China's middle market: Small is beautiful

Looking only at the US dollar-denominated funds, the China PE market has thinned out since the pre-global financial crisis boom years. The sub-$750 million space is occupied by VCs and a handful of others - perhaps no more than 5-6 in each vintage. A select number of country-focused managers have kicked on into the $1 billion-plus territory, but are they leaving a lucrative opening in the market?

There is some economic reasoning behind progressive fund size increases; it is not just pure greed. In 2004, China's nominal GDP was $1.9 trillion; last year it was more than five times larger. Average PE deal sizes have gone up - from $19 million in 2004 to $42.7 million in 2014, in part a reflection of the emergence of larger, more complex companies, and in part a reflection of increased competition for deals.

And then, of course, the opportunity set has changed. Having built their reputations on minority growth investments and well-timed IPOs, most China-focused GPs are now looking to effect greater change in their portfolio companies. Control transactions are the clearest path to achieving this and investors say they are seeing more traction among entrepreneurs. Succession planning, intensifying competition, and greater recognition of the role PE can play are among the reasons given for this.

In each of the past three years, China PE buyouts have numbered around 30, a substantial improvement on the historical average but still a fraction of growth capital deal flow. However, it is also worth noting that GPs in general are willing to write bigger checks for a bigger say in businesses on a minority basis, and they are investing in their operating capabilities so as to bring this influence to bear.

The question left hanging is how many China-focused PE investors are capable of committing capital in increments of $50 million or below?

There are still plenty of small and medium-sized enterprises facing the challenges outlined above - and perhaps unable to raise capital through conventional channels - that would benefit from support. It might be argued that any PE firm paying out $50 million for a controlling stake would be hard pushed to build a business to sufficient scale that a public market or trade sale exit is a viable option within five years. But then maybe a savvy GP can achieve satisfactory returns as a significant minority investor.

CDH Investments is not about to find out. The GP raised $2.55 billion for its most recent fund and is looking to make investments of around $100 million. Hony Capital is in a similar position and even the likes of FountainVest Partners might struggle to go too small. If those managers that are left in the middle market (or maybe it's now the lower middle market) start delivering some interesting deal flow, who will join the party?

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• Topics
• Greater China
• GPs
• Buyouts
• Expansion
• Fundraising
• China
• GPs
• Fundraising
• buyout
• Growth capital