China webinar: Still a safe bet?

The participants: Simon Eckersley, co-founder and chief executive officer of Hao Capital; Li Yi, partner at Lunar Capital; Simon Yang, director at Blackrock Private Equity Partners; Sally Shan, managing director at HarbourVest Partners; with Matt Fish, co-founder and managing partner of New Pacific Consulting, acting as moderator.

On IPOs as an exit strategy

ECKERSLEY: Clearly for the last couple of years, the IPO environment has been challenging, onshore and offshore. That has an impact on companies we have previously exited where liquidity becomes difficult, particularly in the offshore market. But the impact is limited because strategic sales have been a focus for some time. In our current portfolio, probably two thirds of the exits over the next 12-24 months are likely to be trade sales rather than IPOs. Trade sales are not always uppermost in the entrepreneur's mind, especially in the healthcare sector, but in many situations they make sense.

LI: We believe that a controlled-oriented focus within a mid-market private equity investment strategy is the best way to create a win-win scenario. In 2012, we had two exits, both through trade sales. We are planning to get another exit in 2013. When you are making the investment, you really have to think about your exit strategies. That's why we take an operationally involved approach; it helps us to develop the company more effectively so we more exit opportunities.

SHAN: The majority of PE investments in China are still minority investments and so GP influence over the CEO and the overall strategy of the portfolio company is limited. As a result, China has historically relied on the equity market for exits. This is in sharp contrast with more mature markets such as the US where only 6% of PE exits in 2012 came through IPOs, with the rest split between secondary and M&A activity. So the current IPO-driven environment is not sustainable for China.

YANG: Some portfolio companies are on a very steady growth path and they be able to do a couple of rounds of dividend recapitalizations, which has been a really good way to return the capital to investors even there is no complete exit. We are also looking at other stock exchanges in the region that have mainland Chinese companies - such as Taiwan and even London - as to whether they could offer a fair market value for the exit. We are not only invested in China-dedicated funds, but also some pan-regional funds and we see more activity between GPs, like one GP selling to another. I think we still see limited activity of this nature in China, but on a global basis, if the current IPO continues, we could see more of these secondary sales.

On the impact of consolidation in the renminbi fund space on US dollar vehicles

LI: The collapse of renminbi funds means more opportunities are available for US dollar funds. That's really a good sign for firms like us that have always taken a good approach to the market and focused on results.

ECKERSLEY: I think few years ago, there was certainly a lot of competition in the market and a lot of activity in setting up renminbi funds. As for the impact of that on us, it has been reasonably limited - many of these funds are fairly small and our typical investment size is above theirs. Renminbi funds also focused on IPOs as an exit strategy - that is one of the reasons why the lifespan of these funds is relatively short, maybe only five years - and I think has to change. Given that their valuations weren't rational, a shakeout among the renminbi funds is good. A lot of players might like it.

On foreign private equity managers using renminbi-denominated funds

YANG: Many of our US dollar managers, when they get to a certain size, want to set up renminbi vehicles. In most of cases, these are work out okay. They keep separate teams and are well-balanced in terms of resources and timing between the two funds. As for the deal pipeline, they are unique because they have both-way investment vehicles. According to the Limited Partners Agreement, the US dollar funds we support definitely have the priority in terms of deal flow over our renminbi funds. The renminbi funds are only used for investments in areas that are categorized as restricted by by the Chinese government.

SHAN: There are similarities and differences between US dollar funds and renminbi funds. But at the end of the day, the successful sectors all are the same. Regarding track record, it is not only about portfolio investment returns, but also managing through difficult times when exit channels are limited. The strategy has to match the capabilities of the team as well as the size and the status of the funds, the sector and geography. For example, it is hard to see a Chinese team with no global experience focusing on a cross-border strategy. Finally, portfolio company value-add should take the form of introducing strategic partners and making operational improvements. We are glad the renminbi market has changed and it's no longer the case that anyone with the right connections can raise money. This created excessive competition and had a negative impact on the overall investment environment.

On healthcare and consumer as hot sectors

ECKERSLEY: I don't like to use the word of "hot" to describe sectors - "hot" things have a habit of becoming "cold" at some point. I think in the sector the most important point is that the attractive fundamentals of a sector will remain, and create opportunities for capital, for many years to come. China has become more focused on consumption, the environment and urbanization over the last number of years. We spend a lot of time on healthcare and have seen significant change and great opportunities in the sector. We like traditional Chinese medicine. We also focus a lot on equipment and related services. If you look back for the few years to when we started making investments, we found it quite difficult to get minority shareholdings in some equipment businesses. You would often find the products hadn't been developed. Now, though, there is the scale to support large R&D teams and large businesses are quite regional and focused. Our approach is driven by the difficulties investing in this market and we have made quite a lot of investments in healthcare. On the consumer side, I think it will be a little bit difficult, particularly in the retail. We find most businesses are just too expensive.

LI: We are targeting businesses mainly driven by consumer demand, particularly in China's central and western regions. We are looking for companies with a strong regional presence, as well as the brands, ingredients and distribution to satisfy consumer demand. So where do we see the opportunities? Agricultural products, apparel, baby products, branded beverages, beverage ingredients, consumer inputs, food ingredients, retailers, and snack foods. Last month we closed an investment one of the three largest beef jerky snack food producers. This is actually a regional brand and with the potential to grow nationwide.

On using outbound investment as a portfolio tool

ECKERSLEY: We are generally focused on China companies - those tied to domestic consumption. But a number of our companies have the ability to build an international presence. One of the first investments we made was a company that sold all of its products in China. It has diversified and now sells 40% overseas, with customers in about 60 countries. The company has done an extremely good job in expanding its brand and products overseas. We helped them with a number of strategic acquisition opportunities. Meanwhile, we are also looking for opportunities to acquire technologies overseas that we can use within our healthcare platform in China. It is not a core strategy for us but it is important in certain situations.

LI: The beef jerky business we recently invested in does have the potential to go cross-border because it uses halal meat, so it's actually quite a good fit for the Muslim market. We can definitely help the company to build this business. However, I think in most cases foreign brands are trying to leverage portfolio companies' domestic distribution channels to build a presence in China. In the long run, China has the ability to sell branded products overseas as well.

YANG: Part of our strategy is acquiring majority stakes in overseas companies in order to get hold of technical know-how. The GP is basically acting as the underwriter in the process and receives a minority holding. Given that a lot of Chinese strategic partners are appearing, cash will be available for strategic acquisitions that add to their know-how and technology. I think it will grow slowly and steadily, but it's very promising.

On venture capital market development in China

YANG: From an LP perspective, it depends on whether venture capital is early-stage or late-stage. In China, many late-stage VCs are actually growth capital firms, so we evaluate them as such. The early stage is a little bit different. Firstly, globalization has stepped in and some of the trends in Silicon Valley can transfer to China. We are seeing some business concepts get proven overseas and then translated in China to suit local consumer habits. From that perspective, I see some good potential for early-stage VC firms.

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• Topics
• Greater China
• Investments
• Exits
• BlackRock
• China
• Lunar Capital Management
• Trade sale
• HarbourVest Partners
• IPO
• Exit
• Growth capital
• Hao Capital