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Investors can solve China Puzzle with SMEs

Over the past decade, private equity firms have been clamoring to invest in China’s manufacturing, commodities and consumer products sectors.  According to one estimate by a boutique investment bank, private equity firms have invested $230 billion in 10,000 companies over the last ten years.

Many private equity funds have learned the hard way how difficult it is to navigate China’s complexities. Differences regarding due diligence, bureaucracy, intellectual property, ownership and rule of law combine to present unprecedented challenges for international investors. Some private equity firms were fortunate to exit portfolio companies via IPOs, the preferred method in China. Some fled with lighter wallets. Others are sticking it out.

Economic uncertainty in China is on the rise with slowing growth, faltering housing prices and slow-moving IPO market. Many general and limited partners are increasingly wary of investing in the country. However, they also recognize that China’s sheer dimensions make it impossible to ignore. It is home to the second largest number of billionaires and a growing middle class. It has more than double the growth rate of the United States and EU and higher consumer confidence ratings. The question remains: how can investors crack the China code?

Making money in China

To navigate the intricacies of China’s markets, transaction experience and connections within Asia are essential, as well as long-term perspective.

China’s overall growth may be decelerating, but it will remain important at +5/6 percent for many years to come. More importantly, several sectors still offer significant potential: healthcare, environmental protection, advanced manufacturing and luxury consumer goods. These conditions create an ideal climate for foreign, niche export-driven small-medium enterprises (SMEs) and an attractive investment opportunity for private equity managers. 

However, small is not beautiful in China, and small foreign companies find themselves at a distinct disadvantage. While multinational corporations can absorb margin pain in favor of future growth, SMEs have the most to gain or lose in China and cannot afford to invest the time, money and risk to explore opportunities on their own. An intermediary or investor capable of offering local support and capital to develop their Chinese presence will enjoy a significant hedge in helping desirable European and U.S. SMEs expand in both China and other global markets.

My firm, Mandarin Capital Partners, can serve as a case study in supporting export-driven foreign businesses to capitalize on upside potential in China. For example, one of its ten portfolio companies, Euticals S.p.A., based in Milan, Italy, was a leading pharma chemical business looking for a financial partner to fund the group’s development in Asia. 

MCP bought out the majority stake in the company (83 percent), investing 24 million euros ($33 million) structured as an LBO using a newco financed by debt at 3x EBITDA. Through subsequent investments, MCP invested a total of 39.9 million euros.

MCP’s China-based team helped management put in place a successful cost-saving program focused on supply chain efficiency in China. This made a remarkable reduction in the purchase price of intermediate products possible, growing margins nearly three percentage points and significantly increasing the EBITDA margin. The higher profitability allowed Euticals to implement an ambitious buy and build strategy.  

MCP has since become a minority investor following the sale of a portion of its stake to a new entity financed by a group of investors led by Clessidra and including MCP. The realized return on the investment was 44.4 percent with a 2.6x multiple on capital contributed.

For most European and U.S. SMEs, China is an untapped market for substantial growth. With cogent guidance, these companies can succeed in China by deciphering the intricate webs of Chinese markets.

Alberto Forchielli is managing director of Mandarin Capital Partners, which he founded in 2006.