(Private Equity in China, Part I)
In the realm of Private Equity (PE), many consider China to be one of the most strategically important markets. Because flows of funds and competitive forces are increasingly complex, and change so quickly, thought that evolves with equal speed is essential for PE firms’ success.
Last year brought cash in more easily and quickly than a tough 4Q09. Eighty-two funds closed and 31 freshly launched, a nearly 30% improvement on the 2007 banner year. Average new fund sizes reflected a less cavalier posture toward risk. ‘We want to be in there,’ investors seemed to say, ‘but we need to tighten the scope of expansion a bit.’ Although the $US 27.6 billion that poured in was more than double the anemic increase in funding for 2009, it was less than half of the $60 billion sent hunting in 2008. Think up-down and up-down again on the funding see-saw, all for the obvious reasons. The rush to get started in a time of excess liquidity (’08), the slam of the nastiest global crunch since the 1930s (’09), the beginning of a rebound fueled in part by the realization that interest rates in the West would continue to languish (’10), a pattern which has spilled into this year.
But the most significant development in 2010 was the proportion of total funds closed by Chinese institutions. In 2009 the share was less than two-thirds; in 2010 more than four out of five. In the West, the crisis hit harder and still shows every sign of lingering much longer. (‘How long is the rest of your career?’ quipped one Wall Street veteran.) Independent foreign funds raised 50% more than local funds in dollar terms ($15.8b vs. $10.6b), but without counting the biggest buy-out funds, it looks more like a dead heat. A handful of ‘elephant’ closings by major foreign players such as TPG, IDG, Carlyle and Blackstone, indeed, confuses the overall figures. The quickly budding category of Sino-Western JVs—many of them hookups between large PE groups and provincial or municipal governments—closed $1.2 billion.
More startling than the changing lineup of overseas versus domestic players is the shift from foreign currency to RMB denomination. Of 82 funds closed, 71 were denominated in Yuan, a more than threefold increase over 2009. (View his in terms of what comes next.) The vectors are clear—more local sources, local partners and RMB denomination—and those echoes you hear ahead are in RMB-driven bond markets. Important to note: the huge foreign buyout funds distort the view of both total-funds-raised and RMB-vs-foreign currency denomination. The nominal buy-in for RMB funds was less than 40% of the elephant-inflated total, despite more than trebling ’09. My own view of this is, ‘it’s not the harvest so much as the rate of increase in the number of trees in these two orchards, and the kind of fruit they’re bearing, and whence it flows when it’s picked.’
Deals more than tripled in 2010 vs. 2009 (363 vs. 117). Despite this, the 308 PE funds that reported activity increased investment only 20% over 2009 to $10.4b. This signals a trend toward smaller investments, in keeping with the reduction in average fund size among closings as well as launches. Take out the data for the elephants and it looks more like flat terrain with small deals replacing big.
The largest allocation was to expansion financing, which accounted for nine out of ten deals and nearly three-fourths of all funds invested (325 and $7.5b). The average deal was less than $25m; minus the whoppers is was probably in the range of $10-15m. More like what the banks would do if they did their job, and clearly the face of expansion, not asset buys. The four-fold increase in the number of transactions speaks worlds of PE firms’ organizational expansion and rapid penetration of the still-explosive entrepreneurial market. Government authorities and many banking and legal firms are increasingly comfortable with their roles in closing PE deals.
Yet while authorities continue to be concerned with tides of hot money from overseas sources, the sources of ‘disequilibrium’ (code for stretched asset prices and deal costs too frothy to keep everyone’s sober risks in line) have now shifted to inexperienced players who are a little too desperate to place their bets. Some municipal government-PE partnerships invoke added risks: a mixing of motives between investment returns and use of public funds for development and enterprise expansion which invite conflicts of interest among officials who share in decisions. The more things change, the more some of them remain the same?
Price-inflating amateurs and mixed motives aside, it is inescapable that Chinese funds have outperformed foreign ones, committing to 217 of 325 investments (60%). That’s counting deals without regard to quality, perhaps a sister casualty to reckless overpays. Domestic vehicles were responsible for 46.5% (US$ 4.8b) of aggregate PE investment, against 40.7% for foreign ones, and without the elephants, the scales have clearly tipped to the domestic side. Sino-foreign cooperative deals were not negligible (12.1%), and are expected to eat further into the foreign share as more such relationships are formed for purposes we are all beginning to understand.
From a currency standpoint, RMB-denominated funds have already measurably eroded some of the fresh investment share held by foreign currency funds. Their 238 investments in 2010 totaling US$ 5.64b were 66% vs. only 54% in ’09. But most eye-catching is the dramatic drop of foreign currency fund investment value from US$ 7.13b to US$ 4.69b.
Is The Market in Equilibrium? The Overcapacity Trap
The arena has been flooded by a host of new players with illusory hopes of easy profits, fueled by attractive p/e multiples boasted by Chinese exchanges (45x on SZSE and 22x on SSE main boards in December 2010 ). The current excess of funds raised vs. invested ($28b raked against $10b allocated in 2010), however, clearly signals that the scepter of overcapacity looms over the Chinese PE market. An ongoing rush to enter and to increase investments shows a failure by too many firms to recognize the gathering forces boosting risks and likely to reduce returns.
Two principal forces are driving up prices paid for acquiring companies. Stiffer competition reflects the ever-increasing number of players. This has been exacerbated by new and inexperienced PEs caught in a steep wave of asset overpays and rosy views of future revenues. Too eager to win deals over established players with stronger reputations, many of these PEs contribute to a vicious circle of rising prices. Even veterans have trouble distinguishing between the uncertain physics of continued growth and the uncertain tenure of ‘the amateur’s knock-on effect.’ (The longer it lasts, the more it resembles a future reality, though it’s our bet now that a reckoning is coming within the next six to 15 months.)
Go stand in a veteran’s boots, and ask yourself to stop writing checks. It’s not as easy as it looks, when you’re sitting on eight or nine figures of investors’ expectations. Pulling a bit back from the brink, we also have the recent advent of small (many of them prudently managed) PE and investment funds sponsored by local governments which are characterized by lower pressure for financial performance. Remember the Chinese tradition of the long view, and resisting fashion and haste along the way? The calamities waiting to happen are countless and rife in this market, but there are relatively safe harbors, too, for investors and managers alike.
The p/e multiples witnessed by Chinese stock markets in the past few years are not likely to show up soon. The current battle of the Chinese government against inflation and its twin demon, an export-chilling wage spiral in the face of soft demand once again in North America and Europe, will not succeed soon, unless it’s a ‘win’ based on an undesirable intensity of cooling. PBOC’s recent interest rate hikes have brought swift and significant reductions in average p/e ratios in the first half of 2011 (-30.22% on SZSE and -22.45% on SSE main boards since the beginning of the year). Healthy for everyone in the long run, though not especially welcomed by PEs with an eye on the exit door; or companies needing money to expand, cash out investors or reorganize for a new order of battle in the marketplace.
The inescapable physics of these opposing forces—added competition for deals pushing money across the table with an added measure of risk, and p/e’s in the stock market which attract less demand for funds there—will serve to squeeze PEs, and even crush some who don’t see what is happening. The indeterminate wait for p/e recovery also clouds the timing of payday (and the added risks of that) for the PEs, as well as the size of the paycheck when the markets are again robust enough to deliver it.
But make no mistake, it is the overhang of uninvested capital and the overeager rush by less experienced players that presents the most risk. Sound deals and good use of ‘ripening time’ in the best-managed PE orchards will eventually bring rewarding returns, from trade sales or deal-book consolidations, if not from IPOs and additional stock offerings. And as we know, the larger, wiser, more experienced and therefore more flexible PEs will have the staying power to weather the cycle and find the cleverest exits. It’s always the less seasoned players who found a way in without much thought to when and how they’d get out, who then find themselves with withering trees that are past the time for harvest, and long faces to show their investors as well as sting in their eyes to show the saviors who buy their books.
In the short run, all PEs must contend with the turbulence of hyper-competition and equity markets adjusting to simultaneous forces, including higher interest rates as well as the necessarily cooling economy. But two steps into the intermediate term will reveal the comeuppance over-anxious players are making for themselves while they trouble everyone else. And while all PEs may now be staring at lower returns because of what they’ve navigated through already, the strong possibility of a broad consolidation over the next 36 months will bring the PE market back to equilibrium.
And so, for the moment, a third pressure is felt in the offices of PE fund managers. Some three to four quarters into the funds-accepted-to-funds-invested overhang of 2010-11, depending on when it started for many of the funds, the questions from investors have started to pile up. ‘Why so much cash?’, ‘Why so many deals opened but not closed?’, “Why are other funds doing deals and ours is not?’ And since answers of the wisest sort often focus on risks and reduced returns, most of which materialize 18 to 40 months hence, there’s not much for investors to go on today except the judgment of managers they’ve chosen to trust with their money. For Chinese investors, institutions, municipalities and home-grown local PE funds to overseas giants and global PEs, there’s a wide array of response—to the situation, and to investors clamoring for comfort, whether from high-flying expectations for investments completed or a sense of calm relief that their PE funds are holding back right now.
Our view in mid-summer, with stocks still cooling and the Chinese government fighting inflation across a broad front from housing to wages to food, is that investment caution characterizes the seasoned players and eagerness, even swagger, continues for many PEs who may not see the end of 2012 as the independent entities they are today. What strikes us most of all right now is that famous investors’ feeling amongst so many PE fund managers, that China, once again, will find a fresh equilibrium relatively quickly through economic growth. Others see a wider pattern of rough weather ahead.
SMEs that can’t borrow and can’t expand with internal cash flow in a cooling global marketplace for goods, and aren’t ready for a stock offering in a market receptive to precious few of those right now, had an unstoppable savior in PEs now suddenly twitchy about everything from stalled orders for good to indeterminate windows for exiting investments.
There’s pressure to invest, pressure to overpay, pressure to close another fund and be ready, pressure to intensify the hunt—and most of all, a daily mix of investor impatience with the stall and managers’ impatience with the uncertainties. But the higher costs, reduced returns, added risks and exit delays are starting to look real, especially with stock p/e’s telling a tale of the wider market. Is it time to hunker down and manage what’s in hand, or to simply hunt more carefully? For PEs, tomorrow is today. The next 12 months will be pivotal for the profession. Is it time to recall, in a different era, that famous quip of J.P. Morgan: “You eat better at 10%, but you sleep better at 2%.”
For PE funds expecting to continue in China for at least the next two decades, this is a time to be picky with investments, stand toe to toe with investors who want action, and wait for opportunities, between strong deals, to pick deals up by the bookfull, a year or two from now, at a very tasty discount.
This is Part I of a two-part article. In Part II, to be released later this week, Alberto Forchielli examines the interactive relationships of banks, stock markets and private equity funds in sourcing and allocating capital in a marketplace characterized, as China’s is today, by frequent change and a regulatory and legal framework in the process of becoming more mature .