China can be a land of opportunity for foreign private equity (PE) firms, provided that they proceed with caution and play by the right set of local rules. While many international firms continue to raise increasingly large U.S.-dollar funds on the mainland, one of the largest PE firms, U.S.-based Blackstone, unveiled plans on August 14 to team up with the Shanghai Pudong government to set up a 5 billion RMB fund. Reuters reported at the time of the deal’s announcement that the RMB-denominated venture is Blackstone’s first local-currency fund, and Blackstone is the first major global buyout firm to establish a large presence on the mainland via a wholly owned Chinese subsidiary.

But as Blackstone’s and other foreign funds take off, they will be facing increasing domestic competition. That competition ranges from small PE firms and funds like Hopu, founded by Goldman Sachs China financial wizard Fang Fenglei, which just invested around US$800 million (of the US$2.5 billion it raised from overseas investors) in dairy giant Mengniu and is also planning to raise a domestic PE fund.


Whether the funds are RMB or U.S. dollar denominated, what all these investors will tell you is that PE in China is not easy. Most daunting is the often mind-boggling array of regulations, which can discourage investment in a country with a US$2 trillion surplus that is not capital hungry. But there are plenty of other hurdles to clear along the way and the challenges become even greater when deals involve state-owned enterprises (SOEs). For one thing, SOEs get access to preferential bank loans, obviating one of the major uses of a PE investment. Now, the pressure is on foreign PE investors to demonstrate to the SOEs’ numerous stakeholders – from government bodies to senior executives – that they have much more than money to put on the table.


Investing Pitfalls


Recent deals, of course, offer plenty of lessons from which PE investors can learn. A case in point is The Carlyle Group, a Washington, D.C.-based firm that announced in 2008 that it was walking away from a US$375 million plan to buy 85% of Xugong, China’s biggest construction equipment maker. The episode reads like a primer of what not to do when investing in Chinese companies. One of its biggest mistakes was to assume that the deal would be a good public relations exercise, so its executives confidently began talking to the press while the deal was still being settled. By revealing the price of the deal, “people were worried that they were getting such a good company for such a low price,” says an investor who works for a global PE firm.


It wasn’t long afterwards that Carlyle’s name was tarnished in China. “As soon as the deal got so much press, you knew it was in trouble,” recalls a local industry expert, who works with a number of American PE firms. “I prefer my deals going quiet.”


Arguably worse than that, he says, was that Carlyle’s executives believed the government would embrace the deal and what the firm’s brand name could bring to China. “When it comes down to it,” the expert says, “Carlyle was only providing money.”


Another sticking point experts cite is that the American PE firm tried to acquire too big of a stake. By offering to buy 85% of an asset that the government considers nationally important, Carlyle essentially scuppered the deal by putting the government in a situation that made it feel threatened, according to sources. The final show-stopper, however, was that the deal was not seen by the authorities as being beneficial to China. In the end, China’s Ministry of Commerce, which had the power to ratify the deal, refused to approve it.


It was a different story for German automaker Volkswagen. When it purchased a small stake in a manufacturing company around the same time, it agreed to provide technology and operational expertise. The Volkswagen deal succeeded.


“You really need to provide something more than the money you can bring to the table,” says Niklas Ponnert, CFO of Origo Sino-India, a PE investment and consulting practice focusing on China and India.


Indeed, one of the first questions a PE investor needs to ask is what it can offer a target. Since SOEs have access to cheap money from the government for investing outside the country, one thing a foreign PE can do is offer a target “access to a foreign partner, or be their foreign partner,” says Ponnert. Chinese companies seeking PE capital – whether an SOE or otherwise – are putting a premium on the value-add in areas like technology, access to foreign markets or a track record of bringing companies to foreign capital markets, he notes.


What are they less interested in? “Best practice” management, according to one PE investor. “There is a tendency both among entrepreneurs, who have built the business themselves, and SOEs, who have ingrained practices, to ignore, or at least not want to pay for, ‘management’ expertise,” he says.


Buyer Beware


Even with value-adding offerings, many foreign PE funds are finding out that SOEs are notoriously difficult targets of investment. There are a number of reasons why. For starters, how does a PE investor know what a target is actually worth? “A big problem with SOEs is that valuation is a struggle,” notes another PE investor. SOEs may use discounted cash flow (DCF) or price to earnings (P/E) as references, “but they often use an overstated book value instead of looking at earnings generation.” The result is that “you end up having to pay a lot of money for a not very profitable company, so a lot of deals break [because of] that. I heard rumors that [SOEs] were going to change that, but it’s going to take a very long time.”


There are also myriad legal and regulatory twists and turns to contend with. Two separate bodies of law govern private companies and SOEs, with the SOE law being more complex and containing more state-approval requirements, says Rocky T. Lee, a partner and head of PE and venture capital in China at law firm DLA Piper. Numerous “burdensome” national and provincial laws and public policies for certain sectors can hamper deal-making, he says. Even the definition of an SOE isn’t straightforward. Lee notes that all companies with the word “China” as part of their name — China Petroleum, China Construction Bank and so on — are likely to be state owned, as are educational institutions. “These are SOEs by definition, and ones in which we cannot directly invest without some type of regulatory approval,” he says. Any company that has SOE ownership, “even 1%,” is by definition an SOE. That requires not only heavy regulatory involvement, but also a restructuring plan to be in place before an acquisition can go ahead.


Investors also have to be aware of restricted areas. “Even in the United States, there are certain industries foreign firms can’t buy, even though people don’t word it that way,” says Lee. “There just happen to be more of them in China.” A foreign-investment ban has been slapped on sectors like telecoms and oil and gas. Other bans include television and radio given that “anything that has to do with content is basically prohibited.”


Once a deal gets the green light, a key success factor is how well the interests of PE investors coincide with those of the target company’s stakeholders. “A problem with an SOE investment is that it’s difficult to get that alignment of interests when the state is also involved,” says Ponnert.


At a recent conference, Jiang Yaoping, a deputy economic minister, said that although the government wants to “actively encourage mergers and acquisitions,” the aim is not to “maximize the benefits of one particular company. The concerns of the wider public and the country are more important.”


But SOEs don’t always have the same goals as their new investors. As another global PE investor observes, “The PE model is built on the alignment of interests, but if you’re in bed with an SOE enterprise that may or may not be profit seeking and may have a different agenda, it’s a fundamental misfit for the way that PE [deal] is set to work.”


In addition, he says, the more investors involved, the more complicated things will be. SOEs always have the State-Owned Assets Supervision and Administration Commission, the top SOE supervisory organization, as a shareholder, but there are other players to consider as well. “It’s often not clear who has real control over the company,” adds the investor. “Power distribution differs in different locations.” He recalls one instance when his firm was looking at a promising company but withdrew because of one major drawback: the local government was a shareholder. “The local government saw it as a little goldmine,” he recalls. “So if you restructure it, you have to bring in a lot of governance, which makes it a lot more complicated.” And it could be a never-ending saga as the officials in charge change jobs regularly and the new overseers will want to revisit, and even renegotiate, old agreements.


As Ponnert puts it: “You want a firm that has clear ownership over what it does and transparency in terms of processes [around] negotiating and structuring deals.” That’s not always as straightforward as it could be. Many SOEs have gone through some restructuring, which means there can be “a lack of clarity as to which of the holders of assets have potential claims to the business,” he says.


Yet foreign investors in certain sectors or regions have no choice but to buy a stake in an SOE. And while rare, there are examples of foreign PE firms purchasing SOEs successfully. One of the most prominent examples is the acquisition by U.S.-based Newbridge Capital of 17.89% of Shenzhen Development Bank in 2004. “Never underestimate the approval or disapproval coming from Beijing,” says David Ching, managing director and head of South China at Balloch Group, a boutique financial-advisory house. China’s banking sector was suffering in 2004 and senior officials felt that foreign banking experience could help.


It was the first time that a foreigner ran a modern Chinese bank — namely John Langlois, formerly of Morgan Stanley, who sat on the boards of both Shanghai Bank and Nanjing City Commercial Bank. And while Newbridge didn’t succeed in all of its goals, the future still looks bright — Ping An Insurance Group is in talks to buy the bank, and there is speculation that Newbridge could make five times its initial investment.


SOEs also have an advantage over other targets. SOEs have longer track records than private companies in China, which can be helpful in judging a company’s performance potential. What’s more, as a local investor with a major U.S. fund in China comments, SOEs sometimes have more reliable numbers. “Although the numbers, like everywhere in China, are less detailed than they are in the States, people have less incentive to lie about them. Also, because SOEs are a lot less efficient to start with, it’s easier to make them more efficient. And thanks to lighter government rules, it’s also easier for SOEs to go public, which helps if a firm’s exit strategy involves a domestic listing,” he says.


Having the government as a partner can indeed be useful. As a recent article in Beijing-based Caijing magazine noted: “Industry analysts said a partnership with COFCO, which is a state-owned company, would help Mengniu reduce operational risks, as there might be more of a possibility to gain a government bailout in times of need.”


Private Possibilities


Even though investing in private companies allows firms to bypass some of the pitfalls of investing in SOEs, it doesn’t mean great returns are to be had easily. Both public and private investments hold the same keys to success, including a deep knowledge of the market, especially the players. One reason that investors set up local offices is that “you can’t be flying in from New York or London to do transactions,” says Ponnert of Origo Sino-India. “Also, you don’t want someone who has to go back to their boss in New York [to make every decision]. The entrepreneur wants to look you in the eyes and make a decision on that basis.”


This is where local relationships come in. Given that PE in China is a young industry, people with PE experience who aren’t foreigners or from Hong Kong or Taiwan are mostly returnees who don’t have the same deep local network as someone who has spent a whole career in mainland China. But there are ways to work around that. “The good Chinese entrepreneurs tend to recognize that when you bring in an investor, you want someone who can help with things like corporate governance or raising more money from investors,” says Ponnert. “This counterbalances some of the ‘local benefit.’”


Still, not having local knowledge can slow down a deal dramatically. A lot of it boils down to getting to know who’s who in the chain of command. PE managers have to spend time building relationships with local partners and don’t want to sink time into developing ties with someone who is not a decision-maker, or even worse, someone who is on the way out in the next few months. In 2007, KKR invested US$112 million in Tianrui Cement, one of China’s top cement manufacturers. Li Liufa, the entrepreneur who built up the company, fired top managers with whom KKR had forged goodwill, throwing off the relationship.


And many technical concerns have to be kept in mind, even when investing in private companies. Because the RMB is not a fully convertible currency, foreign exchange regulations are a big consideration. “A foreign person can only convert US$50,000 out of the country each calendar year, so you can imagine how difficult it is to invest in China and convert, say, US$10 million, or US$100 million,” says DLA Piper’s Lee. That is another reason why deal sizes are still relatively small in China. “If the RMB became a fully convertible currency, there would be increased liquidity in the market, better valuation and a lot more firms setting up shop here.”


It’s too early to tell how foreign PE companies that have already set up shop in China are faring. “We’ve only had one real vintage in exits, in 2005 and 2006, and in the U.S. having a single vintage of exits would not be a significant track record,” says Lee. 

But what’s certain is that there won’t be a dull moment. “There will be a bit of a shakeout with the foreign firms,” says Ponnert. “With so much money being raised in such a short period of time, we will soon see who the more permanent players will be.”