China Briefing: Eyes On The Road
This article was originally published on Private Equity International on September 01, 2015, written by David Turner
China is one of the world’s most challenging places to invest. But the opportunities are too good to ignore.
China’s rapid economic growth has made it an extremely popular market among private equity firms in recent years, with a huge amount of capital – international, but mostly domestic – chasing opportunities in the country.
Some foreign investors warn, however, that China is at risk of becoming too popular, with the number of profitable opportunities hampered by a lack of management expertise and a balance between supply and demand that is pushing returns down.
Private equity investment still looks attractive, but investors need to find the right sector and management team, and avoid some of the traps peculiar to the local market.
Private equity funds transacted a record $19.7 billion deals in 2014, according to data from Preqin, though the pace has slowed down this year, with only $6.0 billion of deals by late July. Funds concentrating on venture capital had transacted an impressive $19.7 billion by late July – making this year a record year already.
This reflects the strong interest of international firms and the growth of their local counterparts, a large number of them set up by rich Chinese looking for suitable investments for their newly made fortunes. Some state-owned or -affiliated organisations also invest through private equity, though experts say they are increasingly focused on private equity opportunities abroad.
“China is one of the oldest private equity markets in Asia, and these days it’s the largest market after the US,” says Viswanathan Parameswar, head of the Asia programme of Adveq, who manages a fund of private equity funds in Zurich. “There are more than 500 private equity managers in China.”
There is a problem, however. “The lack of transparency and of quality management teams means that the investable universe is small,” says Chris Lerner, partner in the Shanghai office of Eaton Partners, the fund placement agent. This leads to a rise in valuations, depressing profit opportunities. “There’s a sense out there that there’s a lot of capital chasing a limited number of deals,” adds Lerner.
HIGH VALUATIONS
“Back in 2007-09, gross fund returns of 7x or 8x were not unachievable for venture capital,” says Anand Prasanna, director in the Shanghai office of Morgan Creek Capital Management, a multi-asset manager based in Chapel Hill, North Carolina.
Morgan Creek puts money into venture capital and private equity in China, both as a limited partner and through co-investment. “Nowadays, instead of these crazy returns, you might get 3x or 4x,” adds Prasanna.
For larger, private equity-sized deals, “a lot of people were getting a gross IRR of more than 40 percent. Now you can only get 30 percent, and at some of the big funds probably even less”.
The changing supply-demand balance can also be gauged by the reduction in proprietary deals. “There were way more proprietary deals earlier than today,” says Prasanna. He thinks that perhaps one in three or two in five deals are proprietary today, compared with more than half in 2007-09.
In the high-growth sectors, such as ecommerce and healthcare, companies are sometimes being bought at as much as three to five times sales, says Lerner, with, in certain cases, stakes in companies changing hands at as high as 40 times price to earnings. In businesses not enjoying the same rapid growth, however, he still sees pricing at high single digits to EBITDA.
The market has even become prone to bubbles, say some investors – particularly in the consumer sector, recently beloved of investors anxious to tap into the rise of the Chinese middle-class consumer. Parameswar cites a 2010-12 bubble in ecommerce. “Valuations were so high that fundamentals lagged way behind. A lot of capital was invested in ways that resulted in a lot of heartburn later on,” he says.
The latest bubble is in companies facilitating China’s move from an offline to an online country – the O2O sector. “Investors need to be very careful about that,” Parameswar adds.
One solution is to wait longer before exiting. Parameswar used to see cases where it did not take much more than two years to enter and exit a company with a high profit. Now, however, this has changed. “I don’t think quick returns are going to be a feature anymore,” he says. “You have to pull other levers other than just timing.”
Another solution is to invest sooner. “Groups are investing at an earlier and earlier stage,” says Lerner. Even though early-stage returns have also fallen, they are still potentially higher than for later-stage investments.
“Venture capital in China is extremely promising,” says Mounir Guen, chief executive of MVision, the fund placement agent, who moved to Hong Kong recently because of the strength of China and other Asian markets.
A further option is to work with the companies to improve management. “When we invest in a company we bring much more than just capital,” says David Li, head of Asia-Pacific and managing director at Warburg Pincus in Beijing. “We help the company to build up functionally and we act as growth-oriented investors.”
The move to early-stage investments is not uniform, however. For international firms, the deal sizes are too small to make a dent in their funds. Actis, the emerging market private equity specialist, has been pushing up the size of its typical investments from $20 million-$50 million to $50 million-$150 million – with typical returns on equity of 2x-3x, says Dong Zhong, Beijing-based partner and head of Actis China.
Zhong has also noticed an increase in opportunities for the sort of buyout deals that are mainly the preserve of developed markets. “The first-generation entrepreneurs are approaching retirement age, but the second generation often does not want to hold onto the current business,” says Zhong. “This has increased the opportunity for private equity to invest in family businesses through buyouts.”
AVOIDING BUBBLES
Another solution is to pick sectors that are not yet bubbles. “It’s imperative to maintain investment and valuation discipline, rather than following the market’s flavour of the day,” says David Liu, member, co-head of Asia private equity and head of China at KKR.
KKR China’s philosophy is, as Liu puts it, “to identify sectors and themes with long-term growth potential even in a slowing economic environment”.
China’s GDP growth has eased from 10.6 percent in 2010 to 7.4 percent last year, with an official target of 7 percent in 2015. These themes with long-term potential are in many cases in “businesses that address critical societal needs”, says Liu. He cites as examples KKR China’s investments in water treatment and recycling solution provider United Envirotech Limited and China Cord Blood, the first and largest umbilical cord blood-bank operator in China.
“We tend to take a top-down approach, looking at which sectors can benefit from China’s megatrend: the restructuring of the economy towards domestic consumption,” says Li of Warburg Pincus. “It’s really the broad consumer thesis that has created a lot of opportunities, as Chinese people upgrade to better-quality and more branded goods and services.”
In line with its interest in the consumer sector, in 2012 Warburg Pincus turn $200 million on a 25 percent stake in China Auto Rental – since renamed CAR Inc – before turning it into the largest auto rental company in China.
Its reasoning was that the car rental market was highly underpenetrated. There are more than 250 million licensed drivers – a number that has room to grow, given a population of 1.37 billion. However, the number of passenger cars is only 123 million, because of their high cost relative to income and the restrictions placed on car ownership in China’s biggest cities. This left a huge potential client base interested in renting cars for holidays or day trips.
Warburg Pincus helped the company acquire the China business of Hertz, its rival, before taking the company public on the Hong Kong stock market last year. In May it sold $401 million-worth of shares, leaving it with a remaining holding worth about $500 million.
The sector within the consumer super-sector most often cited by private equity firms is healthcare. Zhong, of Actis, says this sector is benefiting from China’s ageing population and government increases in health insurance coverage. Actis has a particular interest in the med-tech sector and recently invested in Nanjing Micro-Tech, which manufactures disposable endoscopy tools.
Amid all this frenetic activity, do environmental, social and governance (ESG) issues receive much attention?
“We have in some cases brought up ESG concerns,” says Prasanna of Morgan Creek, who invests through local Chinese firms rather than through the international houses that maintain strong ESG policies in China.
However, “normally we don’t see the managers spending a lot of time or effort on ESG. The issue is not even on the checklist”.
Prasanna’s explanation: general partners are not focused on it because neither are the Chinese investors who are their biggest clients. Another concern cited by investors is the sometimes less than helpful role of the state. Lerner, of Eaton Partners, advises investors to steer clear of companies whose revenue depends largely on selling to the state, because this revenue stream is subject to the vagaries of government budgets.
Another complication is assessing the role of China’s “princelings” – the sons and daughters of leading Communist Party officials, who have formed a powerful and corrupt business class – when making private equity investments.
In some ways, however, the government’s ongoing corruption clampdown may be making things easier. “There’s been a lot of change in the ability for private equity firms to leverage connections,” says Lerner. As a result, “a lot of the princelings associated with private equity funds have fallen back into the shadows or left the business altogether”.
If this helps to make competition in the Chinese private equity market more meritocratic then it can only be welcomed by firms from developed markets.
EXIT BLOCKED
A ban on IPOs is making it harder to find a route out, writes David Turner. Imagine that a private equity investment in China has gone well. A brilliant ecommerce idea from a well-run company, invested in at an early stage, looks set to reap a handsome reward – judging, at least, by the stratospheric rise in EBITDA. There is only one stage left: the exit, perhaps through a well-timed initial public offering on one of the mainland stockmarkets.
The trouble with this is that the Chinese authorities are notoriously trigger-happy about suspending IPOs. Having already barred all IPOs eight times in the past, they did so for the ninth time in early July, in an effort to stop sharp falls in the markets. They have not said how long the ban will last.
However, Anand Prasanna, of Morgan Creek Capital Management, citing talk in the market, thinks it will be at least six months. A particular problem since “the deal backlog is very large”. The backlog is so large, says Prasanna, because of a 14-month suspension in 2012-13. This caused problems for private equity investors since IPOs account for the majority of exits every year.
“It coincided with the point when a lot of investors were in the harvesting period for funds begun in 2006-08,” says Chris Lerner, of Eaton Partners. “This depressed the distributions of a lot of China funds during a time when there were unprecedented levels of distribution in the US.” Because of the bar, the number of private equity exits in both 2012 and 2013 remained below a 2010 peak of 59, before rising to a new peak of 61 in 2014, according to data from Preqin.
Other private equity investors are more relaxed, because they managed to find other viable routes during this time. “A lot of companies have the flexibility of multiple possible exit routes,” says David Li at Warburg Pincus in Beijing. “There’s a pretty active M&A market, and if the China market is closed companies can still list in Hong Kong or the US.”
He cites the example of portfolio company 58.com, the largest online classified ad company in China, which listed on the New York Stock Exchange in 2013.
