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Distressing Times — China’s Weak PE Firms Look to Sell Out

January 7th, 2009 Leave a comment Go to comments

Ming Dynasty Ivory Luohan

 

Look up. Those are vultures circling over China’s Private Equity market. The vultures, in this case, are distress investors, including AIG and GE Capital. They have quietly begun shopping for the investment portfolios of hard-up private equity and venture capital firms who spent the last three to five years investing in China. The price they are offering: as little as five to ten cents on the dollar. In other words, a PE fund that invested $100mn in Chinese private companies could liquidate those investments for as little as $10mn in cash.

Who would be crazy enough to sell at that price?

Good question. It’s hard to see why any PE or VC fund would want out at that sort of price. After all, their investors (aka LPs) are locked in for the long haul, about 7-10 years on average. This is the signal difference PE and VC firms enjoy compared to hedge funds, whose investors usually can redeem either quarterly or annually. A PE or VC fund has better balance of assets and liabilities: its illiquid investments are matched by liabilities to its investors that are similarly long-term. 

This means a PE or VC firm can ride out any market turbulence, even one as severe as what we’re experiencing now. China’s stock markets are off 60% over the last 12 months, and IPO activity (the usual exit route for PE and VC investments in China) has all but dried up.   

And yet, you can be sure there are PE and VC firms that will sell out in coming months to distress investors. Why? It’s not because these funds will be legally or contractually or even morally obliged to sell. It’s more a matter of confidence – or lack thereof. While LPs can’t withdraw their money, they can make life very tough for PE or VC partners whose investments are in deep trouble. 

Another reason, PE or VC partners don’t much like the prospect of nursing investments for many years, during a difficult period, with no strong likelihood of a successful exit. VC and PE partners like to say they’re long-term investors. But, the reality is, they like to get in and out within two to three years, collect their share of profits, use this success as a selling point to raise more money from which they can collect even higher management fees. And so the wheel spins. At least in good times. 

Well, the good times are over. 

I’ve run a VC firm through the last down-cycle following the crash of the internet bubble in 2000. It takes a different kind of mindset than that of many PE and VC investors, especially ones who had a relatively easy time during the boom years, when some very mediocre companies can achieve successful exits. 

China’s PE market today is quite reminiscent of Silicon Valley venture capital after the 2000 crash. A lot of Silicon Valley VC firms (generally those with the weakest ability to make winning investments) sold out to distress investors back then. A similar pattern is emerging in China – the weakest will perish.   

The good firms know how to keep the vultures at bay. They are the ones who know how to manage in lean times, and how to work harder, faster and smarter with their portfolio companies to improve operations and cash flow. 

 

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