Student projects/outputs
No.020
Private Equity (PE) in China— Impact of the Financial Crises and Challenges of Foreign PE in China
Mareike Mueller MBA2008 China Europe International Business School, China China Europe International Business School, China 699, Hong Feng Road Pudong, Shanghai People’s Republic of China
Agenda 1. The financial crises and the role of PE 2. Investment specifics for the Chinese PE market 3. Interview: Why foreign PE companies fail on the Chinese market? 4. Trends and chances in China
PE can be one element for the bridge between China and the west. It helps to create an understanding for the other culture and exchange of entrepreneurial ideas. The following market research paper will impact of the financial crises on the PE European and Chinese PE sector and potential challenges for European PE 1 investments in China. 1. The financial crises and the role of PE Before the financial crises the EU PE industry enjoyed a steady increase as can be seen in the graph below.
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The PE growth was mainly possible due to an extensive financial market liquidity, access to this liquidity to low interest rate and a rising asset value. Since the financial crises and the following economic crises the value of new global private equity investments fell precipitously, from $765 billion in 2007 to $234 billion in 2008. 3 Less access to financing and higher bond-yield triggered this reduction in PE activities. The long term commitment of the institutional investors like Pension Funds in PE companies and accompanying restrictions on early redemptions have protected those funds from withdrawals. 4 In the crises fundraising was especially difficult as banks, some insurances and some pension funds are affected by liquidity squeezes. One effect was a rapid Internationalization for fund raising as well on a portfolio level e.g. Earlybird, Germany €130m, 2 lead investors Abu Dhabi Investment Authority, U.A.E. and Osaka Gas, Japan. 1
For a description of the PE industry in Europe, please read the appendix.
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http://ec.europa.eu/internal_market/investment/docs/other_docs/reports/equity_en.pdf
3
Arnold, Martin, “Buy‐out bosses see halcyon days fade away,” Financial Times, January 2, 2009;
http://www.ft.com/cms/s/0/eb460fc2‐d8f8‐11dd‐ab5f‐000077b07658,dwp_uuid=e8477cc4‐c820‐11d b‐b0dc‐000b5df10621.html. 4
Robert J. Shapiro , The Role of the Private Equity Sector Promoting Economic Recovery.
In the EU the crises also took it victims. Candover, before considered as gold standard of European PE, is one of the most striking one. It agreed a deal to terminate the investment period on its €3bn buy-out fund, leaving it without a pool of money to invest in new deals. On the other side APEX partners signed a deal with China Investment Corp and is following a trend of European PEs to diversify or collaborate and invest in more promising areas like China. 5 China’s slowdown does not seem to have deterred private equity fundraisers. What does slowdown mean? A slowdown in Chinese standard means an expected 7.5% instead 9% growth by the World Bank. As responds to the financial crises the Chinese government released a $586 billion stimulus plan, to invest in infrastructure spending and lower interest rates to free up capital. In regards of the fundraising there was a steady increase in the PE industry in China. ChinaVenture, a research and consulting group, calculated that the industry raised in 2007 $11bn and in 2008 $12bn to invest in China. 6 Chinese PE companies invest mainly in domestic Small and medium sized (SMEs) companies. The growth of the SMEs will allow PE/VC an expected growth of 10 times in the next years, from less than $100 billion yuan to $1 trillion Chinese yuan ($147 billion) over the next five years. 7 China was able to increase its PE attractiveness index globally the most over the last years, following the IESE Global Venture Capital and Private Equity Country Attractiveness Index. The underlying SWOT can be seen below. 8
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FT, Europe’s private equity herd thins out, Martin Arnold, Published: December 4 2009 22:23
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The Deal LLC, Custom Market, Eyes on world market, Winter 2009,
http://www.thedeal.com/pdf/EWM_2009.pdf 7
China Venture Capital Association (CVCA),
http://www.cvca.org.cn/CVCANewsletter/detail.asp?ArticleID=1161&sYear=2009&sMonth=11 8
Information taken from H. Liechtenstein, IESE, The Global Venture Capital and Private Equity
Country Attractiveness Index, 2009/2010 Annual.
Table: China SWOT analysis 9
Graph: China SWOT analysis 10 China is interesting as target for European PEs based on a wide range of opportunities, the survey especially highlights lower investment costs (97.4%) e.g. tax incentives from their investments, more rational investment mentality (69.2%); an increasing emphasis on the value-added service for portfolio companies (43.6%); and the surface of high-quality deals (41.0%). 11 The China Venture Capital Association (CVCA) remains confident, that the mid-term outlook will be positive in China. The survey of the CVCA in 2009 released the following results: Short-term due to the uncertainty of the financial crises and the weakness of the Chinese economy the outlook of Chinese PE/VCs are weakened to a certain extent (based on 43.6% of all survey responses). Long-term the confidence in the Chinese economy in the PE/VC industry is unchanged positive (84.6% of responses). The industry is expected to recover in the next 1-3 years. 12
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Graph: China PE market recovery expectations after the financial crisis (base year 2008)
In 2008 some of the raised money was not invested due to a difficult IPO environment and weak M&A market. Based on the research from Dealogic, China-related IPOs in 2009 are down 45% this year, and trade sales and private placements are increasingly used for exit at the moment.
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Information taken from H. Liechtenstein, IESE, The Global Venture Capital and Private Equity
Country Attractiveness Index, 2009/2010 Annual. 10
Information taken from H. Liechtenstein, IESE, The Global Venture Capital and Private Equity
Country Attractiveness Index, 2009/2010 Annual. 11
http://216.39.100.211/PRNewswire/release/137844.html
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http://216.39.100.211/PRNewswire/release/137844.html
2. Investment specifics for the Chinese PE market China is still an emerging country with common problems like a not fully functional public equity market (though the stock exchanges are improving), an arising corporate bond market and a weak legal environment. This research report will mention the main challenges for PEs but will not be exhaustive. Deloitte defines, based on interviews, seven disciplines for successful PE investment in China. 13 They are mainly aligned with the research Mike Wright did, to identify key issues and differences between the Chinese and European PE industry. 14 The key elements for successful investment are therefore the following: • In China for the deal sourcing “Guanxi” (social capital network) is a key success factor. This is one of the reason why in the next section the PE director recommends to have a local team in China as foreign PE company. • Investment environment in China is challenged by a lack of institutional stability, poor property rights, weak rule of law and asymmetric information. Different than in Europe the PE companies rely less on interviews with the entrepreneur and his business plan and more on market information and their own due diligence. A competitive advantage can be gained if the PE is able to navigate though this complex political and regulatory environments. The lack of information infrastructure increases the time needed for information gathering and deal development. • Managing intellectual property and contracts in an weak institutional environment is seen as another success factor. • In China IPOs are not as much an exit options for PE than strategic sellers. EU PE companies can add an increased value due to their network outside China. PEs have to define clear pathways for exit through innovative legal structures. • Last but not least the right staffing of local executives is key for success. Furthermore the PE companies have to educate the entrepreneurs as private companies are relatively new in China and corporate structures, shareholder rights, governance, IP protection etc. are new. 15
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Deloitte, Seven disciplines for venturing in China,
http://www.deloitte.com/assets/Dcom‐Colombia/Local%20Assets/Documents/DTT_DR_SevenDiscipli nes_012006(1)(1)(1).pdf 14
Mike Wright, 2007, Venture capital in China: A view from Europe.
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Deloitte, Seven disciplines for venturing in China,
http://www.deloitte.com/assets/Dcom‐Colombia/Local%20Assets/Documents/DTT_DR_SevenDiscipli nes_012006(1)(1)(1).pdf
3. Interview: Why foreign PE companies fail on the Chinese market? In the last section the key challenges and differences between European traditional PE investment and Chinese required PE investment are drafted. In an interview with a director from one of the leading Chinese PE companies several of these theses could be validated. The interview covered his view on the current challenges and potential mistakes EU PE companies have done in the past.
Table: Top 30 Private Equity Funds in China of the Year 2008 16 Based on the interview the 3 core failures are no local team, inflexibility in the deal structure and cultural unawareness were mentioned. Mistakes in this areas have led EU PE companies to move slower on the Chinese market. The fastest foreign PE player in the Chinese market is the US followed by EU and Japan. Below you will find the detailed answers to the interview questions. What are the main failures of EU PE companies in China? a) Missing local team and experience: The Chinese economy moves fast and can be risky. Long decision processes are often a reason for failed opportunities of EU PE companies. Other than the speed cultural differences need to be understood and reflected in the investment decisions to minimize risk. Not everything is explicit in the Chinese culture. b) Wrong deal structure: EU PE companies are used to take mainly the majority stake in the companies they invest in. This behavior is a deal 16
Zero2IPO, China Venture Capital & Private Equity Annual Ranking 2008,
http://events.zero2ipo.com.cn/2009vcranking/en/
breaker in China. Chinese PE companies usually do not take the majority stake. The founder, his core team and his external network (“Guanxi”)are evident for the success. The role of PE in China is more seen as a coach and less in the professional management of the company. c) No open mindset: In the interview a different mindset between EU PE and Chinese PE was described. Chinese PEs are often more open minded, more risk taking in structuring the deal and less conservative e.g. in regards of technology transfer in JVs. Elements which are seen for him as elementary to be successful on the Chinese market. Will there be an increase in Chinese PE investment in Europe mid-term? Chinese PE companies will help the Chinese clients to invest in Europe, e.g. M&A, set up sales channels or other strategic movement. As far as the company of the interviewee was concerned no investments in European companies directly will be done, based on legal restriction as the fund money needs to be invested in China. What are the short-term trends? The potential local, growth industries in scope are consumer products, service industry, brands and Cleantech to a limited extend. This is aligned with the research described in the next chapter.
4. Trends and chances in China The trends mentioned in the interview are supported by other research literature. Environmental protection and new energy, consumer products and services, and healthcare sectors will be the key areas for foreign VC/PE investment in the next 1-2 years based on the China Venture Capital Association (CVCA). Within the financial crises a shift from export oriented to consumer oriented investments in the China PE industry could be seen. Furthermore the oversea exit option has narrowed with the financial crises but the local exit environment is improving. As a result the focus is moving more to China domestic companies for local VC/PE companies. The current weaker valuation of companies as result of the financial crises provides an increased possibility to pick up a better investment for PEs/VCs. As regulatory to set RMB funds up has been improved, there is an increased interest in RMB funds from foreign PE companies as shown in the graph below.
Graph: PE companies invested in China and planning to invest in RMB funds in future This investment in RMB funds is increasing the barriers for entry for international PEs. Last but not least an trend to partnering among foreign and Chinese PE can be seen, e.g. investment and cooperation of Carlyle and Bohai investment fund. PEs will transform Chinese companies in global player. The high savings in hand of domestic and local PEs make it possible. 17 PE reduces the risk of Chinese companies investing outbound and help European companies to develop wider supplier base to invest in local, innovative products.
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According to PEChina.
Appendix:
Table: The European private equity industry18 Venture Capital Venture capital is focused on young, entrepreneurial companies and is an essential part of value creation in the whole private equity financing cycle. It provides finance for start-ups- at their inception or shortly after their first technical or commercial developments. Much of this segment is technology-related in e.g. new information and communication technologies, life sciences and healthcare, electronics and new materials industries. Investments are often in individual minority shareholdings with a number of venture capital funds investing alongside each other in successive rounds of financing. The investors are closely involved in determining the investee company’s strategy, hiring key employees, organizing the search for further financial resources and negotiating partnerships with larger corporations. Expansion Capital In later stage expansion (or growth) capital finance is provided to purchase holdings in existing, generally profitable companies by subscribing new capital (as equity or quasi equity). Investee companies here have growth profiles that necessitate the consolidation of their financial structures to e.g. develop new products or services, set up a foreign subsidiary, make an acquisition or increase their capacity. Buy-out Capital Buy-outs are typically majority investments made in companies together with existing management (management buy-out or "MBO") or with a new management team (management buy-in or "MBI"). These normally use sophisticated financial techniques that involve bank financing. Opportunities for buy-outs are created from the sale of family-owned businesses, the sale of a non-core subsidiary by a large corporation, taking a listed company private and the sale by financial shareholders. Buy-out funds do not focus on any one industry, though most managers have sector specialisms. Typical characteristics of the Private Equity industry 1. Investment by a dedicated professional team predominantly in unquoted companies; 2. Involving active ownership driving value creation; 3. Drawing capital from a defined pool; 4. Negotiated contractual relationship with qualified/professional investors; 18
European Commission, July 2006,
http://ec.europa.eu/internal_market/investment/docs/other_docs/reports/equity_en.pdf
5. Profit-sharing schemes which align interests with investors; 6. Strong self-regulation with defined reporting and valuation requirements; 7. Involving stand-alone management of each individual company 8. Investing on the basis of a medium to long term strategy and holding period; 9. With a focus on financial gain through exit by sale or flotation.