Monday, January 10, 2005
China private equity
Successful exits are encouraging
Matei Mihalca
Money is pouring into China private equity—direct investment into the country’s unlisted enterprises. Money is pouring into China, period, of course, and private equity is one destination among many. This is relatively new, and needs to be put in context.
Foreign direct investment into China remains much larger than private equity, but it’s worth noting that FDI today usually involves control of the business being invested. Private equity, at least in China, mainly involves minority positions without control; buy-outs are rare.
This is just as well, since financial investors are not industry insiders, lacking the hands-on understanding of strategic investors. And China is a particularly complex place in which to do business, especially for outsiders.
The reluctance to accept lack of control may be one reason why private equity investment in China, where legal recourse remains difficult, has taken time to develop.
So why is China private equity activity picking up? What has changed?
Most important, private equity investors (and their investors) have seen returns. In 2004, a large number of Chinese private equity-backed companies have seen initial public offerings or trade sales.
Behind these exits have been generally supportive markets and growing interest in China on the part of multinationals. Chinese companies, especially in technology, have also been buyers of local start-ups funded by private equity.
At this point, it’s useful to distinguish between two types of Chinese companies that receive private equity capital: technology companies, which are generally young and prefer to list in the US, and more traditional companies, either in the consumer or manufacturing sectors, which tend to go public in Hong Kong.
The trends above apply to both categories: companies in both groups have rewarded investors handsomely. But the two groups also differ in terms of the background of companies in each, their size, growth, and hence stage of private equity investment.
Chinese technology companies receive what’s better described as venture capital, not private equity. The companies in question are typically founded by returnees, whose background in the US or elsewhere helps establish credibility.
There have been three areas of technology where venture capital has made a difference in China. The first is telecom value-added services, where companies like Linktone, Tencent, and Kongzhong have already gone public. Notable venture capital investors in this space include Fidelity.
The second is online games, and the leader here is Shanda. Recently, another player, The9, also went public on Nasdaq. Finally, semiconductors. A couple of contract manufacturers or “foundries” have listed (SMIC and CSMC) and more may yet do so (Grace), together with some chip designers.
Spreadtrum, a telecom chip design house, is a highly anticipated offering. Venture funds like Walden and Taiwan’s PVP have done much to support the emerging semi sector in China, and increasingly US houses like Doll and Granite, and even General Atlantic, best known for its software expertise, are joining in.
Technology venture capital in China faces two—or really one—challenge. First, the entrepreneurs are generally well-connected, and so there is little proprietary deal flow. There are few language or cultural barriers, and firms are clustered in Shanghai, Beijing, or Shenzhen.
This profile pushes up valuations. Second, and this also helps push up valuations, many venture capital funds have grown very large (so much so that some have started to return capital to their investors), and the supply of new technology companies in China is still limited.
This means that, again, entry prices tend to be high, premised on the hope of even richer IPOs, and that lower quality companies also get funded. One approach, pursued most notably by IDG, the venture capital arm of the US media group, has been to invest small amounts in many early-stage companies; so far, this has worked.
The non-tech sector is a rather different animal, though both categories have yielded successes for private equity investors recently.
Non-tech entrepreneurs, for example, are seldom as cosmopolitan, and the geographical distribution of companies is more widespread. This means proprietary deals are more likely. The entry of private equity happens later than in technology.
There’s almost no early stage investment in the manufacturing or consumer sector in China; instead, private equity is focused on expansion or growth capital.
The privatisation of state assets is affording some opportunities for buy-outs, though these are still rare. The Carlyle group’s bid for Xugong, a state-owned construction equipment manufacturer, may be a milestone event.
The private equity professional investing in closely-held traditional-industry Chinese companies has a lot of work to do convincing the target to accept outside capital.
This is not the case in technology, where entrepreneurs understand the game as well, and sometimes even better (!), than the venture capitalists.
Businesspeople in the manufacturing or consumer sectors, who have founded and managed successful enterprises, wonder why they should take in private equity capital and why they should eventually list.
With limited access to bank lending and a strong sense of pride, China’s private sector is cash-rich. Private equity investors must therefore sell a new vision, of helping to create longer-lasting, larger-scale, stronger businesses; yet these benefits can seem abstract.
One fund that has been successful at this model is CDH, a now independent group formerly affiliated with Morgan Stanley’s Chinese partner, CICC.
CDH’s successes include Meng Niu, one of China’s leading dairy companies, Li Ning, a sportswear brand, and Nanfu, a battery company sold to Gillette’s Duracell. It helps that CDH is headquartered in Beijing and its professionals have deep roots in China.
The problem with traditional industry is that private Chinese businesses are complicated, and there often is more than meets the eye. (That’s why private Chinese companies often prefer to stay that way —private.) Entrepreneurs can be stubborn, and there is little minority investors can do. Local knowledge and humility, a rare combination, are critical for the success of this type of private equity investment in China.
The success or failure of private equity depends to a large extent on the state of the capital markets. When the markets are good, exits are easy.
It’s also true that the best companies should be able to list even in difficult times. ASMC, a Chinese foundry that is being late in floating, should do well when it finally hits the market; that’s because it is a great company in a specific niche—the manufacture of mixed-signal chips.
All other things being equal, technology companies from China should continue to do well, both in terms of attracting private equity and in terms of liquidity events for investors.
Fundamentally, Greater China has at least three areas of strength in technology: telecoms, semiconductors, and LCD; these should be reflected across an increasing number of companies.
Over time, Hong Kong may begin to rival Nasdaq as a destination for Chinese tech companies; this would be good because, Hong Kong is geographically closer than the US and a more natural home. The concern with Chinese technology start-ups, again, is that too much capital is flowing in their direction.
China’s non-tech sector is broader and deeper than its tech sector. It, too, should spawn successes, especially in sectors driven by domestic consumption. The uncertainty here is more related to corporate governance.
As in the West, the current focus of China private equity on expansion capital should be replaced over time by larger-size investments in buy-out situations.
One day, China may resemble today’s Japan and Korea in this respect, but that day is not yet here. For now, we’re likely to see the continued coexistence of venture capital, growth capital, and, increasingly, buy-outs.