Proceed with caution

CHINA'S BRUSH WITH THE GLOBAL economic downturn was relatively light and it was among the first nations to come out the other side. And for all that the events of the last two years have served as a reminder to private equity professionals of the risks tied to investment, interest in China continues unabated. With economic growth still close to double-digit rates, massive levels of foreign direct investment and a fast-growing consumer market, the country remains an attractive prospect for domestic and overseas funds.
Learning the hard way

For the past 15 years, PE players have been deploying top investment veterans in the Greater China region - typically basing them in Hong Kong, with frequent sojourns into the mainland - and their hard work has begun to deliver better-than-decent returns to general and limited partners.

The primary risks have typically concerned regulation. Efforts to restrict "round tripping" - whereby domestic money is taken offshore and re-enters China as foreign capital - and embezzlement in the past threatened to undermine PE investment structures; the introduction of the foreign investment catalogue has limited involvement in sectors in which the government seeks to retain control; and it has taken regulators a long time to develop rules for legal onshore investment structures for foreign PE funds.

The experiences of the Carlyle Group in China are instructive. The purchase of a majority stake in state-owned Xugong Group Construction Machinery was thwarted in 2007 by local opposition and bureaucratic foot-dragging, illustrating the perils of trying large-scale buy-outs in sensitive sectors. Four years on, the exit from China Pacific Insurance in January, with Carlyle earning a six-fold return on its original $800 million investment, was one of the global PE veteran's biggest success stories and a measure of the progress the industry has made.

Yet just a few months ago, news broke that two companies in Carlyle's portfolio - Hong Kong-listed China Forestry and Nasdaq-listed China Agritech - are facing fraud charges. It is a reminder that even the most experienced of investors are not immune from potential management malpractice in Chinese mid-cap firms. But is it a fair reflection of the state of the industry?

"Several private equity players have recently achieved success around high-profile deals, and the market is becoming increasingly attractive to PE players. Still, the media tends to report more extensively on the dramatically unsuccessful PE investments in China as these are often more sensational than the success stories," says Violet Ho, managing director and head of Kroll's operations in China.

The growth niche

But the China Forestry and China Agritech cases are pertinent as these companies represent the typical target for foreign PE investors: privately-owned companies in the growth capital sphere. Fraud risks aside, investors face a number of challenges. First of all, this space is becoming highly competitive, particularly with the emergence of local, renminbi-denominated funds pursuing lucrative exits on domestic exchanges.

A further problem lies in the difference in investment philosophy between private equity and venture capital firms - with the PE approach not necessarily suited to relatively unknown Chinese firms. "PE funds tend to over-rely on the target company's past success in securing financing from angel investors or venture capital firms, and will sometimes invest into the targets based on these assumptions without carrying out their own independent due diligence," says Ho. She stresses the importance of "fresh eyes" able to scrutinize each investment opportunity before major investments are made.

Due to the comparatively small size of the companies and the scarcity of buyout opportunities for political and cultural reasons, deals tend not to be blockbusters. And this is a often a turnoff for Chinese LPs who don't see sufficient value in their involvement. Ho explains that growth investments in are typically minority stakes in companies, and while these deals come with board seats, PE professionals are generally not involved in the day-to-day management of these companies. This limits their ability to make efficiency gains and implement operational expertise.

Ho believes more should be done to educate local Chinese institutional investors, conveying the message that GPs are often long-term players looking to implement value-add initiatives rather than fly-by-night investors only interested in short-term returns.

The number of limited partners has proliferated in China, leading some GPs to say that it is both faster and easier to raise renminbi than US dollars if the fund size is relatively small. However, industry insiders note that LPs have yet to fully come to terms with the investment process. One GP who has been an active investor in China from both dollar- and renminbi-denominated funds says emerging LPs sometimes ask to redeem their committed capital or even secure that committed amount from the investment.

All businesses need to mature before a profitable exit opportunity becomes viable, and that takes time, Ho concludes. The promise of China's growth sometimes blinds GPs and LPs of the immense risks - human or corporate - associated with their portfolio firms.

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

• Topics
• Greater China
• Regulation
• The Carlyle Group