China middle market: Filling the void

The first time CDH Investments backed Fujian Nanping Nanfu Battery in 1999 it was a minority deal completed while the team was still part of China International Capital Corp. Three years later the newly independent GP acquired Nanfu in full, putting $17 million to a deal involving a handful of co-investors.

CDH is once again owner of the business, having acquired it from Procter & Gamble last year at an enterprise value of around $600 million. The PE firm's equity contribution was $200 million. The investment came from CDH's fifth US dollar-denominated fund, which has a corpus of $2.5 billion. Fund I, raised in 2002, was worth $100 million.

The private equity firm made its name taking minority stakes in Chinese companies and helping them restructure offshore with a view to going public, mainly in Hong Kong. Now, though, the average equity check size has risen from below $50 million to more than $100 million. Buyouts like Nanfu are more CDH's style.

"The interesting question is did the strategy change or did the market change? People see the increase in investment size and assume we are doing something different, but we're not. What has changed the most is that China's GDP has been growing at around 10% a year for 10 years - which means that the same type of investment that we made back in 2002 is now exponentially larger ," says Stuart Schonberger, managing director at CDH.

He notes that in 2002 Nanfu was, as it is today, China's largest manufacturer of alkaline batteries; but output and revenues have grown enormously.

Up-sizing

CDH is one of a handful of China-based PE firms - including but not restricted to Hony Capital, CITIC Capital and Orchid Asia - that have seen a marked increase in fund size over the past decade. There are also a select few younger GPs that have started out big. FountainVest Partners and CITIC Private Equity, for example, each raised around $900 million for their debut funds and have since followed up with second vehicles of more than $1 billion.

While Schonberger claims CDH has moved with the market and follows a similar investment thesis but on a larger scale, there is arguably a dearth of quality participants in the middle market space it and others have vacated. Are investors missing out on an opportunity?

"There are very few firms left in the middle market, or at least very few that can raise funds," says Kallan Resnick, managing director at placement agent Park Hill Group. "The middle market has been a difficult place for fundraising in the last couple of years. Where we have seen activity is in TMT [technology, media and telecom], healthcare-focused ventures and then at the larger end of the market."

A total of 1,185 China-focused private equity funds have achieved a final close since 2005, according to AVCJ Research. Three quarters of these are renminbi-denominated vehicles, most of them dating back no more than four years. Between 2001 and 2008, five US dollar funds raised in excess of $750 million. The remaining 140 or so closed on $600 million or below. Since 2009, the number of funds that have raised at least $750 million stands at 17, including nine of $1 billion or more.

Of the 100 other China-focused vehicles reaching final closes, 41 sit in the $250-749 million sweet spot generally acknowledged as being middle market or lower middle market. However, more than half of these are venture capital funds. Of the approximately 40 final closes since the start of 2013, around 60% have been by VC managers. In the $250-749 million space the share is over 70%, such is the appetite for exposure to the high-growth technology space.

This is in part an LP problem. The trend in PE globally is for institutional investors to consolidate GP relationships and deploy more capital with a smaller number of managers. At the same time, many of the larger LPs are forced to overlook smaller managers due to minimum check sizes and rules preventing them from accounting for more than 10% of the overall fund size.

"There is a disconnect between the opportunity set, the LP universe and the GP universe. More and more money is going into $1 billion-plus funds," says Myron Zhu, a partner at FLAG Squadron Asia, speaking a personal capacity. "Sovereign wealth funds and large pension funds are increasingly coming to Asia but they are can't commit less than $100 million per fund so they are gravitating to the more institutionalized platforms."

Although the headline US dollar fundraising numbers, including incremental and final closes, for 2007 and 2014 are similar - $11.6 billion versus $10.3 billion - the number of GPs receiving capital fell by nearly half. Between 2001 and 2008, average fund size was $155 million. For 2009 to the present, it is $292 million, as larger vehicles tip the balance.

"Right now it's easier for a pan-Asian fund to raise $3 billion than it is for a China fund to raise $500 million," adds one GP. "If you want $500 million then it is $25-50 million a time, 10-20 times. If you are raising $3 billion you get $100-200 million at a time from a bunch of state pension funds, and it usually goes through the gatekeepers."

Several middle market firms are currently fundraising. Lunar Capital is said to be seeking up to $500 million for a consumer sector buyout fund, while Ascendent Capital Partners and Bull Capital Partners have are expected to set hard caps of $650 million and $500 million for their latest vehicles. Trustbridge Partners is at the upper end of the space, having targeted around $750 million, and then the likes of Abax Global Capital and Capital Today are also in the market, the latter for an evergreen vehicle.

There is choice, but anecdotal evidence of strong demand for a small number of managers in the space suggests that LPs are not getting as much choice as they want. "It's not the case that there are no firms in the middle market or lower middle market, it is more about the quality of the players," says Doug Coulter, a partner at LGT Capital Partners. "A lot of good managers in China are chasing early-stage TMT deals or they have raised a lot of money and are going after $50-100 million checks."

Park Hill's Resnick notes that size in itself is not enough of a differentiator: GPs have tried and failed to raise funds on the back of the notion that, with many PE firms now raising funds of $1 billion or more, there is a need for groups in the middle-market hole. "You need to have a good track record or at least something that is differentiated in the strategy," he says.

The new normal

The middle market space is stigmatized in the eyes of many by an association with minority, often passive, participation in pre-IPO deals - the idea being that the GP would provide expansion capital and then exit via the public markets at a valuation multiple substantially higher than the one at which it invested. With GPs having limited influence over business operations or the timing of exit, a number of these deals floundered.

At the same time, riding on the coattails of industry growth is no longer a relevant strategy in many cases. Chinese middle market companies face an array of challenges, including a tougher commercial environment, cross-border expansion or domestic consolidation imperatives that are beyond their current operational and financial resources, and transferring ownership to a younger generation within the founding family that can't operate the business alone or perhaps doesn't want to operate it at all.

"After the global financial crisis growth wasn't happening and so it made no sense to do growth investing - helping a company build a new factory and double capacity. The second factor was the IPO market became very tight and middle market companies weren't going to get that multiples pick-up on listing," says Kyle Shaw, managing director at Shaw Kwei & Partners. "Now the pool of opportunities is driven by demographics, low interest rates, and the lack of growth. A lot of guys are struggling to stay where they currently are. They appreciate that they must do something different with their business."

Shaw Kwei is currently investing its third fund, which has a corpus of $450 million, and most of the capital has been going into turnarounds and succession planning situations. Rather than putting in new capital to accelerate growth, it is buying people out and addressing particular problems. To get traction on these deals, the seller needs to be convinced of the buyer's ability to engineer a transformation.

"Domain knowledge is important. Entrepreneurs have become more sophisticated and they are not only looking for capital - it is now a commodity to a certain extent - the strategic angle you can provide is going to make the difference," says FLAG Squadron's Zhu. "We have seen GPs secure deals at 20% discounts to the market price because they are perceived to be able to add value to the company."

Sector specialization is the most obvious example of how a GP can bring domain knowledge to bear. It is very much a characteristic of the middle market in the US and China appears to be moving in the same direction, albeit gradually. Shaw Kwei concentrates on high-end manufacturing, which often necessitates dealing with companies that have operations in multiple countries. Lunar, meanwhile, targets branded consumer goods businesses that rely on domestic demand.

Both GPs are control-oriented and both are excited about succession planning. Derek Sulger, managing partner at Lunar, notes there were $12 billion worth of consumer buyouts completed in China last year, most of them small- and medium-sized enterprises (SMEs) that meet the firm's investment criteria of being sub-listing in size and generating $100-150 million in annual revenue.

"Only 2% of those consumer buyouts went into private equity hands but that pool is growing dramatically because China has a massive succession problem," Sulger says. "It is a huge opportunity but it is very largely overlooked. I think this is because a lot of people don't have the ability or desire to run these companies and manage them through this transition. It is a very labor-intensive process."

Resources management

This issue of labor intensity gives some LPs pause for thought. When deciding whether or not to back a GP, the first consideration is usually the quality of the team and the track record of individual members. If that box is ticked, the question becomes whether the approach is suitably focused and differentiated from the rest of the market. Furthermore, can this strategy be executed and is its competitive advantage sustainable?

A buyout strategy requires industry knowledge, operational expertise and relevant business networks. For many middle-market China managers it is unknown territory and LPs are not convinced that the bench is deep enough to make the transition from growth deals.

FLAG Squadron's Zhu says he has seen numerous instances of private equity firms enjoying success with one buyout and then seeking to raise a larger fund in order to do more such deals. "We say to GPs, ‘You are doing great on this but look at how many resources it is occupying - it is the single largest deal in the portfolio.' We need to be cautious about the significant additional resources required to replicate this model,'" he explains.

The general view is that minority transactions will continue to account for the bulk of deals in China's middle market. Indeed, Bull Capital is one of a number of GPs not looking to attain control of businesses.

"The best deals are generally state-owned enterprise (SOE) spin-offs and we are not the best positioned to capture those opportunities," says Guillaume Dry, managing director at the firm. "And we are not yet geared or prepared to do transactions where you need real operational knowhow and the ability to change management if needed. We could do it but we would need to add resources."

Bull Capital is looking for opportunities in the industrial sector, where companies want to upgrade their operations and accumulate new technology and expertise, and also in business-to-business services, which is expected to benefit from companies outsourcing non-core functions such as human resources of facilities management. The firm ensures its minority voice is heard by only investing as the lead participant in a round and insisting on a board seat.

Ascendent is also typically a minority investor in deals but makes brings its influence to bear through a merchant banking-style approach to private equity, providing companies with capital in conjunction with advice and solutions. The firm's value-add is strategic rather than operational, but Kevin Zhang, one of the co-founders, told AVCJ last year that this is good fit when working with established industry leaders.

"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," he says. "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."

When working with smaller companies, much rests on a manager's willingness and ability to contribute in areas that can be time-consuming and relatively mundane. Firstly, a typical middle-market company with less than $200 million in revenue is likely to be lacking in back office administration. The accounting department may be weak on cost controls, there may be no enterprise resource planning (ERP) system and no Big Four auditor, and bank relationships could be poor.

Sales and marketing is another area with plenty of scope for improvement. It is not uncommon for middle-market companies to have gained traction through a couple of key sales executives who have strong ties with key clients. This is not a long-term solution and so institutional sales force management is required.

"Then you get into things like rationalizing production facilities, perhaps in areas that made sense once upon a time but don't any longer, and no one wanted to take the hard decision to lay people off," says Shaw of Shaw Kwei. Only once these basic goals have been achieved can the business move forward, drawing up plans for capital investment in new equipment or altering the positioning of brands.

CITIC Capital also pursues a buyout strategy, although with a fund of $925 million it sits at the upper end of the space. Large, relationship-based deals - often club transactions in which the firm gets a piece by virtue of its connections to state-owned CITIC Group - sit alongside SOE restructurings and a handful of middle market companies in the portfolio.

Eric Xin, senior managing director for China private equity at CITIC Capital, explains that smaller deals come into focus in areas where the firm has particular expertise. The GP also finds limited availability in the upper middle market, defined as companies with annual sales of at lesat $80 million, because they are often just waiting for an IPO. At the same time, there is a reluctance to go too small, for the reasons outline above: it means engaging with companies that are generally poor on compliance and have weak management systems.

"It is not practical for us to buy small companies," Xin explains. "For businesses with RMB100-200 million ($16-32 million) or so in sales, we sometimes ended up spending more time on them than on Focus Media [CITIC Capital participated in a $3.5 billion privatization of the display advertising business]. Management teams in these companies generally struggle to think strategically so they need all the help you can give them. You have to get your hands very dirty."

Judgment day

China funds get raised for all kinds of reasons that aren't necessarily tied to track record: a perceived princeling connection that promises access to premium deal flow; a principal who previously worked for a large institutional player and carries with him the goodwill of LPs plus the odd anchor commitment; ties to a domestic brokerage that can tap pre-IPO opportunities; or just maybe an articulate manager with a good story.

The current generation of middle-market funds will ultimately be judged on their ability to generate exits, an area in which some of their forbears fell short. If the strategy plays out and the minority investor is able to guide portfolio companies to new markets and technologies and the buyout deal serves as a platform for an M&A spree, there should be sufficient scale or value to secure decent returns. It helps that entry valuations in the space are said to be reasonable by China standards.

Just as important, these GPs are not wholly dependent on the whims of a narrow set of public markets. According to Schonberger, CDH became wary of listing middle market companies in the past because of the risk of poor liquidity on overseas markets and the uncertainty of listing on the domestic markets. The firm is now more optimistic about the prospects for these companies listing domestically, in spite of the general skepticism that international LPs still have about exits in China.

If that doesn't work, those same private equity firms that vacated the middle market to go up-scale are now ready and willing buyers, as are numerous strategic players. Consolidation is a prevalent theme at all levels of China's economy in response to slowing growth.

"If you invest in mid-market companies with strong growth, these companies will be listable on the China's domestic stock markets. The key risk is timing and execution. So, it's critical to be very disciplined and focus on companies with strong fundamentals and sustainable businesses," Schonberger says. "Today, the middle market looks a lot more interesting than it once did, and it is underserved."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Expansion
• Buyouts
• Fundraising
• China
• buyout
• Growth capital
• Fundraising
• Lunar Capital Management
• Ascendent Capital
• Bull Capital
• Shaw Kwei & Partners
• CITIC Capital
• CDH Investments Management