Don’t speak too soon on China buyouts

There is a general expectation among industry participants that conditions will ultimately change as the market matures. Entrepreneurs are likely to become more comfortable with divesting large stakes, especially where there is a perceived alignment of interest. It is also possible that state-owned enterprise restructuring will throw up control opportunities for PE investors, although access is likely to be limited. On the financing side, the internationalization of China's currency and regulatory liberalization will be key factors.

So much for the long term, but isn't this change happening already? One of the highlights of Bain & Co's 2012 China Private Equity Report is the emergence of more buyout deals.

According to Bain's calculations - which are in part based on data supplied by AVCJ Research - there was a marked increase in deals worth $200 million or more: they accounted for nearly two thirds of the total invested, compared to less than half in 2010 and about one quarter in 2009. Growth capital still dominates the market, but buyout transactions more than doubled by value and volume in 2011 over the previous year.

It would be unwise, however, to read too much into this trend. While the argument for more buyouts in the long term is solid, the recent spike in activity has been influenced by one factor in particular: the underperformance of US-listed Chinese companies.

Management buyouts (MBOs) of Harbin Electric and China Fire & Security, supported by Abax Global Capital and TPG Capital respectively, together came to more than $700 million, a significant portion of the buyout total. Had CNinsure's attempted privatization, which included a $620 million investment from TPG and CDH Investments, not fallen through after problems were uncovered during due diligence, the share would be even higher.

Chinese companies listed in the US are trading at a 40-50% deficit to their Hong Kong counterparts, down from 70% a year ago, but it still makes for attractive valuations. According to Roth Capital Partners, 14 MBOs and strategic buyouts have been completed since February 2011 - at least four of which saw PE participation - and a further 15 are still in progress.

Industry sources report continued interest from company chairmen who believe their assets are undervalued - largely a result of accounting scandals in some firms that have dragged down stocks across the board, irrespective of fault or allegations of it. However, more MBOs are discussed and discarded than reach the execution stage.

Aside from red flags exposed during due diligence, there are numerous potential pitfalls that can sink a deal before it gets off the ground. If the ultimate aim is to re-list the company in Hong Kong, investors must consider the bourse's merit review-based system, which requires a track record of profit. The Hong Kong Stock Exchange also is also unlikely to endorse applicants incorporated in the likes of Nevada and Wyoming - the jurisdictions of choice for many Chinese companies listed in the US. There is the option of re-domiciling to the Cayman Islands, but this could result in a sizeable tax bill.

Perhaps the clearest evidence of uncertainty is in the stock prices themselves. The single MBO announced in April, Winner Medical Group, is still trading at a 10% deficit to the bid price.

Clearly some investors will continue to profit from valuation distortions, but this is a temporary phase rather than a long-term trend. It is also an opportunity laden with risk, so isn't suited to all PE players. The China buyout opportunity is slowly gathering pace and it might be 5-10 years before it blooms. It is not happening now, whatever the numbers might suggest.

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• Topics
• Greater China
• Buyouts
• China
• buyout