Private equity goes primetime in China

CHINA RIGHT NOW SITS FRONT AND center in the sights of almost all major investors seeking access to Asian growth. Private equity, no exception to the norm, is delivering a flood-tide of both investments and funds to the Middle Kingdom - China accounted for approaching half of all Asia Pacific fundraising in 2010. And at last, China is delivering measurable returns to international GPs and LPs.

Yet China has also delivered disappointments as well, time and again, in previous cycles, as far back as the ‘Mr. China' days of the early 1990s. Skepticism persists among more seasoned Asian investors, and continuing uncertainty over the proliferation of the RMB private equity ecosystem in parallel to the already complex offshore investment structure adds to the doubts and hesitations. The oft-repeated clichés in investor presentations about redressing centuries of imbalance away from China need to be weighed against actual experience and understanding of the market's true capacity to deliver value - even as a herd of fresh investors flee underperforming Western venues and head East. Whether or not you buy the predictions that China could be the world's largest private equity market - bar none - by 2020, the PRC simply cannot be ignored.

Running the numbers

Statistics clearly demonstrate the extent of China's lead over the rest of Asian private equity. In 2010, the PRC drew almost $13.4 billion of commitments to China-focused funds, according to AVCJ Research figures, against a total of just over $30.2 billion for the whole of Asia Pacific - i.e. 44.2% of all the region's fundraising. Furthermore, this is a 106% increase on the 2009 total. Total private equity capital under management stood at almost $57.4 billion at end 2010, against just under $50 billion at the end of 2009, with China now accounting for just over 22% of total private equity capital in Asia Pacific - its largest share ever.

International investors are clearly voting with their feet on the way in to the China market. "The macro-economic environment in China - robust economic growth and a booming stock market - underpins a great opportunity," affirms Hiro Mizuno, Partner with Coller Capital. "The potential returns for private equity investors are enormous."

On the investment side too, the story continues to be solidly in China's favor. The PRC saw just over $19.7 billion of private equity deals through 2010, according to AVCJ Research data. A healthy increase on the just under $14 billion of deals done in 2009, this figure accounts for 37% of total Asia Pacific private equity investment in 2010.

But it was on the way out that China really stood out in 2010. AVCJ Research stats put the total capital raised from private equity-backed IPOs over the year as $58.4 billion from 208 listings, up from just over $24.8 billion and 88 IPOs for 2009. This was an all-time high figure, topping 2007's pre-crisis total of $57.7 billion. And trade sale exits, while hardly stellar at a few percentage points down on the previous year (a trend reflecting broader patterns in China's M&A market), stayed solid at just over $6.5 billion. And Greater China's bourses - Hong Kong, Shanghai and Shenzhen - together raised more capital in IPOs than their US peers during 2010.

Skeptics might argue that the IPO numbers for 2010 in particular were skewed by the dual listing of Agricultural Bank of China in Hong Kong and Shanghai, which raised over $10.4 billion in the former market, and nearly $8.8 billion in the latter. In these cases, certainly, the ostensible investors were actually semi-sovereign entities - the Kuwait Investment Authority, Qatar Investment Authority, and Temasek Holdings in Hong Kong, and China's own National Council for Social Security Fund in both markets - with only small stakes in the total business, but the wider numbers do bear out both anecdotal and statistical feedback from private investors.

According to some leading institutions, international private equity LPs with Asian programs are now seeing the majority of their returns coming from China, or China-focused investment stories. And a 2010 survey by the INSEAD Global Private Equity Initiative (GPEI) and AXA Private Equity found that the historical returns achieved by LPs from China funds, with some programs dating back well over a decade, were a 2.4x gross multiple - the highest for any region in Asia Pacific, and very close to the 2.6x that the survey's sample of LPs expect, or hope, to achieve in Asia. So the strong returns story from China is demonstrably more than just a statistical blip.

RMB or USD?

The topic of China funds relative performance leads inevitably on to the question of RMB funds - rarely far away now whenever PRC private equity is mentioned. And, the data shows, with good reason. RMB-denominated vehicles accounted for fully 78.3% of all private equity fundraising for China in 2010, according to AVCJ Research.

Unfortunately, this rapidly rising tide is raising all boats, and some of the money piling in to China vehicles of all types is simply going to end up uninvested, or delivering sub-par returns. RMB funds in particular are garnering an unwelcome reputation as mostly poorly conceived short-term pre-IPO speculative vehicles, with poor alignment of interests. But RMB funds are not the only problem; As Matt Fish, Managing Partner with New Pacific Consulting, observes, "this is not an issue of global versus local or RMB versus USD, it's good fund versus bad fund. Today, there are simply a lot of bad fund managers that are having a hard time attracting targets, talent and a track record." But not, however, having a hard time attracting capital.

Signs of relative immaturity in the fund platforms available are all too common. Upsets for investors include such bizarre developments as the recent announcement by Gongquan Wang, founding partner of CDH Venture Partners, the VC arm of market-leading CDH Investments, that he was giving up everything - including his responsibilities to LPs - to elope with his mistress. As Mizuno observes laconically, "China's risk/return profile is really very different from what you see in the developed markets of the US and Europe. It is certainly too early to regard China as a mature and sophisticated private equity market."

For the right China vehicle, though, quality investors will queue up. Take Qiming Ventures Fund III, recently closed at $450 million, with incumbent LPs including Princeton, Robert Wood Johnson Foundation, Siguler Guff, CommonFund, Grove Street Advisors, and Emerald Hill, joined by Harvard University Endowment, and UTIMCO (University of Texas Investment Management Company).

And despite the doubts and uncertainties, the impact of the RMB fund proliferation remains for now one more imponderable to add to the many for China investors. "No-one is yet sure how the emergence of RMB funds will impact USD and offshore funds," Coller's Mizuno believes. "It remains to be seen how Chinese GPs will regard foreign investors in comparison with local funding sources."

Onshore or off?

The continuing debate over RMB funding has led to something of a crisis of confidence among some Western private equity firms in China. Fears are that local entrepreneurs and target companies may overwhelmingly opt for local RMB investors, able to execute quicker with fewer approval hurdles and aim straight for a lucrative and highly valued Shanghai or Shenzhen IPO. But many feel that this has been overstated. "Recently, the relative disadvantages of global fund managers in China have been overblown and oversimplified," remarks Fish. "For a lot of deals, a domestic fund is the clear fit; likewise, for various companies and entrepreneurs, the resources of a leading global fund are ideal."

Douglas Ferguson, Partner in Private Equity Advisory with KPMG in Hong Kong, feels that in fact international GPs can definitely prove their worth as investors. "There are so many ways - technical input, improved processes, supply chain cost savings, integrating and bolting on synergistic companies, financing structures, governance, acting as a critical sounding board, etc. These contributions definitely help when it comes time for an IPO story or trade sale exit in other markets, and the same should hold true in China."

Mizuno also observes that, if anything, local and global GPs have been able to work well alongside each other and build the PRC private equity market from different directions. "China-focused GPs have developed a strong skill set. It's been a win-win situation: global investors and local players have benefited from working with each other."

Fish concludes that, "it's true that, for global buyout funds, two big guns of reputation, and capital, are somewhat less of a competitive differentiator in China. However, as mid-market companies and increasingly seeking operational and strategic input, a few of the global funds are able to clearly stand out."

How to invest in China

However developed the local private equity sector has become, though, investing in Chinese companies remains a challenge at the best of times - though at least GPs from international firms can console themselves that local peers often encounter the same difficulties. From the start, the price at entry is often a considerable hurdle.

Valuations have been a challenge for funds for years now. Mark Qiu, founding CEO and MD of China Renaissance Capital Investment, describes these as, "in hotly-followed sectors (e.g. the internet), very high." But, he adds, in "neglected sectors," levels are likely to be more reasonable.

Ferguson sees no improvement in this regard. Entry valuations, he remarks, are "high still. Many deals that were done in late 2008-09 are looking like wise investment decisions compared to comparable valuations this year. Lots of deals appear stuck in negotiations, where vendors and bidders are re-trading on pricing from original term sheets."

As well as the price, investors in China also need to take a close look at the nature of their target and the reality behind the representations. "Investors often look at a company and see that it has massive sales growth and huge margins," cautions Ben Wootliff, Director and Head of Corporate Investigations, China, with Control Risks. "But once they make the acquisition, they then realize that the sales process is riddled with corruption which - especially considering the increasingly onerous enforcement of the FCPA - they have to get rid of. This drives down revenue and margins. We advise clients that it's better to be aware of these issues early on, even before the letter of intent is signed."

How the market breaks down

The appeal of China's most attractive growth sectors, however, is liable to keep investors coming in the face of the valuation and probity issues. Consumer-focused plays of various kinds are almost a default choice for China investors. "This is a natural evolution for a country very rapidly developing middle- and upper-class tastes," confirms Ferguson. "The domestic consumption thesis is definitely a solid long-term play for private equity."

Qiu, however, sees the problems in simply playing the consumer growth card. "It is a long-term thesis at a very high level," he concedes. "But as an investment strategy, one has to be mindful of timing and competition. Consumers' taste and purchase behavior is expected to evolve rapidly." And investors in these propositions are not necessarily delivering the best results. "It is not that the thesis is not big enough. Rather, investors are not innovative enough. They all go for the same formula en masse." His preference, in contrast, is for, "businesses that help businesses reduce labor intensity, help companies upgrade their products/services, reduce costs of doing business (e-commerce), and improve the general quality of people's lives, such as food security and healthcare."

Ferguson adds that, "historically, healthcare deals in China were geared more towards pharmaceuticals, medical equipment and research and development, but now (with the easing of regulations surrounding foreign investors participation), there is also a buzz around private hospitals. The aged care sector in China is also generating a lot of attention."

Whatever sector is in focus, however, the original founder or promoter is liable to be key to the success of the business, and the fortunes of the investor, no matter what the ostensible structure. Here, GPs may be ready to simply take a less than ideally protected position for the sake of participation. "Many private equity firms we speak to recognize the very key role that the local founding Chairman and shareholders play in driving the company forward, so long as they get some real input into company direction and value creation," notes Ferguson. At the end of the day, though, the private equity investor's situation remains problematic, pending the development of a true market in control. "Minority investors are always going to have issues with their position in any jurisdiction in which they invest," warns Wootliff. "The problem is in China that the few rights which they do have can be difficult to enforce. Trying to get your rights as minority shareholder enforced through the courts is a last resort, and a poor one at that."

But at least, private equity investors in China can be assured of a far more informed and receptive audience than hitherto. Private equity, thanks partly to the government's eagerness to promote the RMB fund ecosystem, is now a popular buzzword, a plot device in TV soaps and a lynchpin for game shows. Whether or not Chinese private equity becomes the asset class's biggest market worldwide, it certainly has carved out a permanent place in the world's future biggest economy - hardly a bad outcome for the industry as a whole.

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• Topics
• Greater China
• Renminbi fund
• People
• Venture
• Fundraising
• Coller Capital
• CDH Investments Management
• Qiming Venture Partners
• Hiromichi Mizuno