Goldman Sachs private equity
Most investors, over time, will underperform the stock market as a whole. This is as true for people investing their own money in shares, as it is for mutual fund managers, hedge funds, PE and VC firms. So, any investor with a big sustainable “unfair” advantage should seize it.
Right now, in private equity industry in China, certain private equity firms have this unfair advantage. They get the most cash, the most good deals and the most certain exit through a domestic IPO in China. These PE firms are one part of a tripartite alliance, the likes of which the investment world has never seen. The other two are China’s National Social Security Fund, soon to be the largest source of investible capital in the world, and the CSRC, China’s securities regulator, which has all the say in approving all domestic IPOs.
The PE firms get funding through one, and profits through the other. The deck is heavily stacked in their favor. For the hundreds of other PE firms active in China, including the global giants TPG, KKR, Carlyle, Blackstone and Goldman Sachs, making money investing in China is riskier, harder and slower.
Among the PE firms that are members of this new elite in China are CDH, SAIF, New Horizon, Hony Capital. To many investment professionals outside China, these names will be unfamiliar. Yet, they operate in an environment, and achieve outcomes, that ought to be the envy of other investors.
The firms mainly got their start about ten years ago. They were present at the creation of the Chinese PE industry. They raised their initial capital, in most cases, from prestigious American investors, like Stanford and Princeton endowments. The firms’ investment focus has shifted somewhat over time – from technology deals to more traditional industries, from investing only dollars to now using also Renminbi. They did well almost from the beginning. This early success set in motion policies and preferences that have led more recently to their position today.
The two key developments took place within the last 18 months. First, in October 2009, China’s Shenzhen Stock Exchange launched the ChiNext （创业板）board for private companies to go public. It’s been a resounding success, with over 230 companies now listed, having raised over $5 billion from the public. Chinext’s total aggregate market cap is now over $100 billion.
The Chinext p/e multiples, from the start, have been well above levels in the US and Hong Kong. Currently, the average is 42X trailing year’s earnings. The high valuations make it a very profitable place for PE firms to exit from their investments. But, the CSRC acts as a strict gatekeeper, controlling both the number and quality of Chinese companies allowed to IPO on Chinext. Most Chinese firms who apply for Chinext listing are turned down.
The CSRC has a clear preference for companies that have received PE finance from one of the top PE firms in China, since this means, in effect, the company has already passed through a more rigorous due diligence process than the CSRC can attempt. The CSRC’s logic is impeccable: if a good PE firm was willing to put its own capital at risk when the company was private, that business should be a safer investment for public shareholders than a Chinese company without a top PE investor.
Who comes top of the CSRC’s list of favored PE firms? The firms listed above. This means that the companies invested in by these PE firms have a better chance of being chosen by the CSRC to go public on Chinext. In turn, because of Chinext’s high valuations, this all but guarantees these PE firms achieve better annual investment returns than others.
When the NSSF announced it was going to begin investing up to 10% of the national pension system’s capital in alternative investments, particularly PE, only a few firms were able to pass through its rigorous selection criteria. It chose firms with strong performance and high standards. Leading the list when the NSSF started handing out money last year: CDH, SAIF, New Horizon, Hony Capital.
The favored PE firms now have access to enormous capital from the state pension fund, along with what seems to be preferential access for its deals to China’s IPO market. In the future, any gains these favored PE firms have from investments using NSSF funds will flow back into higher pensions for millions of Chinese retirees. Will the CSRC consider this, when it deliberates which Chinese companies should be approved for IPO? It seems a fair assumption.
China’s pay-as-you-go pension system only got started recently. So, most of the profits from the PE deals won’t get distributed to pensioners for many years. In the meantime, the gains will be recycled back into more PE investing in domestic companies that then get preferential access to China’s capital markets. It’s a process as elegant as it is practical: Chinese investors bid up the shares at IPO, locking in high profits for a PE firms investing NSSF money. The major part of the PE’s profits is then returned to the NSSF to finance higher pension payments in the future to those same Chinese investors.
All the other PE firms outside this loop, including the global giants, will claim the system is rigged against them, that it’s harder and harder for them to compete with the favored PE firms, and to get approval for their portfolio companies to IPO in China. They probably have a point. But, in the end, this system in China will result in more private Chinese companies getting growth capital, leading to more jobs, more successful IPOs, and more comfortable retirements for China’s many millions. Those are outcomes most Chinese, as well as many others, including me, can endorse unreservedly.
The flow of money into private equity in China is fast becoming a deluge. Six months ago, new rules were introduced to allow the country’s insurance companies to invest up to 5% of their Rmb4.8 trillion of assets in PE funds investing in China. If fully invested, that would be Rmb240 billion ($36 billion) of new capital for an investment class that is already flooded with liquidity. Insurance assets are growing by over 15% a year, which means at least another $5 billion a year available in coming years for PE investing.
The other fire hose of capital is the National Social Security Fund (NSSF), subject of a recent blog post of mine. The NSSF is pumping Rmb80 billion ($12 billion) into PE investing in China, and expects to add an additional $1.5 billion a year in new capital for same purpose. Never before, in the space of twelve months has so much new capital poured a single class of illiquid investing.
In part, these institutions are chasing returns. Insurance companies and the NSSF both have very large longer-term liabilities, mainly in the form of retirement pensions and life insurance policies. PE investing can jazz up overall returns for institutions that otherwise park their money in safe but tepid investments like government bonds.
PE investing in China has certainly been performing well lately. The more successful firms have been earning returns of +40% a year for investors. For insurance companies, that kind of performance (40% returns on 5% of its assets) would deliver 2% base annual return. For the NSSF, with up to 10% of its assets going to PE, the potential rewards would be higher.
The investments in PE also serve a patriotic purpose. By providing additional growth capital for Chinese entrepreneurs, PE investment should help increase employment and overall economic growth in China. The insurance companies are all majority state-owned. The NSSF is a branch of government. Invest carefully, earn a good return and contribute to building China. That summarizes the management goals for insurance companies and the NSSF alike.
Less clear is what overall effect of all this state-controlled money on the PE industry in China. Like any other asset class, the more capital that pours in, the lower the overall returns are likely to be. The insurance companies and NSSF aren’t the only – or even the main – source of capital for the PE industry. There is already billions of dollars available for PE firms from LPs in China, the US, Europe, Japan. By some estimates, as much as $30 billion in new capital has already flowed into PE firms over the last year for investment in China. This excludes the money from the NSSF and insurance companies.
All this new capital is enough to fund PE investments in over 5,000 companies, based on a typical PE deal size in China. Are there that many good deals out there? It’s hard to say. Overall, I’m very bullish about the number of great private companies and great PE investment opportunities in China.
The big bottleneck is certain to be within the PE firms themselves. The good ones, currently, do anywhere from 10-15 deals a year, and look seriously at another 25- 40 companies. They don’t have the partners and skilled staff to review, close and manage many more deals than this a year. The irony here: while PE firms demand portfolio companies use PE capital efficiently and scale quickly after investment, PE firms generally have no such ability. Adding capital to PE firms is like adding salt to soup. More is not necessarily better.
As the amount of capital has surged, the preferred deal size of the more successful PE firms in China has risen steeply, from $10 million per deal, to over $25 million now. But, in China, bigger deals are not generally better deals. Often, the opposite is true. The best PE investment I know of, for example, was the $5 million investment Goldman Sachs made in Shenzhen pharmaceutical company Hepalink. Its investment rose 240 times in value, based on Hepalink’s IPO price last year.
More capital also can also skew the priorities and tame the animal instincts of PE firms. When money is easy to raise, as it is now, PE firms can spend more time on this than hunting for great companies. It’s easy to understand why. For every $100 million they raise, a PE firm generally keeps $2 million in annual management fees. This management fee income keeps rolling in like an annuity, regardless of how well the PE firm is doing in its “day job” of putting capital to work on behalf of investors.
Insurance companies and NSSF can generally negotiate a lower management fee. But, the incentive is still there for PE firms to focus on raising money rather than investing it.
The PE industry in China is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. My view: over the next decade, PE deals in China will produce more wealth for entrepreneurs and investors that any other major asset class anywhere in the world. Anything less will mean many opportunities in China were squandered rather than seized.