China beats the drum

China has changed beyond recognition since former premier Deng Xiaoping cautiously started to lift the “bamboo curtain” in the 1978. Many of the country’s 1.3 billion inhabitants have embraced capitalism with gusto and individual prosperity and consumerism have taken root, especially since the country joined the World Trade Organisation in 2001.

The country’s burgeoning middle class – conservatively estimated to be more than 250 million strong – continues to demand greater access to western-style brands and services regardless of the credit crunch that has stunted growth in the west.

The country’s still booming economy, coupled with its government’s apparent enthusiasm for private equity as an asset class, has enabled private equity investment to flourish in recent years. The fact that bank loans are near unobtainable by privately-owned businesses has further fuelled the sector’s growth.

“Rising incomes and a high savings rate are creating a burgeoning domestic consumption theme in China,” says Gigi Chan, fund manager at Threadneedle asset management. “In this respect, China is a mirror image of the developed western economies – while the UK and US are grappling with high consumer indebtedness and a sharp slowdown on the high street, Chinese retail sales are growing at around 20% per annum.”

Investors are so dazzled by the Eldorado that China presents – many economists expect its economy will shrug off the global economic blues by posting growth of 7% to 8% in 2009 – they are prepared to tolerate higher risks than would be deemed acceptable in many other markets.

China syndrome

Tantalised by the fact that average internal rates of return (IRR) were 67% in 2007, almost twice what they are in Europe, several of the world’s largest buyout houses have in recent weeks opened Beijing offices, after recruiting local big-hitters with bulging contacts books and strong governmental and regulatory connections to assist their cause.

In early August, Blackstone officially opened its Beijing office. The US-based firm, which since last year has been part-owned by the Chinese sovereign wealth fund CIC, appointed Fu Shan, a former official at China’s National Development & Reform Commission, China’s top economic agency, as its chief representative. A few weeks earlier, London-based CVC Capital Partners opened a Beijing office, with Zhu Wei at the helm. Zhu formerly ran Goldman Sachs Gao Hua Securities, the Shanghai arm of Goldman Sachs.

A recent survey by the international law firm Simmons & Simmons confirmed that M&A activity across the Asia Pacific region is set to increase in the coming year. And a separate survey by the specialist consultancy Epiven found that 88% of European LPs intend to boost allocations to China in the next five years.

“The message is that China will continue to lead the way in regional M&A,” says Jane Newman, head of Simmons’s Shanghai office. “Clearly the respondents do not perceive the China economy and market to be suffering from a post Olympic Games hangover.”

Fundraising of China-focused private equity funds is showing little sign of slowing down. According to the Beijing-based consultants Zero2IPO, 64 new private equity funds raised US$35.6bn in 2007 – a 60% rise by number of funds raised and a 151% rise by value on what was raised in 2006. And this figure looks set to be exceeded in the current year, given that ten new China-focused private equity funds raised US$12bn in the second quarter of 2008.

“The combination of higher expected returns and a rapidly growing pool of talented private equity fund managers is continuing to drive institutional investors to emerging markets,” says Sarah Alexander, president of the Washington-based Emerging Market Private Equity Association.

Risky business

However for all the razzmatazz associated with the Olympics, political and regulatory risks do remain high in China. Each and every deal must by assessed by a range of different regulators, ministries and councils. Government regulations can change at the drop of a hat. Deals often get delayed or torpedoed because of turf wars between financial regulators or because local governments fail to implement state decrees.

Dominic McGlinchey, managing partner of specialist consultants Epiven, says: “There are always three parties in any transaction in China – the buyer, the seller, and the government. You have to consider the government as a third party even if they are not physically sitting at the table.”

Also political corruption is rife and many Chinese companies lack financial transparency (with some keeping two sets of accounts, one for the benefit of the taxman and another for internal consumption). The country’s legal framework remains patchy.

So anyone engaging in private equity investment in China should have no illusions. They are entering a lawless world with parallels with the Wild West – or at least late 19th century America. Chris Ruffle, managing director Martin Currie investment management in China, says: “There’s a form of primitive capitalism here which makes it a perfect stamping ground for latter day Henry Clay Fricks and John Pierpont Morgans.”

There are obviously real dangers to doing business in such a culture, especially when the language remains impenetrable even to those who have lived there for a while. However despite some early high-profile blunders by US buyout houses like Carlyle and Texas Pacific Group, it seems that western private equity players are learning fast.

Brian Lim, pan-Asia portfolio director at London-based CDC Group, says US private equity houses are “learning fast” about how to do business China. “The same thing happened when the American houses first came into Europe in the late 1990s and early 2000s. They rapidly learnt they had to do things the local way.”

Even though it is ostensibly a cheerleader for the industry, industry players also need to be aware that the Chinese Communist Party (CCP) has a Janus-like approach towards the industry. Although the government is prepared to listen to western firms in its pursuit of best practice, it remains unenthusiastic about the sale of majority stakes in local businesses, especially if they are large, state-owned ones. Many sectors, including defence, media and energy, remain off-limits to western capitalists and the government has also recently been showing signs of wishing to tilt the playing field towards domestic, renmimbi-denominated private equity players.

There is also the issue of the human rights, with many in the west outraged by abuses committed by the regime in Tibet, Darfur and in mainland China. However Andrew Ostrognai, a fund formation partner at law firm Debevoise & Plimpton in Hong Kong, points out that the way in which the CCP has lifted 300m Chinese out of poverty with its economic reforms ought to be taken into account. “That has had a profoundly positive impact on human rights in the country.” He also points out that private equity investors – who often invest alongside multilateral investors such as the World Bank’s International Finance Corporation – are often showing a way forward in this area.

“In my view, the biggest barrier right now is that the Chinese renmimbi is not fully convertible,” says Ostrognai. “A secondary barrier is that China still does not allow foreign investors the same freedoms to invest as are given to local players. Another big issue is that companies that want foreign private equity ownership are practically finding it very difficult to transfer ownership of their assets offshore.”


Shaun Rein, chief executive of the China Market Research Group, who quit the private equity industry in 2003, believes China’s private equity market has evolved considerably since the mid 1990s. At the time, “pretty much everybody lost money in China and this was a clear deterrent to US investors,” says Rein. “A key reason was that many of those pursuing deals were either foreigners or returning Chinese who often lacked local understanding.”

Alberto Forchielli, founding partner of Mandarin Capital Partners, puts it more bluntly. “Back in the mid-1990s private equity houses got slaughtered in China.” This period has been brilliantly evokved in Tim Clissold’s bestselling book, Mr. China,

In Rein’s view that private equity in China turned a corner in 2003-04, when a number of private equity-backed companies floated successfully. These included the travel portal, advertising firm Focus Media, search engine group Baidu, dairy China Mengniu and insurer Ping An. “That showed there was money to be made in China and tons of money came flooding back into the market,” says Rein.

He also says that nowadays the market has matured to the extent it now has “an ecosystem of lawyers, accountants, investment banks and local private equity guys.”

The danger however is that this wall of money coming in has had a palpable effect on corporate valuations.

Wang Gongquang, a partner at one of China’s most successful indigenous private equity houses, CDH Investments, says venture capital deals became extremely competitive after 2006 because of the “trigger happy” approach of foreign funds which often lacked understanding or experience of the subtle nuances of the Chinese market. He says: “It meant the number of good deals that actually completed was very low.” Competition became particularly fierce in the technology, media and telecoms sector.

Ruffle says: “The amount of private equity money that has come into the market has pushed private company valuations above listed company valuations.” The fact the benchmark Shanghai stock market index has tumbled from a peak of 6124.04 in October 2007 to around 2700 in early August has also clearly played a part in this state of affairs.

This inversion has had a clear impact on private equity firms willingness to deploy their cash and to make exits. In the year to mid-May, private equity firms had deployed only US$512.4m (£259m) in China, against US$624.4m in the year-ago period, according to figures from Thomson Reuters. And exits too have become thinner on the ground in recent months. According to Zero2ipo they fell by 37.5% in the second quarter of 2008.

Ruffle warns that investment opportunities, especially sizeable ones, are currently hard to find. “It has become such a seller’s market that a lot of PE funds are just sitting on cash at the moment,” he says.

A mug’s game

Generally speaking, China remains a growth capital rather than a leveraged buyout market. This is partly because banks are forbidden to issue loans to fund equity investment under the People’s Republic’s general regulations on bank loans.

Forchielli says “Buyouts are a non-starter in China, particularly where state-owned enterprises are concerned. And where smaller, private companies are concerned the risk with 100% buyouts is that the management just leaves and sets up another company across the road to do the same thing.”

Rein believes that seeking to buy controlling stakes in state-owned enterprises is probably a mug’s game. However he disagrees with Forchielli’s views about buyouts of private SMEs, accusing the Italian of having “very 1990s” views on this topic. “That was true in the 1990s but time has moved on. There’s a lot more honesty in the Chinese market now.” Rein says it would be unimaginable for the top executives at companies like Focus Media, Baidu and to set up similar businesses across the road after selling out to private equity backers.

According to Forchielli fast-growth businesses are falling over themselves to obtain growth capital from private equity firms, so he believes it makes sense to focus on this market segment. “Making investments is very easy as everybody here wants to IPO and they see private equity as their passport towards an IPO. It means they have a strong need for us and means that the openings for PE is enormous.”

“Also, because of the government’s focus on fighting inflation there are constraints on how much lending domestic banks can do – the lending really isn’t there. In some ways you could say the credit crunch is good news for private equity in China – since leveraged buyouts were impossible before the credit crunch it hasn’t really affected things much.”

However there is plethora of views about how the country’s private equity market is evolving. One observer disputes Forchielli’s view that China remains a growth capital market, saying it is already shifting towards 100% buyouts. He says: “Both Hony and CDH – two of the most successfully indigenous private equity firms – cut their teeth of growth capital. But Hony has just closed a $1.2bn fund and CDH has closed a $1.6bn fund. They’re not going to be able to invest all of that on growth capital – buyouts are certainly on their agenda.”

China crisis

Another risk to doing business in China is that its economy could stall. Although growth has averaged between 9% and 11% for the best part of two decades, London-based Centre for Economic and Business Research believes it will slow to 7.4% in 2009. CEBR believes the slowdown will be prompted by a post-Olympic cut in public spending as the Chinese government seeks to rein in inflation – which currently stands at about 7.1%.

Sam Baker, director of Asia research at Tran-National Research Corp, believes a shaper slowdown may be imminent. He points to unsold inventories of cars in China, which rose to a four-year high of 170,000 vehicles in July, a rise of some 50% rise on the start of 2008. “Rising inventories have always been a potentially important ‘canary in the coal mine’, indicating imminent macroeconomic vulnerabilities,” warns Baker.

However CDC Group’s Lim says even if economic growth slows from 11% to say 8%, it would still remain significantly ahead of that in more developed markets. He is convinced that opportunities remain for private equity funds to make decent returns in China, adding “our GPs say they welcome the stock market falls seen over the past 10 months. It is leading to more realistic pricing expectations among vendors. They believe it will enable them to pick good companies at very good valuations.”

He believes the most promising areas are consumer-driven businesses, which is partly because they are dependent on the domestic market as opposed to exports. He said this includes restaurants, infrastructure and services. Lim adds “China is the world’s biggest online market, with 253m people online – the next biggest is the US with 220 million people online. The difference is in penetration. In China it is barely 17%-18% but in the US it is 70%.”

Epiven’s McGlinchey says: “Even if overall economic growth were to slow, there are many sectors where earnings can be expected to grow very rapidly. In clean-tech and renewable energy companies, for example, annual earnings growth of 100% is not uncommon.”

According to a recent World Bank study, China has 16 of the world’s 20 most polluted cities. This means that over the next half decade China is bound to become the world’s biggest market for clean-tech, not necessarily because of green ideology but simply out of pragmatism.

Rein is very optimistic. Like Lim he believes that China’s secret weapon is going to be its burgeoning middle class will continue to swell in number and should continue to spend. “The vast majority of Chinese middle-class youth expect to spend considerably more money in 2008 than 2007,” he says. “The continued optimism of households earning between US$6,000 and US$15,000 per year is driving compelling investment into companies that target them.”

He says that domestic Chinese businesses targeting this growing pool of newly affluent Chinese will be seeking to become increasingly competitive versus their global peers and to expand overseas. Given the absence of bank funding, many will be wanting Western investors with contacts and knowhow to help them achieve that.

Lim says: “The industry is relatively nascent compared to Europe or the US. There have been some stonking returns in recent years – with some high double digit IRRs. I don’t see how some of those IRRs are going to be sustainable but I believe there are still some very good times ahead.”