AVCJ at 25: Yichen Zhang of CITIC Capital

The speed at which PE has gone from obscurity to household name in China surprised everyone," observes Yichen Zhang, CEO of CITIC Capital. "The asset class is probably better known in China than in the US. And it's generally a positive view: you invest in companies, they go public, everyone makes a lot of money."

But is this view still accurate? Factor in the inevitable lag period and China fundraising follows investment, which follows the trajectory of capital markets. All have started to suffer over the past 18 months, calling into question the pre-IPO model that has defined Chinese private equity for much of its decade-long history. Mainland listings have slowed - with exit multiples a fraction of what they were 18 months ago - while Hong Kong's IPO market started to dry up towards the end of last year. Growth capital investment has stuttered and fundraising is declining, particularly among renminbi-denominated vehicles.

"We have never focused on pre-IPO deals, although if you look back to our first fund in 2006-2007 that's probably what we should have done," says Zhang. "Instead we chose the hard way, focusing on state-owned enterprise (SOE) restructuring, so we never followed the momentum in the market. In the early days you had funds trying to scrape together $100-200 million; it wasn't until 2006 that people realized the industry was going somewhere."

Zhang founded CITIC Capital in 2002 with Brian Doyle, having previously worked at parent company CITIC Group and before that as a banker with Merrill Lynch. Now jointly owned by CITIC Group and China Investment Corporation, it has $4.4 billion under management.

Back in 2006, however, there was only the $425 million debut vehicle. Its first investment came later the same year. Leading a group comprising Warburg Pincus and a local private equity firm, CITIC Capital took a majority stake in state-owned Harbin Pharmaceuticals. The transaction, which was almost two years in the making, is a typical example of what remains the firm's approach to this day. SOEs account for about half of its portfolio.

Harbin Pharmaceuticals was also typical of the kinds of issues faced post-investment: ushering out managers who are part of the fabric of the state system; eliminating overcapacity, corruption and ineffective spending; and replacing inefficient working practices.

Before CITIC Capital and Warburg Pincus invested, Harbin Pharmaceuticals was spending four times its annual net income on television commercials and investing in a portfolio of 100-plus products, many of which didn't make any money at all. Furthermore, each subsidiary maintained its own finances, which meant that profit-making businesses were receiving low interest returns on bank deposits while loss-making units paid heavy premiums to borrow money.

Action was necessary but it had to be incremental because it meant facing down resistance from managers desperate to hold on to power.

While CITIC Capital was implementing this turnaround the market was inflating. "In 2002-2003, Chinese stocks were trading at a discount; by 2006-2007 they were on a par with international equities; by 2007 a China premium emerged and it got even bigger after 2008 because growth was so strong," says Zhang. "The capital markets were clearly driving up primary market valuations and at the same time more was coming into private equity."

Valuation upheaval

The impact on valuations was felt by all China-focused managers, regardless of strategy and currency. In the early- to mid-2000s, private equity firms could invest at 5-6x forward price-to-earnings (P/E) ratios. Within three years, valuation expectations had more than doubled and by 2010 entrepreneurs were asking for as much as 15x. "Now it's sort of stuck, adjusting a bit but not fast enough," Zhang says. "Anything more than 10x and you still need to think about it carefully. By comparison, public-to-private deals can be done at 10x or less, if you take out the cash."

The full extent of the damage to portfolios caused by falling public market exit multiples has yet to be calculated. Success stories - a company lists within two years, generating an exorbitantly high IRR - are widely publicized but failures take longer to emerge. A portfolio judged on a mark-to-market basis in 2007 might have looked great because investments were recent and tended to be marked at cost. Four to five years down the line, the metrics are different.

"If you weren't able to cash out, you took a very nice ride, but now valuations have retreated and you can't mark up anymore," says Zhang. "At the height of the market the overall picture was distorted. LPs might have have had unrealistic views of PE given the early vintage funds were doing so well. However, the true stories will eventually come out."

GPs with reasonable track records, particularly those that manage US dollar funds and renminbi vehicles, are expected to emerge largely unscathed. The problem children are local currency funds raised on an overstated promise of strong returns within a 24-36 month timeframe.

Many are expected to go bust - and even if the multiples swing in their favor the IPO pipeline will not. It is estimated there are 4,000-6,000 of these renminbi funds. If they made 8,000 investments and the public markets were able to absorb 300 per year, it would take more than 20 years for the backlog to clear. CITIC Capital is already seeing situations in which existing shareholders are agitating for an exit and forcing management teams to find new investors capable of buying them out.

"The entrepreneurs don't want these guys in the company anymore," says Zhang. "When we negotiate with the entrepreneurs we offer to buy out the investors but ask for more equity on top of that. This creates change-of-control opportunities that would not otherwise be there. And these are good companies."

It points to a widening of CITIC Capital's target market. Previously it was easier to persuade local governments to give up control of companies than entrepreneurs: while the former had little vested interest in holding on to an underperforming assets, the latter wouldn't countenance giving up a majority stake because of what it might be worth to them personally post-IPO.

This is now changing, driven by weaker public markets but also by an evolving industrial environment and company owners recognizing the value of partners that offer additional managerial expertise and technology.

"Doing business in China is very hard," says Zhang. "Entrepreneurs never get off work - even after leaving the factory they are wining and dining government officials - and many now see the prospects are not as bright as before so they think about slowing down. The one-child policy also means there are limited succession options. That's why we see entrepreneurs becoming more receptive to buyouts."

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• Topics
• Greater China
• Buyouts
• Buyout
• People
• Yichen Zhang
• CITIC Capital
• buyout
• China