China Private Equity

CFC has just published its latest Chinese-language research report. The title is 《私募基金如何创造价值》, which I’d translate as “How PE Firms Add Value ”.

You can download a copy here:  How PE Firms Add Value — CFC Report. 

China is awash, as nowhere else in the world is,  in private equity capital. New funds are launched weekly, and older successful ones top up their bank balance. Just this week, CDH, generally considered the leading China-focused PE firm in the world, closed its fourth fund with $1.46 billion of new capital. Over $50 billion has been raised over the last four years for PE investment in China. 

In other words, money is not in short supply. Equity investment experience, know-how and savvy are. There’s a saying in the US venture capital industry, “all money spends the same”. The implication is that for a company, investment capital is of equal value regardless of the source. In the US, there may be some truth to this. In China, most definitely not. 

In Chinese business, there is no more perilous transition than the one from a fully-private, entrepreneur-founded and led company to one that can IPO successfully, either on China’s stock markets, or abroad. The reason: many private companies, especially the most successful ones, are growing explosively, often doubling in size every year.

They can barely catch their breath, let alone put in place the management and financial systems needed to manage a larger, more complex business. This is inevitable consequence of operating in a market growing as fast as China’s, and generating so many new opportunities for expansion. 

A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrow”. This means that running a company in China often requires more improvising than long-term planning. I know this, personally, from running a small but fast-growing company. Improvisation can be great. It means a business can respond quickly to new opportunities, with a minimum of bureaucracy. 

But, as a business grows, and particularly once it brings in outside investors, the improvisation, and the success it creates, can cause problems. Is company cash being managed properly and most efficiently? Are customers receiving the same degree of attention and follow-up they did when the business was smaller? Does the production department know what the sales department is doing and promising customers? What steps are competitors taking to try to steal business away? 

These are, of course, the best kind of problems any company can have. They are the problems caused by success, rather than impending bankruptcy.

These problems are a core aspect of the private equity process in China. It’s good companies that get PE finance, not failed ones. Once the PE capital enters a company, the PE firm is going to take steps to protect its investment. This inevitably means making sure systems are put in place that can improve the daily management and long-term planning at the company. 

It’s often a monumental adjustment for an entrepreneur-led company. Accountability supplants improvisation. Up to the moment PE finance arrives, the boss has never had to answer to anyone, or to justify and defend his decisions to any outsider. PE firms, at a minimum, will create a Board of Directors and insist, contractually, that the Board then meet at least four times a year to review quarterly financials, discuss strategy and approve any significant investments. 

Whether this change helps or hurts the company will depend, often, on the experience and knowledge of the PE firm involved.  The good PE firms will offer real help wherever the entrepreneur needs it – strengthening marketing, financial team, international expansion and strategic alliances. They are, in the jargon of our industry, “value-add investors”.

Lesser quality PE firms will transfer the money, attend a quarterly banquet and wait for word that the company is staging an IPO. This is dumb money that too often becomes lost money, as the entrepreneur loses discipline, focus and even an interest in his business once he has a big pile of someone else’s money in his bank account.   

Our new report focuses on this disparity, between good and bad PE investment, between value-add and valueless. Our intended audience is Chinese entrepreneurs. We hope, aptly enough, that they determine our report is value-add, not valueless. The key graphic in the report is this one, which illustrates the specific ways in which a PE firm can add value to a business.  In this case, the PE investment helps achieve a four-fold increase. That’s outstanding. But, we’ve seen examples in our work of even larger increases after a PE round.

The second part of the report takes on a related topic, with particular relevance for Chinese companies: the way PE firms can help navigate the minefield of getting approval for an IPO in China.  It’s an eleven-step process. Many companies try, but only a small percentage will succeed. The odds are improved exponentially when a company has a PE firm alongside, as both an investor and guide.

While taking PE investment is not technically a prerequisite, in practice, it operates like one. The most recent data I’ve seen show that 90% of companies going public on the new Chinext exchange have had pre-IPO PE investment. 

In part, this is because Chinese firms with PE investment tend to have better corporate governance and more reliable financial reporting. Both these factors are weighed by the CSRC in deciding which companies are allowed to IPO. 

At their best, PE firms can serve as indispensible partners for a great entrepreneur. At their worst, they do far more harm than good by lavishing money without lavishing attention. 

The report is illustrated with details from imperial blue-and-white porcelains from the time of the Xuande Emperor, in the Ming Dynasty.

China’s private equity industry is on track to break all records in 2010 for number of deals, number of successful PE-backed IPOs, capital raised and capital invested. This record-setting performance comes at a time when the PE and VC industries are still locked in a long skid in the US and Europe.

According to my firms’s latest research report, (see front cover above)  the best days are still ahead for China’s PE industry. The Chinese-language report has just been published. It can be downloaded by clicking this link: China First Capital 2010 Report on Private Equity in China

We prepare these research reports primarily for our clients and partners in China. There is no English version.

A few of the takeaway points are:

• China’s continued strong economic growth is only one factor providing fuel for the growth of  private equity in China. Another key factor that sets China apart and makes it the most dynamic and attractive market for PE investing in the world: the rise of world-class private SME. These Chinese SME are already profitable and market leaders in China’s domestic market. Even more important, they are owned and managed by some of the most talented entrepreneurs in the world. As these SME grow, they need additional capital to expand even faster in the future. Private Equity capital is often the best choice

• As long as the IPO window stays open for Chinese SME, rates of return of 300%-500% will remain common for private equity investors. It’s the kind of return some US PE firms were able to earn during the good years, but only by using a lot of bank debt on top of smaller amounts of equity. That type of private equity deal, relying on bank leverage, is for the most part prohibited in China

• PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the original PE firms in China anticipated, or can cope with. What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO

Our goal is to be a thought leader in our industry, as well as providing the highest-quality information and analysis in Chinese for private entrepreneurs and the investors who finance them.

It wasn’t supposed to turn out this way. Shanghai has lost its leading position at the center of the private equity industry in China. Instead, Beijing has grabbed the mantle, and is now the city in China with the densest network of active, top tier PE firms.

Could this be an example of the failure of central planning? It’s certainly the case that Chinese governments for the last twenty years have pursued explicitly the goal of making Shanghai the financial capital of China. The frequently-cited analogy: Shanghai, like New York, would serve the center of finance and trade, while Beijing would more closely resemble Washington, as a less commercial, more politically-focused city.

For quite awhile, this division of power prevailed. Shanghai’s stock market became the country’s largest, acting as magnet for banks and brokerage companies. Many of the first PE firms to enter China followed along, setting up their main offices in Shanghai.

Beijing, meanwhile, remained something of a financial backwater. It attracted the headquarters of the largest state-owned companies (like China Mobile, Sinopec, China Telecom), but never developed a capital market of its own. Beijing-based PE firms, in the main, were several steps behind their Shanghai competitors.  The capital and top talent were concentrated in Shanghai.

Today, the axis has shifted. Beijing is clearly in the ascendant. The money, the people and the future of the PE industry in China all seem to be going Beijing’s way. This shift was not the result of any specific government policy benefitting Beijing’s PE firms.

In fact, it’s only in Shanghai where such inducements are in place. The local government in Pudong, for example, has made a special push to attract PE firms, offering them various tax breaks to locate there.

How did Beijing gain the upper hand? Two main factors stand out: China’s central government has become the most significant large new source of PE capital. Second, the locus of IPO activity is also shifting from international stock markets, principally Hong Kong and New York, to China’s domestic exchanges. This has elevated the importance of Beijing-based China Securities Regulatory Commission (CSRC, or证监会  in Chinese). It makes the decisions about which Chinese companies can IPO in China and when.

There is simply no comparison between the work of the CSRC and the US Securities and Exchange Commission (SEC), the institution on which it was loosely modeled. The SEC lets the market decide which companies should IPO. The CSRC is nowhere near that laissez-faire. It decides which companies, from which industries, with what kind of profit level should IPO, and when the IPO should take place.

Any PE firm that needs domestic IPOs to achieve an exit needs to know how the CSRC works, and when necessary, how to properly influence them. Beijing-based PE firms are in the right place to influence this key decision-maker in the process of gaining exit for their portfolio companies.

There is no rule that says investment funds from the central government should be managed in Beijing, by investment firms based there. But, in practice, that’s what’s happening. This is very noticeable when you look at the PE firms selected to received renminbi funds from China’s enormous National Social Security Fund (NSSF or 社保 in Chinese), which has over $100bn in total assets, and growing fast. It plans to invest around 10% of its assets in private equity and other alternative investments. This will soon make the NSSF the largest Limited Partner for private equity firms.

Of the 20 PE firms so far selected to receive NSSF funds, a significant majority are Beijing-based, including powerhouses like SAIF, CDH, Legend Capital, NewHorizon. In addition, the NSSF has chosen to provide capital to a group of domestic PE firms, including Brightstone .

The NSSF isn’t the only Chinese government body providing funding for PE firms. Two other powerful and cash-rich institutions, the National Reform and Development Commission (发改会 in Chinese) , and National Investment Commission (国资会)，are also playing a role steering capital to PE firms.

The more crucial advantage, however, is probably the Beijing firms’ deeper connections with the Beijing-based CSRC. Staging an IPO in China is a complex, time-consuming process and not terribly transparent process. It often requires many levels of central government involvement and approval. The CSRC is at the apex of this bureaucratic pyramid. It has the final say on which companies can IPO and when.

For a PE firm, building good relations with the CSRC is almost as important as choosing good companies to invest in. Those portfolio companies will have a better chance of a timely and successful IPO in China if their PE investor knows how the CSRC works, and how to push the approval process through to a successful conclusion. Beijing firms are usually best at working these and other levers of Chinese power. This skill trumps any advantage Shanghai may have as China’s official “financial capital”.

It’s a cumulative process:  the Beijing firms’ are growing richer and more skilled in the intricacies of Chinese decision-making and IPO planning. Their edge over Shanghai firms is therefore only likely to grow in coming years.

My company has felt the impact of this shift towards Beijing, and we’re responding to it. I’m certainly traveling there more and more. Our goal is to help clients become highly successful publicly-traded companies by arranging pre-IPO PE investment. The Beijing PE firms have a decided – and increasingly decisive – advantage.

They are well-integrated into the system that makes the key decisions in China, both by receiving funding from the central government and by building consistent and productive working relationships with the CSRC and other key agencies. We advise our clients to consider very strongly the advantages that Beijing PE firms hold.

Beijing has another key asset. The firms we work with are all well-led, with great people, both at partner level and below. For Chinese companies seeking PE financing, the road to success more often leads to and through Beijing.

My congratulations, both personal and professional, to Carlyle Group, which announced last week the launch of its first RMB fund, in partnership with China’s Fosun Group. I happen to know some of the people working at Carlyle in China, and I’m excited about the news, and how it will positively impact their careers. 

Carlyle is the first among the private equity industry’s global elite to take this giant public step forward in raising renminbi in partnership with leading Chinese private company. It marks an important milestone in the short but impressive history of private equity in China, and points the way forward for many of the private equity firms already established in China. 

The initial size of the new renminbi fund is $100mn. By Carlyle’s standards, this seems almost like a rounding error – representing a little more than 0.1% of Carlyle’s total assets of $90 billion.  But, don’t let the size fool you. For Carlyle, the new renminbi fund just might play an important role in the firm’s future, as well as China’s. 

The reason: Carlyle will now be able to use renminbi to invest more easily in domestic companies in China, then help take them public in China, on the Shanghai or Shenzhen stock markets. Up to now, Carlyle’s investments in China, like those of its global competitors, have been mainly in dollars, into companies that were structured for a public listing outside China. Carlyle has a lot to gain, since IPO valuations are at least twice as high in China as they are in Hong Kong or USA. 

That means an renminbi investment leading to a Chinese IPO can earn Carlyle a much higher return, likely over 300% higher, than deals they are now doing.  By the way, the deals they are now doing in China are anything but shabby, often earning upwards of five times return in under two years. Access to renminbi potentially will make returns of 10X more routine.  Carlyle has ambitious plans to keep raising renminbi, and push the total well above the current level of $100mn. 

As rosy as things look for Carlyle, the biggest beneficiary may well turn out to be the Chinese companies that land some of this Carlyle money. PE capital is not in short supply in China, including an increasing amount of renminbi. But, smart capital is always at a premium. Capital doesn’t get much smarter – or PE investing more disciplined — than Carlyle. They have the scale, people, track record and value-added approach to make a significant positive impact on the Chinese companies they invest in. 

This is the key point: the best opportunities in private equity are migrating towards those firms that have both renminbi and a highly professional approach to investing. That’s why the leading global PE firms will likely join Carlyle in raising renminbi funds. Blackstone is already hard at work on this, and rumors are that TPG and KKR are also in the hunt. 

Carlyle now joins a very select group of world-class PE firms with access to renminbi. The others are SAIF, CDH, Hony Capital, Legend Capital and New Horizon Fund. These firms are all focused primarily (in the case of SAIF) or exclusively on China. While they lack Carlyle’s scale or global reach, they more than make up for it by commanding the best deal flow in China. SAIF, CDH, Hony, Legend and New Horizon have all been around awhile, starting first as dollar-based investors, and then gradually building up pool of renminbi, including most recently funds from China’s national state pension system. 

Like Carlyle, they also have outstanding people, and very high standards. They are all great firms, and are a cut above the rest. Up to now, they have done more deals in China than Carlyle, and know best how to do renminbi deals. Carlyle and other big global PE firms will learn quickly.  As they raise renminbi, they will elevate the overall level of the PE industry in China, as well as increase the capital available for investment. 

The certain outcome: more of China’s strong private SMEs will get pre-IPO growth capital from firms with the know-how and capital to build great public companies.