China SOE investment: Uphill battles

Investing in Chinese state-owned enterprises (SOEs) is not a new phenomenon. Before CITIC Capital made headlines for carving out China businesses from international players like McDonald’s and Pearson, most of its buyout activity involved Chinese companies. Many of the sellers were SOEs.

Some of these deals turned out well. Auto components manufacturer Nanjing Aotecar was purchased from Nanjing Lukou Airport in 2007 and sold to a local investment fund six years later for a 4x return. Others have yet to turn out at all. Harbin Pharmaceutical was CITIC’s first SOE restructuring deal in 2005. It teamed up with Warburg Pincus to acquire a 45% stake and spent a protracted period ironing out inefficiencies. In the past two years, CITIC has taken out Warburg Pincus and acquired further shares from the state-owned parent to take its holding to nearly 61%, but LPs are still waiting for an exit.

SOE deals are not for everyone – in the past, an SOE affiliation has helped; think CITIC Capital and CITIC Group or Hony Capital and Legend Holdings – and even those that get access don’t necessarily get free rein. The list of potential pitfalls is daunting: incumbent management that is difficult to shift and impossible to reform; SOE stakeholders, which may or may not be shareholders, stymieing proposed operational improvements; government policy playing havoc with planning; and obstacles to exit.

There are more than 100,000 SOEs in China, but only 98 of these are within the purview of the State-owned Assets Supervision & Administration Commission (SASAC), which has used forced M&A to cut the total from over 150 a decade ago. Others are controlled by local branches of SASAC, or by other government entities, that often have their own priorities.

As a result, SOE reform has been patchy. It is a longstanding central government policy, but the tenacity of execution – and it is a tortuous process – ebbs and flows. China watchers tend to break it down into distinct waves, largely driven by economic expediency and the need to resolve growing debt burdens, with intermittent reassertion of central control when it is politically expedient to do so.

Some would argue that a key objective of the Xi Jinping administration has been to strengthen government influence over business. The prevailing philosophy in SOE restructuring – mixed-ownership reform – should be viewed in this context: it is intended to introduce private sector capital and best practices to SOEs without ceding government control. SASAC said last year that 50 SOEs have undergone reforms as part of two pilot rounds. A third involving 19 groups was imminent. Meanwhile, local governments have been encouraged to list or sell off other assets.

Mixed-ownership reform arrived on the private equity agenda in 2014 when Sinopec sold a 29.99% stake in its fuel retail unit for RMB107.1 billion ($17 billion). A total of 25 investors participated. One quarter were recognized PE investors and only half of those have offshore funds, including Hopu Investment, RRJ Capital and CICC Capital. Other foreign GPs looked at the deal but were put off by Sinopec’s reluctance to permit much due diligence or discuss reforms. The unit has yet to go public.

Since then, mixed-ownership reform has been referenced in numerous deals. These include Hony’s participation in a RMB6.9 billion investment in COFCO Capital Investment; a RMB78 billion fundraising exercise by China Unicom that featured domestic technology companies and government guidance funds, including the China Structural Reform Fund, which was set up for just this purpose; and even CITIC’s progression to a majority position in Harbin Pharmaceutical.

This year, two private equity deals have received the mixed-ownership reform imprimatur. They couldn’t be more different. In July, Ouyeel, an online-to-offline (O2O) trading platform for the steel industry, has raised RMB2 billion from a group of domestic financial and strategic investors. Then last week, PAG agreed to pay RMB3.8 billion for a 58% stake in a biotech unit of Zhejiang Hisun Pharmaceutical. It was the only qualified investor in a competitive process, having got the jump on its rivals due to a familiarity with the company.

There are clearly going to be more investment opportunities for private equity firms arising from efforts to drag SOEs into the 21st century, but they will vary in size, structure and accessibility. And no matter what reform moniker is attached to these deals, they will remain a hard slog.

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

• Topics
• Greater China
• Regulation
• GPs
• PIPEs
• Buyouts
• China