China investment: Looking up in a downturn

An assortment of Chinese managers kept their powder dry in 2018. Countless opportunities were initiated or nurtured, and term sheets were signed, but more often than not, they declined to proceed. In a climate of macroeconomic uncertainty and public market volatility, the valuations just didn’t click.

FountainVest Partners deployed nothing between April and mid-December, while Tony Jiang, a partner and co-founder of Ocean Link admits his firm “slowed down in terms of pulling the trigger.” The deals Ocean Link completed last year were slow-burners that had been initiated some time ago. Similarly, CDH Investments’ large-cap activity in 2018 was restricted to a take-private in Australia and a couple of bolt-on acquisitions. Ascendent Capital Partners made no new investments at all.

“Maintaining discipline in this part of the cycle is of particular importance,” says Liang Meng, a founding managing partner at Ascendent. “Towards the end of 2018, investment conditions started to become more attractive. Overall confidence levels began to waver as the trade tensions dragged on, while some companies were impacted by changes in the regulatory environment. Valuations have become much more reasonable.”

These experiences are Chinese private equity’s immediate past and present in a nutshell. Investment reached $90.8 billion in 2018, the second-highest annual total on record, according to AVCJ Research, but activity slowed markedly from the middle of the year. The $13.6 billion committed in the final three months represents the lowest quarterly total in more than two years. However, Ascendent is not alone in suggesting that 2019 could be different.

“The deal team is getting quite excited,” says Stuart Schonberger, a managing director at CDH. “There should be more opportunities for real private equity, whether that is control deals or situations where you can help companies with M&A and industry consolidation. Debt tightening should make it difficult for mediocre players, but we haven’t seen a capitulation yet. Our team is waiting, expecting valuations to become more attractive. The next two or three years could be a good entry point for smart money.”

The extent of China’s economic challenges hit home in January when it was announced that GDP growth came in at 6.6% for 2018, the slowest annual rate in almost three decades. This capped a 12-month period in which key economic indicators such as industrial output, retail sales and fixed-asset investment reached multi-year if not record lows. But these woes were reflected by a decline in the Shanghai Composite Index that began well before the US imposed its first round of trade tariffs. 

“China’s economy is slowing mainly due to domestic headwinds caused by earlier policy tightening. The government tightened monetary conditions in 2016 as part of its deleveraging campaign and kept conditions tight until the middle of last year. Credit growth slowed sharply as a result, which is now weighing on activity,” says Chang Liu, a China economist with Capital Economics. “The trade war with the US has had a small impact on the Chinese economy so far.”

What the ongoing trade tensions have done is engulf the pre-existing economic fragility with uncertainty. Consumer and investor sentiment plummeted. And if all the indicators point downward, how could private markets valuations continue to head upward? Transaction advisors claim that valuations in areas such as consumer and healthcare have dropped by 30-50%. Confidence has been replaced in some cases by near desperation to get funding locked down. 

“From the latter part of 2014, there were a lot of situations where companies would set very tight timelines and a renminbi and US dollar funds would go in at high valuations without much due diligence,” says Ocean Link’s Jiang. “Now it is back to more rational levels. There has been a clear shift in terms of bargaining power.” 

Attractive entry points

While this has created openings for opportunistic investors, most private equity firms are looking to deliver on existing long-term strategies at more attractive prices. Mid-market consumer buyout firm Lunar, for example, sees the moderation in China’s economic growth as part of a long-term trend that should be accompanied by rising household consumption. Parallels are drawn with Japan and Korea, with China trailing its North Asian peers by approximately 40 years and 20 years, respectively. 

The transition to a consumer-driven economy is broken down into three stages: hypergrowth (GDP expansion of 10% and above), strong growth (8-10%) and maturing growth (1-5%). Consumption evolves from being focused on staples to emerging premiumization to discretionary. China is moving from phase two to phase three, with luxury goods, cultural experiences, entertainment, and high-end foods increasingly on the agenda. 

“As the economy slows, people start to live for today rather than for tomorrow. It happened in Japan and Korea and now we see it in China as well – people aren’t working as hard as they used to, they settle into less hectic routines, and they consume more,” says Derek Sulger, a partner with Lunar. “It is a fantastic environment in which to invest because companies are waking up to the fact that to tackle the new reality of China, they need more operational and strategic help.”

Sulger points to sportswear retailers as an example of how to adjust for slower growth. In 2012, the likes of Li-Ning and Anta found that their aggressive expansion plans had begun to work against them. Li-Ning’s CEO said in the 2013 annual report that the company’s “wholesale model had caused it to become detached from rapidly changing consumer trends as it operated at arms’ length from its customers. Eventually, its channels were saddled with aging inventory and unprofitable stores.”

By then, Li-Ning was mid-way through a transformation that involved strengthening management, streamlining its brand and distribution network, and building out online channels. After posting annual losses from 2012, the company returned to profit in 2015. Its stock has gained 230% since then, and risen 38% year-to-date, comfortably outperforming the Hang Seng Index. While Anta never posted a loss, it overcame a dip in turnover and profit in 2012 and 2013, and its stock has benefited accordingly.

Private equity investors are looking to help other consumer companies respond to the need for change. “PE professionals are really trying to focus on value creation and performance improvement,” adds Erica Su, a managing partner for transaction advisory services at EY. “When everything is growing fast, nobody worries about the bottom line. But if you start to see a slowdown, you push portfolio companies to focus on earnings and working capital, rather than purely on top-line growth.”

The professionalization of management, introduction of leaner processes and adoption of technology also gives these businesses a competitive advantage over their peers, creating opportunities to absorb those that cannot stay the course. This is the consolidation that CDH has been waiting for.

“China has overcapacity in so many sectors. Brand leaders should be able to acquire mid-market players that never had a competitive edge. Many of these companies had easy access to debt and the ability to expand into second and third-tier cities to keep growing as the general market slowed down. That game is over,” says Schonberger. “Businesses that are overleveraged and can’t pay back the banks should be ripe for acquisition. Some of our portfolio companies have strong cash balances and are poised for more M&A.”

How to engage

While consumer and services – sometimes technology-enabled – remain the focal points for a lot of activity within private equity, approaches to deal-sourcing vary. CDH mines its existing relationships, combing the 2,000 companies it has interacted with over the years. As a travel and tourism specialist, Ocean Link for the most part operates in a narrower vertical but looks to exploit a deeper level of understanding. Lunar takes a similar approach to consumer, though through a buyout lens.

CITIC Capital, meanwhile, has found itself a niche in carve-outs. The GP was relatively busy in 2018 and seven of the transactions it agreed involved the extraction of a non-core asset from a corporate group, six of them multinationals and one a domestic state-owned enterprise. “Corporates tend to divest during downturns, and it’s usually the wrong time to sell,” says Eric Xin, a managing director with the private equity firm. “We can go in, buy at a reasonable price, and then when the cycle comes back, we do well.”

The key is knowing where to look and how to engage. Adapting to a commercial environment characterized by slower growth may make companies more open to outside solutions. There is a general trend of GPs receiving more inbound inquiries from founders and entrepreneurs within their networks seeking assistance. Those conversations may result in transformation-oriented partnerships, divestments, full buyouts, or nothing at all.

“Through value-add initiatives and interesting ideas, companies can accelerate growth. We are seeing situations in which companies are facing a temporary squeeze on the balance sheet or there are specific supplier, competitor, and customer interactions that call for careful analysis of a situation and the provision of a solution,” says Ascendent’s Meng. “We find that companies are seeking advice in areas like strategic alliances and acquisitions, they need a sounding board for what to do.”

Ascendent is especially relevant in this context because the firm positions itself as a corporate consigliere, providing advice and solutions to businesses – sometimes over extended periods of time – with a view to contributing capital when appropriate. If volatility, slower growth, and diverging trends within industries take hold in China, this kind if investment proposition should get more traction.

The firm has seen situations where an investment was not possible several years ago reemerge as opportunities because the target’s circumstances have changed. As the Chinese economy continues to deleverage, a similar dynamic is expected in non-core carve-outs. 

A spike in acquisitive activity by Chinese companies in 2011-2013 ended abruptly in 2014. At the time, Ascendent was able to acquire a hospital from a telecom cable manufacturer and a dairy business from a department store chain. These opportunities abated in 2016 as entrepreneurs found it easier to obtain credit, but the trend started reversing towards the end of last year. The past three months have been particularly busy with an acceleration of opportunities progressing towards a close.

Future and past

While changes in China’s economy may unlock new opportunities, that is only half the battle for investors. They must stay ahead of the curve, identifying how the dynamics around an industry or company might adjust and responding accordingly. Now, perhaps more than ever, they will be judged on their ability to pick winners. There is no rising tide that will float all boats.

At the same time, past investments will be stress-tested. Ocean Link has been busy working through its portfolio companies, ensuring their balance sheets are robust enough to survive not only a slowdown in consumer spending but also a period in which follow-on funding might be sparse. Businesses that work with franchisees, such as restaurants, hotels and coworking spaces, require close attention because the shockwaves are felt at different levels.

“These franchisees are small business owners and they are very sensitive to what is happening in the market,” Jiang explains. “We encourage our companies to make life easier for franchisees, for example, by introducing new storefront designs that don’t require as much capex.”

If this behavior is the equivalent of applying a band-aid, some companies require open heart surgery – and the frequency of such incidents will tell LPs everything they need to know about a manager’s discipline during the boom period. Of the $253 billion invested between 2016 and 2018, approximately 36% went into growth-stage technology deals. There were 34 rounds of $500 million or more, seven of them for companies that have since gone public. Five are now trading below their IPO prices. 

These businesses may have sufficient scale and funding access to prevail in the long term. But such public market difficulties – at least for late-stage investors that are likely to be underwater – suggest more trouble is lurking out of sight in the private sphere where the liquidity could easily be turned off. As one China-focused manager observes: “I don’t know how that unicorn-hunting strategy can work anymore. They are having existential crises as to how much these companies are really worth.”

Edward Grefenstette, president and CIO of The Dietrich Foundation, which has significant venture and growth exposure in China, is optimistic about the current vintage. He cites the pullback in competition, especially from renminbi funds, the moderation in valuation expectations from founders, and greater stability in the GP community as spin-outs abate and capital gravitates towards a handful of elite managers. But there is some uncertainty around fourth quarter valuations on existing investments.

“As we know from experience, if the auditors are doing their work, a sharpened pencil will be put to some valuations,” Grefenstette says. “We are seeing some resistance to markdowns – they say it is a temporary blip in the market. In China it seems the stigma of a markdown is intolerable to some founders, so I am curious to see what the data will show.”   

 

SIDEBAR: Policy permutations 

When the global financial crisis left export-oriented manufacturers reeling and consumers spooked, China responded decisively. A RMB4 trillion (then $586 billion) stimulus package was unveiled, capital was plowed into infrastructure projects, and banks were instructed to issue loans as fast as they could. The broader macro picture is different this time around, but will Beijing resort to using the same tools as it seeks to revive an economy hurt by deleveraging, US trade policy, and weak consumer sentiment?

Starting from mid-2018, stimulus measures were introduced such as inducements for local governments to step up infrastructure spending, a gradual depreciation in the renminbi to help exporters, and cuts to the reserve ratio requirement (RRR), so banks can lend a larger portion of deposits. These efforts have intensified, with new loan issuance hitting a record RMB3.2 trillion ($477 billion) in January, while Beijing has said that special local government bond (SLGB) issuance – typically used for infrastructure investment – is set to hit RMB2.15 trillion in 2018, up 13% on 2017.

Nevertheless, Betty Wang, a senior economist with ANZ, believes the policy response is “likely to be conducted in a controlled way instead of a very aggressive one.” She observes that the RRR cuts are not expected to be accompanied by interest rate cuts because that would represent too strong an easing bias. On the fiscal side, SLGB issuance is up and tax cuts have been announced, but the fiscal deficit has not been increased as much as the market expected.

One reason for restraint is that the government doesn’t want to undo what deleveraging was designed to achieve – easing the debt burden. “With officials concerned that another surge in credit growth would worsen China’s structural problems, we expect the scale of stimulus this time to be smaller than during previous easing cycles. A rapid economic turnaround is therefore unlikely. Our forecast is for growth to stabilize in the second half of the year,” says Chang Liu, an economist with Capital Economics.

Indeed, the recently announced RMB2 trillion package of value-added tax (VAT) cuts across manufacturing, construction and transport, and services is seen by some as a new and encouraging policy response. “Usually the response to an economic crisis or slowdown is to increase infrastructure development. But this time, they’re taking a slightly different approach by reducing the tax, which I guess is intended to increase the competitiveness of Chinese industry in the trade war,” says Boqiang Lin, dean of the China Institute for Studies in Energy Policy at Xiamen University.

Economists note that Beijing has reaffirmed its support for the private sector, although it is difficult to say what impact this will have. The same applies on a longer-term basis, with economic liberalization seen as the key to sustaining rapid economic growth. Liu of Capital Economics observes that the current leadership “seems to have little appetite for further market reforms,” while Lin of Xiamen University argues that housing prices are the fundamental obstacle to private sector or consumption growth.

“I believe that housing prices are the single most serious problem the Chinese government must confront,” he says. “It can try to control prices in hope that people use the money they save on consumption. The difficulty is that, while you cannot let prices go up too fast, you also cannot let them go down.” 

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• Topics
• Greater China
• Buyouts
• Expansion
• Consumer
• China
• Lunar Capital Management
• Ascendent Capital
• CITIC Capital
• Ocean Link
• CDH Investments Management
• Growth capital