2Q analysis: China in the spotlight

1) China investment flatters to deceive

China private equity investment had been robust ever since April-June 2009 when the market overcame its global financial crisis blues. Over the next 13 quarters, deal flow slipped below $5 billion on only three occasions, peaking at $10.1 billion in April-June 2011. All that changed towards the end of 2012: investment fell to $2.9 billion in the final three months of the year and has never really recovered.

The figures for the first quarter of 2013 are deceptive. Deal value jumped to $6.5 billion from $1.5 billion in the previous three months but 60% of the capital deployed went into one deal: Guolian Industrial Investment Fund Management paid $3.9 billion for a minority stake in PetroChina Tubes Union.

The transaction involved the spin-out of pipeline owned by PetroChina into a new joint venture with third-party investors contributing development capital, which means AVCJ Research classifies it as an early-stage deal, albeit an unusual one. It is also unusual for state-owned assets to be opened up to private capital - indeed, it is a pipe dream for many PE players - and it will likely remain the exception rather than the rule.

A management buyout of Pactera Technology, backed by The Blackstone Group, which values the US-listed tech outsourcing firm at $660 million, offered some impetus to buyouts that wasn't present in the first quarter. Similarly, Hony Capital weighed in with a $289 million PIPE investment in real estate firm Shanghai Chengtou Holding and Warburg Pincus secured a $250 million growth deal for shopping mall developer Sasseur Group.
But these spots of relatively large-scale activity highlight the new reality facing Chinese private equity.

Buyouts spiked in the third quarter of 2012 deal flow was going to be sustained only as long as there were chairmen of US-listed Chinese companies unhappy with public market valuations. Pactera was one of three take-privates announced in the second quarter and four since the start of the year. Eight were announced in the second half of 2012 and five of those have now closed. There may come a time for more buyouts in China but it's not here yet.

Growth deals are a more protracted story, moving in fits and starts, but generally downwards, since the last few months of 2011. The decline mirrors that of public market exit multiples and there are likely three factors behind investors' hesitance to jump in.

First, the IPO hiatus should end within weeks and the public exit arbitrage opportunities will return, but they will be more muted than before. Second, the waiting list for IPOs is so long that a company joining it today can see barely a chink of light at the end of tunnel. Third, the previous two factors have yet to pervade entrepreneur consciousness, which means private market valuations, though lower, are still too rich for many PE firms.

According to the industry zeitgeist, now is a good time to invest in China. There is talk of consolidation opportunities, the emergence of succession planning situations as ageing founders consider their options, and entrepreneurs increasingly willing to accept equity partners - plus practical assistance - in a more challenging business environment.

All of these may well be true, but the trends have still to be meaningfully borne out by the data.

2) But China exits are encouraging

What China taketh away with one hand, it giveth with the other. The country's investment numbers may have flattered to deceive in the second quarter of 2013 but exits were genuinely encouraging. China accounted for nine of the 15 largest exits in the region, and although the total transaction value was similar to the first quarter - $4.1 billion versus $4 billion - there was a healthy spread of trade sales and open market exits.

Topping the list is Goldman Sachs, which sold off the rest of its holding in Industrial and Commercial Bank of China (ICBC) for $1.1 billion. Cumulative proceeds from a string of block trades stand at $9.58 billion make it the largest-ever private equity cash exit in China. This is followed by a couple of US take-private deals, in which the minority VC investors are being taken out, and then five trade sales - each buyer being a Chinese strategic investor. The significance of this shouldn't be underestimated.

Both China Modern Dairy and Yashili, a dairy producer and an infant formula manufacturer, respectively, were investments made in the wake of China's melamine scandal, which saw tainted milk products claim the lives of several infants. The private equity participants - KKR and CDH Investments at China Modern Dairy and The Carlyle Group at Yashili - can claim to have taken steps to reinvigorate consumer confidence in the industry and thereby add value to the assets.

Now they have realized that value. China Mengniu Dairy, the country's largest dairy producer, was the buyer in both cases, clearly looking to augment its upstream and downstream resources and capabilities.

Two more trade sales involved technology assets: Baidu bought PPS' online video business, creating an exit opportunity for venture capital backers including Ceyuan Ventures, Qiming Venture Partners and Vision Knight Capital; and Datong Telecom Technology agreed to buy Yaowan, mobile games developer that counts Haitong Capital among its investors.

There has been a lot of talk about Chinese domestic technology companies - principally the four internet giants, Baidu, Alibaba Group, Tencent Holdings and Sina - making acquisitions and what started with small bolt-on deals now appears to be gathering momentum further up the scale. The onus is on these giants to build broader and more sustainable businesses, which could prove to be a boon for the VC backers of their targets.

What the four trade sale exits have in common is the private equity investors held minority positions. Admittedly, China Modern Dairy and Yashili are already listed so the alignment issues that often thwart trade sales - most entrepreneurs only want to do an IPO - don't apply, but the exits were amicable and driven by a strategic imperative.

This speaks volumes not only for the evolution of China's PE exit environment but also for the evolution of corporate China and the emergence of increasingly confident and acquisitive domestic players.

3) Disappointing, differentiated fundraising

Fundraising in the second quarter of 2013 was, quite frankly, appalling as Asia-focused vehicles attracted $4.4 billion. We have become used to saying that the latest quarterly figure is the lowest in four years, but April-June 2013 total is nearing the 2009 nadir when fundraising came to just $4.1 billion in the first quarter.

The demise in growth capital deals is inevitably a factor with growth-oriented funds receiving just $859 million during the three-month period. AVCJ Research's numbers are provisional so the total could yet be revised upwards, but it is unlikely to match the $9.4 billion that went into growth funds in the first quarter - a level not seen since renminbi-denominated fundraising exploded in 2011 - or the $4 billion-plus in each of the three quarters before that.

China is central to this growth capital conundrum. Although the country attracted $2.9 billion in April-June 2013, more than two thirds of the capital went into two state-linked infrastructure vehicles.

The removal of plain vanilla growth funds has created more of a mixed bag among the largest funds to reach a final close in Asia as a whole during the period. Venture capital funds are represented more heavily than normal in the top 15 alongside distress, special situations and infrastructure vehicles. Perhaps it is further proof that to raise a fund in Asia these days you need an element of differentiation.

Brand names and track records also count, as evidenced by KKR announcing a final close of $6 billion on its second pan-Asian buyout fund earlier this month.

Ending on a note of optimism, the KKR contribution to the July-September fundraising numbers - specifically the $3 billion it raised after announcing a first close last year - means the third quarter total is already closing in on the previous quarter's figure.

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• Topics
• Exits
• Fundraising
• Greater China
• Exit
• Fundraising
• KKR
• CDH Investments Management
• Goldman Sachs
• Ceyuan Funds
• Qiming Venture Partners
• Vision Knight Capital
• China