What’s in private equity for China?

Studies of the effect that China’s nascent private equity industry has had on the country’s overall economy – in which it is a still small, but very proactive element – have been limited-to-none, depending on how one categorizes these things. But a recent European Union Chamber of Commerce/Bain & Company joint survey – taking in as it does the social as well as economic impact – is unique.

As to how it came about, Andre Loesekrug-Pietri, chair of the Private Equity & Strategic M&A Working Group at the European Union Chamber of Commerce in China (EUCC) says it grew out of a sort of ten-year celebration of private equity activity in China. The EUCC reckoned there was too little data on the broader economic and social impact of the asset class in the country and decided to fill the gap.

“We think everything is linked to the social change happening here,” he told AVCJ. “Also, what we’ve seen in many countries, even those that are the most pro-private equity, is that at some point you inevitably have one, or even a few, cases of scandal or reports of people being laid off, at the same time when there’s a big carried interest waterfall for the team, which is shocking. We’ve seen it in the US. And in the UK, where four years or so back one such story emerged and shortly after there was a bill in the House of Commons proposing a raise in the carried interest taxation from 10% to 40%. Obviously, we’d like to avoid that.”

So EUCC approached a number of consultancies which had access to significant numbers of funds and deals, plus the people and procedures needed to do credible market studies, analysis and statistics – and were at the same time independent of EUCC. In the end, Bain & Company was chosen.

Comments Bain partner Weiwen Han, who headed their team on the project:

“We thought it was a good time to do this because private equity investment had fallen to a low point, sparking speculation as to whether the asset class had been hamstrung long-term, and also about the real performance of private equity-backed portfolio companies.”

A wave of public approval

Taken overall, the results are complimentary to private equity. For example, among the report’s more interesting claims is that private equity is widely perceived as having helped drive China’s remarkable economic growth story over the past few years, and by a much wider swathe of people than its immediate financial services peers; in particular , by the Chinese government, and stakeholders such as  entrepreneurs and company management teams. These feel that the private equity effort has created jobs along with entrepreneurial success.

This attitude stands in sharp contrast to the way private equity has been viewed in Japan and Korea, to name just two other jurisdictions in Asia.

But the EUCC study also cautions that this could all change if, for example, ongoing financial turmoil prompted poor returns, or stories of questionable management behavior, or evidence of failed deals.

As to hard data indicators – based on Bain’s data compilation – here are some interesting samples on the social impact side of the equation: private equity-backed companies have increased their numbers of employees by 16% over the survey period; the equivalent number among publicly-listed companies was 8%.

(The study examined the period from 2002-08, and included more than 50% of all private equity investments over the period. Deals closed after 2006 were excluded in favor of enabling the tracking of post-investment performance for a minimum of two years.)

So back on the social findings, not only did private equity-backed companies generate 50% more new employment than their public sector counterparts, salary growth rates among them were also 7% higher; and they tended to hire better-trained candidates and thereby increase job quality as well as quantity, which the study concludes, is “… helping to move China’s economy towards greater domestic consumption and more social stability.”

Retail sector complexities

“When you talk to a lot of private equity funds, they’ll tell you that, while every segment is complicated, retail in particular, in a fast-growing market like China, requires huge amounts of skills,” Loesekrug-Pietri explains. “And the difference in performance between the private equity-backed, consumer-linked companies and the listed ones is the biggest among the six industries we surveyed. This suggests that the value add that a private equity house can have for a retail business – because it mixes marketing skills, product development skills, logistics skills, fast expansion skills, financial skills and the adept handling of working capital issues – adds up to this segment being the one where private equity investment is best deployed.”

He further notes that the listed companies in the PRC, because of the long lines of companies waiting to be listed, are assumed to be generally the best-performing companies in the country.

“That means that if they generate a 16% increase in revenues and profits versus the 47% gain shown by private equity-backed retail entities, the benchmark is already relatively high. We think this is very interesting.”

The study did not differentiate between international and domestic private equity funds, partly because, during the time period under surveillance, the latter had barely begun to be an important new factor. Plus, there was the complex issue of defining exactly what constitutes a domestic fund.

LBOs insignificant

Both Loesekrug-Pietri and Bain partner Han point out that 90% of the deals covered were either growth capital or venture capital. So unlike the phenomenon seen in the US and Europe over the past few years, LBOs in the Chinese market were a non-starter.

“There are good reasons for that,” Petri contends. “First, buyouts don’t happen simply because you want to do buyouts. Rather it’s because a carve-out is in the offing and the company management can’t take the majority (of shares) because they don’t have enough money. Or there are generational issues, all these entrepreneurs who set up their companies in the 1960s and 1970s who started selling out in the late 1990s and early years of this new century because they had no successor.”

These two were the main factors driving the LBO activity in the West, plus an identifiable pattern of relatively stable cash flows and relatively low growth.

“In China, it’s a very different pattern,” he continues. “There you have fast-growing companies, profitable companies, but usually very tight on cash because the cash is needed for working capital to be ploughed back into expansion and so on. 99% of the companies we see are first generation. So you’re essentially talking minority positions because people think that the upside is still in front of them, not behind. Thus leverage is a very small consideration.

Exits

Another indicator that private equity is a real factor in improving PRC companies can be seen in the overall exits mix.

Worldwide, typically 75% of exits happen via trade sales or management buyouts, compared to about 25% via IPOs. In China, it’s the opposite Loesekrug-Pietri says, and this preponderance is evident even when compared to other jurisdictions in Asia.

A key factor underlying China’s IPO exit dominance is rooted in measures taken on financial markets there since 2006 aimed at increasing the number of shares available for purchase. This grew out of a chronic shortage of paper in the years before.

“The simple fact of this big, growing and constant flow of IPOs with new products to buy for retail and institutional investors alike was obviously fuelled by private equity, in part because of the criteria that needed to be met in order to get a listing,” Loesekrug-Pietri notes. “First, companies seeking to list obviously needed to show they are profitable. And while private equity isn’t needed for that, it can be a big help. Secondly, they needed to show they were fast-growing which again provided an incentive for private equity involvement. And thirdly, they needed to have relatively good governance, audited accounts and so on.

“We found that there was a kind of virtuous circle shaping up, evidenced by the fact that by 2007 a lot of companies didn’t have to be pushed for audited accounts anymore – the push having been already provided by the IPO criteria.”

In reverse, it was very useful for the private equity funds to have this pressure because while having high potential for IPO exits and liquidity is a staple objective for them more than any other type of investor.

Further bolstering this, the fascination with IPOs is unlikely to diminish in China because it is multi-faceted, comprised of desirable visibility and social status for the entrepreneur as well as a means to raise capital.

R&D enhancement

Another key finding on the social side, according to the study, is that private equity funds provided more resources for research and development in investee companies than did companies in the public sector, while also helping to ensure that these directed their R&D spending to clearly identified goals.

As one private equity fund manager put it:

“We help to create a framework for prioritizing R&D opportunities and put in place criteria for decisions around R&D investment.”

This goes beyond the amount spent, though that itself is about three times more vis-à-vis the percentage of sales in private equity-backed companies (1.8%) compared to listed companies (0.6%).

Overall, the big theme that became clear was focus: the capacity to focus on priorities rather than spreading the R&D funding over a lot of different projects. Just as important is having real teams.

The problem with R&D seems to be is what, precisely, is R&D? Are the people involved actually improving processes? Or are they in labs that are essentially separate from the company? You can be very much an ‘R’. But that doesn’t necessarily transmit to product development, for instance.

“You need specific teams because of specific allocations and responsibilities,” Loesekrug-Pietri explains. “This seems to produce better results.”

There’s also the push to patents to consider. There has to be a readiness to spend the money because a patent is an investment. And it’s a risk too because the process involves disclosing confidential information in exchange for protection. But first you need to disclose.

Go west, young entrepreneur

Another, and at first glance somewhat curious, social impact the report cites is how private equity is contributing to China’s ‘Go West’ policies. It’s claimed that since 2002 private equity investments have flowed more or less evenly to the hinterlands as well as the much better known eastern coastal destinations.

“From an investment standpoint, the government has its influence as to where the economic river is flowing, so to speak. But from a strictly private equity investment perspective, inland cities, Tier 2 and 3 particularly over the recent stressed period and maybe even longer, have provided two things. One is stability. During the crisis a lot of coastal cities much more focused on exports actually got harder hit than the inland cities. Actually, many of these didn’t get hit at all,” explains Weiwen Han, Bain’s project leader. “But the main point is that these Tier 2,3 and even 4 cities are where growth is entering a takeoff stage; so they offer better growth prospects for investments made.”

The inland investment curve had been accelerating prior to 2008, when it leveled with inland companies attracting $5.6 billion in total private equity deals over $20 million.

Loesekrug-Pietri concurs and adds that while government concern over growing social and economic imbalances between inland and coastal regions, the GFC provided a tough test to rank regional growth with. The result? The hinterland tracked as performing at 7-10x that seen on the coast. There’s also probably only one international private equity fund represented in, say, Chengdu compared to Shanghai. The competition can be scorching, so it too is spurring the move west.

Loesekrug-Pietri makes another interesting point in emphasizing that thus far the private equity impact on Chinese stock markets has been marginal:

“When you look at the number of deals, the number of listed companies, there are 2,400 of them. I’d estimate maybe 1,500 of these are in Shanghai or Shenzhen. Whereas when you look at the total number of deals done over our 6 year survey period, there were about 170 over $20 million (though many more below),” he says.

“Yet 20 out of the first batch of 28 companies listed on the new ChiNext Growth Enterprise Board in Shenzhen, the country’s third bourse launched last October, have private equity in their equity structure.”

Food for thought.

But in the here and now, AVCJ data indicates that last year’s general breakdown across Asia of investments by investment stage showed buyouts once again in front, comprising 56.4% of all deal activity over the year, aggregately valued at about $30 billion. PIPE financings added a further 20.5% in the runner-up slot ($10.8 billion) with growth capital third with 12% ($6.4 billion). Also, depending on what criteria are used to demarcate the various categories, consumer products and services investments amounted to just 6.2% of the year’s volume ($3.3 billion).

Nevertheless, private equity’s effort in China has been inarguably significant, and there are results that underscore this. So sometimes success is best viewed as a journey rather than a destination.

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• Topics
• Greater China
• Performance