China's PE boom

According to analysis released by PricewaterhouseCoopers (PwC) in the second half of January, M&A markets in China, including private equity activity, were firmly back on a record-breaking roll in 2010.

In general, they say, the number and value of domestic, inbound and outbound deals reached a high water mark of 4,251 announced transactions valued in excess of $200 billion, a 16% increase in terms of the number of deals, and a 27% increase by aggregate value over the year before.

More particularly, in China's private equity space - which is evolving into an important source of capital for private companies in the country - the uptick was even more pointed, expanding by a whopping 66% year-on-year. Moreover, two-thirds plus of these transactions were initiated by domestic Chinese private equity entities, demonstrating the vigor of the thrust toward localization of the industry there.

Our own AVCJ data told essentially the same story. It pegged private equity investment at $19,760 millions in 2010 vs $13,982 millions in 2009 on the strength of 431 and 365 deals respectively. Thus current activity in the space sits well atop the $15,263 millions (on 575 deals) seen in 2008, $15,082 millions (on 724 deals) in 2007 and $10,796 millions (on 480 deals) in 2006.

An interesting sidebar to this macro picture is the growing RMB presence. In 2009 that 21 RMB funds had raised some $8.7 billion, compared to 9 USD funds which raised a collective $4.23 billion. In 2010, $10.6 billion raised by 71 RMB funds, averaging $150 million each.

Learnings

Says David Brown, PwC's Greater China private equity group leader. "The growth and localization of the private equity industry in China is unstoppable."

Quite likely. But as AVCJ learned in speaking to a number of long-experienced China PE market players from different disciplines, that market situation is complex and therefore difficult to sum up in black and white terms.

Logically, the first inquiry ought to be into what created this boom? Ed Sun, a Partner in international law firm Milbank Tweed's China private equity practice, says he's not sure he would characterize it as a ‘boom' but notes that Milbank has seen a substantial pick-up across the full spectrum of its private equity work including new fund formation as well as investment activity.

In China, however, back in 2008-2009, when the GFC impact was sharpest, there was an effective market standstill, he recalls. As events turned out, private equity specifically didn't take much of a hit apart from those titular entities under its umbrella that were associated with the principal balance sheet of the investment banks. But the actual PE funds, or at least those whose money was already raised, usually in closed-ended funds of long duration, sustained no direct damage. Nevertheless, the entire environment, Sun says, prompted them to be cautious and wait. In addition, falling public market valuations made deals at the former valuations intrinsically less sensible; but sellers and founders had not yet reduced their expectations, resulting in a valuation gap.

Changing attitudes

"The last year and a half or so - the period some are now starting to call a boom - is when that money (in these funds' coffers) has begun to be deployed again: because the money that had been raised was just sitting there in funds with limited lifetimes," he explains.

And with investors made restive by the GFC, fund managers are only too aware that they're not getting paid high management fees to keep their investors' money in bank accounts earning 1.9% interest.

But this only amounts to one driver. Even more significant has been the shift in the Chinese government's attitude toward the asset class, which has resulted in new policy initiatives or alterations to encourage it. And the proof is the burgeoning number of RMB funds

Andre Loeskrug-Pietri, Beijing-based chairman and managing partner of European-focused "A" Capital, adds some interesting perspective:

"What's really striking, if you come from Europe, where the AIFM regulation has put a lot of constraints on PE funds and added considerably to their fixed costs, is that it is the opposite situation in China. To give only one example, in September 2010 the China Insurance Regulation Commission authorized insurance companies to invest up to 5% of their assets into alternative investments."

The motive, he says, was to diversify the types of capital that firms (particularly private Chinese firms) can tap into. This basically falls into a broader scheme of increasing exit routes, as per the Shenzhen Growth Board 2009, which is another way of raising capital. At a stroke, the CIRC authorization seriously broadened the Chinese public equity industry's LP base.

"The most important of these, sitting on a lot of cash, are the insurance companies," Loeskrug-Pietri explains. "The government didn't want to start with the cash because of the whole story of Chinese banks already lending a lot; they didn't want that increased. So it's very interesting. PE is now seen as a way to compensate for the traditionally weak financing of the private economy by banks in China. It's a very positive change."

But Ed Sun points out that from foreign PE component standpoint, the development has a negative aspect as well, because it creates much stronger competition for these firms that have seen such a sizeable renaissance over the past 18 months or so.

Another prominent Chinese PE player, who asked to remain unnamed, agreed that market conditions for foreign firms are tightening, citing as an example the recently created Foreign Investment Review Panel.

He too notes the convergence of the large amounts of offshore money going into China at the same time as a new availability of capital within the country to many RMB funds.

"It's likely in five years' time there will be a shakeout, as not every investor can make money," he told AVCJ.

Andre Loeskrug-Pietri also sees distinct limitations on the current boom, "Over the past six months I've been hearing that even RMB funds that are very connected, and have a very extensive network, are complaining that they're having more and more difficulties in accessing good projects. That's because the market is just too flush with liquidity," he says.

Moreover, he reaffirms that the invested capital overhang of 2007-2008, now increased by the money raised in 2010, has exacerbated the overabundance of cash situation; the amount of money actually invested at present amounts to about half of all that has been raised.

Competition or cooperation

But as to the increased competition between international and domestic funds, like many things in China, there is often much more in play than is apparent on the surface.

Loeskrug-Pietri says that where, in private equity terms, internationals and locals enjoyed a more or less level playing field until about 2007, over the last 2-3 years this has changed because of the RMB fund emergence. And these have at least three big advantages:

First, they can be much faster because, as an RMB fund investing in a Chinese company, it's not necessary to navigate the same time (and money) consuming MOFCOM authorization process, which can take 2-3-4 months.

"In a very competitive environment, time is of the essence of course. So the best deals - and best entrepreneurs - probably consider this in choosing the funds they go with."

Secondly, for Chinese funds there is now a growing pool of capital they can tap into which is essentially off-limits for foreign funds, other than the elite members of this group, those which happen, for instance, to be CIC investees.

Thirdly, there is the exit aspect. IPOs and even trade fair/sales M&A dropped significantly in 2009 globally. By comparison, the Shenzhen market was booming. According to the latest CSRC data they've seen at "A" Capital, over the first 15 months of the Shenzhen Growth Enterprise Board's existence, 162 listings raised a staggering $17 billion.

"That's simply massive," he says.

But, on a sobering note provided by prominent Chinese PE player, while hot stock markets encourage more capital inflow into PE, "...in general, the Chinese stock markets have not been doing well. Their performance was, in fact, the second worst in the world last year."

Also, as Ed Sun points out, there is a cooperative dimension to the international/domestic RMB funds dynamic that is seldom reported.

Among the totality of RMB funds, while the elite firms may be comprised of, or led by, ex-Warburg Pincus or Goldman Sachs types, many others are very local in the sense that they've never been out of China, never worked at a top tier international investment bank.

"Some of the smaller local players may be from various sectors, but they usually have good business sense and connections. And some of the local funds are more advisory in nature; some may even have very limited amounts oraised and set aside operating instead on a deal-by-deal basis," he explains. "With these types of players, one obvious kind of cooperation is bringing bigger money into the deals they've sourced or can add some value to. Basically it boils down to helping both sides source deals."

Of course this doesn't much leaven the hard fact that the rise of the RMB funds is making - and will continue to make - the securing of deals much more competitive, and particularly price competitive. And within this competition, RMB funds have some telling advantages, such as getting access to deals because they have a better network, or know people better internally; and in cases where "backscratching" is required, they may be better able to position themselves. They're also likely to be more competitive from a regulatory point of view, because they are, by definition, already onshore. Finally, the same is true of deals where the issuer prefers, for whatever reason, Chinese money over foreign money.

Exits

Another defining characteristic of the Chinese PE market is the near total dominance of the IPO exit. But while the proportion of this shows little change, the nature of effecting it has. One of our sources points out that 2007 was the peak of the famous pre-IPO plays, where basically money was injected into a company and six months later it got listed; it was pure PE arbitrage taking advantage of a very liquid stock market environment. But the 2008-2009 IPO freeze was so brutal that a lot of funds were suddenly forced to realize that portfolio management and actually working with invested companies was suddenly very important.

That created other problems, namely that a lot of funds were staffed with people who were good dealmakers but with little or no experience of running business operations in real terms. So many instantly increased their ‘grey hair' quota, or tapped into consultants and/or industry specialists capable of doing the hard yards in areas such as downsizing, and re-gearing for lower revenues, and lower demand to conserve cash essential for riding out the bad time. If a fund was unable to execute under these conditions, it was essentially lost in the jungle. But the result of all this is a Chinese PE industry that is much more mature today.

Milbank's Ed Sun sees it a little differently in that most of the present activity is around is in identifying pre-IPO opportunities as before, but not necessarily in the last year before IPO. Rather they want the company at a growth stage where the fund believes it can still add value and help grow the investee over, say, 2-3 or even up to 5 years. In other words the goal for most remains the same, but over a significantly longer time frame.

On trade sales, while our unnamed Chinese PE says they are and always have been active, the others reckon that they only amount to perhaps 5% of exits. "With the mentality here, while nobody would actually say so, going this route amounts to an admission of failure, because the company couldn't IPO and they were unable to wait. It's a valuation concept; an IPO return is many times higher than a trade sale exit," Sun explains.

Hurdles

Finally, there are a number of concerns despite the market allegedly being in boom times. One is obviously around too much money chasing too few deals. But curiously, none of our informants considered that particularly worrying. Partly that's because of the unbalanced nature of the Chinese PE market of today, divided as it is into the major centres like Shanghai, Beijing, Guangzhou and essentially the eastern seaboard where, as one puts it, there's almost a dot.com mentality with, as Loeskrug-Pietri puts it, "...everybody chasing the same high-tech, e-commerce entrepreneur who as a result is commanding huge valuations."

That should correct, however, as PE investors move further afield, into the interior and second tier cities where affordable and viable targets apparently still abound.

Another is the inevitable rise in the risk of poorly diligence transactions.

PwC's David Brown says of this: "We have seen some funds that are conducting ‘tick the box' diligence, the so-called ‘agreed upon procedures' or simply dispensing with the diligence process altogether. I think some funds have an inherent belief in a market that will float all boats and in their ability to fix problems as they arise. As well, some of these funds see that if they are user friendly and able to close deals quickly, that will give them an advantage (and it probably does). So if the question is then will that lead to more bad deals being done, I think the answer is certainly yes. But in due course there will be a shakeout (as noted above), with some PEs unable to raise second funds while other emerge as serious long-term players eventually move up on to the global stage. China's TPG and Bain Capital may in fact be born already."

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• Topics
• Greater China
• CIC