SAIF

Too Few Exits: The PE Camel Can’t Pass Through the Eye of China’s IPO Needle

The amount of capital going into private equity in China continues to surge, with over $30 billion in new capital raised in 2011. The number of private equity deals in China is also growing quickly. More money in, however, does not necessarily mean more money will come out through IPOs or other exits. In fact, on the exit side of the ledger, there is no real growth, instead probably a slight decline, as the number of domestic IPOs in China stays constant, and offshore IPOs (most notably in Hong Kong and USA) is trending down. M&A activity, the other main source of exit for PE investors,  remains puny in China. 

This poses the most important challenge to the long-term prospects for the private equity industry in China. The more capital that floods in, the larger the backlog grows of deals waiting for exit. No one has yet focused on this issue. But, it is going to become a key fact of life, and ultimately a big impediment, to the continued expansion of capital raised for investing in China. 

Here’s a way to understand the problem: there is probably now over $50 billion in capital invested in Chinese private companies, with another $50 billion at least in capital raised but not yet committed. That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15mn. 

At the moment, only about 250 Chinese private companies go public each year domestically. The reason is that the Chinese securities regulator, the CSRC, keeps tight control on the supply of new issues. Their goal is to keep the supply at a level that will not impact overall stock market valuations. Getting CSRC approval for an IPO is becoming more and more like the camel passing through the eye of a needle. Thousands of companies are waiting for approval, and thousands more will likely join the queue each year by submitting IPO applications to the CSRC.

Is it possible the CSRC could increase the number of IPOs of private companies? In theory, yes. But, there is no sign of that happening, especially with the stock markets now trading significantly below their all-time highs. The CSRC’s primary role is to assure the stability of China’s capital markets, not to provide a transparent and efficient mechanism for qualified firms to raise money from the stock market. 

Coinciding now with the growing backlog of companies waiting for domestic IPOs, offshore stock markets are becoming less and less hospitable for Chinese companies. In Hong Kong, it’s generally only bigger Chinese companies, with offshore shareholder structure and annual net profits of at least USD$20 million, that are most welcome.

In the US, most Chinese companies now have no possibility to go public. There is little to no investor interest. As the Wall Street Journal aptly puts it, “Investors have lost billions of dollars over the last year on Chinese reverse mergers, after some of the companies were accused of accounting fraud and exaggerating the quality and size of their assets. Shares of other Chinese companies that went public in the United States through the conventional initial public stock offering process have also been punished out of fear that the problem could be more widespread.”

Other minor stock markets still actively beckon Chinese companies to list there, including Korea, Singapore, Australia. Their problem is very low IPO price-earnings valuations, often in single digits, as low as one-tenth the level in China. As a result, IPOs in these markets are the choice for Chinese companies that truly have no other option. That creates a negative selection bias.  Bad Chinese companies go where good companies dare not tread. 

For the time being, LPs still seem willing to pour money into funds investing in China, ignoring or downplaying the issue of how and when investments made with their money will become liquid. PE firms certainly are aware of this issue. They structure their investment deals in China with a put clause that lets them exit, in most cases, by selling their shares back to the company after a certain number of years, at a guaranteed annual IRR, usually 15%-25%. That’s fine, but if, as seems likely, more and more Chinese investments exit through this route, because the statistical likelihood of an IPO continues to decline, it will drag down PE firms’ overall investment performance.

Until recently, the best-performing PE firms active in China could achieve annual IRRs of over 50%. Such returns have made it easy for the top firms like CDH, SAIF, New Horizon, and Hony to raise money. But, it may prove impossible for these firms to do as well with new money as they did with the old. 

These good firms generally have the highest success rates in getting their deals approved for domestic IPO. That will likely continue. But, with so many more deals being done, both by these good firms as well as the hundreds of other newly-established Renminbi firms, the percentage of IPO exits for even the best PE firms seems certain to decline. 

When I discuss this with PE partners, the usual answer is they expect exits through M&A to increase significantly. After all, this is now the main exit route for PE and VC deals done in the US and Europe. I do agree that the percentage of Chinese PE deals achieving exit through M&A will increase from the current level. It could barely be any lower than it is now.

But, there are significant obstacles to taking the M&A exit route in China, from a shortage of domestic buyers with cash or shares to use as currency, to regulatory issues, and above all the fact many of the best private companies in China are founded, run and majority-owned by a single highly-talented entrepreneur. If he or she sells out in M&A deal,  the new owners will have a very hard time doing as well as the old owners did. So, even where there are willing sellers, the number of interested buyers in an M&A deal will always be few. 

Measured by new capital raised and investment results achieved, China’s private equity industry has grown a position of global leadership in less than a decade. There is still no shortage of great companies eager for capital, and willing to sell shares at prices highly appealing to PE investors. But, unless something is done to increase significantly the number of PE exits every year,  the PE industry in China must eventually contract. That will have very broad consequences not just for Chinese entrepreneurs eager for expansion capital and liquidity for their shares, but also for hundreds of millions of Chinese, Americans and Europeans whose pension funds have money now invested in Chinese PE. Their retirements will be a little less comfortable if, as seems likely,  a diminishing number of the investments made in Chinese companies have a big IPO payday.

 

 

 

A Nominee For A PE Medal of Honor

medal

If they gave medals for valor and distinguished service to the PE industry, SAIFs Ben Ng surely earned one this past week. In a twelve hour stretch, he met with the laoban (Chinese for “boss”) of four different Chinese SME, at four different company headquarters, and probed each on the merits of their particular business.

The companies were at four different stages, from start-up to a 14-year-old company with a household name in much of southern China, and from four very different industries, from robotic manufacturing to a major fast-food chain, from agriculture to e-commerce.

Ben never wavered, never tired, never lost his genuine enthusiasm for hearing great entrepreneurs talk about what makes their businesses special, while explaining a little about his own company. As I found out later, Ben left a deep imprint with each entrepreneur, and in his understated way, showed each of them why SAIF is such an outstanding success in the PE industry in China, SAIF has backed more than 80 companies during its 10 year history, with $3.5 billion under management, and some of the more illustrious Limited Partners of any PE firm in the world.

By the end of the day, Ben was still full of life, mind sharp and mood upbeat. I, on the other hand, had a case of “PE battle fatigue”. I got home and almost immediately crawled into bed, trying to recall, without much success, which laoban had said what, and which business model belonged to whom. I’ve met a lot of company bosses in my 25-year career. But, I can’t recall ever having so many meetings at this high level in one day. Ben, on the other hand, mentioned he has days like this quite often, as he travels around China.

Ben is a partner at SAIF, with long experience in both high-technology and PE investing. He’s one of the professionals I most like and respect in the PE industry in China. I wanted these four laoban to meet him, and learn for themselves what top PE firms look for, how they evaluate companies, and how they work with entrepreneurs to accelerate the growth and improve the performance of their portfolio companies up to the time of an IPO, and often beyond.

Every great company needs a great investor. That about sums up the purpose and goal of my work in China.

I’d met these four laoban before and knew their businesses fairly well. In my view, each has a realistic chance to become the clear leader in their industry in China, and within a few years, assuming they get PE capital to expand, a publicly-traded company with market cap above $1 billion.  If so, they will earn the PE investor a very significant return – most likely, in excess of 500%. In other words, in my view,  a PE firm could be quite lucky to invest in these companies.

Will SAIF invest in any of the four? Hard to say. They look at hundreds of companies every year, and because of their track record, can choose from some of the very best SME in China. SAIF has as good a record as any of the top PE firms in China. According to one of Ben’s partners at SAIF, the firm has an 80% compounded annual rate of return.

That’s about as good as they get in the PE industry. SAIF’s investors might consider nominating the firm for a medal as well.

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Carlyle Goes Native: Renminbi Investing Gets Big Boost in China

 

Qing Dynasty lacquer box from China First Capital blog post

My congratulations, both personal and professional, to Carlyle Group, which announced last week the launch of its first RMB fund, in partnership with China’s Fosun Group. I happen to know some of the people working at Carlyle in China, and I’m excited about the news, and how it will positively impact their careers. 

Carlyle is the first among the private equity industry’s global elite to take this giant public step forward in raising renminbi in partnership with leading Chinese private company. It marks an important milestone in the short but impressive history of private equity in China, and points the way forward for many of the private equity firms already established in China. 

The initial size of the new renminbi fund is $100mn. By Carlyle’s standards, this seems almost like a rounding error – representing a little more than 0.1% of Carlyle’s total assets of $90 billion.  But, don’t let the size fool you. For Carlyle, the new renminbi fund just might play an important role in the firm’s future, as well as China’s. 

The reason: Carlyle will now be able to use renminbi to invest more easily in domestic companies in China, then help take them public in China, on the Shanghai or Shenzhen stock markets. Up to now, Carlyle’s investments in China, like those of its global competitors, have been mainly in dollars, into companies that were structured for a public listing outside China. Carlyle has a lot to gain, since IPO valuations are at least twice as high in China as they are in Hong Kong or USA. 

That means an renminbi investment leading to a Chinese IPO can earn Carlyle a much higher return, likely over 300% higher, than deals they are now doing.  By the way, the deals they are now doing in China are anything but shabby, often earning upwards of five times return in under two years. Access to renminbi potentially will make returns of 10X more routine.  Carlyle has ambitious plans to keep raising renminbi, and push the total well above the current level of $100mn. 

As rosy as things look for Carlyle, the biggest beneficiary may well turn out to be the Chinese companies that land some of this Carlyle money. PE capital is not in short supply in China, including an increasing amount of renminbi. But, smart capital is always at a premium. Capital doesn’t get much smarter – or PE investing more disciplined — than Carlyle. They have the scale, people, track record and value-added approach to make a significant positive impact on the Chinese companies they invest in. 

This is the key point: the best opportunities in private equity are migrating towards those firms that have both renminbi and a highly professional approach to investing. That’s why the leading global PE firms will likely join Carlyle in raising renminbi funds. Blackstone is already hard at work on this, and rumors are that TPG and KKR are also in the hunt. 

Carlyle now joins a very select group of world-class PE firms with access to renminbi. The others are SAIF, CDH, Hony Capital, Legend Capital and New Horizon Fund. These firms are all focused primarily (in the case of SAIF) or exclusively on China. While they lack Carlyle’s scale or global reach, they more than make up for it by commanding the best deal flow in China. SAIF, CDH, Hony, Legend and New Horizon have all been around awhile, starting first as dollar-based investors, and then gradually building up pool of renminbi, including most recently funds from China’s national state pension system. 

Like Carlyle, they also have outstanding people, and very high standards. They are all great firms, and are a cut above the rest. Up to now, they have done more deals in China than Carlyle, and know best how to do renminbi deals. Carlyle and other big global PE firms will learn quickly.  As they raise renminbi, they will elevate the overall level of the PE industry in China, as well as increase the capital available for investment. 

The certain outcome: more of China’s strong private SMEs will get pre-IPO growth capital from firms with the know-how and capital to build great public companies.


The End of the Line for Old-Style PE Investing in China

Ming Dynasty flask, from China Private Equity blog post

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

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If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.