China: Hope and Reality?

Asia ex-Japan is likely to see 8% GDP growth this year, much of it driven by direct or spillover benefits from the domestic banking stimulus packages pumped into the Chinese economy. The recovery of US consumer demand – and with it, the ballooning US import-driven trade deficit – implies that even the supposedly lost, ultimate destination for China’s manufacturing businesses has returned. But concerns over a real estate bubble, and recent worrying cases such as the attempted removal of Bain Capital’s directors from GOME Electrical Holdings and the legal struggles of investors in Hunan Taizinai Group, come as a warning that the returns from investing in China are attended by very real risk. As the AVCJ Private Equity & Venture Forum China 2010 convenes in Beijing, PRC investing is well due a balanced assessment.

The China investment climate

Institutional investors worldwide are naturally keen to tap into one of the major remaining reservoirs of growth in the global economy, but participants in the investment story are careful to temper their positive assessments with proper consideration of the potential downsides.

“Generally, we are positive. We see a lot of opportunity,” avers Johannes Schoeter, Founding Partner at China New Enterprise Investment.  “However, we are watching very closely the real estate economy. In a scenario where share prices have come down, real estate prices have continued to rise, and again are at a point where they are unaffordable for many. This may cause the government to take measures that will have an impact on general economic growth.”

Mark Qiu, CEO and MD of China Renaissance Capital Investment, sees an overall, beneficial qualitative improvement in the private equity ecosystem in the PRC. “The private equity investment environment in China is getting rational and active. Deals are getting done. We start to see more valuation discipline and thematic focus by fund managers.”

Overall M&A interest is also giving valuable exit visibility to the market. “We are seeing a lot of strategic M&A in the market, including domestic and regional consolidation plans, and a number of sectors where there is a great deal of interest, such as cleantech, healthcare, consumer and e-commerce,” says Sherry Yin, Partner with Morrison & Foerster in Beijing. “While the multiples may not be as high as they would be for an IPO, the opportunity for such exits seems to be re-invigorating the interest of PE/VC funds to make investments in China.”

Schoeter feels that although the real estate bubble is probably the biggest immediate risk to the economy, it may be overstated. “The real demand in China is there. There are many more people wanting to buy apartments in China than there are [apartments that are] available, or affordable.”

And investor sentiment and LP commitment does seem to be recovering. “The fundraising environment appears to be improving,” Qiu notes. “New managers appear to be able to raise substantial amounts of money. It is always a good sign.”

Regulation, access and risk

China, however, is not always the easiest market to access, not least given the regulatory constraints on outside investor access to various sectors. “From a regulatory perspective, it is a mixed situation,” says John Gu, China Tax Partner at KPMG. “It is positive in certain sectors, such as retail, healthcare, green energy and technology, due to changes of government policy to promote domestic consumption and to upgrade industrial structures, while it is negative in sectors such as real estate (to restrict financing and curtail prices) and steel (to scale down energy-inefficient plants), where government policy has impacted negatively.”

Markus Ableitinger, Director and Head of Asia Investment Management at Capital Dynamics, makes an objective evaluation of the opportunities in China – and the risks. “In terms of regulatory risks, international risks, market risks, we made a bit of a bet that this is outweighed by the opportunities.”

Schoeter sees one source of deal flow in China that is unlikely to dry up without a major shift in PRC political priorities and banking policies. “The main reason there are so many deals is that Chinese banks do not give long-term funding to SMEs. Everywhere in the developed world, the banking sector is the major funding source for SMEs, but not so in China. No matter how much private equity you raise, you can never make up for a gap that is caused by a dysfunction in the banking system.”

And Ableitinger concludes that what keeps Capital Dynamics investing in China is, “the potential of having a couple of percentage points more of return. That’s what everyone is after. So if we think about a 15-20% IRR from GPs in the US and Europe, we generalize and say 500 basis points more; it should be achievable.”

The RMB revolution

China’s development of a separate but parallel RMB private equity ecosystem, running alongside the established US dollar-denominated private equity platform, is not just a striking development for the market – it is also historically unique. “How it works is unprecedented,” Ableitinger points out. “In the whole of history, as far as I know, there has never been a dual management of funds with dual terms, and different audiences.”

Debate continues on what the consequences for China private equity will be, for good or ill. “RMB funds are a positive development for China’s private equity industry,” avers Qiu. “Fundraising outside China for many talented local managers has always been an obstacle. RMB funding enables more talented players to become participants.”

Ableitinger, however, feels that the current crop of RMB funds at least is in danger of dragging down standards in the industry overall. “There’s too much inexperience within these RMB fund teams.”

“I think it will be a mixed picture,” says Jack Lange, Partner at Paul, Weiss, Rifkind, Wharton & Garrison. “Having powerful local players involved in private equity on a substantial scale is bound to be good for the industry as a whole - giving it greater acceptability, and political and regulatory ‘cover.’ But the domestic funds will be tough competitors for the international players, since they will have generally better access to deal flow and, for a variety of reasons, will be able to close deals faster.”

Schoeter also feels that RMB funds, mostly formed by relatively inexperienced local teams, can impact the whole sector negatively. “Very often, compared with foreign-run funds, they are less disciplined. They very often have no sense for risk. They just think growth of a company will continue to happen, and as a result, they are willing to pay very high prices.”

Some market participants and observers find fears of RMB/USD fund competition overblown. “For middle-market deals we have seen less competition between RMB and foreign funds than previously expected,” notes Matt Fish, Managing Director at New Pacific Consulting. “Basically, this has been a function of entrepreneurs having a real preference or bias towards the type of fund they are comfortable partnering with and the role they expect the financial partner to play.”

“When we look for deals, we almost never bump into competition from foreign-managed funds. We are beginning to experience situations where we are close to a deal, and an RMB fund comes along and offers a much higher valuation,” cautions Schoeter. However, he adds, “that’s a minority of situations.”

There is also the risk of competition of a different kind: for access to funds and GPs, rather than deals. “For international investors, at some point, they may have to start to compete for access to quality managers as a result of increasing availability of local funding,” Qiu points out. “But on the other hand, it broadens the talent pool for them as well. Results break the language barrier.”

“RMB funds allow GPs to access a pool of Chinese LPs that have not traditionally been active in the private equity landscape,” remarks Yin. “However, there are still a number of differences between the expectations and time horizons among foreign and domestic LPs, and therefore foreign LPs will remain in demand for the foreseeable future.”

“From an international investors’ perspective, the impact of the growth of RMB funds on deals probably remains neutral, on the basis that there is not yet any reported case where offshore international funds are losing out to RMB funds,” concludes Gu. “However, the current restrictions on foreign exchange conversion for international investors to invest in RMB funds, and unclear rules to permit international investors to directly invest in local RMB funds, may create negative impacts for these investors.”

Factors in China investing success

The ingredients for a successful investment into a Chinese company obviously vary, but many firms, both domestic and international, return to particular themes as especially important when trying to select an investment target and develop it successfully post-investment.

“There are some areas where almost all Chinese companies need support,” Schoeter remarks, citing: “corporate governance, which is controlling management information systems,” and “professionalization of marketing and channel management.”
“Post-crisis China-focused funds have placed a much greater importance on commercial due diligence and strategic/operational portfolio involvement,” observes Fish – a trend similar to private equity firms worldwide.

One definite development is a big increase in China GPs’ prioritization of operational improvement, with staffing up to match. “A manager has many ways to help maximize the value of investees,” says Qiu. “The most fundamental of all, of course, is to help improve the operating matrix.”

“Pre-crisis we could count the number of China-based operating partners on one hand; today we are having trouble keeping up with all the new operating professionals in Beijing and Shanghai,” notes Fish.

“Skillful foreign funds should also be able to leverage their international networks of portfolio companies to bring benefits to their Chinese portfolio companies and help them to go global,” notes Lange. “It will be a while before domestic funds will be able to replicate those benefits – although that day will come too.”

Local versus foreign firms in the market

Questions of deal access and post-deal value creation, allied with the RMB fund dichotomy already discussed, sharpen the distinctions between local and international funds in China. But the differences between the two may not permit any easy or convenient breakdown for investors seeking to enter the market with one or the other.

Seeing no consistent trend, Schoeter maintains that “You really have to look at it case by case.” But he does point out that, “Nothing is easy in China. It is a complex environment. It has a lot of opportunity, and a high degree of complexity. If you understand the rules, you can minimize your risk. But if you are not sufficiently deeply rooted locally, and are not very disciplined in applying international standard practices, then you just will not have the same standard of execution that you would expect in a mature market.”

“Local funds can access certain sectors, banks and media for instance, without too many impediments,” as Qiu points out. “They are often more local hence able to access deals earlier than [their] peers. International funds are more institutionalized. They offer LPs more legal protection. They tend to have less LP interference and broader access to global capital markets.”

Ableitinger sees some professionalization and maturation among the local funds. This goes along with healthy internal competition, and structures to institutionalize and perpetuate these initiatives. However, he also sees high barriers against widening this trend. “You can only do that when you reach a certain size, and you need money for it. It’s tough for a young firm to aim for that, but you’re going to need it, and it’s going to be tough without it in this environment.”

“There will always be some important roles for the leading foreign funds,” says Lange. “Many Chinese companies – both private companies and SOEs – will prefer not to get too deeply intertwined with politically powerful local financiers. Frankly, they may think of foreign funds as being a bit easier to keep under control. And the brand-name foreign funds will always be helpful as a ‘seal of approval’ in marketing an IPO, so they will be able to continue to work the private/public arbitrage.” 

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• Topics
• Greater China
• Performance
• LPs
• Renminbi fund
• Markus Ableitinger
• Mark Qiu
• Johannes Schoeter
• Capital Dynamics
• CNEI
• China Renaissance Capital Investment