The important role of Private Equity
In a more and more globalised world, Mergers and Acquisitions are an essential mechanism of shareholder value enhancement, facilitating access to new markets, competencies and technologies as well as enabling organisations to leverage their existing core competencies.
In these respects, Private equity, through its expertise and networks, plays a significant role in providing shareholders and management with a number of interesting alternatives to enhance value. However, challenges to successful M&A are considerable. A proper strategy usually makes the difference between success and failure in deal making. Identification of the right targets, appropriate value analysis and negotiation of satisfactory terms are critical issues for achieving optimal results in the M&A domain.
The key points amid a deal execution
Concerning the choice investment targets, healthcare tops the list for almost half of survey respondents, a likely reflection of its growth potential irrespective of economic cycles. IT and telecommunications likewise retain their attractiveness compared to other sectors, suggesting an expectation that web-based services will continue to expand irrespective of the downturn. Furthermore, China’s seven strategic industries, including alternative energy and biotechnology, new-generation information technology, high-end equipment manufacturing, advanced materials, alternative-fuel cars and energy-saving and environmental protection are reasonably going to attract considerable attention, due to gathering policy momentum. Lastly, an increased focus on second- and third-tier cities is materializing, providing interesting insights on future deal opportunities.
Several private-equity executives should adopt a more hands-on approach to the management of their portfolio companies. The purpose, of course, is to increase the value of each investment prior to exit. While private equity firms employ various strategies to create value in their portfolio companies, a common approach is to acquire a “platform” company and grow the platform through further “add-on” acquisitions. Ideally, the synergies of the combined entity create a more efficient whole, both operationally and financially.
Beyond the target’s business model, the deal evaluation process must take into consideration government regulatory policies and trends, investment structure, and foreign IPO feasibility, internal rate of return, management team formation.
One of the most frequently used paradigms in evaluating earning generation of the target company is to focus on the potential expansion capacity. Simply stated, this is the market share a firm does not have minus the share it will never get. We can concentrate on finding out how many potential customer switchers are available and what is missing in the existing product offering by looking at historical sales trend in terms of backlog as well as the market saturation. In short, the market has to be big enough and deep enough to accommodate investments. Furthermore, market growth must be sufficient to ensure a satisfactory exit in the future.
More attention should be awarded to the study of the industry, to intellectual property concerns in recognition of differences in corporate culture and values and to the governance and change policies of the target company.
Two suggestive arrangements could help PE claim back the funds through IPO more fluently under current circumstances. First, PEs should add a few defensive clauses in the investment contract signed with the target companies. For instance, stock repurchase agreements could be executed to force the company buy back the shares when the performance falls below expectations. Second, domestic PEs should hold enough shares to have sufficient control on the target company when making investment decisions. Accordingly, the resolution of listing could be passed by management board more easily. Besides that, PE also could switch to another exit route like trade sale much conveniently when facing obstacles in IPO.
Post-acquisition management is even more important than the previous step, in particular when a PE takes on a majority interest stake in the M&A deal. Too little attention is often paid to the post-acquisition phase once the deal is done. A mere hold-and-sell strategy hardly works. Rather, success hinges on issues such as whether to proceed on a second or third vertical or horizontal acquisition, how to manage the post acquisition integration in terms of culture and communication, how to put together a cohesive and clearly defined management team, whether there is any collision or impediment, how to realize cost reduction synergies, operational improvement, etc. PE veterans tend to be more bullish on developments of the portfolio companies compared to less experienced competitors.
Is domestic IPO always the best choice for the PE exits?
Most Chinese bosses of Chinese venture-backed SMEs believe a domestic IPO on national Stock Exchanges is always the ideal choice. In China P/E multiples on IPOs are generally much higher than in Hong Kong or US stock market (almost twice), as a result of the fact that Hong Kong and US IPOs are valued on a forward P/E basis. Domestic Chinese IPOs are valued on trailing year’s earnings. FY2010 was a record year for the number of IPOs across all the Greater China stock exchanges. There were 349 IPOs with total funds raised of USD 72.3 billion in 2010, compared to 99 IPOs with USD 27.5 billion in 2009. ChiNext, launched in October 2009, showed robust development, with the number of new listings reaching 117 and USD 14.6 billion raised. In terms of P/E multiples, in Shanghai most of the IPOs were offered at over 30 times in 2010. The majority in Shenzhen were offered at over 50 times. High stock pricing enables the company to raise more funds in the first day listing as well as a robust unrealized book profit for PEs, which seems to disgrace any other exit methods.
But is this strike so easy to get right? The answer seems to be No. Requirements in China tend to be tougher for younger privately run companies compared to the United States, given the rules imposing a minimum level of profitability. Joining the main board in Shanghai requires compliance with quite strict listing criteria. Firstly, companies need a three-year trading track record with an aggregate profit of at least RMB 30 million (about USD 4.72 million), with net profit being the lowest amount before any extraordinary item. Secondly, operating income should exceed RMB 300 million (USD 47.2million) for the last three years or the cumulative cash flow from the operating activities exceeds RMB 50 million (USD 7.88million). Thirdly, before issuance, the minimum share capital should reach RMB 30 million. Companies must float a minimum of 25 percent of their share capital, unless the total issued share capital exceeds RMB 400 million (USD 63million), in which case the percentage can be reduced to 10%.
In addition, secondary offerings are quite harder to implement for a domestically-listed Chinese company than on Hong Kong or USA markets. The issuing has to be approved by SEC. So if the candidate engages in real estate, financial services or is frequently cash exhausted, it is preferred to go public aboard, where secondary offering procedures tend to be less demanding.
There are a lot of firms waiting to list in Shanghai (over 600 companies in a queue to go public, corresponding to a 2-3 years backlog). Listing decisions are often politically driven, depending on which industries the government is keen to develop. Private companies tend to find it tougher to list than those with governmental ownership or indirect backing.
Structuring an IPO in China means embarking in quite cumbersome sequence: 1 year of tutorship period conducted by sponsors, 2-4 months for listing materials preparation, 3 months for examination and approval by CSRC, 1 month for answering comments and revision of prospectus and, finally, CSRC’s approval within 6 months after the receipt of listing application. The whole process is about 2 years. Furthermore, PEs in China are typically unable to sell their shares immediately after flotation, as they are subject to lock-up undertakings (always 3 years) included in the underwriting agreement and some stock exchanges impose a compulsory lock-up period on pre-IPO shareholders. PE funds normally have a limited lifetime (5-10 years) and any profits or capital gains need to be realized before maturity date. Given these considerations, trade sale will often be a more feasible way-out strategy. A trade sale exit is a complete and immediate exit. Though P/E multiples or EBITDA multiples achieved in such transactions are lower than those offered by stock markets, they allow to bypass CSRC’s approval and saves the high front-up transaction fees.
The optimal methods for foreign PE funds
In terms of foreign PE funds, the following strategies are optimal to expand deal flow in China.
The first one involves focusing on familiar sectors in which these funds have either foreign portfolio companies or valuable contacts, so that they can leverage these resources by transferring them to Chinese target.
Another is to team up with local funds or big local companies. To have powerful local partners can sometimes provide interesting opportunities. However, PE funds implementing such approach must conserve their ability to evaluate each opportunity independently.
An attractive “niche” for foreign vehicles is represented by buyout deals that local funds are not so willing to do, since they are complex and relatively time-consuming. However, foreign funds doing buyout deals in China, especially if buying from a local entrepreneur, should always possess good relationship with local governments and create a smooth channel with authority departments to exchange ideas and updates.
Relationships between PE funds and Chinese banks can magnify the chances of success. Companies can be more robustly, flexibly, durably and convincingly financed. Banks can strengthen their portfolios through diversification and risk-sharing with PEs that are mutual supportive. This makes shares in banks and PEs more attractive to their own shareholders as well. Stock markets, moreover, can attract a higher number of quality listings that are more credibly supported by combined lending and PE investment.
Deal sourcing is largely conditional on “Guanxi” (the creation of a network of social relationships characterized by reciprocity) is a key success factor. This is one of the reasons why putting together a local management team is another sizable problem for a foreign PE. A qualified local operator who has a good understanding of the domestic or even local background might be mandatory in these instances. Foreign PE operators sometimes outsource part of their business in order to avoid taking on an overwhelming degree of business risk. However, seeking a good local partner able to find out what you have neglected and to offer his specific insights from the very beginning, can save much more time and money than ex-post outsourcing assistance. Foreign players, furthermore, typically have limited knowledge of Chinese laws and regulations. One needs to work closely with officials to understand how rules are likely to be interpreted and where the true boundaries lie.
We need a more conservative investment methodology
Equity markets suffered heavy loss for the previous three quarters in 2011, as uncertainties about EU sovereign debt crisis and concerns over a global double dip recession inhibited investors’ sentiment. In China, equity market plunged since the beginning of the year on worries about credit deterioration and corporate earnings downgrades.
Concentrating on the PE sector, the aggregate US$ 217.3 million invested in October 2011 corresponded to a 2-year low, halting the recovery pattern that has characterized the entire 2010. On the exit side, emblematically, no PE-backed IPO occurred on Chinese exchanges and in Hong Kong in the same month. The once-buoyant stock markets do not appear to be comfortable landing venues anymore.
Lastly, a non-negligible number of SMEs is suffering from liquidity crunch problems generated by the tightening of monetary policy.
All these phenomena should alert PE practitioners, especially with respect to deal screening. An increasing number of unqualified deals will deepen investment difficulties and risks. More and more PEs will be competing for a smaller an smaller pool of attractive investment opportunities, inflating investment costs and P/E multiples paid by PE buyers. Therefore, adopting a more prudent and cautious investment strategy in every aspect of the deal execution is likely to be a crucial move for survival and financial success in these hard times