Private Equity in China: IPOs Are Out for Now, but Opportunities Exist

on June 29 2009 11:35 AM

As private equity luminary Hugo Shong, founding general partner of China-based IDG Technology Venture Investment, noted at the recentWharton Global Alumni Forum in Beijing: The IPO market is pretty much dead. Since IPOs are a crucial exit route for investors, you might think a panel titled, Private Equity in China: Challenge and Opportunity, would have been a downbeat affair. But Shong's mood -- and that of his fellow panelists -- was anything but morose.

The panel, which included some of China's top investors, painted a picture that included opportunities in every sector and geographic location in China. Venture capital (VC) and private equity (PE) investors are branching out into everything from agribusiness to health care, while regions barely known in the West are proving to be new sources of deals. Despite the downturn, the panelists said, the opportunities are abundant.

They also acknowledged some tricky challenges. While dispelling a number of common misperceptions about China's investment environment (notably the idea that too much money is chasing too few good deals), the speakers highlighted problems ranging from regulatory risk to entrepreneurial overreach. As a result, investors need to be prepared to work closely with entrepreneurs and state sector-management to try to keep everyone on the same page. They also need to influence and understand official thinking during the design and implementation of new regulations. Carrying out exhaustive due diligence is another must, they said.

World-class in Two Years

But the dominant mood was one of overt optimism. Part of the excitement, said Andrew Yan, managing partner of SAIF Partners III and SB Asia Investment Fund II, derives from the speed with which investments can be paid back. It is possible to invest in a small Chinese company, and within one or two years, the company can become world class.

I remember in 2003, we invested in a company called Shanda, which [was] a very small company at the time, said Yan, who was voted venture investor of the year in 2004 and 2007 by the China Venture Capital Association. We invested in May 2003 and the company went public on Nasdaq in July 2004. And within a year, the company became the largest online game company in the world. There are many such examples, he says.

The extraordinary growth rate, the immense addressable market in China can make this happen. I think that, as a private equity investor, this is really a dream [scenario] for you to work in, Yan said.

The nature of these opportunities is changing, though. Despite the rewards they have reaped from investments in tech companies, Yan and his fellow panelists said that many future money making possibilities will lie outside traditional sectors and current geographical areas of interest. Yan is a keen agribusiness investor, for instance, and he recently closed a deal involving China's largest potato grower. (Potato growing is a very high- margin business, he noted.) Health care, now the focus of renewed government reform and investment, is another area in which he sees huge potential.

Gathering policy momentum will likely help to grow investors' interest in another sector that has provided good returns: Renewable energy and environmental technologies. Alternative energy is still one of the key areas we think the Chinese government will really put a lot of emphasis on, and there will be a lot of investment opportunities for us, said DT Capital founding managing partner Joe Tian. His company invested in China's largest wind turbine blade manufacturer, Tang Wind Energy, which Tian predicted this year may become the largest global manufacturer in its sector.

IDG Technology Venture Investment (IDGVC) focuses on the consumer sector (ranging from film and entertainment to healthcare), and Shong highlighted the strength of the domestic market despite the global downturn. The vast majority of successful domestic firms do not rely on overseas business at all, he noted. Even China's high savings level, which implies lower consumption, can be turned to investors' advantage: Financial services is now an area of great interest for IDGVC.

Mirroring the breadth of sectors that offer investment openings for VC and PE, opportunities are increasingly geographically diverse. Yan observed that his company's five agribusiness investments range from the northern border with Russia to mountainous Jiangxi in the south.

There is an increased focus on second- and third-tier cities. Perhaps 80% of VC/PE capital still flows to first-tier cities, Shong estimated, adding that he has seen the number of consumer and natural resource deals in second- and third-tier cities grow. Indeed, the label second-tier or third-tier can be misleading, Shong pointed out: The infrastructure in these cities today is far better than was the case in first-tier cities a decade ago. Even better opportunities exist in these locations today than did in places like Beijing and Shanghai ten years ago.

I think obviously in Beijing, Shanghai we can still have a lot of opportunities, but [for] certain investment opportunities, certain second- or even third-tier cities probably have more, Tian noted. This is partly because, under the centrally planned economy of Maoism, industrial clusters were set up in certain areas, he added.

Assessing Potential Deals

Whatever the deal opportunities, however, investors need to carefully assess the opportunities by sector. Sun Chang, managing director of Warburg Pincus Asia, explained how his company goes about doing this using three criteria.

The first is size: The sector has to be big enough, deep enough to accommodate investments, he argued. It takes time and money to investigate a sector so it needs to promise more than one deal in ten years. The second criterion is growth. Assuming our multiples are the same going in and going out, your return on capital will be equal to the growth rate of the business. Lastly, Warburg Pincus assesses the willingness of the companies or the entrepreneurs to accept our capital.

Real estate is one sector that interests Warburg Pincus, because businesses are willing to accept capital from outside investors. It is also big, and growing. Before the average income per capita in China reaches US$8,000, most of the real estate investment will be in apartments - not in houses. So we see a very long runway for real estate.

Ambition's Limits

Amidst the optimism, panelists admitted that not everything is possible, even in China, and offered their insights on typical difficulties.

Although in recent times Asia saw an onslaught of (then) liquidity-flush investment bankers hunting for buyouts, the panel agreed that China does not offer much scope for this. Why? Sun argued that Chinese entrepreneurs are like American moguls a century ago. If you had tried to buy out Rockefeller or JP Morgan back then, they would have shown you the door; the same goes for the current crop of Chinese entrepreneurs, who are fired up to build their own business empires.

Entrepreneurs' ambition can be an Achilles heel, said Sun. The desire of China's early stage ventures to take on big cash injections is not always matched by the capacity to produce a convincing estimate of the income they can generate. The challenge with start-ups is they really don't know how much they're going to make, he said. It is not unknown for the gap between what a company claims it can make and what PE firms project it can generate to differ three-to-one.

One solution (apart from recommending companies to hire chief financial officers) involves a ratchet. A company might want an injection of capital equal to ten times the net income they think they will make in the next year -- for instance, US$9 million dollars. But the prospective investor reckons that US$3 million is more realistic, so he will only offer US$30 million. To navigate this impasse, the two sides could agree that for every million dollars missed on the bottom line, the valuation shrinks by ten million. This has since become a common way of valuing companies.

Growth companies, at the pre- or post-IPO stage, bring related trials. The challenge there is the unbridled ambition of the entrepreneur versus realism, commented Sun. If they really go very aggressive, they risk ruining the company's future by piling up too much debt, or making an acquisition that will not work.

Putting together management teams is another sizable problem, added Yan. In order to be successful in China ... you need a manager who can not only manage the business locally, but also can deal with international business, he said. Although the large number of returnees who have been educated oversees provides a good talent pool, to find a qualified local operator who has a good international background is still a challenge

Investment in state-owned enterprises, meanwhile, presents a different set of hurdles. These flow from the poor alignment of managers' interests with those of the company and its investors: Managers lack a stake in the business, yet manage its earnings.

Sun gave the example of a pharmaceuticals manufacturer Warburg Pincus invested in a few years ago. Every year, the net income of the company is a negotiated agreement between management and the shareholders, he explained. Shareholders might demand 200 million Renminbi, but managers say they can only spend 100 million. The final figure will be a compromise.

The result is lower efficiency and transparency. Year end, [we found] out that the manager of [a certain] division had paid everybody, including the kitchen staff, 10,000 Renminbi [each] in bonuses without telling [us], he said. The division in question has around 600 employees. One year, he gave everybody a big LCD TV ... without telling us.... Another year, we found out that the taxi drivers were all wearing mink coats that he passed out. Aligning interests in state companies is Warburg Pincus's biggest headache, Sun said.

Direct state intervention can also have serious implications for investors. On the macro level, I would say China still is one of the most regulated economies in the world, said Yan. Besides the need to work through many layers of bureaucracy to gain approval, a policy decision by one of many government agencies can alter the business environment overnight.

According to Shong, this makes it important to try to influence how laws are designed. Even so, since China's laws tend not to be black and white, most of the time you really work in the grey, he said. Investors need to work closely with officials to understand how rules are likely to be interpreted, and where the true boundaries lie.

Contrarian Truths

Whatever the difficulties they face, the assembled investors nonetheless downplayed some common objections to their rosy picture of China's private equity scene. There has been a general perception that China has suffered from too much money chasing too few good deals, for instance; valuations can be extremely difficult, say some; and doing deals can be an ethical minefield.

Deal referrals from trusted sources help, but ethical issues certainly exist, noted DT Capital's Tian. However, investors go to great lengths to make sure they are not caught unaware. His company conducts many layers of due diligence, even getting to know the potential counterpart's network. We know your previous boss, we know your local government...  And sometimes, good or bad, we even know your family, or it could be your friend, he said. This effectively allows the firm to build up what it calls surrounding influence, so that the damage done to entrepreneurs' reputations in the event of wrongdoing would be serious.

The panel gave shorter shrift to the other objections. For starters, Yan noted that the returns on capital that his firm has received are twice the U.S. average, implying that the idea that valuations are tricky is wrong.

I think there that there is a general misperception that there is too much money chasing too few deals, he said. Statistically, last year China saw a historical high of VC and growth capital investment of US$3.83 billion, he noted. Meanwhile, the U.S. reached a figure of US$30 billion (although in purchasing power parity terms the chasm shrinks to a multiple of around four). China, which contains a fifth of the world's population, manages a level of private equity investment not unlike that of Israel, with an estimated population of 7.5 million. One cannot argue that US$3.8 billion in private equity investment in China is too much money chasing too few deals, he concluded.

While conceding that in recent times, entrepreneurs could shop around for deals, leaving too little latitude to probe fundamentals, Shong said that the time when too much money chased too few deals has gone. Here, he added, the current crisis has shown a silver lining. I really like [times of] crisis, he said, noting that some of IDGVC's best returns have come from investments made following crises, as when it took a share in Baidu after the Asian financial crisis in 1997-1998. Both entrepreneurs and investors approach a deal with more rational and reasonable expectations of each other. 

If so, the depth of the current crisis could bode well for private equity's future in China.