China private equity: A question of control

Focus Media remains a landmark transaction in Chinese private equity. It was the first time PE investors managed to de-list a sizeable business from a US stock exchange and then re-list domestically – achieving a significant valuation mark-up in the process. All this was achieved without needing to replace management because the company’s founder and CEO participated in the deal.

More than 30 take-privates were announced in 2015 as it became clear that Focus Media would end up on a Chinese bourse, although not all of these closed. The majority involved a founder who rolled over his equity into the acquisition vehicle, retaining control of the company and taking third-party capital providers along for the ride. These were buyouts, but not as most private equity investors would know them.

This is not merely an attempt to add an asterisk to graphics charting the development of China’s buyout market. Control has become the mantra of private equity firms operating in the country, but it remains to be seen how many of them have the resources and ability to run a company once they own it. 

The China buyout opportunity is generally expressed in three forms. First, the succession planning situation. This does not necessarily involve an aging founder who is approaching retirement without a natural heir; a generation of younger Chinese entrepreneurs are increasingly embracing the notion of lifestyle change with a view to enjoying the spoils of their labor. 

Second, the aspiring global player. An entrepreneur has taken his business far but recognizes that continued progress requires third-party assistance. This typically means the introduction of global best practices and cross-border expansion with a view to accelerating growth. The entrepreneur is willing to give up control in the expectation that a private equity investor can make a 20% stake more valuable in five years’ time than his 100% interest is worth now.

Third, the corporate carve-out. Three years ago a multinational was on a China expansion drive, gobbling up organic or inorganic opportunities to grow market share. Having found this growth was harder to realize than anticipated – perhaps due to changes in the competitive and regulatory dynamics, flaws in local execution, or just because the goals were unrealistic – the multinational decides to sell. Private equity investors queue up to participate in the auction process.

In each of these scenarios, elements of the incumbent management team may stay in place post-acquisition. It is not unusual for a retiring founder to retain a minority equity interest, either permanently or during an agreed transition period. This signals his endorsement of the private equity owner and encourages employees to do so as well. Aspiring global player and corporate carve-outs situations, meanwhile, are often structured more like partnerships. Founders and existing management teams have an equity stake in the business and an alignment of interest with the PE investor.

However, there is no guarantee of stability. Obstacles will inevitably emerge during the ownership period and a PE firm will be tested in ways it was not when pursuing growth capital deals. Operational capabilities must be brought to bear and wholesale change might be required – to the point that people have to be parachuted in to take charge. This raises two questions. Does the investment team understand the business well enough to make these decisions? And is an operating team available, either internally or externally, to execute plans in the event that management cannot?

Some private equity firms have already offered answers to these questions: 60 China control deals have been announced in the last two years, only a handful fit the US take-private model, and a number have involved challenging operational situations. However, as the China buyout opportunity continues to expand and concerns about a shortage of deal flow dissipate, will they be replaced by concerns about a shortage of quality investors?

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• Topics
• Greater China
• Buyouts
• GPs
• China
• Operating partners