Opportunities lie within secondary market exits, growth capital investments, and outbound strategic acquisitions
by Kevin Wang, MBA ‘13
Wallace, the IPO Project Manager for QS Solar, a privately held alternative energy firm based in Shanghai, met with 50 potential private equity investors over the span of a few months in 2007. This guest-list included leading firms such as Warburg Pincus, SoftBank Capital, as well as 12 exclusive international and domestic investment banks. With this much attention, the dream of an IPO for QS Solar was almost a solidified reality. Then, the financial crisis sprouted from the US in late 2008 and soon reached global scale, and a shake-out in the Chinese market followed suit. Almost overnight, the investors disappeared, and the future of QS Solar suddenly became clouded with uncertainty.
Stories like this were not atypical in the pre-financial crisis China. However, despite the tumultuous 2008 crash, a strong interest in private equity investment is back in The Middle Kingdom. According to PwC research, PE funds raised in 2011 reached $48B USD, 20% higher than the pre-crisis record of $39.9B USD.
With this mounting demand for return on investment, how can PE managers maximize the return on these funds raised, and to which areas should they be deploying committed capital? How are the investment opportunities in China different from those of the US? This article aims to analyze the current state of the Chinese PE market, and highlight three major areas of opportunity – secondary exits, growth capital investments, and strategic outbound acquisitions.
Major Types of Private Equity Funds in China
In order to answer the aforementioned questions, it is important to first understand the types of players that are on the landscape. There are mainly four types of equity funds in China: traditional US based funds, national and local government funds, private small cap funds, and individually directed funds by one or two partners.
Traditional US private equity firms rely on well-established investment methodology and stable committed capital to capture large cap deals – Examples of this type of firm include TPG, KKR, and Carlyle. A high-profile deal was completed in 2012 by Carlyle and CITIC Capital Partners for the acquisition of Focus Media, Inc., valued at $3.7B USD.
Chinese national banks and provincial governments that make investments in equity deals can sometimes be called “special vehicles” or even incubators – Examples include Bank of China International, China International Capital Corporation, and China Agricultural Bank (AgBank Private Equity Fund). Since they often have tie-ins with the government, the goals of these funds are to make a financial return and also to stimulate the local economy.
Privately organized conglomerates mainly acquire target firms for strategic growth – One example of this type of fund is Dalian Wanda Conglomerate Group, which acquired AMC Entertainment for $2.6B in 2012.
Private equity funds run by individual managers – They pool together the funding received for private investments mainly in small-cap regional firms.
Growth Stage Capital Infusion is the Main Vehicle of Investment
The types of private equity investments are different in China than those in the US. In the US, PE partners typically pursue LBO as a way to inject capital as well as to take over the control of a target firm. In China however, most of the firms in industries attractive to PE investors, such as telecom, energy, and transportation, are owned and operated by the government. As a result, this fact obviates LBO as a viable investment strategy.
By contrast, growth capital is the preferred method of investment by the majority of PE investors, according to recent KPMG research. This is supported by the fact that the SME sector in China is occupied by privately held firms owned and operated by independent entrepreneurs. These firms require bridge capital that will increase the scale of their business.
Challenges and Opportunities for PE/M&A related to China
Given the current condition of the market, I see the following three major areas of foci for PE investments in China.
PE firms need to foster a robust secondary market, as China’s IPO market is still soft as an exit route – According to China First Capital, an investment bank based in Shenzhen, more than $100 billion, much from the US, remains invested. And of that, some $22 billion is tied up in 2,200 deals completed before 2008, meaning time is running out fast for firms to find a way of returning cash to investors over the standard 5-7 year period. With the China IPO market remaining soft, this challenge is forcing PE managers to attempt to foster a burgeoning secondary securities market, so that investors could recoup their investments. In addition, CFC research suggests that secondary securities have several benefits, such as shorter due diligence duration, lower opportunity cost, and reduced legal risks.
Focus on strategic and branding opportunities for large Chinese conglomerates – As mentioned before, the majority of mature firms in China are either state owned, have strong connections with the government, or are conglomerates ran by wealthy individuals. The goal of these firms is not only financial, but also more strategic in nature. As an example, there were recently three major acquisition deals which highlight this trend: Shuanghui International buying Smithsfields Foods for $4.7 billion, Li Ka-shing’s consortium acquiring AVR Waste Management for $1 billion, and conglomerate Dalian Wanda Group acquiring AMC Entertainment for $2.6 billion. This could suggest that there are more opportunities for outbound investments from China, as Chinese firms are including brand value in their selection criteria, in addition to revenue generating capabilities. This appetite for foreign expansion bodes well for PE groups who own brand name portfolio firms, particularly in the consumer goods industry.
In terms of deal sourcing opportunities, firms that are facing the critical “talent-gap” may hold promise – According to Bain research, many privately held firms in China have risen to prominence since their humble beginnings in the 1970s, when a change in national policy started to privatize many of the formerly state owned industries such as manufacturing. The original investors and entrepreneurs in these firms are now reaching the age of retirement, and many of them are having trouble finding suitable leadership talent to take over. One natural exit route is going through a sale to PE investors, however many of these initial investors demand some operating responsibility even after the deal closes.
PE Investment Strategy Needs to be Tailored to the Local Chinese Market
Private equity has indeed rebounded in China. Within the unique market context of China, the opportunities in the local private equity sector are different from those in the US. As global sentiments rebound, more and more investors will rekindle their focus on China. PE managers need to be perceptive of the local market dynamics in China, and if they can focus on identifying secondary exits, strategic outbound investments, and target firms that are in generational transition, then they will most likely achieve attractive risk adjusted returns in China’s fast recovering capital market.
Update: Additional China outbound deals announced since the post of the article include China Mengniu Dairy offering $1.6 billion for baby formula firm Yashili on June 18, 2013
Proprietary research and interviews
WSJ – For Private Equity, a Door to Deals Opens in China
E&Y – Private Equity Round up in China
KPMG – Market Sentiment Survey
CNN – Slow China IPO market limits private equity exits
PwC – PE Reflections on 2012 and Outlook