proprietary research

M&A in China — New China First Capital Research Report, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China”

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M&A in China is entering a new, more promising phase. At no previous time was the environment as favorable to identify and close, at attractive valuations, the acquisition of a profitable, high growth, well-run, larger private business in China.

This is the conclusion of a recently completed research study by China First Capital, as part of our M&A advisory work. (An abridged copy of the report is available by clicking here.) The report is titled, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China: Sourcing and executing successful corporate acquisitions and buyouts from unexited PE deals in China“.

The industrial logic of doing acquisitions in China has never been in doubt. The scale, high annual growth rate and fragmented nature of China’s domestic economy all create a powerful attraction for control investors. The challenge has traditionally been a negative selection bias on the sell-side, that the Chinese companies available for purchase are often troubled,  state-owned, inefficient or poorly-managed. China’s best corporate assets, its larger private companies, were not previously available to control investors.

As a result, M&A in China, for all the predictions of an impending take-off, has never gotten into gear. The theory behind most deals, if there was one, was to tie two stones together and see if they float.

The reason for the positive change in the environment for control deals in China is the serious degradation in the environment for minority ones. Specifically, China’s private equity industry is in a state of deepening crisis. Having financed the growth of many of China’s best private companies, the PE firms are now finding it increasingly difficult to engineer a liquidity event before the expiry of their fixed fund life. They are emerging as distress sellers of desirable assets — in this case, strong PE-backed companies that are left without any other viable means for investors to exit.

As elaborated in earlier research reports from China First Capital, (read  here, here, here) there is a large overhang of over 7,500 unexited private equity deals in China. Most of these deals were done on the expectation of exiting through an IPO within a few years. That was always statistically improbable. In no year did more than 150 PE-backed Chinese private companies IPO.

An IPO has gone from statistically improbable to virtually unattainable. This is not only impacting the thinking of PE firms, but of the entrepreneurs they back as well. The exit math for private company bosses in China has changed dramatically over the last 12 months. M&A looks more and more like the only viable path to exit.

For business owners, the challenge to getting a deal done are both psychological and practical. First, owners must accept that valuations are way below where they hoped them to be, as well as well below the level two years ago, when they topped out at over 100 times last year’s net income. Second, the number of companies looking to sell will quickly begin to outnumber the qualified and capable acquirers. This will put further downward pressure on valuations.

In other words, for private company bosses looking for a liquidity event, the pressure to consider selling the business is mounting. For investors, owners and acquirers, the result is the beginnings of a genuine market for corporate control for private sector businesses in China.

The new China First Capital report is directed towards all three classes of potential acquirers — 1) global businesses seeking China market entry; 2) corporate acquirers seeking market or margin expansion in China through strategic or tuck-in acquisitions; 3) China domestic or global buyout firms seeking quality operating assets that can be built up and sold.  Their methods, timetable, metrics and deal targets will often differ. But, all three will find the current situation in China more suitable than at any previous time for executing M&A transactions of USD$100mn and above.

While the number of attractive targets is increasing, the complexities of doing M&A in China remain. The invested PE firms are almost always minority investors. A control transaction will need to be structured and staged to incentivize the owner to sell at least a portion of his holding alongside the PE firm, and then likely remain for at least several years at the helm.

The report offers some possible deal structures and timing mechanisms, included using “blended valuation” to determine price. It also charts the all-important  “when does cash enter my pocket” timing from the perspective of a selling majority owner.

PE investment in China, the report concludes,  has altered permanently the business landscape in China. It has also prepared the ground for a surge now in M&A activity.

Over $150 billion in PE capital was invested to propel the growth of over 10,000 private businesses. PE finance helped create a more dynamic and powerful private sector in China. In quite a number of cases, the PE-invested businesses have emerged as industry leaders in their sectors in China, highly profitable, innovative, fast-growing, with revenues of $100mn and above.

These companies have the scale and established market presence to permit a strategic acquirer to substantially increase its activity in China, extending product range, customer relationships, distribution channels. For buyout firms or corporate acquirers, taking over a PE-invested company should offer satisfactory financial returns. Buyout ROE can be significantly enhanced in certain cases by using leverage to finance the acquisition.

The supreme irony is that this moment of opportunity in domestic M&A comes at the same time quite a number of PE firms are pursuing highly questionable “take private” deals involving troubled Chinese companies listed on the US stock market. (See earlier blog posts here, here, here, here.) The risks, and prices paid, are far higher than doing well-targeted domestic M&A in China.

When junk is priced like jewels — and vice versa — is there any doubt where the smart money should go?

 

 

 

China Private Equity Secondaries — the new China First Capital research report

 

In the current difficult market environment for private equity in China, secondary transactions provide a valuable way forward.  Staging successful IPOs or M&A will remain severely challenging. This is the conclusion of a proprietary research report recently completed and published by China First Capital. An abridged version is available by clicking here.  You can also visit the Research Reports section of the China First Capital website.

Secondaries potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments. And yet these secondary deals still remain rare. As a result, General Partners, Limited Partners and investee companies, as well as China’s now-large private equity industry,  are all at risk from serious adverse outcomes.

This new CFC research report is a data-driven examination of the potential market for secondary transactions in China, the significant scope for profit on all sides of the transaction, as well as the no less significant obstacles to the development of an efficient, liquid, stable long-term market in these secondary positions in China.

The report’s conclusion is that secondaries have the potential to benefit all three core constituencies in the China PE industry — GPs, LPs and investee companies. The universe of deals potentially available for secondary exit is large, over 7,500 unexited investments made in China by PE firms since 2000.

However, the greatest potential for both PE sellers and buyers across the short to medium term is in a group of select companies CFC terms “Quality Secondaries“. These are PE investments that fulfill four criteria:

  1. unexited and not in IPO approval process, domestically or internationally
  2. investee companies have grown well (+25% a year) since the original round of PE investment, and have continuing scope to expand enterprise value and achieve eventual capital markets or trade sale exit in 3-6 year time frame
  3. businesses are sound from legal and regulatory perspective, have effective corporate governance, and a majority owner  that will support secondary sale to another PE institution
  4. current PE investor seeks secondary exit because of fund life or portfolio management reasons

CFC’s  analysis reveals that the potential universe of “Quality Secondaries” is at least 200 companies. This number will likely grow by approx. 15%-25% a year, as funds reach latter stage of their lives and if other exit options remain limited.

At the current juncture, in this market environment, and assuming “Quality Secondary” deals are done at market valuations, these investment represent some of the better values to be found in growth capital investing in China.  DD risk is significantly lower than in primary deals, and contingent risks (opportunity costs, and legal risks of pursuing other non-IPO exits) are lower.

Despite the current lack of significant deal-making activity in this area, secondaries will likely go from current low levels to gain a meaningful share of all PE exits in China.

The secondaries market in China will have unique factors compared to the US, Europe and elsewhere. There will likely be limited investor interest in any secondary deal involving a Chinese company or a portfolio that has underperformed since PE investment, or could otherwise be characterized as a  “distress” situation.

Quality Secondaries transactions in China will involve PE investors “cherry-picking” good companies at fair valuations.  The primary motivation for selling PEs is misalignment between its remaining fund life and the time required and risk inherent in achieving  domestic or offshore IPO or trade sale exit during that shortened time frame.

In contrast with secondary deals done outside China, we do not expect to see much activity involving the sale of all or most of a PE firm’s portfolio of investments. Specialist secondary firms operating elsewhere (e.g. Coller Capital, Harbourvest) do not currently have the experience or manpower in China to take on the complexities of managing and liquidating all or most of an existing portfolio of minority investments.

Rather, we expect those PEs with strong operating performance in growth capital investing in China to exploit favorable market conditions by becoming active buyers of Quality Secondaries.   GPs that prefer larger deals, (+USD25mn/Rmb200mn), should be particularly interested in Quality Secondaries, since company scale and investment amount will likely be larger, on average, than primary deals in China.

Selling PEs can pursue exit strategies based on option of selling either part or all of a successful unexited deal. A part liquidation in Quality Secondary transaction can mitigate risk and return capital to LPs while still retaining future upside. A full exit through secondary can increase fund’s realized IRR and so assist future fundraising. Importantly, a selling PE needs to act before pricing leverage is transferred mainly to buyers — generally this means secondary deals should be evaluated and priced in market when fund still has minimum of two years left of active period.

While clearly the most acute need for exit will be investments made before 2008, more recent investments need also to be assessed based on current market conditions. Many GPs are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve.

In particular, much of this “wait and see” approach is based on the hope that Hong Kong’s once-vibrant, now-moribund IPO market for Chinese companies returns to its earlier state. The US stock market will certainly remain off limits to most Chinese companies for a long time to come. Exit through China’s domestic stock market is now seriously blocked by bureaucratic slowdowns and an approval backlog that even under optimistic scenarios could take three to five years to clear.

The need for diversification is no less paramount for exits than entries. Many of the same PEs that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on  a single path to exit: the Hong Kong IPO.  By itself, such dependence on a single exit path is risky. In the current environment, it looks even more so.

The flood of Chinese IPOs in Hong Kong basically came to a halt a year ago.  When they do resume, it may prove challenging for all but the best and biggest Chinese companies to successfully issue shares there. What will become of the other deals? How will GPs and LPs profit from investments already made? That’s the focus on this new report, titled, “China Secondaries:  The Necessary & Attractive Exit For Private Equity Deals in China“.