Private equity could offer a lucrative opportunity to benefit from China's economic boom, as long as you accept the rules of engagement are very different from the rest of the world. Joseph Mariathasan explains.
Private equity is another avenue for gaining exposure and as Chris DeAngelis, a director of Vermilion Partners in Beijing, put it: "Private equity generally in China is growing and has been year on year. Everyone tends to read about the difficulties faced in completing the large deals, but the underlying environment is healthy and deals are getting done."
The real opportunities for private equity investments in China are very different from those seen in the US and Europe, where the mega buyout funds have attracted most interest and generated attractive returns historically.
As Benjamin Cheng, a partner in the Beijing office of Actis, explained: "The growth in the buyout market will occur, but not very fast. It is more likely to happen in the private sector than in a state owned enterprise (SOE) spin-off, although there are some cases. A lot of the time, it is management or insiders who buy.
"We have seen private entrepreneurs who have spent eight to ten years working 24/7 and are simply tired. They have seen internet entrepreneurs selling out and doing very well. This is coupled with succession issues, which are exacerbated by China's one child policy, so we are now seeing people with a different bias than has been the case in the past."
Another issue for the mega funds that dominate the US and Europe is that, with the exception of certain state-controlled industries, there are few companies with nationwide scale.
"It is only recently that you are starting to find companies with sufficient size and capital to expand beyond their core markets," said DeAngelis, adding: "If you take the retail sector, for example, you may come across a company that purports to have thousands of stores throughout the country and so on, but if you start delving deeply, you will find the company really has a dominant position in one or two regions, with a scattering of stores in other areas that may well not be profitable. So if you are a mega fund, the opportunities are very limited if you are looking outside of SOEs."
Whilst China has always been seen as a centre for low cost manufacturing for exports, the sectors that are attracting private equity interest are often not export driven at all. DeAngelis commented: "The most attractive opportunities lie in areas driven by the growth in domestic consumption. Some of our international clients tell us they are not going to build additional factories in China for exports due to the rising costs."
Private equity firms are often cautious now of export oriented businesses that rely on cheap labour for their main competitive advantage. As Cheng explained: "Labour costs in China are very low relative to other countries. But the problem is that there are tons of other people who can set up factories selling the same cheap goods and, on the other side, you have Wal-Mart pushing margins down."
Cheng went on to say the attractive sectors were beneficiaries of rising consumer power, e.g. FMCG, distribution, retail, education, healthcare, an argument DeAngelis added weight to with the exclamation: "Where else can you find a company growing at 30% a year through domestic growth?"
Location is key
A key aspect for private equity investors is the geographic location of businesses in a country as large and diverse as China.
DeAngelis explained: "Everyone is trying to move beyond the large tier 1 and coastal cities, but the results are mixed. People would tend to say for some retail businesses that Beijing and Shanghai are saturated and you need to move to tier 2 and tier 3 etc. But we are finding that the difficulties of developing businesses in tier 2 and tier 3 cities are much higher than tier 1, and even higher than when companies first entered the tier 1 marketplace 20 years ago, as the local competition tends to be much stronger now.
"It still remains more difficult to do business in the smaller cities, but, more profoundly, they are also very locally driven economies. Some 80% to 90% of products in the large hypermarkets are locally sourced, so you cannot just develop a centralised procurement system and expect consumers across the country to buy the same brands or products."
It is very difficult to grow organically across China because each province is so different. DeAngelis argued the way to tackle the tier 2 and 3 marketplace was by M&A, which "plays to the strengths of private equity".
This way, he argued, "people are buying local businesses that may be dominant in their area with a view to selling them at some stage to national international or domestic chains".
The marketplace for private equity in China is becoming increasingly sophisticated and private equity firms have to bring more than just money to the table. Sourcing investments is always going to be a difficult task in a highly fragmented marketplace where the Chinese concept of guanxi (connections) is often the most critical factor. Cheng himself focuses "more on securing deals rather than introductions".
He explained: "Nowadays, the issue is not just getting your foot in the door of a company. That might have been the case a few years ago. But now it is about proving your ability to add value and seeing that deal close. Even after you've signed a term sheet, don't be surprised if someone tries to lure your target company with a 10% higher valuation. The value you can bring will increasingly help in closing some deals."
Cheng sees his own firm, Actis, adding value in two areas.
"The first area usually means helping firms in their financial management," he said. "Most Chinese companies have a very poor financial function. Rightfully so, as they have been focused on growing the business at 30% to 50% p.a."
Secondly, many international private equity firms focus on operational improvements and the improved strategy they can bring to the investee company through their network and access to sector expertise. Whilst many firms would lay claim to an international presence spanning the globe, converting that into actual collaboration in adding value to an investment is not so straightforward.
Actis, according to Cheng, tries to have a "One Firm" culture, which he explained as follows: "Through offsites, project groups, training programmes and so on, we create opportunities to build bridges amongst team members across regions. We also embed this in our reward and staff evaluation systems. The result is that when you seek help, you get multiple responses and referral from around the world."
This is brought to bear in China as Cheng described: "Through our network we have identified people who are experts in their field, whether in China or abroad. They come in, help the company and are very often retained by the company as non-executive directors or as consultants."
Exits are where the uncertainty may be greatest in a marketplace where the regulations are evolving at a rapid pace. "Before we make an investment, we want to make sure that it is a long term sustainable business, so that if the IPO window closes, the business will continue to prosper," explained Cheng.
The major route for Actis has been offshore IPOs, with Cheng offering the following straightforward explanation: "They have all been minority investments so far and it would be hard to do a trade sale on a 20% position."
However, one of the problems that currently exists, according to DeAngelis, is that "as a result of the changes to the M&A laws in 2006, which now require additional approvals that have not yet been forthcoming, private equity investors' most reliable exit strategy has been made significantly more difficult, although not impossible to accomplish".
As a result, he argued private equity firms need to consider "either a sale to a trade player or a listing on a domestic exchange as an alternative exit strategy".
He continued: "The bad news is that a domestic listing can be quite challenging. To do so, a foreign invested enterprise must first obtain approval at the national level to convert into a foreign-invested company limited by shares, which must then apply for listing.
"Moreover, the rules of the relevant stock exchange will prohibit the sale of shares of stock for a period from one to three years and it is unclear whether the domestic stock markets will be developed enough to provide the desired liquidity at the time of exit."
The bet is that it is in everyone's interests to ensure the private equity market functions effectively and the Chinese authorities will ensure the regulatory environment is adjusted accordingly.
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