder involved by encouraging him to retain minority ownership. But how large should this stake be, and does it form part of a step-back agreement whereby the owner’s equity interest and involvement diminish over time? There is no consensus view on the best way to address so that a deal can be secured in the first place and then managed post-acquisition. 

EQT takes a flexible approach. Half of the opportunities it looks at each year are pure buyouts and the other half are co-control, where the GP has the right to put the company up for sale and replace the CEO if certain performance targets are not met. With Laobaixing Pharmacy Chain, for example, EQT acquired a 48% stake in 2008, while the founder retained 46%. They worked together on organic expansion and add-on acquisitions, took the business public in Shanghai in 2015.

“If you insist on control transactions it can reduce your deal flow. A typical LP would say, ‘If you are only doing pure buyouts, you risk focusing on the worst companies, the ones people want to get rid of or the ones where entrepreneurs have taken the business through a high-growth phase and now need capital to get out of that into a new area,’” explains Martin Mok, a partner with EQT. 

Good management

Of the 14 companies EQT backed through its first two China funds, seven have required new CEOs for reasons of succession planning as well as performance. Filling out relatively thin middle-management layers with talented professionals has been a characteristic of most investments. It underlines the importance GPs must attach to recruitment, a task many industry participants cite as the most challenging aspect of buyouts.

“We don’t have a deep talent pool in China. We don’t have professional CEOs and it takes time to develop the talent required to run a business,” says James Ieong, a managing partner at Pagoda Investment. “There are country heads of multinationals, but the resources and level of support at a local business versus a multinational is completely different.”

CITIC Capital fills the management gap with a dedicated recruitment team and an executive reference program for corporate gray hairs who work for the firm on a part-time basis. They serve as board members and coach CEOs or step into leadership roles if a situation requires it. Nexus Point has a similar model, bringing in executives to work for the GP on deal-sourcing with the option of deployment to a portfolio company. 

It can take up to two years to manage the transition from founder CEO to professional CEO, from finding the right person to putting their go-to-market strategy to the test. The PE investor holds the CEO accountable through the board, but during this period, investment professionals must still be reasonably hands-on. For the first two years of EQT’s investment in Laobaixing, Mok spent 50 days a year at the company’s Changsha headquarters as well as participating in weekly calls with the chairman and CEO.

The rise of the China buyout is irreversible. Entrepreneurs who have traditionally been unwilling to sell are already wavering, worn down by the passage of time and the realities of an increasingly complicated market. Even the stock market – which has offered founders valuations beyond what private equity can pay and without giving up control – cannot be a refuge indefinitely. And should this take longer than expected, PE firms have more sources of control deal flow than ever before. 

“If you look back at the US 30 years ago, it started with privatizations of large listed companies, governance issues created opportunities for carve-outs, there were smaller roll-up deals, private company succession deals, and then secondaries. Now a lot of deals are private equity to private equity, but we don’t have enough liquidity for that in China,” says CITIC Capital’s Xin. But even on this point there is some dispute, with Mark Webster, a managing director at BDA Partners, pointing to emerging secondary buyouts as evidence of a maturing market.

A GP that completes two control deals in its current fund, may move to four in the next vintage, and ultimately become a buyout specialist. However, this evolution must be accompanied by a modified approach to portfolio management that recognizes the need for more time to be spent on operations.

“Growth capital funds focus on making investments and less on post-investment value creation,” says Kung of Nexus Point. “But doing control buyouts means rolling up your sleeves and focusing on EBITDA improvement. The mindset shift is extremely difficult. You are doing fewer deals a year, holding investments for longer, and having your team concentrate on value creation.”   

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• Topics
• Greater China
• GPs
• Buyouts
• China
• M&A
• The Carlyle Group
• CITIC Capital
• Morgan Stanley
• GIC Private
• MBK Partners
• EQT Partners
• Pagoda Investment
• Nexus Point Partners