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Private Equity in China, 2012: CFC’s New Research Report

April 26th, 2012 No comments

Around the time of Confucius 2,500 years ago, the Greek philosopher Heraclitus wrote, “Nothing is permanent except change.” It’s a perfect quick summary of the private equity industry in China. In its short 20 year history, PE in China has undergone continuous transformation: from dollars to Renminbi; from a focus on technology companies to a preference for traditional industries; from overseas IPO exits to domestic listings;  from a minor financing channel to a main artery of capital to profitable private companies competing in the most dynamic and fast-growing major market in the world.

Where is private equity in China headed? Can future performance match the phenomenal returns of recent years? Where in China are great entrepreneurial opportunities and companies emerging? These are some of the questions we’ve sought to answer in China First Capital’s latest English-language research report, titled “Private Equity in China, Positive Trends and Growing Challenges”.

You can download a copy by clicking:  Download “Private Equity in China, 2012 – 2013.

Our view is that 2012 will be a year of increasingly fast realignment in the PE industry. With the US capital markets effectively closed to most Chinese companies, and Hong Kong Stock Exchange ever less welcoming and attractive, the primary exit paths for China PE deals are domestic IPO and M&A. Both routes are challenging. At the same time, there are too many dollar-based investors chasing too few quality larger deals in China.

Adapt or die” describes both the Darwinian process of natural selection as well as the most effective business strategy for PE investing in China.

I’ve been working with entrepreneurs for most of my 30 year business career. It’s the joy and purpose of my life. Good entrepreneurs profit from change and uncertainty. Investors less so, if at all. This may be the biggest misalignment of all in Chinese PE. The entrepreneurial mindset is comfortable with constant change, with the destruction and opportunity created by market innovation. In my view, the PE firms most likely to succeed in China are those led by professionals with this same entrepreneurial mindset.

Chinese Private Equity Moves from IPO to IRR

April 10th, 2012 1 comment

Most investors, including me,  would be delighted to make 15% to 20% per year, year after year. But, for many private equity firms active in China, that kind of return would be cause for shame. The reason is that recent past returns from Chinese PE , and so the expectations of LPs, is much higher, often overall annual increases of 40%-60% a year, with successful individual deals increasing by 100% a year in value during a typical three to five year holding period.

But, it is quickly becoming much more challenging to earn those +40% annual rates of return. My prediction is that profits from PE investing in China will soon begin a rather steep downward slide. This isn’t because there are fewer good Chinese companies to invest, or that valuations are rising sharply. Neither is true. It’s simply that a declining percentage of PE deals done in China will achieve those exceptionally high profits of 500%-800% or more over the life of an investment.

The reason is that fewer and fewer PE deals in China will achieve exit through IPO. Those are the deals where the big money is made. There are no precise numbers. But, my estimate would be that in recent years, one in four PE investments made by the top 50 firms active in China managed to have an IPO. Those are the deals with the outsized rates of return that do so much to lift a PE firm’s overall IRR.

In the future, the rate of successful IPO exit may fall by 30% or more for the good firms. For lesser PE firms, including many of the hundreds of Renminbi firms set up over the last three years, the percentage of deals achieving a domestic IPO in China may not reach 10%. If so, overall returns for each PE firm, as well as the industry as a whole, will fall rather dramatically from the high levels of recent years.

The returns for most PE and VC firms across the world tend toward bell curve distribution, with a small number of highly successful deals more than covering losses at the deals gone sour, and the majority of deals achieving modest increases or declines. In China, however, the successful deals have tended to be both more numerous and more profitable.  This has provided most of the propulsive thrust for the high rates of return.

The higher the rate of return, the easier it is to raise new money. PE firms each year keep 1% to 2% of the money they raise every year as a management fee. It’s a kind of tithe paid by LPs. PE firms also usually keep 20% of the net investment profits. But, this management fee is risk-free, and usually is enough to fully pay for the PE and VC firms salaries, offices, travel and other operating expenses, with anything left over split among the partners.

So, high rates of investment return in the past ends up translating into lots of new money unlinked to actual investment performance in the future. It’s a neat trick, and explains why the PE partners currently most actively out raising capital are mainly those investing in China. The more you raise now, the longer your guaranteed years of the good life. In other words, even if overall investment results deteriorate in coming years, the guaranteed income of PE firms will remain strong. Most funds have a planned lifespan of seven to ten years. So, if you raise $1 billion in 2012, you will have perhaps $20mn a year in guaranteed management fee income all the way through 2022.

The more new capital that’s raised for PE deals in China, the more investment deals can get done. The problem is, IPOs in China are basically a fixed commodity, with about 250 private companies going public a year. These domestic Chinese IPOs are the common thread linking most of the highest return PE deals. The Chinese IPOs will continue, and most likely continue to provide some of the highest profits available to PE firms anywhere. But, with the number of IPOs static and overall PE investment surging, the odds of a PE-backed company in China getting the green light for IPO will drop — rather precipitously if the current gusher of new money for PE deals in China persists.

Meantime, the number of Chinese companies going public outside China is dropping and will likely continue to. The US has all but barred the door to Chinese companies, following a spate of stories in 2011 about fraudulent accounting and false disclosure by Chinese companies quoted there. In Hong Kong, the only Chinese companies generating investor enthusiasm at IPO are ones with both significant size (profits of at least USD$25mn) and an offshore legal corporate structure. It used to be both simple and common for Chinese companies to set up holding companies outside China. The Chinese government has moved aggressively to shut down that practice, beginning in 2006. So, the number of private Chinese companies with the legal structure permitting a Hong Kong (or US, Singapore, Korean, Australian) IPO will continue to shrink.

Add it up and the return numbers for PE firms active in China begin to look much less rosy going forward than they have in the past. More deals will end in mandatory buybacks, rather than IPOs. This is the escape mechanism written into just about every PE investment contract. It allows the PE firm to sell their shares back to the company if an IPO doesn’t take place within a specified period of time, typically three to five years. The PE gets its original investment back, plus an annual rate of return (“IRR”), usually 10% to 20%.

This way PE firms can’t get stuck in an illiquid investment. The buybacks should become an increasingly common exit route for PE deals in China. But, they only work when the company can come up with the cash to buy the PE shares back. That will not always be certain, since pooling large sums of money to pay off an old investor is hardly the best use of corporate capital. Fighting it out in court will likely be a fraught process for both sides.

The direction of Chinese PE is moving from IPO to IRR.  As this process unfolds, and PE returns in China begin to trend downward, the PE investment process and valuations are likely to change, most likely for the worse. IRR deals seldom make anyone happy—not the PE firms, their LPs or the entrepreneur.

Chinese PE still offers some of the best risk-adjusted returns of any investment class. But, as often happens, the outsized returns of recent years attracts a glut of new money, leading to an eventual decline in overall profits. In investing, big success today often breeds mediocrity tomorrow.