Private equity heads into China’s hinterlands

Developing the country's hinterlands has been on the Chinese government's agenda ever since the establishment of the "Go West" policy more than 10 years ago. State-owned enterprises, foreign strategic investors and - more recently and increasingly - private equity and venture capital firms have responded by making the journey along the Silk Road and put their money to work in emerging commercial centers. Opportunities may abound but the road isn't easy to navigate.

Central to the project is Chongqing municipality and the provinces or regions of Gansu, Guizhou, Qinghai, Shaanxi, Sichuan, Yunnan, Guangxi, Inner Mongolia, Ningxia, Tibet and Xinjiang. Between them they account for nearly three quarters of China's land area but only about one quarter of its economic output. In addition to the headline policy, Beijing has rolled out infrastructure initiatives and ordered minimum wage hikes in a bid to close the wealth gap between costal and interior residents.

Fixed asset investment in western China reached RMB7 trillion ($1.1 trillion) in 2011, three times the 2006 level. More capital is likely to come as the Chengdu-Chongqing Economic Zone, established last year, gathers momentum. The aim is to develop a commercial giant to challenge the Bohai region and the Yangtze and Pearl River Deltas. Its financial and technological heart will be Chongqing's Liangjiang New Area, the third sub-provincial new area in China.

"The Liangjiang New Area could offer preferential policies comparable to, or even more preferential than, those available in the Pudong New Area and Bohai New Area," says Sun Hong, a partner at Norton Rose who specializes in M&A.

TPG Capital has already moved to leverage the opportunities being created, with its RMB5 billion fund, TPG Western China Growth Partners I, partly backed by the Liangjiang New Area Development & Investment Group. The vehicle will target investments that contribute to the development of the area as a financial services and innovation center.

East to west

Both Chengdu and Chongqing offer tax breaks to private equity firms that set up in the region, while the latter is one of four cities nationwide to participate in the Qualified Foreign Limited Partner (QFLP) scheme, through which overseas investors can convert US dollars into renminbi for use in investments.

According to a recent study by Bain & Company and the European Union Chamber of Commerce in China (EUCCC), more than half of all private equity investments in China since 2009 have been in businesses with headquarters in the country's western region.

"While markets in coastal regions and first-tier cities are now overwhelmed by competition and capital, many private equity firms are moving to the destinations - Chongqing and Chengdu in particular - that are hungry for capital, less competitive and ready to provide government-backed preferential treatment," Hong adds.

Derek Sulger, founding partner of Lunar Capital, also sees telling contrasts between coastal and interior regions. "When you look at Shanghai back in 1990s, the arms of entrepreneurs were open wide for PE players to grow their companies," he says. "They are less humble now, while the investment environment in western regions is similar to that of coastal areas 10 years ago."

By the end of last year, Chongqing had registered over 80 private equity and venture capital companies. They include Aktis Capital, which has footprints in both Hong Kong and Singapore, and started its business in Chongqing six years ago. The private equity firm, which has about $100 million in assets under management, launched its Aktis China West Fund in 2010. The vehicle primarily targets consumer and policy-driven sectors in the region, including credit businesses for small- and medium-sized enterprises, affordable housing and domestic tourism.

"Chongqing, as a transportation and logistics hub, has been a backbone for western China's growth," Eric Slighton, a partner of Aktis Capital, tells AVCJ. "The rapid growth in tourism, for example, is a direct result of the increasing domestic wealth and consumption power of people in China."

Lunar Capital, a private equity group that positions itself for spreading urbanization and China's inward development, set up an office in Chengdu over five years ago. While manufacturing and commodities are a draw or many investors in the region, Lunar Capital tends to focus on assets in the consumer products and services and agricultural spaces.

Part of the rationale is an increasing consciousness of food safety among consumers in western China. This is in part a natural byproduct of rising disposable incomes and the transformation of subsistence-level citizens into consumers with the spending power to make brand-based purchasing decisions.

Lunar Capital this week agreed to pay $50 million for a 60% stake in Sichuan Zhiqiang Group, a local beverage brand. The private equity firm and Sichuan Zhiqiang's original shareholders will form a joint venture to own and operate the business. The former head of Vitasoy China has been installed as CEO and Sulger will serve as chairman.

"The reality is that people still underestimate the power of consumers in central and western China," Sulger explains. "Consumers in western China will be far more aggressive and important to both Chinese and global growth in the coming decade, so understanding their needs and behavior is critical."

Human capital

For all the tax breaks and subsidies that local governments in China's hinterlands offer to private equity firms, little thought is given to building up a professional environment capable of sustaining the industry in the long term.

"In the absence of a well-thought-out regulatory system, investors may either be hesitant to go west, or position themselves to take advantage of the short-term incentives by exiting quickly after getting the first pot of gold, " Norton Rose's Hong says.

Lunar Capital's Sulger also adds that some larger international funds are still flying in and out to look at the PIPE deals or pre-IPO investments rather than transactions that involve a high degree of operational involvement. "I believe private equity firms targeting these regions must understand operations and add tangible value, versus doing due diligence from afar," he says. "We try to be actively involved in running these companies - by buying majority stakes and allocating operating individuals to their management boards."

This view is endorsed by other industry participants who note that Western China is not an ideal environment for private equity to do passive financial investments because there are limited established assets with experienced operating techniques. On the other hand, adding value in western China is complicated by the shortage of qualified transactional and operational professionals.

This shortage of human capital is generally acknowledged as the major challenge of investing in the region - and LPS are said to be increasingly skeptical of GPs who claim western China as an area of focus yet have few feet on the ground. In areas where private equity is still a relatively unknown quantity among entrepreneurs, local networks are crucial for deal-sourcing and local knowledge helps deployed capital work more effectively.

"Western China is at the stage where it is only just developing its experience with foreign investment," says Slighton. "Experience does not come out from thin air and the role of a foreign team is to bring in an international operation model that is tailored to the western region from the outset."

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• Topics
• Greater China
• Investments
• China
• Lunar Capital Management
• TPG Capital
• Aktis Capital