Tuesday, May 20, 2008

China Economic Review on the Form of Private Equity in China

This month's edition of China Economic Review focuses on private equity in China. The editors have kindly released two of the articles to the public for free, Private equity investment: The real deal, and PE investment about more than just money. The most interesting thing in these articles is probably the test of potential investing targets that the CEO of Crestpac, Shelly Singhal, describes, "The best way to find out how committed they are is to send an email at 10pm and see how long it takes for them to respond." The second most interesting thing, and the one I want to spend a little time with, is the different form of private equity investments in China that comes through in the articles.

The most common form of private equity in China is also the most common form of private equity everywhere else in the world: growth capital in the form of minority investments "in more mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business [from Wikipedia where it was stated so simply]." One new factor in these investments is developing, and another factor will enter the picture in the next few months.

The developing factor is that for foreign firms to get the bid they are going to increasingly need to bring something more than just money to the table by showing how they can "eradicate inefficiencies and unlock value." Domestic Chinese PE firms, and foreign PE firms are very active in China, and to make an investment the bidding PE firm needs to demonstrate its own value in the transaction.

The other factor that should alter PE for foreign firms is the forthcoming laws that will allow foreign PE firms to make investments in RMB as onshore entities, rather than in US dollars through offshore companies. The inability of firms to operate in RMB has partially contributed to the reason that only one leveraged buyout has happened in China.

Leveraged buyouts, "an acquisition backed by loans secured against the assets of the target company," are common elsewhere in the world, but they have been limited to a single contested instance in China for several reasons:
  • There are a limited number of companies in China willing to give up a controlling stake in their companies.
  • "Foreign exchange controls prevent the use of assets in China to guarantee a loan made outside of China."
  • "Domestic banks are generally unwilling to lend money for" leveraged buyouts.
The China leveraged buyout discussed in the article is slightly contested as being a true China LBO because it involved foreign loans, and the acquisition of an offshore entity that operated a WFOE in China.

The articles also discuss a growing sector of informal private equity funds supported by China's growing ultra-wealthy. Not something most of us will have any access to, but nice to be aware of.

Venture Capital, that well-known subcategory of private equity, takes on a much different form in China than we are familiar with in the US. Rather than taking stakes in tech companies with little or no profits, VCs in China "are making bigger and later-state investments." The article points out that this is allowing VCs to make returns on their money more quickly and with less risk. These VC firms are also "behaving more passively than they do elsewhere," due to government restrictions and the unwillingness of the company founders to give up control. But, this isn't hurting the VC firms' bottom lines as "top-quartile Chinese firms provided the rate of return globally, giving VCs 30-60 times what they had originally invested (emphasis added)."

I highly recommend these articles, they make great reading.

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