At the Finance and High-Tech Industry Summit held on May 25th and 26th in Beijing, Chinese investment bankers, private equity fund managers, stock exchange reps and Chinese entrepreneurs debated the current state of private equity in China. The summit, organized by the China Beijing International Hi-Tech Expo, was an overtly upbeat affair – not surprising, given the boom that China’s PE sector is experiencing.
Alex Ding, vice president of Hong Kong-registered Asia Business Consulting Capital (ABC), told the audience that of the 15 PE projects the company has invested in since 2002, 10 were launched in the past two years. As Ding put it, ABC has seen PE in China rise from a “valley” in 2001, when ABC first entered the sector, to a “peak” in 2007. This growth is confirmed by figures reported by the official Chinese news agency, Xinhua: While investment by PE funds in China was only $11.7 billion out of a global total of $738 billion in 2006, in the first three months of this year Asian PE funds alone pumped in $7.6 billion, the agency said.
And if the mood at the conference is anything to go by, this is just the beginning of the boom. According to Xia Xiaoning, managing director of AIF Capital, his company sees plentiful opportunities ahead in China. AIF, which manages total assets of $1.5 billion, has recently extended the scope and coverage of its investments into manufacturing, banking, logistics, steel and other sectors. At the same time, Xia said, there has been a large influx of foreign PE funds into the Chinese market place, and indigenous funding institutions have multiplied. Many foreign funds have become localized in China by moving their headquarters to Shanghai or Beijing and hiring predominantly Chinese employees. Meanwhile, domestic funds are trying to develop their international reach by hiring professionals educated overseas, and are becoming increasingly competitive, said Xia.
Drivers of China’s PE Growth
What lies behind the boom in China’s PE? In Xia’s view, the abundance of PE opportunities stems from several factors. First, there is a growing number of potential targets for investment, including state-owned enterprises (SOEs) and increasingly successful private firms. “Currently, with China’s integration into the supply chain of various industries, we are seeing a shift of major production and processing links and value-added procedures into China,” Xia noted.
The increase in the scope of private sector opportunities has also been accompanied by the greater profitability of individual firms. “A few years ago, most private enterprises – even the successful ones – were of relatively modest size, with profits of no more than $1.3 million,”Xia noted. “But now it’s very common to find a private enterprise with profits running over $13 million.” The constantly improving investment environment due to China’s rapid economic growth is a second factor, Xia said, adding that a much higher level of awareness of PE is also helping to make it a force for the development of small- and medium-sized enterprises.
According to Joe Tian, managing partner of DT Capital, the perception among investors that there is more room for growth is another factor which explains the surge in investors’ level of interest in the PRC. “China’s case is unique,” he noted. Investors are attracted to the range of opportunities that simply cannot be replicated in older economies, said Tian, giving the example of China’s high growth automobile and components industry versus the less dynamic market in Western Europe. China’s insurance sector resembles that of the U.S. 50 years ago, he stated. “I think currently the reason why so many investors are [interested] in China is because they do not believe that many of the uniquely Chinese situations or projects can be emulated in the U.S. market place.” The rates of growth in emerging industries in China are difficult to match elsewhere.
Furthermore, fund managers said that they stand to benefit from trends in China’s stock markets. “We think that currently the A share market in China is quite robust,” said AIF’s Xia. “That is why we are looking at investment opportunities in those enterprises that have exited the A share market.” Alex Ding noted that increased “flexibility and freedom” in trading A shares on the domestic market is another driving factor. “I think that will also open up the doors for PE activities,” he said.
Opportunities Old and New
Where are PE investors concentrating their capital in the Chinese market? Wang Fanglu, a managing director at Hong Kong-registered CITIC Capital’s Beijing offices, says that his company focuses mainly on leading traditional industries, i.e., state-owned enterprises. But investors’ appetites are already ranging well beyond traditional industries. AIF’s Xia noted that the appreciation of the Rmb and increasing raw material costs have also exerted significant pressure on traditional industries, meaning a sharp decline in gross profits. Investment prospects in some older industries are therefore on the decline. In the search for the firms with the highest revenues offering the highest returns, investors are looking for inroads into industries that appear poised for breakthrough growth.
The good news for investors and fund managers alike is that many companies undergoing rapid growth in emerging industries are still not in a position to launch IPOs, according to speakers at the conference. “Only when they have received some support from private equity, for instance, will they be able to proceed from that stage to the listing stage,” said Alex Ding of ABC Capital.
Speakers specifically highlighted industries such as pharmaceuticals, petrochemicals and solar power as being ripe for PE attention. But new opportunities are arising thick and fast. Even the expanding children’s toys, clothing sectors and beauty salons are reportedly catching the eye of PE funds. And emerging industries that coincide with favorable government policies are potentially doubly attractive. “Another focus of interest is environmental projects and new energy projects because of the policy support of government and the requirements of social development,” noted Wang Fanglu of CITIC.
Financial services also continue to attract PE firms. “We are interested in the service sector in a broad sense, including financial services and the high tech sector and their interaction,” said Wang, adding that until now, PE investment in financial services in China has concentrated on large scale commercial banks and state-owned insurers. However, the market has already begun to mature somewhat. Commercial banks have greatly improved their management expertise through strategic investors, Wang pointed out, and can be expected to get stronger and stronger. This means that PE firms may have to be more creative with their investments. In CITIC’s experience, however, plentiful opportunities remain for establishing cross-sector investment platforms between insurers, securities firms and banks.
CITIC also has its eye on the education, media, pharmaceuticals and healthcare industries. “All these sectors share one thing in common — a high requirement placed on human capital,” said Wang. “What they lack is not only money, but also human capital – people, great people…. In choosing the right people we are focused on teams that are good at marketing. In the recent past we have found many good projects that have interesting technologies, but technologies themselves cannot generate profits. So while we look at the technology, we are more focused on sales and marketing capabilities.”
An Increasingly Risky Business
Along with a sense of optimism among conference participants was an air of caution, as several speakers raised concerns about the growing risks of PE in China. “My feeling is that in recent years the issue of risk has really posed a challenge for both investors as well as companies,” noted Alex Ding of ABC Capital. “Before around 2005, I don’t think there was any silly money in the private equity market. But I think over the last year, there has been a blind rush to put money into the private equity market – something similar to the current situation in China’s A shares market.”
Xia Xiaoning of AIF Capital agrees. “There is too much of an inflow of hot money, too much liquidity in the market,” he warned. “Currently, because of the phenomenal growth in the A share market, the bubbles that have come to accumulate in certain industries, and some of the regulatory changes, we feel that for the PE industry certain risks are still lurking.” Xia said that adjusting to the constantly shifting regulatory and legal tides may hold up transactions or even cause some PE ventures to be abandoned.
And investors beware: In the search for as much financing as possible, some businesses do their best to “polish” their accounting figures and exaggerate their performance, said ABC’s Ding. Armies of accountants, law firms and investment consultants are now available to help Chinese companies beef up their documents for presentation to investors. Account polishing may do a disservice to investors and companies alike as companies prove unable to satisfy their performance requirements, Ding said. He also warned that many Chinese entrepreneurs are not able to formulate well-defined plans on how best to utilize funding resources.
Competition for scarce human resources is not just a problem for the education, media, pharmaceuticals and healthcare industries. “The overall situation in the China PE market is fiercely competitive,” said AIF’s Xia. “The [rapid] development of the PE industry has also led to a shortage of well-qualified professionals, and this has caused some deficiencies in the original planning and outlining of projects.”
Some Words of Advice
As an antidote to the rashness that some speakers warned of, ABC Capital’s Alex Ding had words of advice for investors. First, institutional investors need to have a clear idea what kind of benefits they expect from a PE deal, he said. Furthermore, he warned against the tendency for investors to fail to discuss a specific business plan and to rush into deals too quickly.
Speakers also offered words of wisdom to businesses in need of cash. Entrepreneurs, he said, need to be realistic about their businesses’ stage of development and they must be sure to know who their investors are. In the real world, added Chen Hong, chairman and CEO of Hina Group, smaller companies in the earlier stages of development are probably unable to formulate a clear business plan and are unlikely to attract interest from PE or VC investors. Investment bankers at the conference said that in choosing projects, they consider both the company’s business plan and its existing team, and are reluctant to put a priority on either. Chen also cautioned companies to examine whether receiving new financing was really a prerequisite for their further development.
Nevertheless, company reps on the lookout for investors at the conference might well have taken heart from the variety and size of investments described by the speakers. For example, Xia of AIF Capital said that his firm typically makes investments in single projects across a broad range of between $10 million and $50 million.
Strategies also differ depending on who has the checkbook. Xia noted that AIF does not “position itself as a buyout fund or venture capital firm,” which contrasts with takeovers launched by firms such as CITIC. “We see ourselves as a growth fund. That is, we try to take up a minority share in the company we invest in, and we do not engage in the daily operations of the company,” Xia said. “On the other hand, we are quite active in the various board-related activities and various committees and sub-committees under the board of directors of the company we invest in.” AIF makes relatively long-term investments of up to five or seven years, demanding strong terms of protection for minority shareholders. Alex Ding, meanwhile, stressed that ABC, which started life as a consultancy, aims to leverage its consulting experience by providing a comprehensive set of services to the enterprises they invest in.
In a panel on “exit strategies”. entrepreneurs and investors suggested that investors are keen on launching initial public offerings, and that entrepreneurs, since they are often large shareholders, may also tend to prefer IPOs to participating in mergers and acquisitions. However, IPOs may prove a sticking point with other shareholders, speakers said.
Since increasing numbers of Chinese entrepreneurs who do opt for IPOs are now looking to stock markets abroad, conference speakers pored over the merits and demerits of this strategy. A foreign listing can be a mixed blessing, warned Sean Wang, president and COO of Hurray! Solutions. In the first place, the process of listing abroad can be extremely complex. And, once achieved, as a listed company in the U.S., for instance, Chinese companies face the unenviable task of meeting the demands of both U.S. and Chinese regulators. “This is a very serious problem,” Wang said.
Nevertheless, there are also advantages, he added, including a high money-raising potential and the prospect of quick growth. Michael Yang, executive director, Asia Pacific, for the NYSE, suggested that many Chinese companies want to go abroad to participate in M&As. Being listed on the NYSE helps with this, he said, adding that while listings of Chinese state owned enterprises on the NYSE began to slow in 2005, listings by private enterprises have speeded up. More and more Chinese companies are able to satisfy the requirements of the NYSE, the world’s most regulated stock market, he said.