The challenges of private equity investing in China

CHINA FOCUS SAT DOWN WITH A NUMBER OF INVESTMENT EXPERTS TO TAKE A CLOSER LOOK AT THE DYNAMICS IN THE CHINESE PRIVATE EQUITY INDUSTRY.

The Chinese Private Equity (PE) scene is on the rise. More and more PE companies are gaining a foothold in China to bring in record-breaking funds. China is still considered as an operating field not to be missed, despite the increasingly challenging economic environment and rising scrutiny from regulatory bodies. Consequently, it is vital for PE professionals and their advisors to be nimble, creative and knowledgeable about regulatory specifications.

One of the core drivers for this market's attraction is its rapid development which creates hunger for capital both among start-ups and medium sized companies. Historically, these firms didn't have access to growth capital due to the lack of a developed banking scene. But now, the ubiquitous entrepreneurial spirit leads to promising new foundations and the large Chinese market creates excellent growth opportunities for all players to expand regionally and nationally. Privatisation
of State-Owned Entities (SOE) attracts buy-out capital and the historic lack of funding alternatives has created room for private equity. Nevertheless, the prevailing challenges are keeping PE professionals busy.

State involvement makes it harder

The lack of a clear legal framework and transparent government regulations, combined with a large degree of control exercised by the central government in the venture ecosystem, results in disincentives for both entrepreneurs and investors. It is almost unpredictable whether political objection will occur and it often surfaces at a late stage of the investment process. Hence, some PE firms have run into difficulties closing their deals in China. A prominent example is Carlyle, which has spent two years trying to invest in Xugong, the mainland's largest construction machinery maker, in the face of governmental opposition. Although the purchase of SOE assets at promising valuations still seems to attract a large amount of interest, some growth funds don't even consider these targets: "We don't go for SOE restructurings", one expert said. "There are maybe about ten attractive deals in the whole of China in this area. And even if you come across one of these deals you will not be able to carry out the necessary restructuring in an effective way. A lot of fund managers feel that they have to include these so called opportunities in their pitches, but there is no substance behind this strategy, especially not for smaller players."

Different standards complicate the target search

The term "due diligence" translates in Chinese to "prudent investigation", which for some Chinese companies may imply that they are under investigation for supposed wrong-doings. This often creates distrust which can be worsened by the fact that many Chinese companies haven't developed corporate data on the same professional level western companies have, and are therefore not particularly keen on showing their financial books to an outside investor. Many Chinese mid-market companies simply aren't used to comprehensive due diligence, nor do they have a data room or the means to establish one in the short term. Written company information (such as budgets, financials) is often not available to the extent required by western PE companies. Thus, establishing a deeper and more nuanced understanding of a target's value creation potential is a much more cumbersome process than in the Western hemisphere. Finding gems with real growth potential, or better, separating the wheat from the chaff in China's PE market can be impossible without professional help.

A difference in speed

Many professionals describe the deal cycle as the most striking difference between investments in Chinese and Western companies. Depending on the particularities of each deal including industry sector, size of investment and company specifics, closing times in China can vary from six months to two years. Other factors determining the length of negotiations are the political importance of an industry and how influential the PE firm or dealmaker is in that certain industry. Some "big buck" deals grind to a halt simply because they take place in politically sensitive areas. Investors that are used to a speedy environment like in the US may need to bring a lot of patience to be successful in China. Closing speed also varies substantially between overseas PE firms and their mainland counterparts. The strategy of Chinese PE companies often involves a shorter due diligence period due to their stronger relationships and informal information networks which can be beneficial in terms of shorter closing times. In addition, Chinese PE firms are often more willing to settle for a minority share and many are not focused on a specific scope of investments. Offshore model no exit option anymore The majority of foreign PE investments in China was usually made through an offshore special purpose vehicle. Foreign firms opted for this protected offshore solution not only for tax and currency reasons but also because of the easy way out via public listings. Since September 2006, the ministry of commerce made this easy exit option virtually impossible. In addition, new multi-layered approval processes complicate foreign investment proposals. As for domestic onshore structuring, the restricted capital flow, a non-convertible local currency and missing legal reliability have made China a challenging environment. Immature capital markets and relatively low M&A activities worsen the situation and make the early planning of an exit strategy a must.

Information is the key to successful valuation

The lack of transparency, stability and regulatory consistency also affects valuations. Many small or medium-sized Chinese companies are considered as high-flyers, while in fact their poor efforts are compensated for by the outperforming Chinese economy. Faced with competition in their sectors, these companies would most likely fail. Many Chinese enterprises only copy each other's services and products and are still demanding highly overestimated valuations. Well-run companies that create value-added output and strive for true long-term growth are few and far between. Distinguishing those from their underperforming peers has become the true masterstroke for PE companies in China. Having critical data at hand about the target is the only way to ensure that a possible deal is in sync with the PE firm's strategic vision and will enhance prospects for a profitable outcome. This includes information about the portfolio company's value chain, their potential and existing customers and a third party's opinion on viability of the targets' plans and positioning.

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