AVCJ at 25: Turning points

1987: THE BIRTH OF AVCJ

Asian Venture Capital Journal was supposed to be a transfer investment. A venture capital firm approaches the owner of an established brand in the US or Europe; it pitches them on launching in Asia; a joint venture is set up with the brand owner putting in the name and relevant expertise and the VC firm contributing capital and local management. If all goes well, the brand owner assumes full control after a few years, facilitating the venture capital firm's exit.

In this case, the brand owner was Venture Economics, a US-based trade journal set up in the 1960s in parallel with the emergence of VC as an asset class. However, when Inter-Asia Venture Management proposed a deal in the mid-1980s, it met with a cold response.

"We offered to put in some money and find people to run it," recalls Lewis Rutherfurd, co-founder and managing director of Inter-Asia. "They said, ‘We're not coming to Asia, it's not interesting for VC. Chinese families are running the whole show, so the asset class will never work. They're won't be any subscribers, conferences or customers. And nothing to write about.'"

Inter-Asia had already proved that the transfer model worked in Asia, albeit not for media businesses. The venture capital firm set up in Hong Kong in 1972, raised a $1 million debut fund and completed 15 investments. The first notable deal was the transfer of McDonald's to Hong Kong.

The fast food franchise was established in Japan and the marketing research that underpins judgments as to when new territories are ready for Big Macs was looking further south and willing to listen to proposals from potential partners. Ikea was another transfer success story from fund I and the VC firm continued with this approach, setting up Asia Renal Care, formed in part through a spin-off from Stanford Medical School's dialysis unit.

As for a regional VC publication, Inter-Asia had little option but to abandon the transfer concept and pursue the idea independently. Rutherfurd approached three other Asia-focused VCs for help with funding: Victor Fung of Prudential Asia Investments, Ta-Lin Hsu of H&Q Asia Pacific, and Lip-Bu Tan of Walden International.

"The convincing argument was that we needed a trade journal, we needed a voice for the industry so we could all raise money and find out what everyone was doing," says Rutherfurd. "There were less than 20 players in the whole industry out here in Asia and we had no voice that could be construed to be independent, there were no conferences."

Asian Venture Capital Journal required about $500,000 in start-up capital plus cash for operating costs; Rutherfurd estimates the entire commitment was less than $1 million. The Journal pre-dated the first conference by no more than 12 months. They targeted 100 delegates and failed to reach that in the first two years, but within five years the 200 threshold was crossed.

There were plenty of questions to answer through these platforms. Institutional investors had little sense of the region, the opportunities and challenges for venture capital, how deals were negotiated and structured, the professional background of those engaged in venture investing and who was doing what.

Rutherfurd maintains that Asian Venture Capital Journal helped him and others survive in a challenging fundraising environment. The exit point came around 1990. Inter-Asia and its co-investors made back their money, but the Journal was always more a service to the industry - and the investors' own fundraising needs - than a commercial exercise.

The expectation was that Venture Economics, while wary of the Journal when it was merely an idea, would be more interested in acquiring the business once it was proven. The answer was still no. The investors were eventually introduced to Dan Schwartz, who already owned some financial titles and was interested in Asia, and he bought them out. Schwartz owned Asian Venture Capital Journal until 2006, when it was purchased by Incisive Media.

 

1999: POST-ASIAN FINANCIAL CRISIS RESTRUCTURING

"We didn't spend too much time thinking about how private equity would evolve, it was more about how the Asian economy would evolve," says Weijian Shan, chairman and CEO of PAG. "At that time China, India and Southeast Asia were all about the size of Korea. Japan was the largest economy in the region by far but we knew China would become more important. We also knew that if these countries fixed their banking systems, they would come out of the recession."

These considerations underpinned investment strategy at Newbridge Capital in the late 1990s. Shan joined Dan Carroll as head of Newbridge's Asia operations in 1998, four years after the private equity firm came into being as a joint venture between TPG Capital and Blum Capital.

While they may not have paid much attention to private equity's growth trajectory, the Newbridge team left an indelible mark upon it. They specialized in supporting companies undergoing transition across a variety of industries, but are mostly readily associated with financial services and the turnaround of Korea First Bank (KFB). This deal, arguably more than any other, is responsible for putting Asian private equity in the global spotlight.

"We all knew it was significant because it was the first time that someone from outside Asia had taken over a major national bank in Asia," Shan says of KFB. "It was a failed bank and had been nationalized by the Korean government, so we negotiated to assume control."

Few others were willing to take a shot at reviving the lender. As Korea's credit crisis took hold and Moody's lowered the nation's credit rating, the IMF came in with a bailout package and also singled out two distressed banks that could be sold off: KFB and Seoul Bank. Months of negotiations ensued and Newbridge, the only private equity firm that participated in the auction, signed an exclusive memorandum of understanding for KFB in December 1998 and closed the transaction in early 2000.

There were two main components to the restructuring process. First, Newbridge had to put in place a functional board, organized in accordance with international best practice, and appoint a professional management team to operate beneath it. Second, they had to create a credit culture, a tougher proposition because it meant recalibrating long-standing characteristics of Korea's financial sector.

Newbridge exited its 51% stake in KFB in 2005 when Standard Chartered acquired the bank for $3.2 billion. Other private equity firms invested in Korean and Japanese banks around the time of the KFB deal with varying degrees of success but Newbridge won plaudits for being the first.

Such was the profile of the KFB transaction, and a subsequent investment in similarly distressed Shenzhen Development Bank (SDB), that Shan found people were, inaccurately, describing him as a banking specialist.

Other deals may not have required such extreme turnaround efforts, but results came as a result of putting people on the ground and addressing business challenges. Shan highlights a $350 million commitment to Chinese PC manufacturer Lenovo Group in partnership with TPG and General Atlantic in 2005. The capital was used to support the $1.75 billion acquisition of IBM's PC division but Newbridge's familiarity with both parties meant its involvement stretched integrating the IBM business into Lenovo.

Now installed at PAG and investing the firm's $2.5 billion debut private equity vehicle, Shan claims that after 14 years in the industry he has yet to emerge victorious from an auction situation because he's never participated in one. Moving from a global firm like TPG, which fully absorbed Newbridge in the early 2000s, to a regional outfit, the intention was always to carry over certain strategic tenets, including a focus on transformational- or operational-type opportunities that don't appeal to the mass market.

"We rarely encounter competition for what we do, back when we were doing SDB or now," Shan says. "If you do pre-IPO there is a lot of competition because it's based on price. If you are doing transformational buyouts it is more about your ability to help the target achieve its objectives. You have to bring many more things than capital to the table, but you can also cut your own deal."

 

2000: THE TECH BUBBLE BURSTS

Lip-Bu Tan has won his place in the annals of Chinese venture capital as father of the VIE. This structure goes by two names: formally, it is the variable interest entity; informally, it is the "Sina model," named after the internet portal for which it was originally devised. Though arguably overused and abused since its inception in 1999, the VIE opened the door for much of the $9.2 billion that has flowed into China's IT sector over the past 13 years.

"We came up with a structure that worked," Tan recalls. "It was a case of convincing the Chinese government that it was viable. Fortunately, I'd already made several investments in China and had demonstrated to them that I have experience investing in China, so they were supportive. Then everyone started copying the model."

The VIE was necessary to work around a ban on direct ownership of internet assets by overseas investors. It was acceptable because the onshore asset is owned by Chinese nationals and the foreign investor controls a parallel entity; legal agreements secure this entity's economic interest in the onshore asset.

In the case of Sina, Walden led a $7 million round of investment in Beijing Stone Rich Sight Information Technology, which was set up by Sina's former CEO. This was then merged with a US-based company called Sinanet under a VIE structure and the resulting entity was called Sina.com. Walden then brought in Goldman Sachs and others for Sina's first institutional round, worth $38 million, and the company listed on NASDAQ in May 2000.

Two months earlier, the NASDAQ Composite Index peaked above 5,000 points and by the time Sina went public the index had already slipped to 3,300 before staging a rally. The value destruction that followed over the next two years claimed some notable scalps and wiped out a number of fundraising efforts by Asia-focused VCs as investors backed out.

From the start of 1998 to the end of 2000, just over 300 Asia-focused venture funds raised $6.7 billion, with Japan, South Korea and Taiwan accounting for 23%, 16% and 20%, respectively, of the capital. In the following three years, 290 funds attracted commitments of $4.7 billion; Taiwan saw the most substantial decline. VC investment fell from $4.3 billion in the first three-year period to $1.9 billion in the second.

"Of course our portfolio was affected by the dotcom bubble bursting - growth slowed and it took longer for companies to become profitable and generate cash," says Tan. "But many continued to do well. For example, Mindtree, an Indian IT outsourcing company, remained profitable despite the bubble bursting."

He adds that the fallout was eased by two factors. First, there was breadth to Walden's investments in terms of sector and geography - from consumer appliance manufacturer Wuxi Little Swan in China to Jobstreet.com in Malaysia to a range of semiconductor specialists in Taiwan. Second, there was relatively little competition in the years running up to 2001, which helped in terms of valuations.

Walden was founded in 1987 and the initial LPs were development finance institutions, government and quasi-government agencies and local banks. It took seven years, around when the VC firm launched its third main fund and first China-dedicated fund, for North American investors to get interested.

North American venture capital firms, however, had yet to establish Asian affiliates. "There weren't too many guys from Silicon Valley at that point," Tan says. "They came in after the Silicon Valley Bank trip to China and India a few of years after the tech bubble."

The arrival of these firms plus the emergence of domestic competition has brought critical mass, while the archetypal portfolio company has climbed the value chain from electronics-oriented original equipment manufacturer to a sophisticated brand owner carrying a lot of intellectual property.

However, there are negative connotations too, which to some extent challenges the Walden approach. "Our philosophy has always been to back good entrepreneurs, be disciplined with valuations and pick a 10-year horizon for the company, which is ideally what you need to build up from zero to $500 million in revenue," says Tan. "In the early days entrepreneurs valued long-term relationships but now they want to raise a lot of money very quickly at a high multiple."

 

2005: THE RISE OF CHINA

Back in the 1980s, John Zhao, founder and CEO of Hony Capital, was a junior manager at Jiangsu Radio Factory, a state-owned enterprise (SOE) in Nanjing. The company was a creature of its era - a series of production lines gathered under one roof by local government planners, churning out a variety of goods. Zhao worked in the department that made audio systems for movie theaters.

"The company got twisted into a few smaller pieces and was eventually moved out of the city," he says. "Those pieces still exist but they aren't very good. It's a shame I was too late to restructure them. By the time I returned from the US in 2002 they were already in that shape."

Zhao spent nearly 12 years in the US, first as a postgraduate student and then in several managerial roles. If that period equipped him with the skills to run a private equity firm and interact with international investors, working at Jiangsu Radio Factory taught him all about what would become his target market. "I had no fear of SOEs," he recalls. "I thought most of them had very good assets, they just needed to make their system more market-driven."

Impressed by the economic progress China had made in his absence, Zhao concluded it was an opportune time to start an investment firm. The question was how to go about it.
Several foreign private equity firms had already made their first forays into China and there was one stand-out domestic player, the PE arm of China International Capital Corporation (CICC). It spun out in 2002 as CDH Investments Management and carved out a niche for itself in the growth capital space.

Zhao endorsed a different approach - and it originated from an alliance with Chuanzhi Liu, founder and president of Legend Holdings, that persists to this day. Like Zhao, Liu spotted the potential for buyouts arising from the government-mandated privatization of SOEs and Legend served as the sole LP in Hony's 2003 debut fund, putting up $36 million.

The firm's first proper restructuring deal came later the same year with the acquisition of a majority share in mid-size flat glass manufacturer Jiangsu Glass Group for $9.7 million. Hony made improvements, including incentivizing management by giving executives stock, and took it public in Hong Kong two years later as China Glass. The company then embarked on an acquisition drive, consolidating its position as one of China's largest listed glass makers.

"People still talk about it because it was a classic buyout and restructuring, followed by a successful listing and aggressive rollout through organic and inorganic growth. And then the returns were very good," says Zhao. "We thought it was something we could latch onto and that these kinds of opportunities would continue to pop up. Ten years on, the majority of our assumptions have been proved true."

Of the 70 or so deals Hony has completed to date, about half have been SOE restructuring of various kinds. They range from pure restructuring deals like Shijiazhuang Pharmaceutical to variations on the theme such as construction equipment manufacturer Zoomlion Heavy Industry, where the company was already an established leader in its industry but required assistance to achieve certain strategic goals.

Hony's investment approach evolved as the firm grew in size. Its second and third funds saw substantial increases in corpus size, but it was really the fourth vehicle, the $1.4 billion Hony Capital Fund 2008, that saw the firm establish itself as a player of significant size. Hony also raised China's first-ever renminbi vehicle, which attracted RMB5 billion ($799 million).

With more firepower at its disposal, the firm began to support its portfolio companies in cross-border deals, notably Zoomlion's $580 million acquisition of CompagniaItalianaFormeAcciaioSpA in 2008. Hony also invests in international companies that want to build up a presence in China but have neither the experience nor resources to address the market.

The PE firm's asset base received another shot in the arm in 2011 as it raised a total of $4 billion for its fifth US dollar-denominated fund and second renminbi fund. Hony's evolution foreshadowed that of Chinese private equity as a whole and the asset class is now increasingly mainstream. The explosion in renminbi funds is a principal actor in this and Zhao admits there have been some growing pains, but he remains convinced that private equity has an important role to play in the broader development of the domestic economy.

"China is becoming a capital surplus country and it is better for these funds to be professionally managed rather than controlled by the old institutions," Zhao says. "Private equity has proved it can be a useful force and now we stand before a huge opportunity: China is entering a massive phase of restructuring and it also needs to improve management quality to become a strong global player."

 

2008: RESPONDING TO THE GLOBAL FINANCIAL CRISIS

As the financial crisis cut a swath through global markets, Bain Capital Asia's first instinct was to put people on the ground. The Japanese economy was the worst hit in the region - a mid-2000s recovery rapidly unwound as exports collapsed, sending the country into recession by the third quarter of 2008 - and it accounted for the PE firm's three largest deals. It was logical that the work started there.

Asia portfolio executives, who are permanently embedded with companies to assist management teams, were redeployed to trouble spots. There was also the option of re-tasking deal team members - given the economic uncertainty they were less busy - to supporting roles. A PE executive that previously spent only 25% of his time improving companies saw that percentage rise to 50%, 75% or more.

"We sent in a lot of people quickly to look at changes in direction and focus on cost opportunities, that was a huge advantage," says David Gross-Loh, the Bain Capital managing director who set up the firm's Japan office in 2006 and still runs it. "At one point with D&M we had 10-12 people on the ground and not just in Japan because it's a global business."

D&M, a provider of premium audio and visual equipment, was acquired by Bain for about JPY47.6 billion (then $430 million) earlier in 2008, the transaction closing a matter of days before Lehman Brothers collapsed. Selling mostly into the US and Europe, the company inevitably struggled.

The initial challenge was realigning cost structures that had been drawn up on the basis of a growth strategy, which now clearly wasn't going to come to fruition in the short- to medium-term. D&M reduced costs by about $100 million over 12 months with one eye on consolidating a business that was put together through acquisitions - Denon was spun out from Nippon-Colombia in 2001 and merged with Marantz a year later - but had never been fully integrated.

The other Japanese portfolio companies were less affected - communications equipment specialist Suntel required a small amount of surgery so Bain sold off the company's leasing business in order to pay down debt - and its China interests were largely untroubled. Jim Hildebrandt, a Hong Kong-based managing director at Bain, notes that, while the Asian financial crisis "was clearly happening to us and, in the end, only to us, this one was happening somewhere else. It was very much coming from developed markets and affected emerging markets later."

In this sense, the risk factor was misjudging the severity of the crisis on individual markets and companies. Much the same applied to getting back into the market: would hesitancy over the macroeconomic climate result in private equity firms missing out on attractive assets?

Having announced D&M in June 2008, Bain waited about a year for its next deal, the acquisition of a minority stake in Chinese electronics retailer Gome for $234 million. There was an 18-month wait for another Japan transaction, the $1.0 billion buyout of e-commerce firm Bellsystem24 in late 2009.

What worked in the firm's favor was its relatively short history in Asia. Bain opened its first office in the region in 2005 and raised its $1 billion debut regional fund the following year. The firm's portfolio wasn't that big, which arguably meant the firm was better positioned to see new deals, and it was also wary of getting involved in highly priced and highly leveraged transactions during the boom of 2006-2007 that preceded the financial crisis.

"The flip side of the economy being in a tough position is there are many interesting investment opportunities, Gross-Loh says. "We were cautious pre-downturn and then became active. There was a notion that pricing was getting high, leverage levels were getting high globally, so we were cautious. If you look at all the capital we have deployed in Asia, it might be 13% was deployed pre-crisis and the rest post-crisis.

Two years after Bellsystem24 became Bain's largest ever deal in Japan, the record was broken again with the acquisition of restaurant operator Skylark for $2 billion plus debt. The sellers were among those who got caught up in the 2006-2007 boom period. Nomura Principal Finance and CVC Capital Partners bought the company for approximately JPY280 billion (then $3.19 billion) in 2006. Skylark was restructured in 2008, with Nomura putting in more equity, and then CVC exited its holding to Chuo Mitsui the following year in a debt-for-equity swap.

Bain's acquisition structure featured a lower price and lower leverage, and the development plan for the company is rooted in a back-to-basics approach as opposed to targeting more growth than the market might be able to offer.

"Strategically, it's more aligned with the things we are trying to do in Japan - taking good companies and helping them improve their fundamentals," says Gross-Loh. "It is a country of slow growth and undermanaged businesses. If you look at any metric of profitably, Japanese companies are way below their peers."

For full interviews with these and other private equity practitioners, please see AVCJ's 25th anniversary special publication

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