AVCJ at 25: X.D. Yang of The Carlyle Group

It is difficult and perhaps unfair to assess a private equity firm's experiences in China through the lens of just one or two transactions. For The Carlyle Group, however, the exercise is instructive, throwing light on the challenges and opportunities investors faced when the country first opened up to PE as well as offering a perspective on how the deal landscape might evolve.

This is the story of China Pacific Insurance and Xugong Construction Equipment. The former is reportedly on course to be Carlyle's largest-ever cash exit globally; the latter promised much but a proposed deal never came to fruition.

When Carlyle first came across China Pacific, the country's third-largest life insurer, it was every bit the classic distressed financial services asset: insolvent and losing money, its business - and 200,000 employees - kept afloat by accommodating government shareholders. The private equity firm injected $740 million into the company across two tranches, in 2005 and 2007, through its debut Asia buyout fund. Following a restructuring of China Pacific's subsidiaries, Carlyle ended up with a 19.9% stake in the parent company.

It was a groundbreaking transaction in terms of its size, sector, complexity and the fact that the private equity firm abandoned its typical buyout-only approach and agreed to take a minority stake. Investment professionals also had to put China Pacific's management through a crash course in private equity.

"We knew the company had great potential but a lot of work had to be done," says X.D. Yang, managing director and co-head of Carlyle Asia Partners. "We spent a fair amount of time explaining what Carlyle is. That was a good process for the two sides to get to know each other and I have to give credit to China Pacific's management for recognizing that a global firm like Carlyle could make a difference to their business. It's very different from today. Now everyone knows private equity and they know Carlyle."

China Pacific has also been turned on its head. Reorganized and recapitalized, the company listed in Shanghai in 2007 and in Hong Kong two years later. Based on public market disclosures, Carlyle held a 3.5% stake as of October 2012, having generated about $4.4 billion through a series of block trades.

Time to scale up

Carlyle has been investing in China since 1999, initially pursuing growth deals via its Asia venture funds, the first of which closed in 2000 on $159 million. Early victories included travel website Ctrip, now a NASDAQ-listed company with a market capitalization of around $2.5 billion.

Yang joined one year later from Goldman Sachs' China merchant banking division when Carlyle decided to step up its efforts and target more buyouts. The market wasn't conducive to realizing such opportunities. While the venture space was already well covered - and there was a degree of awareness of how it operated as a result of the tech bubble - the idea of investing in more mature companies was not understood.

"It wasn't a natural thing for an entrepreneur to say, ‘I want some capital, I'm going to talk to a PE firm.' That concept didn't exist," says Yang. "We had to educate people on what private equity could do and it took quite a while. The education period was probably 2000-2004. We looked at some deals, but they were much smaller, nothing more than $100 million."

The standout transactions from that period were strictly minority deals completed by the likes of CDH Investments, Morgan Stanley Private Equity Asia, Goldman Sachs, Hony Capital and Newbridge Capital. This was the era of Mengniu Dairy, Yurun Food Group, Shanshui Cement and Shenzhen Development Bank.

In this context, Carlyle's $375 million bid for an 85% stake in state-owned Xugong, a leading construction equipment manufacturer, in 2005 was an extremely ambitious move. The private equity firm emerged victorious from a 12-month auction process run by Jiangsu provincial government, Xugong's ultimate owner. However, the Ministry of Commerce delayed on granting approval, while the president of Sany Heavy, a rival equipment maker, denounced the deal on nationalistic grounds and said his firm would pay a premium to keep the asset in Chinese hands.

Although Carlyle offered to make concessions, such as reducing its equity stake in Xugong, approval wasn't forthcoming and the investment agreement eventually lapsed in 2008.

From a 10-12 person team making selective investments in 2001, Carlyle now has at least 70 people dedicated to the country. In the Carlyle Asia Partners team alone, there are more than 20 investment professionals, up from 4-5 a decade ago. The firm's buyout, growth capital, real estate and renminbi-denominated funds have invested approximately US$4 billion in more than 60 deals in the country.

"That makes us one of the most active investors, multinationals included," says Yang. "How many companies in the world have invested $4 billion in cash in China?" 

Post-Xugong, the PE firm has focused on minority investments in privately-held companies, partly because such enterprises have grown in size and sophistication. They now regard private equity as a viable funding channel, particularly given the capital markets slowdown and tighter bank-lending policies of the last two years.

Yang, however, is unwilling to write off state-owned enterprise (SOE) opportunities. "In the mid-2000s there was a lot of consolidation, inefficient SOEs were shut down or taken private, and the survivors are mostly very large," he says. "On this basis, the opportunities for PE are likely to be minority stakes, but you can never be too sure. In the next few years SOEs will become more streamlined and divest non-core businesses. This should generate control deals."

The wider issues dictating the role of private equity in China relate to the country's evolving development model. Reorienting policy with a view to boosting the consumption share of GDP and easing dependency on investment-led growth, strengthening social infrastructure, opening up the services sector and slimming down industries bloated by overcapacity; these fundamental changes will create openings for private equity in the next few years, especially if they take place in a slower growth environment.

"We thrive in these uncertain times and that's why there have been more deals recently," says Yang. "Private equity is also very hands-on and very good at managing change and value creation. There was a period dominated by pre-IPO investments and companies that just needed capital, but now PE firms have to be much more involved, helping companies in challenging operating environments."

In this regard, he expects to see just as much consolidation in the private sector as among SOEs, noting that there are numerous industries where major players have yet to emerge, domestically or internationally. Private equity in China is likely to experience a similar transition as marginal players exit and the larger, more successful firms - those with stable teams, strong skill sets and differentiated strategies - consume even more market share.

The upshot is bigger funds and bigger deals. Carlyle attracted commitments of $2.55 billion for its third regional buyout fund in 2010 and is reportedly targeting around $3.5 billion for the successor vehicle. The PE firm is also participating in the wave of take-private transactions that has sprung up recently, with approvals pending for buyouts of US-listed Focus Media and 7 Days Group Holdings, worth $3.5 billion and $635 million, respectively.

"China's GDP is $7 trillion and private equity as a percentage of companies' capital needs is still very small," Yang says. "A $1 billion transaction size isn't that big given the scale of the economy as a whole and investment themes are always evolving. We've had minority deals, SOE deals, private company deals, pre-IPO deals, and more recently PIPE deals and take-privates. This trend of change will continue. I don't think the Focus Media deal is a one-off because at some stage in the life of a company the public market isn't the best place to be."

Exceeds expectations

The situation is far removed from the days of China Pacific or even Xugong, but private equity, like many industries in China, has developed in a compressed timeframe. Indeed, its progress far exceeded Yang's expectations, particularly in terms of the competitive landscape.

He puts forward two explanations for this. First, when Carlyle set up shop, the country was still three years away from WTO membership. While economic growth was expected, the steepness of its trajectory was not - since joining the organization, China's GDP has gone from being about equal to Italy to more than three times the size of Italy. Private equity has ridden on a rising tide of multinational interest in the country.

Second, the emergence of renminbi-denominated funds has been incredible, from zero in 2005 to many thousands today.

PE capital arrived en masse and somewhere along the way local companies began to accept the asset class and appreciate the role it plays. Government policy is more accommodating; entrepreneurs' eyes no longer glaze over at the mention of shareholder agreements, rights and warranties; there is a general acceptance that PE investors require access to financial records, board seats, veto rights, management engagement and exit rights. Executing deals remains a challenge, but it easier than 10 years ago.

"People always project the future based on the past," says Yang. "A decade ago you'd think there would be 5-10 private equity firms investing and the deals would be a bit bigger - $200-300 million rather than $100 million. And you'd expect there would be 20 people on each team and maybe 10 active funds, with the largest about $1 billion. Back then we never thought there would be local funds, but all these things have happened in 7-8 years. To have this mix so quickly is unprecedented."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Buyouts
• Buyout
• People
• The Carlyle Group
• buyout
• China