China buyouts: Small beginnings

China buyout deal flow reached a record high of $18.2 billion in 2015 but the numbers are deceiving. Comfortably more than half the announced deals are take-private transactions involving US-listed Chinese companies where private equity is working in partnership with a local founder who has no intention of ceding full control. Three of these deals alone, Qihoo 360 Technology, WuXi PharmaTech and Momo, together account for close to three quarters of the buyout total.

The largest non-take private on the list is HCP Packaging, in fifth place at $775 million. This was a secondary buyout - TPG Capital sold on the business to Baring Private Equity Asia after a three-year holding period - which says it all about the China buyout opportunity. The deal flow that could arise from the various demographic and economic pressures confronting local entrepreneurs is enormous, but for now it remains a trickle, albeit a slightly stronger trickle than a few years ago.

Frank Tang, CEO of China-focused GP FountainVest Partners, said as much at the Hong Kong Venture Capital & Private Equity Association's (HKVCA) China summit this week: "China is not already a buyout market, but it is a serious thing worth watching closely."

Tang offered a concise picture of the contributing factors: a two-speed economy in which certain companies are struggling to stay afloat and paying more attention to cost; some entrepreneurs confronted by a choice between holding steady or doubling down in pursuit of new growth opportunities, which might necessitate the introduction of third-party capital and professional management; and other entrepreneurs coming to terms with the fact that their offspring do not want to take over the family business.

Tang highlighted FountainVest's investment in a medical diagnostic devices business set up 30 years ago by three entrepreneurs. All three were keen to step back but their children had migrated to Australia, Singapore and Canada, respectively, and had no interest in returning to head up a manufacturing enterprise. FountainVest assumed control, put in a professional management team, and wants to use the company as an industry consolidation platform.

There might be thousands of companies nationwide in a similar situation, making them potential private equity targets, but for now relatively few deals are being completed. Even if there is a willingness to transact on the part of the entrepreneur, the private equity investor must be convinced that investment thesis can be realized.

First, can the GP run the business in the absence of the founder or is he too deeply entwined with external supply chains and internal management? And if it is expedient to keep the founder involved as a minority investor - offering a share of the upside in return for engineering a smooth transition of leadership - is he likely to comply with the requirements of the new owner (and if not, are there measures in place to facilitate a swift removal)?

Second, where professional management is required to bring about operational improvement, is the talent available? Tang noted that China still lacks a deep pool of CEO talent that private equity investors can draw upon. Other factors come into play as well, but if a GP is unable to tick these two significant boxes, then passing up a control buyout opportunity might be the best course of action.

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• Topics
• Greater China
• Buyouts
• Performance
• China
• Fountainvest Partners