Private Equity in China: Challenges and Opportunities

By Kwek Ping Yong

Learn valuable lessons from the newly successful private equity players in China and explore the challenges and opportunities offered in Chinese markets

The first book to deal with private equity finance in China, Private Equity in China: Challenges and Opportunities provides much-needed guidance on an investment concept that has so far proved elusive in Asia. Focusing on the opportunities that the Chinese finance market offers to private equity firms, the book shows how these firms can strategically position themselves in order to maximize success in this new marketplace.

Private Equity in China includes in-depth case studies illustrating both successful and failed ventures by private equity firms operating in China, outlining the challenges faced by private equity firms in setting up new funds. It contains a collection of valuable experience and insights about acquiring companies and turning them around essential for any firm currently operating in, or considering entering, the Chinese market.

• Discusses the challenges faced by private equity firms in China including setting up the initial fund, fund raising, deal sourcing, deal execution, and monitoring and exit strategies
• Provides key insights drawn from keen observations and knowledge of the more mature private equity market in Western countries, analyzing the way forward for the Chinese private equity industry
• Discusses the role of renminbi-denominated funds in the development of the private equity industry in China

Breaking new ground in exploring and explaining the private equity market in China, the book offers incredible new insight into how equity companies can thrive in the Chinese marketplace.

• Language: English
• Publisher: Wiley
• Release date: Jan 12, 2012
• ISBN: 9780470826546

Book preview

CHAPTER 1

Private Equity: An Introduction

This chapter provides the reader with an overview of the basic fundamentals of private equity as an asset class. In addition, the reader will be introduced to the Inventis Private Equity Model, which encapsulates the workings of private equity from entry to exit. This is particularly useful as it provides a model for readers to apply throughout subsequent chapters of the book. Readers who are familiar with the basics of private equity may skip this chapter.

OVERVIEW

Private equity is an asset class consisting of equity securities in companies that are not publicly traded on a stock exchange. Private equity consists of long-dated capital commitments from its investors aimed at achieving long-term value creation through active management of the invested companies in order to achieve higher investment returns than the public markets. Private equity funds are typically deployed to invest in companies in control or quasi-control situations. This differs from public equity that consists of capital that is invested in liquid markets and can be redeemed in a short time period. Public equity funds are typically characterized by a passive approach to shareholder governance. Private equity firms can invest in public companies through private-investments-in-public-equity (PIPE) deals.

For purposes of this book, private equity investments will refer to investments made in firms that are in the expansion-to-maturity stage. This delineation is important to highlight, as the considerations behind a venture capital (VC) and private equity (PE) investment can vary widely. Many people use the terms venture capital and private equity interchangeably. This, however, fails to account for some significant differences between the two. In order to understand these differences, it is important to understand the various stages of development of a company.

Stages of Development of a Company

A typical investment life cycle of a company goes through five main stages: seed, start-up, expansion, and maturity, to distressed. It is important to note that not all companies go through the distressed stage, but it is deliberately included here because distressed companies can sometimes be attractive for private equity investors. As the company expands, there is a perennial need for capital and the absolute amount of funds required will vary across the stages. Correspondingly, its market value will increase; as a result its equity will become more expensive to own for investors and the risk of failure will reduce. In the early seed and start-up stage, the types of investment into such firms are generally called venture capital.

Seed Stage

In the seed stage, equity investments are made in companies that are in the early development stages or companies that are perceived to have a breakthrough invention or idea. Due to the small size of the company, venture capital investments are relatively small, in the range from a few hundred thousand dollars to several million dollars. Investing in early stage investments are high-risk ventures, as the company does not have any solid track record yet. Hence, investors will demand a higher return to compensate for the high risks. Venture capital firms have a long investment horizon that can easily be more than five years, depending on how fast the development of the company is. Venture capital firms can exit their investments through subsequent rounds of financing and by selling their equity stake to other investment firms. An initial public offering (IPO) is typically the most favored exit for venture capital investments.

EXHIBIT 1.1 Stages of Development of a Company

Start-Up Stage

In this stage, the company focuses on product development with the goal to commercialize the product and validate it with its customers. The management team will have to monitor the feasibility of the product and its potential market success. Companies looking to attract financing will have to present a clear business plan on how to realize their ideas and the potential for investment returns. Compared with the seed stage, the risk of losing the investment is lowered as uncertainty is reduced.

Expansion Stage

Equity investments are made in relatively mature companies that are looking for capital to grow their business operations, restructure and systematize operations, enter new markets, or finance a major acquisition without major changes in the control of the company. In expansion stage investments, a minority stake in the company is typically sold in return for expansion capital and management expertise that can add value to the corporate strategies. Companies can also raise capital by being listed on the stock exchanges. The listing process requires significant funds and expertise to accomplish. Stock exchanges have stringent criteria that the company must meet before approval for the listing is given. Private equity firms that invest in the period just before a company lists are called pre-IPO investors. Private equity firms look to capitalize on a higher valuation accorded to its investment by the public market than when it was a private company. Timing the listing process is an important consideration. If market conditions are generally favorable and there is a lot of hype surrounding the IPO, private equity firms can reap significant rewards for its pre-IPO investments.

Maturity Stage

Companies that are in the mature stage generally experience slower growth, but they generate stable operating cash flows. Private equity firms can also invest in companies that are listed on the stock exchange through a PIPE deal, which can be a minority stake investment (typically in China) or majority stake (typically a buyout in the United States and Europe). For the former, there is usually little room for the private equity firm to influence key decisions made by the management, as it has not acquired an equity stake that gives its board voting or control rights unless explicitly structured. However, there are still significant potential upsides to minority-type PIPE deals in China, as evidenced by TPG’s investment in shoe retailer Daphne and Bain Capital’s investment in electronics retailer Gome.

MORGAN STANLEY AND INTERNATIONAL FINANCE CORP INVESTS IN ANHUI CONCH CEMENT

On May 1, 2006, Morgan Stanley Asia Investment, an entity controlled by Morgan Stanley Private Equity Asia and International Finance Corp (IFC), the investment arm of the World Bank, conducted a PIPE deal and purchased a combined 14.33 percent stake in China’s Anhui Conch Cement Co Ltd (SHA 600585; HK 0914) for 1.22 billion yuan, representing about 6.8 yuan per share. Morgan Stanley’s private equity division took 10.51 percent of China’s largest cement producer, while IFC took 3.82 percent.a

Anhui Conch Cement Company Limited is the largest cement producer in China and the fifth largest in the world by capacity. It is one of the leading suppliers of high-grade cement in the coastal areas in the eastern and southern regions of the PRC. Conch was listed on the Hong Kong Stock Exchange in 1997 and the Shanghai Stock Exchange in 2002.b

aMorgan Stanley Private Equity Invests in Anhui Conch Cement, Morgan Stanley, December 29, 2005.

bChina’s Anhui Conch Sells Stakes to Morgan Stanley, IFC for 1.22 Billion Yuan, AFX News Limited, May 1, 2006.

In the latter case, where private equity firms seek a majority stake in a publicly listed company, these deals are called buyout deals. If the deal was done using a mix of equity and debt instruments to finance the acquisition, it is called a leveraged buyout (LBO). As these deals are generally large in the range of a few hundred million or billions of dollars, private equity firms can utilize leverage by pledging the assets of the company as collateral and getting sizeable loans from several banks to help finance the LBO. After the successful LBO by the private equity firms, the company is then delisted from the stock exchange. At this time, the private equity firm would begin to restructure the company—its assets and liabilities, management, corporate strategy—while shunning public scrutiny and periodic financial reporting that was required earlier as a listed stock. The restructuring process is usually long, possibly taking up to a few years before the benefits start to materialize. After the restructuring is completed, the company would be ready for relisting on the stock exchange (known as a reverse LBO). A company going through a reverse LBO would typically command a higher valuation than the initial price paid by the private equity firm.

Distressed Stage

There are the private equity funds that focus on investing in companies that are distressed or in special situations. These companies face a severe decline in their businesses, having serious cash flow problems that put their abilities to function on an ongoing basis in question. Despite the deteriorating situation in the company, there is still intrinsic value in the company’s owned assets, patents, licenses, brand name, and customer base. Private equity firms, which specialize in turnaround investments, have the deep expertise and resources to extract values from these troubled companies. Extensive due diligence is conducted and the private equity firm will prepare a systematic plan to turn around the troubled assets. The firm that is in distress will have to sell assets at below net asset value in order to attract private equity firms. After the sale of the distressed company is completed, the private equity firm will begin to execute the turnaround plan and restructure the company. This may include stripping the company’s assets. The non-core or non-performing assets are sold/disposed of and the rest of the core and performing assets are kept and improved upon. Upon the success of turning around and when the business begins to profit again, the private equity firm will then be able to seek exit opportunities through trade sales or through an IPO.

Differences between Private Equity and Venture Capital

Private equity firms invest in companies that are in the expansion or mature stage, while venture capital firms invest in companies that are in the seed or start-up stage. Expansion or mature stage companies would have a proven operational track record, and a business model that has relatively low risks. These firms would have financial records dating back a few years, which can provide the private equity firms with some key data to conduct their valuation and due diligence. However, a venture capital firm looks to invest in companies that are in the seed or start-up stage. These two stages are typically characterized by a small group of entrepreneurs who have conceptualized a business idea that has the potential to grow bigger. Product development or production may be at preliminary stages. In some cases, the product may only be in the conceptual stage and has yet to bear fruition. Venture capital firms then have the responsibility to sieve through the hordes of business proposals and presentations in order to determine where to put their investments.

Due to the difference in stages of development of the company, the investment size will vary correspondingly. The investment size of private equity firms is usually larger than that of the venture capital’s. Depending on the size of the company, private equity investment size can range from US$10 million to a few hundred million dollars and beyond. This is not surprising, as equity stakes are more expensive in a firm with a proven track record as compared to a firm that does not have a market-tested product and has inherently high risks. To this end, private equity firms have little margin of error in their selection of companies to invest in, as their capital outlay is much higher relative to venture capital firms. It is not uncommon for venture capital firms to play the numbers game and invest in many start-up companies in hopes that a few would become the next Apple Inc. to recoup for the other non-performing ones. This is possible as the investment size is relatively smaller, hence there is a higher threshold for investment risks. Having said this, readers may come across venture capital deals that have large investment sizes. These deals are typically follow-on investments by venture capital firms in companies that have performed and grown to the next stage of the business life cycle, thus are in need of raising growth capital to bring the firm to another level. The following table summarizes the differences between private equity and venture capital investments.

Differences between Private Equity Investments and Corporate Mergers and Acquisitions

Apart from the lack of understanding between private equity and venture capital, many also confuse private equity investments with corporate mergers and acquisitions. The key differences between private equity investments and corporate mergers and acquisitions (M&A) lie in the investment objectives, time frame, and methodologies. The objective of the private equity firm is to invest in a firm and then exit that investment at a significant premium in order to distribute the returns back to its limited partners (LPs)—investors in private equity firms.

Comparing Private Equity and Venture Capital Investments

Corporate M&As are driven by the desire to gain more market share and revenue, to gain new product lines or business, and to acquire companies that have synergy with the company. Depending on the investment strategy of the private equity firm, synergy among its portfolio companies may or may not be a key consideration in its decision to invest in the company. There is generally no need to integrate the companies that it had invested in, as the companies in the portfolio are generally able to function independently.

In addition to this, private equity firms typically avoid having to deal with the integration of company cultural differences and corporate redundancies that are commonly the causes of failures in corporate M&As. Consequently, the due diligence process conducted by a private equity firm and a corporate firm on a potential investment can differ significantly. In general, a private equity firm’s due diligence process is much more extensive due to the much lower tolerance for failed investments, as compared to a corporate firm seeking acquisition. Since the latter already has strong business units that would not be affected by the target firm’s inadequacies, as well as the immediate gain in market share as a result of the acquisition, corporate acquirers typically have a larger risk appetite and may sometimes afford to scrimp on the due diligence process.

Differences between Private Equity Investments and Corporate Mergers and Acquisitions

In order for private equity firms to extract a high investment return from its investments, they need to add significant value to the companies so they become more valuable. Corporate M&A, on the other hand, focus on the integration of the newly acquired company with their own company. The choice of investment for the private equity firm is only limited by its investment strategy, whereas the choice of investment in a corporate M&A is restricted, as corporations have to identify firms that are in similar industries and businesses. The preceding table summarizes the key differences between private equity investments and corporate M&A.

INVENTIS PRIVATE EQUITY MODEL

The Inventis Private Equity Model incorporates the various types of private equity funds and the strategies used by private equity firms (see Exhibit 1.2). The left side of the model denotes public investments (i.e., companies listed on stock exchanges) and the right side denotes investments made in the private sector. The bottom two quadrants denote minority level investments and the two top quadrants denote majority level investments. The Y-axis denotes the level of equity stake from 0 to 100 percent.

EXHIBIT 1.2 Inventis Private Equity Model

When a private equity firm buys a minority stake in a company, it will be concerned with ways to add value to the company in order to exit its investment at a significant premium and to attain the high returns expected by the investor. Since it is a minority investment, control of the board or management is not held by the private equity investors. However, private equity investors can negotiate terms (during the deal structuring stage), such as having the authority to appoint key executives in the firm, including the chief financial officer or members of the board, to monitor the company’s investment.

Private equity firms that take up a majority stake in a private company will have control of the board and company. This allows the private equity firm’s executives to possess board control in order to have more influence over the company’s corporate strategy.

Private equity firms that invest in public companies are called private investments in public equity (PIPE). PIPEs can be both in minority or majority stakes (buyouts). Minority PIPE deals are much less common in Western markets than majority stakes, due to the more advanced financial market platform to structure a leveraged buyout. On the other hand, the less developed, more restrictive financial markets in the Eastern markets have seen fewer such deals. As a result, minority PIPE deals are more common and the returns can also be as attractive, as seen from the recent transactions that involve private equity firms buying minority stakes in Asian public companies with exceptional growth. Moreover, when investing in a new sector or market (i.e., China), private equity firms can utilize PIPE deals as a platform to learn and gain a better understanding of the industry, its value chain, and to develop relationships with suppliers and customers. The experience would then prepare the private equity firm for future investments in private companies that are considerably riskier and more illiquid but possess potentially higher returns. Minority PIPE deals in China will be covered in more detail in subsequent chapters.

In majority PIPE deals (called buyouts), private equity firms typically pay a premium to the publicly listed stock price to buy the entire company. They will also have to contend with shareholder approvals that may pose additional challenges to the private equity firms. In cases where the private equity firm has identified a company that is facing financial difficulties or distressed states, the private equity firm can buy out the entire company. These types of investments are called special situations.

In cases where minority or majority investments in private companies are made, one possible exit route is through an IPO which effectively moves the private equity investment into the left quadrant as illustrated by the arrow in the Inventis Private Equity Model in Exhibit 1.2. A successful buyout or special situations investment will lead the private equity firm to privatize the firm, that is, to delist the firm from the stock exchanges. At this stage, the private equity investment shifts from the left quadrant back to the right side.

PRIVATIZATION OF FUSHI COPPERWELD BY ABAX GLOBAL CAPITAL

Background

On November 3, 2010, Fushi Copperweld, Inc. announced that its Board of Directors received a proposal letter from its Chairman and Chief Executive Officer, Mr. Li Fu, and Abax Global Capital (Hong Kong) Limited, on behalf of funds managed by it and its affiliates for Mr. Fu and Abax. The letter stated that they wished to acquire all of the outstanding common stock shares of Fushi not currently owned by Mr. Fu and his affiliates in a going private transaction for $11.50 per share in cash, subject to certain conditions. The offer to take the company private resulted in a deal that valued it at over US$430 million.

Mr. Fu and his affiliates owned approximately 29.2 percent of Fushi’s Common Stock. According to the proposal letter, Mr. Fu and Abax would form an acquisition vehicle for the purpose of completing the acquisition and planned to finance the acquisition with a combination of debt and equity capital. The proposal letter states that the equity portion of the financing would be provided by Mr. Fu, Abax, and related sources. The proposal letter also states that Mr. Fu and Abax are currently in discussions to engage a financial advisor for the acquisition vehicle that will be formed by Mr. Fu and Abax.

Source: Fushi Copperweld, Inc. Announces Receipt of ‘Going Private’ Proposal at $11.50 per Share, PR Newswire, November 3, 2010.

After the company has been privatized, the private equity firm would be able to restructure the company, retain the assets that are still of value, and sell off the non-core assets. A successful turnaround of the company will provide opportunities for the private equity firm to exit through trade sales or re-listing on the stock exchange. Therefore, private equity investments can be seen as a cycle of moving between the four quadrants of the Inventis Private Equity Model.

STRUCTURE OF A PRIVATE EQUITY FUND

A private equity fund is generally made up of a few key components:

1. General partners (GPs), who are the key people who run the fund.

2. Limited partners (LPs), who are the investors in the funds.

3. The investment committee which is made up of representatives from the LPs and the GPs.

4. A group of advisors/professionals who provide consulting services and administrative work in support of running the fund. (See Exhibit 1.3.)

EXHIBIT 1.3 Structure of a Private Equity Fund

Private equity funds are mainly structured in the form of limited liability partnerships where the GPs or financial intermediaries raise funds from LPs. The fund life varies from around three to eight years, typically with an option to extend the life of the fund for another two years. (See Exhibit 1.4.) The limited partnership is also known as a closed-end fund, as it has a finite life.

EXHIBIT 1.4 Typical Compensation Structure for Private Equity Funds

General Partners

GPs are the managers of the fund. They are responsible for fund-raising, charting out the investment strategy, managing the investment process, sourcing for deals, conducting due diligence on potential deals, executing deals, monitoring the portfolio companies, implementing value-add strategies for portfolios, and exiting the investment. GPs are compensated through the management fees charged and the carried interest generated from profitable exits. They are responsible for the overall management and operations of the business and assume all of its liabilities.

Limited Partners

LPs are the investors of the fund. They typically consist of institutional investors such as financial institutions, social and pension funds, insurance companies, large corporations, funds of funds, university endowment funds, and many others. LPs are committed to the lifetime of the fund which can range from three to eight years and their liability is limited to the capital contributions that they have committed. In general, LPs cannot withdraw from their obligation to their capital commitment.

Investment Committee/Advisors

The investment committee is made up of representatives of LPs and GPs. Their responsibility is to coordinate and oversee the firm’s investment portfolio. In the initial phases, the investment committee determines the firm’s tolerance for risk and defines the financial objectives, risk, and implementation constraints. As the private equity firm starts to mature, the investment committee monitors the company’s portfolio and provides advice on how to achieve best practices. The advisors and professionals support the investment committee with their decision making. The GP or LP elects the advisors for the investment committee. The investment committee functions as the approving authority for all investment decisions made on behalf of the LPs. The GP reports to the investment committee on the performance of the portfolio companies and makes recommendations about any potential deals or exits being contemplated.

Professionals

A team of advisors and professionals, who range from legal counsels and accountants to consultants, supports the private equity firm. They provide crucial advice on certain investment processes such as due diligence on the target companies, exit structures, monitoring of the companies’ portfolio performance, and adherence to the corporate strategy laid out by the private equity firm.

PRIVATE EQUITY INVESTMENT PROCESS

There are five key processes in the running of a private equity fund:

1. Planning, fund-raising, and sourcing for private equity deals.

2. Conducting due diligence.

3. Structuring and negotiating private equity deals.

4. Managing the private equity portfolio.

5. Exit strategies. (See Exhibit 1.5.)

EXHIBIT 1.5 Private Equity Cycle

The execution and management of these five processes are the key characteristics of a true-blue private equity fund. It is also the major difference between a sovereign wealth fund (SWF) and a private equity fund: The sovereign wealth fund does not need to raise its own capital and usually has much longer investment horizons (10 to 20 years) than private equity funds. This implies that SWFs would not face the same pressures from LPs (in the case of the SWF—the government) to produce results in a very limited period of time that would attract the existing LPs to invest again in subsequent fundraisings. Pre-IPO funds are also not considered traditional private equity funds due to their nature and the stage of investment into private companies. They typically buy into late-stage private companies (possibly from a private equity fund) right before they exit through a public listing. Hence, there is typically very little portfolio management involved and much of the work only revolves around the packaging of the company in preparation for the IPO. Many traditional private equity funds would transfer their equity holdings to pre-IPO funds, which specialize in bringing firms public, because they have mandates that restrict them from taking listing and time risks (due to the lock-up periods) and would spend the time more efficiently on investing in a new deal.

Planning, Fund-Raising, and Deal Sourcing

In the planning phase, the general partners need to chart out the fund strategy, determine the type of fund, as well as its fund structure. The roles and responsibilities between each department of the firm and personnel will also need to be strategized. Private equity funds will have to select various service providers such as fund administrators, auditors, financial advisers, and lawyers to facilitate its entire fund-raising process.

The private placement memorandum (PPM) is a document that outlines the terms of securities to be offered in a private placement. It resembles a business plan in content and structure and forms the legal document on the basis of which investment will take place. Refer to Appendix B, Key Points in a Private Placement Memorandum, for key points in a PPM.

It is crucial to determine the investment process and risk management strategy of the private equity fund. The investment committee will have to determine these two components and ensure that the firm abides by them throughout the life cycle of the firm.

Fund-raising requires the general partners to approach potential investors and pitch their own funds. Potential LPs usually are concerned with the firm’s and management’s track record, indications of strong teamwork between the GPs, and investment strategy. It is critical for the private equity firm to also conduct basic due diligence on the LP to understand its background, needs, and constraints. Investors with poor reputations, default records, and dubious backgrounds on the origination of their funds should be avoided.

A limited partnership agreement (LPA) determines how the business will be run and how profits and losses will be shared among GPs and LPs. The key points in a limited partnership agreement are listed in Exhibit 1.6.

EXHIBIT 1.6 Key Points in a Limited Partnership Agreement

Duties and responsibilities of general partners.

Remedies available for breach of those duties.

Key-man clause.

Qualification as a limited partner.

Distribution of profits and losses.

Classification of contributions.

Partnership meetings.

Dissolution and winding-up.

Private equity firms can also engage the services of a placement agent to conduct fund-raising. A placement agent is a company that specializes in finding institutional investors or fund of funds that are willing and able to invest in a private equity fund. The placement agent helps in the marketing of the fund and organizes road shows and follow-ups. They are compensated for their services based on a percentage of the total amount raised or on a fixed fee. Through a well-selected placement agent, a private equity firm is able to tap into its expertise, network, and experience in fund-raising. In addition, with the fund-raising component outsourced, the GPs of the fund can focus more on deal sourcing, portfolio management, and investment strategies.

Deal sourcing requires private equity firms to determine the various approaches to seek out investment opportunities. The GPs need a wide network and a sharp sense of deal-sourcing acumen to source out the good deals. The GPs then need to filter out the deals according to the investment criteria of the fund before starting on the initial due diligence of the potential deal. There are two main sources of deal flows: in-house and external.

In-house deals are generated through internal contacts and company databases through the GPs, LPs, or advisors’ networks. This relies heavily on the ability of the partners to network for deals and research their backgrounds. External deal flows come from referrals and intermediaries, such as deal brokers, investment banks, governments, contacts made through conferences, investment promotion fairs, and so on. Sometimes, it could even be cold call if a GP is particularly interested in a company.

Due Diligence

Due diligence is a term used for a number of concepts involving the investigation of either the performance of a business or person, or the performance of an act with a certain standard of care. It is an essential component in the private equity investment process where the deal is screened and undergoes a thorough process to identify its merits, risks, feasibility, and viability in relation to the fund’s investment mandate and strategy. The due diligence process is complex and can involve many