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Private Equity in China: Risk for RewardThe struggles and rewards of private capital in Chinaby Richard Daniel Ewing Private equity managers today see opportunities in vast sectors of the PRC economy that have no dominant industry leader, and in research labs that are percolating with innovations. Global private equity firms are rapidly opening offices in China and raising hundreds of millions of dollars to invest in the country. As Jim Hildebrandt, managing director at Bain & Co., noted at a recent private equity panel sponsored by the Wharton School of the University of Pennsylvania: "China is the most important growth market for private equity." China's leaders recognize that they must build a vibrant private sector and that private equity plays an important role toward this end. China Venture Capital Association Chair Chang Sun maintains that China's World Trade Organization entry is releasing a groundswell of Chinese entrepreneurship and that private equity can supply the capital those businesses need, accelerating economic growth and raising employment.
Minding the gap between banks and stock marketsDespite the importance of the small business sector, China's financial markets are poorly equipped to fund its growth. Chinese banks loan much of their money to state-owned enterprises (SOEs) and lack the tools to analyze the credit risk of new firms with unproven technology. Besides, most start-ups lose money for years before becoming profitable, making fixed-debt payments difficult to bear. New listings on the Shanghai and Shenzhen stock exchanges were frozen for the past several years, effectively closing the initial public offering (IPO) capital window to private firms (although there are signs of a potential thaw). This means that private equity investors are often the only ones with money to fund entrepreneurial companies. Private equity investors dream of discovering China's new Microsoft, Amazon, or FedEx. These diamonds-in-the-rough exist, but are hard to find. Many private equity investors compare China today to the United States in two earlier periods. The first comparison is with America's technology boom in the 1970s, when investment surged into Silicon Valley. Investors argue that the United States had a successful mix of talent, university research, and capital. China has the first two, but lacks capital and sophisticated investors to direct investments accurately into next-generation technologies. A second parallel exists between America's leveraged-buyout boom in the 1980s and China's need to restructure SOEs. In the 1980s, many large, poorly managed US conglomerates were dismantled to release value trapped in smaller divisions. Whatever the comparison, opportunity currently abounds for private equity in China. Already, there have been some notable successes. In March, Semiconductor Manufacturing International Corp. (SMIC) launched a $1.8 billion IPO on the New York Stock Exchange. SMIC's early investors, such as Goldman Sachs Group, Inc. and Walden International Investment Group, cashed out handsomely. Other Chinese firms have had similar success (see Table 1). Ctrip.com International Ltd. raised $75 million on Nasdaq last year, while Alibaba.com Corp. recently netted $82 million in a private financing round from Softbank Corp. and other investors. Although investor enthusiasm over recent Chinese IPOs may have softened, the long-term perspective on Chinese listings is still bullish. Private equity's new heartthrobThe first private equity firms in China began operating in the early 1980s. Local governments sponsored private equity funds to support new businesses. One of the first was China New Technology Venture Investment Co., founded in November 1985. Foreign firms soon followed. International Data Group (IDG) formed the first foreign venture fund to operate in China in the early 1990s and became an immediate force in the industry. Additional waves of private equity followed over the next decade. Private equity in Asia has closely followed the regional economy, growing steadily in the late 1990s, though still at lower total figures than in North America. Private equity investments in Asia shrank in 2002, but rebounded strongly the next year, rising 90 percent in 2003. Japan and South Korea dominate Asia's private equity market. China accounted for less than one-tenth of the private equity invested in Asia last year (see Table 2). Notably, despite China's clear lead in attracting foreign direct investment, India attracted more private equity annually until 2003. India's predictable laws, multiple stock exchanges, and entrepreneurial history are a strong draw. But global investment firms are reacting positively to new PRC regulations and perceived openness to private business. According to the Asian Venture Capital Journal, China attracted roughly $1.3 billion in private equity in 2003, compared with a fraction of that amount the year before. As much as $1 billion of that capital came in the form of venture investments (see Figure). And much more capital is on its way. In 2002, for example, Warburg Pincus Asia LLC only had about $100 million at work in China, as opposed to $300 million in South Korea and $600 million in India, but is committed to greatly increasing its PRC position. According to Managing Director Xiang-Dong Yang, Carlyle Asian Ventures is planning to invest between $750 million and $1 billion in China over the next two years. An Overview of Private Equity"Private equity" refers to privately transacted equity investments in firms, typically small, growing companies. Private equity investments cover a wide range of deals and include seed, expansion, and pre-offering financing rounds. It also includes buyouts and turnaround investments. While private equity encompasses all of these transactions, venture capital (VC) only refers to funding provided in early stages. High risks and large potential rewards define VC deals. For each successful investment there are many failures. In exchange for helping to add value to these firms, private equity investors typically demand large ownership claims and direct control over management. They are active investors, usually appointing directors and exercising strict oversight during the investment period. These firms often bring reputation and credibility to their business partners, supplying experienced management and industry contacts that young entrepreneurs lack. Private equity serves a critical role in corporate development and in the economy. It fills the void between entrepreneurs and the public capital markets. New firms with unproven technology are too small and risky for capital markets or banks to identify, evaluate, and fund. These firms would likely remain unfunded if not for private equity. VC investors help promote growth in the most innovative and promising sectors of the economy. As Harvard University business professor Paul Gompers noted in a recent paper: "The importance of small business in any economy makes venture capital a central part of any future economic growth." Private equity can come from a wide range of investors (see Table 3). Some, like the Carlyle Group, are pools of capital from high net worth individuals or pension plans. Other sources are large corporations such as Intel Capital, investment banks such as Goldman Sachs Group, Inc. and CITIC Capital, local governments, or even multilateral institutions such as the Asian Development Bank. The World Bank's International Finance Corp., a major private equity investor in emerging markets, is seeking to improve corporate governance and the financial services industry in China through investments in high-quality corporations. — Richard Daniel Ewing The search for investment targetsPrivate equity investors are directing their capital at three categories within China's many potentially dynamic investment sectors. First, hundreds of SOEs are considering selling, restructuring, or privatizing portions of their assets. This attractive category, however, is dominated by insiders and is difficult for foreign firms to penetrate, although the State Asset Supervision and Administration Commission is installing transaction centers and experimenting with opening up the sale of SOE assets and equity. Established private businesses are also attractive. These firms typically manufacture either for export or for the domestic market. Entrepreneurs starting new businesses also provide fertile soil for sophisticated investors. Foreign funds generally target Chinese private firms and start-ups, as these firms are most similar to their typical investment targets. Private equity investors in China also tend to favor information technology, telecom, and biotechnology. China's world-class universities, talented scientists, and strong research programs provide technical staff and knowledge; international private equity firms can provide global experience and management skills. Commercial banking and insurance sectors also have high potential. Rapid changes in China's economy and social structure are, meanwhile, fostering new areas for investment. Chief among those changes are mass urbanization, privatization of state assets, large-scale infrastructure construction, and Chinese baby boomers retiring without the accumulated wealth of their Western counterparts. These trends will fuel sustained growth in areas from construction materials and equipment to telecom equipment and life insurance. Private equity firms are busy trying to identify and develop the companies that will lead these sectors. Each private equity fund develops its own strategy to target firms. Some focus on seed-round technology investments, while others target turnarounds. Each approach requires unique expertise. For example, Hong Kong-based investment bank CITIC Capital takes a two-pronged approach, investing in mature businesses or medium-sized enterprises with an eye to bringing them to IPO, while also investing to capitalize on the relocation of manufacturing into China.
And then there's the local competitionDespite the allure, a combination of developing legal systems, opaque regulations, and unpredictability makes the Chinese private equity market treacherous. "There are a lot more 'X' factors across all fronts," says Eric Wei of Gilbert Global Equity Partners. Private equity investors encounter challenges at every stage in the process—from identifying companies and performing due diligence to negotiating terms and finally exiting their investments. The first major problem is sourcing the right deals. Fund managers look at hundreds of opportunities but only select a few. In the United States, only 1 percent of proposed deals are chosen. Although China is described as a "target-rich environment," it is also a fractured landscape of multiple, distinct markets. Each region, province, or industry requires different resources. Second, negotiating the deal can be extremely difficult. To start, Chinese entrepreneurs and experienced venture capitalists often don't agree on company valuations. Chinese entrepreneurs frequently benchmark high valuations based on similar firms in America. Venture capital (VC) firms in China, on the other hand, stress the differences and country-specific risk. Making matters worse, there is no standard methodology for valuing a company. One example of a possible friction point: Because national growth rates are an important component of a firm's total valuation, valuations for Chinese firms may be boosted disproportionately by China's optimistic growth prospects. Next, gaining control in a corporation can be difficult for investors in China, and entrepreneurs can be unyielding. John Ying, managing director at iVentures, calls this the "head honcho problem" (dalaoban wenti). Frequently a start-up's founding members will refuse to give up control of the company and accept a minority ownership stake (a common condition for many start-ups in exchange for VC funding). Even in larger companies, major investors find it difficult to gain board seats and minority shareholder rights are widely disregarded. Commercial banking is particularly restricted, with the People's Bank of China capping aggregate foreign ownership at 24.9 percent (see the CBR, July-August 2003, p.18). A combination of disagreements over valuation and unwillingness to cede large ownership claims can easily prolong negotiations or frustrate a deal, as Newbridge Capital LLC's prolonged acquisition of a controlling 18-percent stake in Shenzhen Development Bank Co. Ltd. demonstrates. The fourth major problem is finding and keeping a strong management team. Building a new business requires a tremendous amount of talent, sweat, and leadership. Private equity firms will often work with the same seasoned managers on numerous deals over many years; conversely, firms will not enter a deal with personnel they do not trust. At a premium now are Chinese-born, American-educated entrepreneurs who understand the concept of shareholder value and who are returning home to start new companies. As Derek Sulger, founder of Linktone Ltd., argued at an Asia Society private equity conference, "Instituting a culture of transparency, corporate governance, and managerial accountability is critical." Finally, the channels for exiting investments are narrow. The Shanghai and Shenzhen stock exchanges almost exclusively list SOEs, closing that option to private firms. Moreover, founder shares become nontradable legal-person shares when listed domestically, eliminating this venue as a liquidity source. Thus, firms and venture capitalists often look to strategic buyers to liquefy their positions. These buyers, typically corporations looking to acquire new capabilities, snap up smaller, innovative firms. Foreign stock exchanges offer another potential exit. Ironically, the Hong Kong and New York exchanges are more accessible to good local firms than those in Shanghai and Shenzhen. Many of these firms seek to list on Nasdaq, because as Sulger explained, "that's where investors know how to value their businesses." Global private equity firms are increasingly meeting stiff competition from domestic funds. These local firms are nimble, have better contacts, and are quick to strike deals. China's super-rich, leading corporations, and local governments are backing new domestic funds. Domestic funds can move rapidly because they are not bound by the strict due diligence requirements of their foreign competitors, and they are less worried about currency controls, taxation, and exit strategies. For example, one foreign fund manager told a potential partner that he needed several months to perform due diligence, only to lose the investment to a local fund willing to provide funding immediately. Local funds have begun to dominate certain sectors, inspiring this foreign competitor to compare them to the "warlords of early twentieth century China." Room to growDespite these many hurdles, the private equity market in China has been improving. In June 2002 a collection of private equity firms founded the China Venture Capital Association (www.cvca.com.hk) to boost bargaining power and promote entrepreneurial rights. Headed by Chang Sun, managing director of Warburg Pincus, the association has about 50 members, including the Carlyle Group, Newbridge Capital, and Goldman Sachs.
Capital market regulation and the legal system are developing, making the landscape more predictable for investors. In January 2003, the PRC government clarified the Venture Capital Regulations, rules governing private equity investments (see the CBR, July-August 2003, p.24). Those changes promoted investment in high technology and addressed issues of capital formation, capital contribution, and application procedures. In addition, investors are optimistic that the gradual emergence of a professional managerial class will help private equity firms build new businesses. Loosening capital controls and easing the ability of foreign investors to repatriate profits would be welcome changes. Additional positive steps, already under way with the approval of Shenzhen Stock Exchange's separate board for small and medium-sized enterprises, would be to loosen domestic listing requirements for high-growth firms. This would provide access to capital for growing companies and create exit opportunities for VC investors. From high-risk plays to mature financingFor the private economy, VC investors perform the critical role of allocating capital to entrepreneurs who would otherwise be unable to develop their businesses. Entrepreneurial innovation, in turn, will strengthen the Chinese economy. Yet the "high risk, high reward" days of Chinese private equity may be numbered. Many managers see an eventual professionalization of the private equity market coming in a few years. The economy is modernizing and more global funds are rooting themselves in the country. Those forces will eventually create stability, mitigate risk, and reduce the opportunity for exceptional returns. Still, if private equity investors can avoid China's pitfalls, lucrative opportunities may abound. The recent string of deals and the pipeline of mainland companies seeking to list over the next year provide a strong indication that private equity will become increasingly critical to the Chinese economy.
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