This is a time of darkness and despair for most private equity and venture capital guys. Their world came crumbling down last year, as credit and stock markets collapsed and IPO activity came to a halt everywhere — everywhere that is, except China.
If ever there were an example of a counter-cyclical trend, it is the private equity industry in China. It is poised now for the most active period, over the next 12 months, in its young history. There are many reasons to explain why China should be so insulated from the deep freeze that’s gripping the industry elsewhere. For one thing, it has always relied less on leverage, and more on plain vanilla equity investing.
This mattered crucially, since as credit markets seized up last year, PE firms were still able to do deals in China, by putting their own equity to work. Of course, PE firms in the US could have done the same thing. After all, most have very large piles of equity capital raised from limited partners. But, they have habituated themselves to a different form of investing, involving tiny slivers of equity and very large slabs of bank debt. Like any leveraged transaction, it can produce phenomenal results, on a return-on-equity basis. But, without access to the debt component, many PE firms seem adrift. It’s as if they’ve forgotten, or lost the knack of how to properly evaluate a company, to look at cash flows not in relation to potential debt service, but as a telltale sign of overall operating performance.
Many PE firms these days seem to resemble a hedge fund gone bad: they once had a formula for making great piles of money. Then, markets changed, the formula stopped working, and the firms are at a loss as to how to proceed.
China looks very different. Beyond the lack of leverage, there are other, larger factors at work that are the envy of the rest of the PE world. Most importantly, China’s economy remains robust. It’s done a remarkable pirouette, while the rest of the world was falling flat on its face. An economy dependent until recently on exports is now chugging along based on domestic demand. And no, it’s not simply — or even mainly — because of China’s huge +$600 billion stimulus package. The growth is also fueled by Chinese consumers, who are continuing to spend.
There’s one other key factor, in my opinion, that sets China apart and makes it the most dynamic and desirable market for PE investing in the world: the rise of world-class private companies, of a sufficient scale and market presence to grow into billion-dollar companies. In other words, PE investing in China is not an exercise in financial engineering. It’s straight-up equity investing into very solid businesses, with very bright futures.
One common characteristic of PE investing in China, all but absent in the US, is that the first round of equity investment going into a company is smaller than trailing revenues. So, in a typical deal, $10mn will be invested into a company with $50 million of last year’s revenues, and profits of around $5 million. Risk mitigation doesn’t get much better than this: investing into established, profitable companies that are often already market leaders — and doing so at reasonable price-earnings multiples.
China has other things going for it, from the perspective of PE investors: the IPO window is open; dollar-based investors have the likely prospect of upping their gains through Renminbi appreciation; management and financial systems both have significant room for improvement with a little coaching from a good PE firm.
It all adds up to a unique set of circumstances for PE investors in China. It’s a highly positive picture all but unrecognizable to PE and VC firms in the US and elsewhere. Opportunities abound. Risk-adjusted returns in China are higher, I’d argue, than anywhere else in the world. A +300% return over three to five years is a realistic target for most PE investment in China. The PE firms invest at eight times last year’s earnings, and should exit at IPO at 15 times, at a minimum. Pick the right company (and it’s not all that difficult to do so), and the capital will be used efficiently enough to double profits over the term, between the PE investment and the IPO. Couple these two forces together — valuation differentials and decent rates of return on invested capital — and the 300% return should becomes a modest target as well as reasonably commonplace occurrence.
It’s the kind of return some US PE firms were able to earn during the good years, but only by layering in a lot of bank debt on top of smaller amounts of equity. That model may still work, at some future time when banks again start lending at modest interest rates on deals like this. But, there’s an inherent instability in this highly-leveraged approach: cash flows are stretched to the limit to make debt payments. A bad quarter or two leads to missed repayments, and the whole elaborate structure crumbles: just think of Cerberus’s $7.5 billion purchase of 80% of Chrysler.
China is in a world of its own, when it comes to PE investing. My best guess is that it remains the world’s best market for PE investment over the next ten years at least. Little wonder that many of the world’s under- or unemployed PE staff members are taking crash courses in Chinese.
Here’s one of the slides from the PPT that accompanied a recent talk I gave in Shanghai called “Trends in Global Private Equity: China as Number One”.
Private Equity in China 中国的私募股权投资:
Strong present, stronger future 今天不差钱，明天更美好
PE firms continue to raise money for investment in China, over $10 billion in committed capital and growing 私募股权基金仍在继续募集资金投资国内，规模已经为100亿美元并将继续增长
Next 12 months : most active in history ; IPO window open; finding and financing China’s next national champions 未来的一年：历史上最蓬勃发展的时期，IPO 重启，发现并投资中国下一批的企业明星