Mid-Market Firms Reap Rewards of China Offices

Glenn Scolnik has done the math.

Let’s say his buyout firm, Indianapolis-based Hammond Kennedy Whitney & Co., spends $250,000 per year to staff and operate a satellite office in China, where a professional helps portfolio companies source lower-cost parts. (Scolnik said the numbers are hypothetical but illustrative.) Given that Hammond Kennedy typically sells a manufacturing-focused business for at least 5x EBITDA, the firm’s Shanghai office needs to produce roughly $50,000 per year in savings in order to recoup costs.

So when Hammond Kennedy’s Asia director, Ting Zheng, finds an alternate supplier in China that can deliver $100,000 per year in savings, the numbers add up. “When you take the multiplier effect, you’re talking millions,” said Scolnik, president and CEO of Hammond Kennedy. “This multiplier effect can’t be emphasized too much. We didn’t invent it. We just recognized it.”

That recognition prompted the firm in October to move Zheng, a China national who received her undergraduate and MBA degrees from Indiana University, from Indianapolis to the newly created office in Shanghai. There, she scouts for new suppliers, maintains ties with existing vendors, and performs due diligence on United States-based companies Hammond Kennedy is considering purchasing. Typically, U.S. companies already outsource some aspect of their manufacturing process, but that outsourced vendor is often based in America, Scolnik said. By moving that same outsourced production segment to China, the buyout firm can give a portfolio company a shot in the arm.

“It’s an IRR booster,” Scolnik said.

In the last two years, mega-firms have placed Asia, and China in particular, in their sights, opening offices throughout the region and raising massive funds to deploy on overseas targets. Mid-market firms, meanwhile, have found that Asia can be just as fertile for profits, albeit by playing by a different set of rules. Rather than buying stakes in Asia-based businesses, some of the more forward-thinking mid-market U.S. firms have established Asia offices of their own and used them as bases to find sourcing opportunities, to outsource operations and to find new markets to sell products to.

Among those that have made the leap is Baird Capital Partners, based in Chicago, which uses offices in Shanghai, Beijing and Hong Kong to provide a global reach for their U.S.-based portfolio companies. MCM Capital Partners, based in Cleveland, acquired a China-based outsourcing and supply-chain company that provides services for other companies in MCM Capital’s portfolio.

Blue Point Capital, the Cleveland-based LBO shop, opened a Shanghai office three years ago, putting managing director Chip Chaikin in charge. Although Chaikin said it took about six months before the office “was of any use to anybody,” the venture is beginning to pay dividends. In its most recent fund, for instance, Blue Point Capital acquired two of its six portfolio companies with a China strategy in mind. Eventually, the LBO firm wants to have China involved in some fashion in half of the firm’s investments.

Three years ago, when Chaikin opened Blue Point Capital’s Shanghai office, the firm was hoping that it would both facilitate savings for U.S.-based companies and open up new sales markets. Both have come to pass. Of the five Blue Point Capital portfolio companies with operations in China, one is strictly there for outsourcing. One combines off-shoring savings and overseas sales growth. The remaining three, Chaikin said, are in China to boost revenue by selling to their multinational customers operating in China.

In an example of the latter category, Blue Point Capital in July closed on a recapitalization of Quality Synthetic Rubber Co. Inc., a deal that illustrates the way in which a firm’s Asia strategy can evolve beyond simply off-shoring manufacturing. Blue Point Capital bought the manufacturer of precision-molded rubber components based near Cleveland not because the firm figured it could rejigger the supply chain, but because QSR hadn’t realized its sales potential in China. “The U.S. base is a strong, attractive business, but the opportunity is in China,” Chaikin said of QSR.

“If we can invest in a company where we can get EBITDA growth just by outsourcing, that’s a terrific answer for us,” Chaikin added. “But the next favorite is the revenue story for China that serves your existing base of customers.”

If mid-market firms are smart, they’re thinking about China with every single deal, said Ted Revis, who works in China as president and founder of the Norelli Group, a consultancy that helps U.S. buyout firms hone outsourcing strategies. For obvious reasons, firms should consider the prospects of lower-cost production in China. For the same reasons, firms should also expect that their competitors have come to the same conclusion, Revis said.

“China is a threat or an opportunity for practically every deal that a private equity firm will ever contemplate,” he said. “It does not matter whether there is any perceived connection to China.”

Too often, Revis added, firms wake up to the threat only after a crisis erupts. In one case, a portfolio company couldn’t match profit expectations, and the Norelli Group installed one its partners as the company’s CEO and created a new position called Vice President of China Initiative. Within 18 months, the company was producing two new products in Chinese plants and sourcing other components for manufacture back in the United States, Revis said.

Of course, sponsors should be judicious about pursuing opportunities abroad. For example, China is not often the answer for products that weigh a lot or are required for supply chains operating on a tight time line. A container ship leaving the port of Xingang near Beijing will arrive in Long Beach, Calif., in about 13 days, Norelli Group’s Revis said.

But he suggested buyout firms need to be thinking of reasons to take advantage of China, not avoid it. He said it’s a “dream” of his firm that more buyout shops have well-thought-out China strategies in place before a deal closes.