Riches lie in China’s restructuring

It is not the opportunities presented by China’s size that excite John Zhao but those created through the structural changes taking place in the country’s economy. With the government no longer mesmerized by the speed of GDP growth, instead paying more attention to its value, private equity players should be adjusting their strategies.

“From a private equity perspective the most interesting element is the structural adjustment,” Zhao, CEO of Hony Capital, said in his keynote address at AVCJ’s China Forum in May. “Thanks to the global financial crisis, China recognized that the hyper-growth mode we’ve been operating in is not sustainable; heavy energy consumption, heavy environmental pollution, and putting a lot of resources, from manpower to natural resources, into low value-adding manufacturing and shipping to the world.
“Now that decision has been made – the consensus is that we need a new growth model. The first adjustment will be to rely less on being the ‘factory of the world.’ Instead the thrust will be developing domestic consumption, and encouraging more and more players to meet this new domestic demand.”

China’s consumer market is already in a state of flux. Shoppers are no longer satisfied with being flooded by global brands’ dated models, and instead want China-specific products – for which they are willing to pay the market price.

A consumer upgrade phenomenon is fully entrenched and Zhao believes it will be sustained. This is evidenced by people graduating from small cars to larger cars, and from gasoline-powered vehicles to electric-powered vehicles; or from small apartments to larger apartments to houses. The upgrades can be traced right down to the way in which that most basic of staples, rice, is now packaged and sold.

These trends will gain momentum – and, from foreign brands’ perspective, greater financial justification – through ongoing urbanization. “China now stands at about 45-47% in terms of its urbanization ratio,” Zhao says. “It needs to get to about 60%, which means that over the next decade 200-300 million people – more than the entire population of the US – will move from a rural to an urban setting.”

PE euphoria

Lofty expectations derived from the fundamental drivers of Chinese growth have contributed to the formation of bubbles in several markets – property, equities and now private equity. The huge number of new company listings on domestic exchanges, and the investment multiples these stocks command, has led to a rush of pre-IPO deals as loosely assembled funds seek rapid windfalls.

Zhao notes, drily, that he is grateful for the exit opportunities but remains troubled by the valuations. In the last few months, the average price-to-earnings ratio of a stock trading on ChiNext or the Shenzhen SME Board has fallen from 65 to 45. Zhao hopes it will continue this descent, if only to create a more rationale environment in which true private equity can develop. Although he believes a rebalancing is inevitable, certain factors may delay its arrival.

“China’s 12th Five Year Plan stipulates that we’re going to see the number of companies listed on domestic stock exchanges double [between 2011 and 2015]. As long as that is the call, many people will think they can continue to justify a strategy as a pre-IPO firm,” Zhao says.

Other attractions

Another prime – and less risky – opportunity for private equity lies in helping Chinese companies to go global. Many firms have grown rich on the back of rapid domestic growth, but they are now seeking to diversify and tap global markets, creating sustainable business models by becoming less reliant on the fortunes of a single economy.
“More and more of them have the resources and potential strengths, but they don’t have the experience and the scale,” Zhao says. “That’s where private equity can really help.”

In the same way, he believes private equity can play a role in helping foreign firms enter China. There is a strong demand among domestic companies for technologies and brands developed overseas while foreign players recognize the value of China to their business. Beijing and Shanghai are now crucial markets for global luxury brands, Zhao notes, and General Motors now sells more cars in China than in the US.

“This changes the dynamic of global companies when it comes to Chinese markets,” he says. “We are experimenting with inbound cross-border investments. We would invest in a global company with the sole purpose of sitting on their board and helping them to effectively deploy in China.”
Despite the irritations of private equity euphoria, the industry clearly has an important long-term role to play in the development of China’s capital markets. Private equity activity amounts to just 0.3% of the country’s GDP, compared to 1-1.5% in the US and 0.8-1% in India.

“Even more importantly, the capital structure of the majority of Chinese companies – state-owned enterprises and private sector alike – is still skewed toward too much debt and too little equity,” Zhao says. “That’s very exciting because while we have an active, properly regulated market between the start-ups and sizeable, IPO-able companies, there is this void waiting to be filled by private equity.” 

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• Topics
• Greater China
• Hony Capital