Gagen On China… –

The topic of investing in China really became popular during the second half of last year. Having worked in China for quite some time, what does the current landscape of foreign investing in China look like?

Theyve barely scratched the surface of the domestic demand in China. Almost all the deals you see are Chinese companies exporting to markets overseas. Once you add in the initial growth rate of selling those products into China, the numbers are just amazing. Youll see companies growing 100% per annum, and the only issue theyve got is feeding demand.

But whenever you see people suddenly deciding a market is great; buyer beware. It worries the hell out of me that a lot of people have sort of woken up one afternoon and said, Oh yeah, we should be in China. What they should be asking is, Whats our market strategy for our firm and where does China fit into it? Im depressed to hear a lot of people say We need a China strategy, which is kind of the cart before the horse.

That said, I think a majority of the companies will have to be there and therefore will need a strategy. But were seeing this gold rush mentality where everyone buys all the positive pointsbecause there are so manywithout doing the same diligence on the risks. A lot of people dont know the market, they dont have relationships there, they dont understand the culture, and theyre going to lose a lot of money.

What are the possibilities for U.S. and European private equity firms that are intent on owning Chinese companies?

The great thing about businessmen in China is that they understand how to make money. And if they believe that fuller access will benefit their companies and the Chinese economy, then theyll do it. The politicians are very smart about that.

Its a fascinating country in that its Communist politically, but its one of the most entrepreneurial countries youll ever come across. Its bound to get better if only because the demand issues in China are so strong. I think they realize the only way to really deal with it is to open up to trade.

What would you say is the single biggest roadblock there?

There are two. One is the cultural merging of American investor practices with a very traditional Chinese investor attitude, which favors the family and the owners. What we dont even think about here is that if Im invested in your company I get certain rights and obligations to go with that. But there, there is still a very significant number of companies in China that will take your investment, but wont give you any rights of the company. I think that drives fear and slight distrust from international companies going into China.

The second big block is that China is a whole continent in its own right, and any economic or political disruption there would have an enormous effect on the private equity market. So at the moment it all seems very positive, but if theres a meltdown in the Chinese economy and it crashes, it will take everything else down with it. Personally I dont think thats going to happen. But if youre an economist looking at any assets you want in China, youve got this fear and greed thing that says youve got to be there, despite that it is a high-risk market.

There are a number of U.S. and European buyout shops already in China cultivating relationships and taking minority interests there. If a firm has not made that sort of preemptive move into China, is it already too late for them to enter the market?

Probably not. The strategy that those people have is actually what [3i] did when [it] went to China, which is move very slowly, dont invest too much, invest all your energies in relationship building. Its an education process. I applaud firms that move slowly like that to build their experience.

The China story is going to be the story of the next 100 years, so if a firm isnt there now, theyve got a long way ahead of them to go there and still make money. I think I know some of those guys, and the reason they say theyre not there now is because they think the first-movers often lose money. Theyd rather see how the market develops and, when and if it becomes more secure, enter the market with slightly less risk.

Thats not the strategy I prefer because there are some first-mover advantages. Regardless, all the really big firms are going to have very substantial operations in China over the next 10 years, and I think theyre going to make European returns look quite poor.

What are the differences between China and other emerging markets?

One is youve got the highly entrepreneurial culture in China. Youve got a governmentboth national and localthats willing to make the regulatory changes to make the investors come, and youve got a huge domestic market as well as a huge international market.

If you go into Eastern Europe, do you have the same embedded entrepreneurial culture? If you go to Russia, do you really have people that understand the issues of Western investors? Secondly, and bluntly, the regulatory and legal regime in some of those Eastern European states leaves a lot to be desired. I think they are very problematic if you try to execute your liens over property in some of those countries, and you suddenly realize that getting your assets out can be very difficult.

Now, you have similar issues in China, but in China you have a very established offshore investment structure that has been used for years to make at least your shareholding liquid even if your underlying assets arent.

Some have said that China is growing too fast. Is that possible, and what does it mean to private equity if the market gets ahead of itself?

Thats the biggest economic risk. China is now consuming more of the natural resources than anyone else. If you look at their steel usage, their raw material, their commodities, energyeverything is being sucked into it. The risks of an overheating are real. I dont know if it will happen, but if you woke tomorrow to find out the whole economy had rampant inflation, would it surprise you?

And youve got all of the gold rush issues. Lots of companies are being spawned, lots of new investments being made, and common sense and experience tells you a good number of those are not going to work.

Any predictions about the global private equity market as a whole for five to 10 years down the road?

To date, there have always been separate marketsyoure either a venture capitalist or youre a private equity guy. Whats going to really be interesting is people buying a business though a typical buyout methodology but injecting new product launches and new technology through that company in the way that some of these small venture firms do.

Big corporations cant do it for all of the bureaucratic reasons were all familiar with. Venture firms can do it but they have no access to the financial resources and the leverage opportunities that buyout firms do. Whats going to be really interesting as an investment area are those mid-market buyouts that have plenty of financial resources to launch new products and new technology, but they dont have the bureaucratic hindrance or lack of entrepreneurial drive that the big companies do

Economically, if the venture returns start to become poor, as I suspect they will, and the profitability of the mid-market is beginning to slow because there are no great value driversyou bring the two together, you get the high growth rate of technology, with the financial security and corporate discipline of a buyout, and youve got something pretty interesting.