Sharp-nosed Chinese businessmen have been flocking to pre-IPO opportunities in an effort to make fast money as China’s economy flourishes. Private equity firms have relied heavily on the pre-IPO investment type, who would simply buy into companies as minority shareholders, take them public in Shanghai or Shenzhen within an average period of two years, and eventually sell the shares after the lock up period was over, all with a comfortable valuation premium. The typical hold period tends to be more or less 3 years [2 before listing and 1 lock up year], whereas such transactions used to generate considerably high returns of up to more than 10 times cash. It was so lucrative and effortless [sometimes they needed to lobby or even bribe the CSRC officials to get the approval] that it made no sense for investors not to take their shots.
However, the pre-IPO magic is in trouble. The mainland IPO market has been stuck since last December. CSRC has launched a “self examination” project, the most aggressive measure ever taken, requiring that the underwriters of applicant companies re-investigate the authenticity of the filings. While there are still over 600 applicants in the pipeline, 166 companies have already withdrawn their applications. More importantly, as the economy falters, the mainland stock market has fallen to the ground, leading to the decay of investor confidence, which might take even longer to recover. Both the individual and institutions are not as enthusiastic as they used to be about buying expensive shares from the IPOs. The average exit return of the pre-IPO investments is estimated to be as low as 2~3 times for the first quarter of 2013, a dramatic reduction. Results may vary between the US and HK markets, but there is less reason to be optimistic since Nasdaq has nearly shut the door on the Chinese companies that used to enjoy preferential status, and the HK market is much more rigorous about valuation. With stricter IPO scrutiny and a lagging economy, it is to be expected that more companies would back off from an IPO, either because of short performance or the worry over the discovery of past wrongdoings, both on- and offshore. On the other hand, the supply side is still abundant. According to the statistics, there are around 7,500 unexited minority investments on the market, along with the 600+ pipeline applicants that would probably take more than a decade to be fully digested.
It’s true that a pre-IPO is one of the major types of private equity investments. Nevertheless, it has gone too far, just as most things in China tend to get over-invested. It is very likely that the pre-IPO story has come to an end.
Considering a private equity fund’s maximum life is 5+5 years [though in most cases in China they last 5+2 or less], the above facts seem to suggest that the private equity market will come to a standstill for a few years, but this is would be a negative outcome since private equity plays a very useful role in China both socially and economically. Studies by Bain & Co. and Euro Chamber show that private equity investments in China have driven job creation, rising income, corporate R&D activities, financial performance, governance, tax payments, and even served the “Go West” policy of Chinese government. Nonetheless, private equity’s most valuable contribution has been bridging the gap between SMEs and the capital market, funding the backbone of China’s dynamism. The credit environment for SMEs is tough in China as most of the loans go to the SOEs, conglomerates, or public companies. While some may argue that it is the government’s responsibility to use administrative power to alter the lending tendency, the solution is much more complex. The main reason loans go to SOEs is because SOEs are considered risk free, so why would any banker go through the agony of risking his bank’s capital, not to mention his career, to lend to an SME? It takes a minute to pass a bill, but it takes generations to nurture a banking system and a debt market to support the SMEs so as to make the bill usefully actionable. Given that the capital gap and the large human capital built by thousands of private equity firms will still exist in the coming years, it would be a pity to see it disband and disappear, as current conditions would warrant. The private equity industry must adapt to a different environment where an IPO is no longer the exodus, and it would be great to observe China’s institutions favoring this transition. Instead of relying on a single model, an evolving private equity industry should develop in several directions.
Majority buyout is one of those directions. It is always legally viable to buy out, but entrepreneurs used to be unwilling to sell, essentially because through an IPO they could become rich overnight and bring capital to the company without losing control. If IPO’s do not pick up in the coming months as expected, or if investors fail to show interest in the shares being floated, buyouts will be more likely to happen. However, because the debt market in China is not yet strong enough to support the kind of mega-LBO deals that veteran US private equity firms, such as Blackstone or KKR, used to make, the buyout market is unlikely to explode over night. We can still count on a few exceptionally smart and innovative bankers to push the envelope and work out the leverage or byway to be a deal maker, like Michael Milken’s success in the 1980s. It is good to see the M&A markets growing steadily in China, and some adventurous deals have already taken place.
When it comes to buyouts, the “Buy and Build” strategy is another interesting topic. Based on the proven logic that the whole can be worth more than the sum of its parts, buy-and-build investors acquire a platform company that occupies an attractive niche in a fragmented market, and then carefully add on several other closely related businesses. Collaborating with a core management team to integrate the holdings, private equity firms aim to capture the advantages of scale and improve performance to add value. It is akin to assembling a “string of pearls,” made up of many smaller businesses, each of which tucks seamlessly into the platform company. It has been a popular strategy in the US market, and nearly 45% percent of the buyouts from 2009 to 2011 were add-ons to existing portfolio companies. There are many apparent advantages of buy-and-build, among which there is one in particular that deserves a closer look. Add-on investments are usually less risky since both the GP and the management of the platform company are familiar with the business and there are synergies to be exploited and overlaps to be integrated. That is all real value creation. The strategy is popular in the US for many reasons, but there are certain barriers to that strategy in China. The biggest concern is local administrative or political pressure. Buying out an add-on usually means immediate consolidation, resulting in restructuring, layoffs, and even closure of some facilities. Resistance is almost guaranteed. Unlike in the western world, where that resistance comes from labor unions, Chinese companies are forced to go up against local governments, a very difficult counterparty. Although buy-and-build may turn out very successful and grow the target add-ons even larger, the process can be painful, especially in the early stages. Private equity professionals have to develop the required and localized skill sets and tactics to make those deals happen.
A growing segment of the private equity community is talking about direct secondaries and outbound investments, both of which are rather tricky. Direct secondaries are of course a very good complement because they improve the liquidity of the market. However, when the market is flooded with unexited minority deals, secondary buying does not help to eliminate the inventory unless the IPO market picks up. Secondaries booming the market is just a fantasy. As for outbound investments, the only point to be made is that private equity firms ought to set up their own offices around the destination area. If there is no localization and deep rooted teams and connections, outbound investments can stumble, sometimes very badly. Cross border transactions require highly sophisticated approaches and execution and it is reckless to take a blind shot, especially when everyone is watching.
China’s private equity industry is at a crossroads. As the pre-IPO driven model is being broken down, private equity firms will work hard on the transition. Whatever the path that is chosen, the industry needs to bear in mind that every day will not be a jackpot as core competence is continuously enhanced. The private equity industry needs to move forward onto the next phase. In the midst of a stagnating market, this difficult transition could take years. But it is better for this to happen sooner, since what is at stake is not just the small world of China private equity, but the future of China’s entire private sector.