unexited PE deals

Going for broke: the PE world’s big risky bet on China’s internet and mobile industries

China fortune-teller

The World Cup has begun. Along with being the globe’s most watched event it is also certainly the most gambled upon. Thirty-two teams, sixty-four matches to determine the winner on July 13th in Rio de Janiero. To choose the winner, you want to look at the individuals, the team management, the history of past success, the competition. In other words, it’s a lot like the process a private equity or venture capital firm uses to choose which companies to invest in.

It would be ill-advised, if not borderline crazy, to bet one’s life savings on the USA team to win the World Cup this year. Coral, the big British bookmaker itself owned by three PE firms, is offering odds of four hundred to one.

While no one is offering odds or a betting pool, the current mania among PE firms in China for investing in loss-making internet and mobile services businesses looks like an even wilder bet. Herd behavior is a familiar enough phenomenon across the PE and VC world. But, the situation in China has reached almost comical proportions. At the moment, there is little, if any, PE money going to large, profitable, mature, comparatively “de-risked” manufacturing companies. Instead, almost all the publicly-announced deals are investments in a variety of mainly online shopping sites or mobile-phone travel, game and taxi-booking services, none of which has a true technological barrier to entry, and all of which seem to hinge mainly on the same prayed-for low-probability outcome: a purchase down the road by China’s two internet leviathans, Tencent or Alibaba.

A US IPO is also at least theoretically possible. This year has already seen successful IPOs for Chinese internet and mobile companies, including Zhaopin, Cheetah Mobile, Qihoo 360, Leju, Chukong Technologies, Sina Weibo, Tuniu. But, deals being done now are for smaller, newer less well-established China companies that mainly face a steep failure-filled mountain climb of at least two to three years to even reach a point at which an IPO in New York might even be possible.

It is true that China’s online shopping and services industry is booming. Problem is, almost all the money is being earned by these same two large firms. In online shopping, 80% goes to Alibaba. In online gaming, a far smaller money-maker, Tencent is about as dominant. Both have done a few deals in the last year, buying out or investing alongside PE firms in smaller Chinese companies which have gained some traction. At the same time a few Chinese internet companies have gone public in the US and Hong Kong. But, the overall environment is much less positive. There are far too many “me too” businesses with business models copy-catted from the US pouring out PE and VC cash to buy customers or a thin allotment of a 20 year-old Chinese male’s online gaming budget.

China is the world’s best mass manufacturer with the world’s largest, or second-largest, domestic market in just about every imaginable category. Simply put: there are so many better, less risky, more defended Chinese companies out there than the ones now getting most of the PE and VC time and money.

My bet is that Tencent and Alibaba will also soon lose their appetite for buying smaller Chinese internet players. They are at a similar phase as companies like Amazon, Google, eBay, Cisco, Microsoft, Electronic Arts, IAC/InterActiveCorp, once were. These giants at one time bought small US internet companies by the bucket-load. But, most have either quit or cut back doing so. The businesses usually fail to prosper, are non-core, and prove hard to integrate. Minority deals usually turn out worse. Corporate investors make bad VCs.

In other key respects, there is every difference in the world between the US VC scene and this current activity in China. The US has far more trade buyers for successful VC-backed companies, far more genuine innovation, far more success stories, far less monopolistic internet and mobile industries, and a far richer “early adaptor” market to tap. You don’t need to look back very far to see where this kind of investing activity can lead. It’s only a little more than two years since PE firms poured hundreds of millions of Renminbi into Chinese group shopping sites modeled to some extent on US Groupon. Almost all these companies are now out of business or losing serious money. Chinese like group-buying. They just don’t let any company make any money from offering such a service.

Scan through the last three weekly summaries of new PE and VC deals in China, as digested by Asia Private Equity in Hong Kong. Virtually all involve deals to invest in online and mobile services. (Click here to look at the list of these deals.)

I talk or meet with PE partners on a regular basis. I can recall only a single discussion, over the last six months, where the PE firm’s primary focus was not on these kind of deals. This lonesome PE is the captive fund of one of China’s largest state-owned automobile groups. At this stage, about as differentiated as Chinese PE investment gets is whether the money should go into one of the many online sites for takeaway meals or one of the even larger number selling cosmetics.

China PE is slowly emerging from a prolonged period of inactivity and crisis, the result of both a slowdown in IPO activity and PE portfolios bloated with unexited deals. It’s good to see some sign of animal spirits again, that some PE firms at least are looking to do deals. But at least up to now, it looks like some bad old habits are being repeated: too many PE firms enslaved to the same investment thesis, chasing the same few companies, bidding up their valuations, inadequate diversification by industry or stage.

In the US, in most VC-backed companies, one of the busiest members of senior management is the head of business development. This job is often to find strategic partnerships, barter and co-bundling deals to generate more growth at less expense. This kind of thing is much rarer in China. Instead, for most, the primary method of customer acquisition is to spend a lot of money on Baidu advertising.

Baidu is far more accommodating than Google. It’s the dirty, not-so-well-kept secret of China’s internet industry. Baidu, which handles over 60% of all Chinese search requests, lets advertisers buy placement on the first page of what are called  “organic search results”. There is basically no such thing in China as “most relevant” search results. The only search algorithm is: “who has paid us the most”. It’s one reason Google’s pullback from the China market is so damaging overall for the Chinese internet.

The “pay to play” rules in China’s internet leads to companies taking lots of expensive short cuts, often using PE and VC firm cash. There’s more than a little here to remind me of the Internet Bubble years in the US. I ended up running a VC firm in California right after the bubble burst. I still shake my head at some of the deals this VC firm invested in before I got there, when, as is now in China, pouring lots of LP money in any kind of dot.com or shopping site was seen as prudent fiduciary investing. Things turned out otherwise. They turned out messy. They will too with this PE infatuation with online and mobile anything in China. A bet on the USA to win the World Cup offers more attractive odds and upside.

 

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?

 

 

 

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.