China exits: Liquidity lags

CDH Investments returned $1 billion to investors in 2013. It was on course to repeat the feat last year - indeed, the distributions were actually made - when a weak quarter and poor public relations conspired to undermine a partial exit from pork producer WH Group.

The China-focused PE firm first invested in WH Group in 2006. It has backed the company across four funds, supporting the acquisition of US-based Smithfield Foods and then taking WH Group public in Hong Kong via a $2 billion offering last August. However, CDH did not sell any shares in the IPO.

Keen to return capital to investors in the early funds, CDH found a way around the one-year lock-up by pledging shares in WH Group in return for a $500 million loan. This was distributed to LPs. However, shares in the company dropped by around one quarter shortly afterwards, triggering margin calls that required CDH to increase the size of the pledge. The private equity firm decided to cut its losses - interest payments and fees - and repay the loan, which meant asking LPs to give back the money.

The problems were three-fold, says a source close to the firm. First, WH Group reported disappointing third-quarter earnings; second, the chairman bought shares in both the Hong Kong-listed entity and its Shenzhen-listed subsidiary, but only the latter was publicized, which made investors question the parent business; and third, there were rumors that a major shareholder was selling down aggressively.

"There has been a huge focus internally to distribute cash," the source adds. "A pledge is great if you are on an upward trend and the initial reception from investors was positive. But if the situation turns sour then you have a problem."

Investors in CDH's early funds will still get their stellar return on WH Group and this should ease memories of the botched pledge. But the fact that a PE firm with a strong track record on exits opted for a relatively unusual means of achieving distributions is arguably an indication of the pressure all China GPs are under.

At least WH Group achieved a public listing. More than 2,500 growth capital investments were made in China between 2007 and 2011. In the last five years there have been fewer than 700 private equity-backed IPOs and not many more actual exits. The government-imposed embargo on domestic share offerings ended more than a year ago, but there are still concerns about the pace of distributions.

"There is more activity but for those that haven't done anything the pressure is even greater. Other people are exiting so if you aren't it puts you in a bad light," says Brooke Zhou, executive director for Asia Pacific private equity at LGT Capital Partners. "It really depends on the quality of the portfolio and the sophistication or capabilities of the GP."

Exits by numbers

China private equity exits were reasonably robust in 2014, coming in at $12.6 billion in 2014, the fourth-highest total on record. However, VC and technology investors saw most of the action. IPOs accounted for $2.99 billion of last year's exit proceeds, with Alibaba Group and JD.com's New York offerings were between them responsible for $4 of every $5 exited.

Those same two IPOs were also the reason why the cumulative proceeds of offerings by PE-backed Chinese companies reached $52.8 billion. This was generated by 114 IPOs, more than three times as many as in 2013 during the ban on share offerings. But it is still 100 short of the 2010 total when companies raised $61.4 billion.

This was when early investments by US dollar- and renminbi-denominated funds paid off handsomely with lucrative listings in Hong Kong, Shanghai and Shenzhen. The returns achieved in these vintages prompted the surge in China-focused fundraising - particularly on the renminbi side - that created the dilemma now confronting many managers: Passive minority Investments made at heady valuations in companies that may not be of sufficient quality to go public.

The ban was intended to give the regulators time to sort wheat from chaff. Since then listings have come at a more measured pace. There were 62 offerings last year on the Shanghai and Shenzhen A-share markets and on Shenzhen's Chinext and SME Board. In 2010, Chinext alone saw 56 PE-backed IPOs. Meanwhile, Hong Kong remains active - 37 IPOs in 2014 compared to 40 in 2010 - but it is a highly selective market.

One manager notes that he has two companies in the pipeline for A-share listings but doesn't expect them to list until the end of this year or the first half of next year. It is a fairly typical observation.

In this context, the PE industry has a lot riding on China's imminent switch from an approval-based IPO system in mainland China to a market-oriented registration model. There will be stricter disclosure requirements and tighter controls on when and how major shareholders can pare their stakes, but the securities regulator has promised to release its hold on the listing process and let investors have a greater say in which companies should be allowed to sell shares.

"The situation will improve because of the significant reforms that will be implemented. In theory, all companies that are compliant will be able to go public - the government will no longer be in a position to judge business fundamentals," says Ally Zhang, managing director at Siguler Guff.

The implication is that there will be more IPOs. Zhang adds that this should redress the supply-demand imbalance of high growth companies causing high offering prices and price-to-earnings multiples. It has also been suggested that China's registration-based system will ultimately follow that of the US and permit loss-making companies to go public. This would open the door to internet companies that have traditionally gravitated towards US bourses.

A total of 591 companies were waiting for regulatory approval to list in Shanghai or Shenzhen as of February, according to HSBC - 251 on the main board, 125 on the SME Board and 212 on Chinext. It estimates the market can accommodate 300 IPOs this year, up from 125 in 2013 (this includes companies with no private equity backing). Most of these will be small and medium-sized enterprises listing on Chinext.

Amended regulations are likely to be introduced during 2015, but uncertainties remain as to the pace and extent of the reforms. Sammuel Zhao, a partner at law firm Jun He, questions whether the domestic market has the infrastructure required to support a truly market-oriented system. He notes that it "all depends on the regulators' willpower to make it work."

Other options

Some private equity firms, unwilling to bet their fortunes on the chance of a smooth transition, have already responded by looking for alternative routes to liquidity.

"There are a handful of savvy groups that have mitigated the A-share market completely and pushed for M&A-style exits or restructured businesses offshore to list in Hong Kong or elsewhere," says Jonathan English, managing director at Portfolio Advisors. "Groups that have some international component by team make-up or training have been able to find different avenues to provide liquidity to LPs."

Exercising a put options and asking the company founder to redeem the shares is a possibility, usually in situations where performance has not met expectations. These are a standard feature of many investment agreements, although they have to be structured so that it is in the founder's interests to comply. CDH is said to have completed two redemptions in the past three months, securing returns of around 1.5x on Jianhua Concrete Pile and Jinhaiwan Shipping.

There are also an increasing number of reverse mergers, whereby a listed shell absorbs the privately-held portfolio company. Most recently, Meinian Onehealth Healthcare Group announced that it would be acquired by Jiangsu Sanyou Group in a deal worth about RMB5.54 billion ($892 million). This will provide a liquidity event for The Carlyle Group, Cathay Capital and GGV Capital, among others.

Another route is the sale of a position to a strategic or secondary buyer. In the last couple of years, as China's large listed internet companies have started to become acquisitive, a well-trodden path has emerged in the technology space whereby start-ups are picked off by a Baidu or an Alibaba before they are ready for an IPO. Industry participants now see a similar phenomenon in other parts of the economy.

"The exit multiples for trade sales are lower than for IPOs, but at least you have certainty," adds Johannes Schoeter, founding partner at CNEI. "You receive the money immediately and you have no dilution. An IPO procedure in China is lengthy and there is always a lot of uncertainty."

Existing PE investors agitating for an exit are not the only driving factor in these transactions. First of all, founders are more open to selling their businesses. They may be approaching retirement age and have no one from the younger generation of their families willing or able to assume leadership. Alternatively, a full exit might be desirable due to a more challenging commercial environment or a recognition that they cannot take the company to the next level without external capital and expertise.

Furthermore, a range of industries in China are ripe for consolidation and there are plenty of listed companies keen to pick of their peers in order to open up new avenues of growth. Chinese M&A came to $454.1 billion last year, comfortably the largest annual total on record, with more than 5,200 deals announced. Domestic companies are the principal actors, accounting for three quarters of transaction value, compared to 61% in 2013 and 54% in 2012, according to Thomson Reuters.

Private equity trade sales reached to $5.05 billion in 2014, down from $7.07 billion the previous year, although this was partly due to one very large transaction in 2013 - Baidu's acquisition of VC-backed 91 Wireless. However, 2014 saw more trade sale exits than ever before with 75, up from 56 in 2013.

Secondary solutions

Xuong Liu, managing director and head of the Shanghai-based transaction advisory group at Alvarez & Marsal, observes that the consolidation theme can equally apply to secondary buyouts. There is an opportunity for large country or pan-regional funds to build platform investments with a view to exiting them to multinationals that want a ready-made and well-governed footprint in China.

At the same time, others see secondary sales as potentially problematic and a combination of anecdotal evidence and AVCJ Research's records indicate that few have taken place, at least among the US dollar funds. This includes a cluster of full buyouts where the incoming PE investor assumed control of the business, notably CVC Capital Partners' acquisitions of education company EIC Group and restaurant chain South Beauty, which provided exits for minority shareholders Actis and CDH, respectively.

In situations where the founder still holds a majority stake in the company there has to be a willingness to work with a new PE investor. If alignment with the original backer has broken down over the lack of an IPO, sentiment towards the asset class as a whole might have soured. The founder must have a real need for financial and strategic support, while the onus is on the new investor to sell its qualities as a partner.

Similarly, when a controlling interest is put on the block - and it is not already private equity-controlled - the founder has to be comfortable that his creation is being placed in responsible hands. The natural synergies offered by a strategic buyer might be more convincing, although the dynamics vary deal-by-deal. For example, a sale to a domestic rival could be even less appetizing, particularly if the founder wants to retain a minority position.

Then there is the issue of valuations and how desperate a GP is to exit. "There is a lot of talk on trying to find solutions because some of these funds are long in the tooth and light in liquidity and under pressure from the LP base and trying to earn a carry check," says Portfolio Advisors' English. "But the market is bifurcated. If you have been able to generate some liquidity and are at or above your hurdle it's a very different proposition than if you are a zombie-like fund."

There is a sense of soon-but-not-yet, with LGT's Zhou adding that this will become a more serious issue for 2006-2007 vintage funds in the next 24 months. The spurt in renminbi fundraising came later but many of these local vehicles have terms of seven years or less, so the day of reckoning is also looming.

However, Paul DiGiacomo, a managing director at transaction advisor BDA, claims these situations are increasingly common in the deals he is working on. They include PE-backed companies that were primed for IPOs that never happened, leaving the investors to pursue other exit options.

"Let's not pretend that a lot of these are going to get to fruition, but how many minority positions are there in China? Thousands," he says. "It used to be very hard to get a fund to look at another private equity deal in China - perhaps because there is a stigma associated with having to buy someone else's deal rather than finding your own. That has disappeared to the extent that when we bring good businesses to market we will get 10-20 private equity bids. Those will start to get across the line."

Buyout central?

This in turn impacts how GPs address China from an investment perspective. The maturing corporate environment is generating more buyout opportunities; while at the same time private equity firms have learnt the importance of controlling their own destiny in terms of exits.

Control deals now form part of many China investment theses and if these strategies are properly executed exits will become more diversified. It is a gradual process and minority deals - for which IPOs are the logical target - should continue to dominate the market for the foreseeable future, but the previous overreliance on these unpredictable liquidity events will ease.

LPs are divided on how quickly the market is moving. Dayi Sun, a managing director at fund-of-funds Jade Invest, says his firm is already looking for GPs pursuing buyout strategies; John Qu, vice general manager at China Reinsurance, is more circumspect, noting that it will take time for a steady stream of control deals to emerge and questioning how many large-scale transactions are really available.

Moreover, the pressure is now on GPs to shed their passive investor skins and show they can build good businesses.  

"Pre-IPO deals have become more difficult so investors have to look at other strategies. We are seeing more control deals - where equity checks are getting larger and the ability to affect a change in a company is greater," says Liu of Alvarez & Marsal. "Doing buyouts also increases the risk profile because you are acquiring the whole business, you're running it and you are responsible for it."

 

SIDEBAR: The OTC transition

China's ban on new share listings was lifted last year, but nearly 600 applicants are still waiting approval to list on the Shanghai and Shenzhen exchanges. Facing this bottleneck, domestic fund managers are increasingly looking to the New Third Board - formerly known as the National Equity Exchange and Quotation (NEEQ) - as an exit channel.

Last year the board saw more than 1,500 listings - a threefold gain on 2013 - mostly by PE-backed companies. Fundraising totaled RMB13 billion ($2 billion) last year, up from RMB1 billion in 2013.

"We feel that the Third Board presents a valuable exit alternative for our portfolios and must be observed closely. Ideally we should run one or more of our deals through the Third Board process so that we go through the entire learning curve quickly," says Johannes Schoeter, founding partner of China New Enterprise Investment (CNEI).

The board was initiated in 2011 as a pilot program in Shenzhen enabling high-tech focused private small and medium-sized enterprises (SMEs) to raise capital. It expanded into cities such as Shanghai, Tianjin and Wuhan two years ago and then the securities regulator united all the OTC markets and established NEEQ. Listing requirements are less stringent than for other bourses: companies must simply have a clear shareholding structure and two years of financial statements.

However, the board was for a long time hindered by low trading volumes and inactivity. During the IPO backlog, a slew of measures were introduced to boost trading activities, including a market-maker system that allows an investment banks to buy and sell the securities of a listed company. Consequently price-to-earnings multiples have jumped from 10-15x to 20-30x. Qualified investor requirements have been relaxed to include public and private funds as well as individuals.

Several domestic GPs have even listed themselves on the board. JD Capital, formerly Jiuding Capital, listed its parent company last May and another reniminbi fund - CSC Group - followed suit two weeks ago. Two GPs, alongside Heaven-Sent Capital and Cnstar Capital, have set up dedicated funds to invest in companies listed on the board.

Dayi Sun, managing director at fund-of-funds Jade Invest, admits that GPs could earn high multiples given the arbitrage opportunities, although he maintains it is a form of speculation. "Those Third Board-focused funds have a two-year lock-up period. It's too risky to stay for such a long time - the arbitrage period won't last two years. On the other hand, as a long-term investor, I don't feel comfortable in these speculative investments."

The role of the New Third Board is as a testing ground for how a registration-based listing system - which has been promised for the other boards - could work in practice, given the emphasis on financial statements and disclosure. There is also the possibility of companies transferring to the main boards. Sammuel Zhao, a partner at law firm Jun He, adds that an advantage of listing on New Third Board is that companies could get financing from commercial banks by pledging their shares.

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• Topics
• Exits
• Greater China
• Expansion
• Buyouts
• China
• Growth capital
• buyout
• Exit
• Trade sale
• IPO
• Secondaries
• Buyback
• CDH Investments Management
• CNEI