
Results, however volatile, in China
According to the recent AVCJ Private Equity and Venture Capital Report China 2010, around $12.9 billion was invested into the PRC over 2009, accounting for just under 30% of all private equity investment in Asia, China’s highest total ever by market share.
But, however positive the numbers, seasoned investors on the ground can confirm that whatever the relative attractions, the absolute returns achievable in China may not only be less than its breakneck growth would suggest, but also highly dependent on playing a volatile, fast-developing and completely unique market in just the right way. Become a student before becoming an investor, they warn.
Gaining perspective on the market
Views on China are very much dependant on experience on the ground. The great macro potential of this under-penetrated market is often offset by challenges that require very careful handling to deliver sustainable returns.
Stephen Peel, Managing Partner & Group Head for Greater China, Eurasia, India and Southeast Asia for TPG Capital, compares the first third of the firm’s 16 years in China to Tim Clissold’s book, Mr. China. “We had a terrible experience, and begged and screamed for our money back, which we just about got. We then stayed out of the market for four or five years.” However, he goes on: “The last six years have been very active and very good for us.”
For some, such as Jonathan Zhu, MD at Bain Capital Asia, China’s potential is only matched by its volatility. “China is an incredibly dynamic market,” he notes. “Things change. What today is a hot industry can become a [very unattractive] industry. What today is a market leader can turn into a laggard.”
An investor in China since the early 1990s, Jean Eric Salata, Founder and CEO of Baring Private Equity Asia, has seen volatility in terms of investing across cycles. “China has windows that make it more or less attractive depending on valuation, and on regulatory movements. Last year was a fantastic year for investing in China: we had 75% of or investment activity regionally going into the Chinese market. This year, the market looks terrible. Valuations look high… this is not a terribly interesting market currently.” He adds that volatility in China’s market trends can be fast and furious. “It can change – in fact, I think it has changed in the past two or three weeks, so it can change very quickly.”
Qualifying this, he says, “The current uncertainty which we are experiencing is actually very positive for all of us in the investment business … To the extent that that does bring valuations down, I think it will be a very good time to look again at the market.”
Peel remains very conscious of the need to approach the market carefully, and cautiously. “We are long-term illiquid investors. You have to make calls on value on the way in. You have to make calls on the macro. We believe you can invest long-term illiquid capital in China over the next five years, and you have to make long-term calls on sectors. The next 12 months are going to be a very good time to invest in China.”
Private equity’s place in the sun
Despite concerns over competition from public markets capital, and the wall of government-backed stimulus money that hit the economy in 2008-09, GPs in China do find that the asset class not only has a clear role to play, but also has competitive advantages as a form of capital. For Peel, this is very much a structural question, dictated by larger market factors that show no signs of going away over the next few years.
“Private equity in China, like most markets, fills a gap between the bank markets and public markets,” he emphasizes. “That gap is going to get wider as the banks withdraw capital and the public market valuations fall, and the IPO process – through both liquidity and regulatory factors – makes it tougher for firms to get there.”
Salata, meanwhile, finds, “increasingly a real desire by a certain type of Chinese entrepreneur for more than just capital. There is a whole group of Chinese entrepreneurs who just want capital and the highest [valuation]; but there’s another segment of people who are looking for a way to get to the next level.”
The ripe opportunity for private equity in China to some extent illustrates how far the industry still has to go. “The amount of the capital [flowing] into the private equity business has been greatly exaggerated,” observes Andy Yan, Managing Partner at SAIF Partners. He cites figures putting total private equity investment – VC plus buyout – in China in 2008 at $3.88 billion, with VC investment alone in the US that same year almost ten times that value. “Even if you compare China to Israel, the total VC investment [in Israel] in 2007 is $2.8 billion. So China is just slightly bigger than Israel.”
Competition? It’s a big playing field
The internal capabilities of a private equity investor naturally become differentiators in a market hungry for business improvement support; but paradoxically, many of the firms operating in China report relatively light levels of competition.
“Competition: what competition?” says Yan, referring to his top-down numbers on private equity investment in China. “In our 100 deals, in 96 we were the only investor.”
Salata dismisses any significant effect on deal valuation from rival private equity bidders. “What is much more important is what’s happening in the public markets. And the public markets dwarf whatever’s happening in private equity in terms of capital. Whatever is happening in the public markets has a huge impact on valuations; much more so than the bidders… because pricing is going to be set by the value relative to the public markets.” Peel confirms, “We hope to be price-setters, but we are also influenced by the public markets. The A-share market coming down 20% this year is clearly going to be helpful.”
If anything, more competition might help rather than handicap firms in the market, even when domestic and international GPs are rivals for the opportunities.
“Competition enhances and accelerates market development,” believes Zhu. “If you look at the role that private equity or VC investing plays in an economy, we play an active role in capital formation and resource allocation. There’s got to be a community effect. If you’re the only firm doing this, then the impact is very small, and you don’t develop the market.”
GPs also report little pressure from RMB funds. “We’re closing an RMB fund, and it’s not as easy as people think. There’s not as much money as is reported going into private equity,” Yan reiterates. “China today only has one legitimate LP, which is the State Pension Fund. Other than that, zero: no legitimate LP.”
Convincing China of the PE model
As this discussion suggests, GPs may be moving to offer more offer more and better post-deal business improvement capabilities, but this is not so much about competition between firms. Rather, it is a question of persuading the target company to invite an investor in at all.
“We are doing a lot of top-down research, going into sectors and finding companies that we like,” notes Shirley Chen, MD and Head of Private Equity at China International Capital Corporation (CICC). “A lot of the time, we find companies that we really like. We go there – there’s no PE or VCs there [already] – but the founder may say, ‘I don’t want any money.’”
Zhu believes, “Investing in China is always about a lot of due diligence, and doing a lot of work after the investment to make sure that the outcome you anticipated materializes.”
China also may require more than an organization chart filled with ex-industry professionals to project a differentiating advantage. “In China, what’s very important are your credentials and the references that you bring to a deal,” reports Salata. “If you can come to [the founder] and say, ‘We’ve done two or three or four deals in China, in your sector, here they are, go talk to the CEOs,’ that carries a lot of weight.”
One of the most critical pieces in unlocking China opportunities – often underappreciated by Western investors – is that the vendor is usually the owner, which means he is not just looking for the highest price, he is also judging the firm as a partner. This is where experience and know-how trump valuation and where the heart of the model lies.
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