(Private Equity in China, Part II)
In Part I of this article, we focused on the Private Equity (PE) industry in China, particularly its evolution from foreign to local, dollar denomination to RMB denomination, and fewer-larger-experienced players to younger-smaller-and- less-experienced field of players. Average deal sizes are trending smaller, especially if deal and dollar-value totals viewed do not include the activities of such ‘elephants’ as TPG, IDG, Carlyle and Blackstone.
We discussed two important forces now felt throughout the PE industry in China.
First, the competitive pressures arising from more firms hunting investments and the substantial inventory of uninvested fund subscriptions and the resulting available-capital-to-deals-closed ‘overhang’ that translates into what some call overcapacity; these pressures add to risks and, whether immediately or later, reduce returns.
The second broad force is the intensifying reality-check of stock market multiples, in which average p/e’s on the SZSE and SSE major boards have dropped 45% and 22% respectively since December 2010. These lower p/e’s reduce and discourage use of stock offerings as a way-out strategy for PE investors. The markets’ constriction and uncertainty cloud PE investment returns because the timing and pricing of stock offerings—a principal exit ticket for their investors—are pushed deeper into unpredictability as long as stock p/e ratios continue to drop. Having to postpone any listing, especially one that delivers the cash for investors’ exit, always reduces returns for PE investors. And if other exit paths are closed or made singular, returns are pushed even lower (unless they were shaped at the time the deal was organized).
Flowing from the Part I discussion of supply and demand of funds and the cardinal role of stock p/e’s in shaping all stages of the PE cycle—funds acquisition, investment pricing and confidence, and exit strategy at the time of deal closing—we now examine in a little more detail the roles of two other typical stakeholders in SME-financing and the broader economic equation: the stock exchanges and the banks.
Funds supply and demand in PE financing is complicated by the interaction of PE investors with these two other major sources of funding.
Overheated stock markets are a welcome blessing at the time of investment exit. They often shorten the wait, nearly always fatten the price, and support a narrow time window from exit decision to cashing out. But they can also act as a curse when it comes to creating and exploiting worthy investment opportunities.
Secondary exchange boards such as the Chinext in Shenzhen and, to a lesser extent, the GEM in Hong Kong, support the listing of relatively small targets with financing needs even less than US$ 25 million. As a result, the stock market—in its good times—operates as a direct competitor of PE fund investors in the hunt for small and mid-market deals, besides all boards’ welcome service of a potential way-out.
Regulated lending institutions are buffeted and worried by every storm and wrinkle in the expanding business equation, especially when expansion stalls. The necessary crusade against inflation initiated by the People’s Bank of China Monetary Policy Committee in October 2010 had significant repercussions on the availability of loans to Chinese firms. With reference rates as high as 6.56% in July 2011, banks politely but quickly shut their doors to SMEs and unregulated lending began to show 20-25% interest fees. This one-two punch of high costs and low availability of funds from lenders quickly boosted the appeal of PE financing. For many smaller companies with briefer track records or more daring expansion plans, PEs provided the only options available.
Taking a broader perspective, however, current yin-and-yang behavior between PE funds and lenders on the SME front reminds us that in China a practical, workaday marriage between PE and banking has not been celebrated yet. The two sources of funds are still perceived as substitutes, not as parallel participants in which bank commitments can help PEs to close more solid deals and reduce risks for the SME and investors alike. Nor do risk-cautious banks that steer clear of SMEs properly view the PE investment as both a risk-reducer and source of valuable expertise which further eliminates lender uncertainties and prevents stumbles at the target company. Instead of these mutually supportive stances, we see something more like “What do we need you for? You’re just trying to steal our lunch—plus you’ll take your investment profits out and leave us holding a rate-constrained relationship all alone.” Not exactly a song of love.
This ever-cautious if not suspicious standoff brings us to some hard-edged practical, legal and regulatory issues. A lifting of the prohibition for PE funds to leverage the SPVs used to execute transactions could do a great deal to relieve this conflict. This would improve the allocation of capital and the balance of debt and equity financing. It would provide a much-needed backup to stabilize returns in the vital PE sector, which presently bears most of the load in financing SMEs in the medium term. The absence of lenders (at an affordable cost, at least) is crucial right now. The stock markets are less attractive for sourcing capital than they were six months ago, but are still helping many young companies to expand and (more selectively) entrepreneurs to gain access to public ownership, and add liquidity for intangible assets.
Investors are naturally edgy as they survey the field of battle—export markets softer than 2010, materials costs still high and labor costs pushed up by inflation as well as structural catch-up. And with p/e’s still headed south if anywhere from where they are now, both PEs and banks perceive them less and less as promising a safe ride home.
As the trouble still unfolding for several Western PE and hedge funds points out, tackling ‘relationship paralysis’ among different segments of the financial system is anything but easy. Some call it ‘systemic dysfunction’, but both terms mean that some segments shut down while others look closely to themselves without working together.
Wisely tuned safeguards to discourage excessive leveraging and the associated systemic risk are everyone’s asset for the longer run. They serve as a survival aid to those whose vital roles are weakened by easy lending—think soft stock markets as well as PEs. These constraints might even help to nudge the rivalry more toward something like the mutually supported profits and coordinated responsibility we see in mature markets where capital is more efficiently allocated and risk is more widely distributed.
The frictions that characterize PE relationships with banks and stock exchanges are more a symptom of the work-in-progress status of the Chinese financial system, than of any natural conflict. In less than a decade at the current pace of practice, regulation and the law, we’ll see mutual benefit among them as a workaday reality. Getting there cannot be left entirely to the invisible hand of the market. Indeed, the willingness and ability of the PBOC to introduce wise regulatory reforms should be focused squarely upon fostering healthy interaction, especially between PE financers and lenders, and conquering the current face-off of plain substitutability.
The Accelerating Pace of ‘Going Chinese’: Advantages and Risks
Data suggest that the Chinese PE market is, as intimated by the trends reviewed in Part I of this article, becoming more and more ‘Chinese’ in terms of ownership, management, currency denomination and investment decisions, if not in terms of a subtle shift from pure-profit focus towards a development focus as well. This evident transformation involves several dimensions.
First, in contrast to a pre-crisis dominance of large foreign PE groups that ‘imported’ the modern concept of PE into China, the post-crisis environment is characterized by the increasing financial power and more local aims of domestic funds. Chinese funds led the charge in 2010, in terms of both new funds (66 versus 13) and investment deals (217 versus 119) closed. Furthermore, excluding the buy-out segment (still ruled by global mega-funds like Carlyle, KKR and TPG), local funds also managed the lion’s share in terms of amounts funded and invested.
More than a few of these domestic funds are sponsored by local governments, whose participation in the PE industry has become increasingly active since the onset of the financial crisis (either directly or through investment by SOEs). Organizations with roots in political institutions and offices with broader agendas raise natural concerns about the potential for conflicts of interest. The sharpest risks arise from biased allocations of PE financing when personal and political interests take precedence over measured IRR and recovery of capital by non-governmental LPs in pursuit of profit. When choices of capital vendors are made by public officials, even the appearance of conflicts can discourage the spirit of healthy competition in the marketplace.
Secondly, preferences of foreign PE investors, too, are shifting from $US-denominated funds to RMB-denominated funds. Some of the impetus for this springs from increasing costs of, and restrictions on, movements of capital into and out of China. The No. 59 Document issued by the State Administration of Foreign Exchange in November 2010, for instance, introduces a series of additional controls on flows of foreign capital with a view to preventing influx and flight of hot overseas money. This measure sharply increases exchange settlement costs for PE funds denominated in foreign currencies, in addition to the procedural risks it invokes regarding safe performance of repatriation as well as exit from their investments.
The Shanghai RMB Fund Regulation, promulgated by the Shanghai Municipal Government at the beginning of 2011, allows non-Chinese investors to use a much less cumbersome approval process when setting up RMB-denominated funds, than the still-evolving regulation for Foreign-Invested Equity Invested Enterprises (beneath the governing umbrella of the 2003 FICVE Regulation). Under the new regulation, foreign investors simply need approval from the local Administration of Industry of Commerce (AIC) office, avoiding much more complex procedures required by the central Ministry of Commerce (MOFCOM). If the Shanghai RMB Fund Regulation becomes a widely-used model, the result will be something much closer to equal treatment for foreign and domestic PE players, at least in the set-up phase, a step toward the somehow utopic idea of a level playing field between Chinese and foreign PE investors.
Many recent domestic entrants will learn swiftly, or flounder and worse, in this competitive PE market, particularly in the environment of inflation-fighting and a necessarily cooling economy. In the absence of parallel rising tides enjoyed all-round, all ships do not float easily. Investment experience and careful regard for risks, hard-nosed valuation and realistic assessment of exit prospects may have as much power as ‘local advantages’. (A good sheep-dog outperforms a fence.)
As the value of professionalism in investment decisions grows and the environment for foreign and domestic funds improves, perhaps with steadily fewer distinctions between the two in terms of treatment as well as practice, the PE industry can also look forward to a healthier relationship with lending institutions.
Banks in particular must work within an ever-tighter structure with unbending rules and harsh sanctions. They face two sources of skittishness when cooperating with PEs to finance SMEs. One is the difference in head-sets between debt and equity—hard assets versus a going concern with prospects and cash flows. There’s a natural potential for showdowns between debtors and shareholders when a client-company gets into trouble. Still, to a regulated bank, the countless and confusing business risks an SME must navigate along the road to success or failure, are daunting to behold. Partnering with skilled PE investors, perhaps under the support of more favorable regulations, could represent a breakthrough in this sense.
When a company submits its value for stock market validation, it can do no better than to have mentors of debt as well as equity at its side. All too often on behalf of China’s SMEs today, it is the lonesome, risk-taking PE fund that stands beside a client firm. Knowing that a company has backing from both lenders and investors means a lot to potential buyers of stock. Without substantial bank support, China’s business enterprises—its entire commercial sector beneath the blue chip level—and the risk-taking PE funds that fund them, are at a disadvantage competing in global markets.
When PEs, and the SMEs and service-sector businesses they invest in, have a healthier relationship with banks and other lenders (which so far have not joined the party as peers and participants, but we pray will), an era of multiple funding sources can begin in earnest. This vastly improves opportunities for worthy enterprises to expand as their merits and prospects allow—funded quickly, efficiently and fairly on the most level playing field possible.
More starry-eyed aims are not often confidently expressed, but for PEs and banks to genuinely work together, a nation’s enterprises now, more than ever, impatiently wait.