Quality Secondaries

Private Equity Secondaries in China: Hold Periods, Exits and Profit Projections

How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital’s latest research note. An abridged version is available by clicking here. Titled, “Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity” the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.

This new report is, like the two preceding ones (click here and click here) the result of China First Capital’s path-breaking research  to measure the scale of the problem of unexited PE investments in China,  and to illuminate strategic alternatives for GPs investing in China.  China First Capital will publish additional research reports on this topic in coming months.

As this latest report explains, “these [hold period and investment return] models tend to support the thesis that “Quality Direct Secondaries”  currently offer the best risk-adjusted opportunities in China’s PE asset class.”  Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.

“Until recently,” the China First Capital report points out, “private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year.  Those assumptions on valuation differentials as well as hold period are no longer valid.”

There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China’s still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:

  1. IPO
  2. Trade sale / M&A
  3. Secondary sale
  4. Buyback / recapitalization

Our conclusion is the current exit crisis is likely to persist. “Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals.”

Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only,  option available for a PE firm with diminishing fund life. “Buyers of these direct secondaries will not avoid or outrun exit risk,” the report advises. “It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund’s hold period. ”

The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China “Quality Secondaries” offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.

Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.

Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure,  are not available in the abridged version.

 

 

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“.