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Getting real about private equity in China

by John Kuo

April 18, 2012

Capital raising for China-focused private equity funds is booming. In China, however, merely writing a check might not be enough for realizing returns.

According to the Emerging Markets Private Equity Association (EMPEA), private equity funds in China raised $12.9 billion in the first three quarters of 2011, a marked increase from the $7.5 billion generated in all of 2010. Investors are turning to China because they expect strong continued growth, and because they are shying away from turmoil in Western markets.

They are also tantalized by previous private equity successes in China. For example, in 2005, Goldman Sachs and Morgan Stanley sold their 9.9 percent stake in Ping An Insurance for $1 billion after an initial investment of $70 million. Cheung Kong Graduate School of Business (CKGSB) Associate Dean and Professor of Accounting and Finance Liu Jing believes that in the future, private equity firms cannot expect such high rates of return.

“Some private equity firms made a lot of money in the past,” he says. “They had returns of five or even seven times their investments. But that’s not normal. In the future we can expect to see much more reasonable returns.”

Many analysts report that Chinese private equity firms have less stringent due diligence processes, compared to those in the West–and that this is a good thing. According to Robert Partridge, Greater China Private Equity and Transaction Advisory Services Leader at Ernst and Young, having less thorough due diligence is actually a comparative advantage for Chinese firms, especially as they face increasing competition in the private equity market. Oftentimes, international firms must avoid potentially lucrative contracts because they cannot obtain the approval of their investment committees, who have higher thresholds for accepting deals.

“The regional funds are more concerned with their local brand,” Partridge says. “They don’t have a global brand. If something goes bad, the global brand is more worried about what their investors think because their investors are banking them on deals in the United States, London and China. For local funds, if something goes bad, there’s a tendency to say, ‘Hey, it’s China, there’s going to be a black eye every now and then.'”

In China, private equity firms typically exit deals by guiding companies to initial public offerings. Recent private equity- backed Chinese IPOs, however, have been lackluster. While the average Chinese- based company listed in the first quarter of 2011 gained 11.8 percent in its first day of trading, by the end of the second quarter, the average deal had slipped 12.4 percent below its initial offering price. IPOs will still be the preferred method of exit for private equity firms, Harvard University Professor of Finance Li Jin says, but they will be harder to achieve in the future.

“The so-called ‘halo-effect’ of listing your company in an overseas exchange has diminished quite a bit,” says Jin, who researches emerging financial markets. “There is not generally a lot of investor enthusiasm for these companies that are listed overseas because most investors don’t really know what’s going on so far away from their market and as a result, the trading price of a lot of these firms listed abroad is not so great. Some are even delisting from the international market and moving back or contemplating moving back to domestic markets.”

While many company founders turn to foreign private equity firms because they aim to list their companies abroad, others seek to add value to their businesses. When competing globally, for example, Chinese companies turn to private equity firms because they are inexperienced in managing intellectual property and brands. But this can be problematic because the firms themselves may be ill-equipped for the job, as many of their employees hail from finance backgrounds.

“Private equity firms have got finance people who know how to structure financial packages,” said Cambridge University Professor of Finance Peter Williamson, an expert in globalization and its implications for corporate strategy. “Sometimes their mentality is that they bring in the money. Private equity firms need a broader diversity of staff that knows things about intellectual property, people that can help manage brands and help hire and manage international people and help structure compensation packages.”

“So I guess what I’m saying is that successful private equity in China is private equity on steroids,” he added.

Eventually, Williamson believes, the greatest opportunity for private equity firms lies in trade sales. Private equity firms can mold firms to be attractive for foreign companies who are looking for a platform to expand in China, or for state-owned enterprises who are looking to expand their product offerings.

Faced with weak capital markets, some private equity firms are already turning to trade sales as an exit route. In 2007, when Bain Capital invested $41 million in the Chinese chemical company Feixiang, they expected to exit the deal through the public market. Bain sold Feixiang to French chemicals producer Rhodia for $489 million in 2010, but decided to keep a subsidiary, Casda Biomaterials, and used the sale’s proceeds to start Hipro Polymers. On November 21, Bain sold Casda and Hipro for $365 million, eventuating in returns of more than four times their original investment.

Since most private equity deals in China typically provide non-controlling stakes for between 15 to 40 percent of companies, private equity firms must coordinate closely with company owners for future action. Many entrepreneurs may dream of taking their companies public, but trade sales may prove to be the more intelligent move in the long run. It’s just up to private equity firms to make it the right move.

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