China is likely to offer the broadest range of private equity deal opportunities in Asia over the next few years, including government asset disposals, distressed debt and pre-IPO investments, according to US-based financial consultants, Bain & Company.
Michael Thorneman, head of the firm’s private equity practice in China, says expansion capital deals, pre-IPO mezzanine capital have made up 60 per cent to 80 per cent of all China investments over the past five years and will continue to be a significant part of the market. While historically, there have been very few traditional buy-out deals in China, the number of buy-outs will likely grow as the market deregulates.
Average deal size in China is still small by international standards, but has grown steadily from approximately $20m (€16.5m) in 2000 to approximately $35m (€28.9m) in 2005.
This compares with average private equity deal sizes of $59m and $52m in Japan and South Korea respectively at the end of 2004, according to a report on China’s private equity market published last October by Bain and Company.
Broad cross-section
If the approximately $6bn of investments into the three large bank pre-IPO deals in China in 2005 (Bank of China, Industrial and Commercial Bank of China and China Construction Bank) is included, the average deal size surpassed $100m.
Mr Thorneman notes that Bain is seeing significant interest from private equity firms in a broad cross-section of sectors in China, including financial services, branded consumer goods and technology. Expansion capital, or ‘growth capital’, deals will remain an important investment vehicle since many Chinese companies, especially those privately-owned, are experiencing strong growth and capital constraints.
He warns that although the Chinese private equity market is still in its early stage of development and will likely provide attractive opportunities for many funds, the arena is becoming increasingly competitive. This is largely a result of the substantial amount of money already raised, coupled with the recent entry of several large funds into Asia with an eye towards China. The country now accounts for over 12 per cent of the Asian private equity market. Increasing competition means fewer cheap deals.
Mr Thorneman says that while the private equity market in China has its own “special characteristics”, all of the usual rules of do’s and don’ts apply in the country.
The three most important ‘do’s’are:
- Put the right team on the ground from the beginning - in terms of capabilities and culture/language skills,
- Over-invest in due-diligence to identify the full breadth of opportunities and risks, and,
- Have a crystal clear approach of to how to add value after the deal is done.
Italian expertise
The Italian-based Cape Natexis Private Equity Fund is one investment company pursuing such an approach. The fund was launched in 2004 by Natexis-Cape SGR for investment in buy-out and expansion financing transactions in Italian small and mid-cap firms involved in traditional manufacturing industries with a turnover of between €10m and €30m.
Natexis-Cape is a joint venture between Cimino & Associati Private Equity Spa and French-based Natexis Private Equity International, which holds a 49 per cent stake in the operation.
The Cape Natexis Private Equity Fund, which has raised €120m from European institutional and private investors, established a sister company in Shanghai in 2004 – Cape China – to lend legal and managerial support to the subsidiary operations of the 17 Italian portfolio companies it is currently funding.
 | Cape China, which is headed up by Marco Mazzarese, supports these Italian portfolio companies in the implementation of industrial development plans aimed at exploiting the potential of the Chinese market. It also assists in the setting up of partnerships with local entrepreneurs. |
One of the biggest challenges, says Mr Mazzarese, is the ignorance about China among the portfolio companies whose interests he serves.
“We are trying to persuade them that China should not be looked upon as a competitive threat but as a big opportunity to leverage cheap labour,” he says.
Out of the ashes
The firm is presently providing legal and managerial support to eight subsidiaries of Italian portfolio companies in China. Three of these subsidiaries are involved in the aluminium extrusion industry. For instance, an Italian portfolio company called Phoenix International has established the biggest factory in the world for producing dyes for aluminium extrusion in Guangdong province. The other five subsidiaries include manufacturers of medical equipment, plastic pots and high pressure cleaners, while two are marketing companies for Italian-based makers of high-priced loudspeakers and heaters.
While Cape China has concentrated on supporting the marketing and outsourced manufacturing operations of Italian portfolio companies for the last two years, it plans to invest directly in a Chinese company later this year.
Mr Mazzarese says: “We are trying to leverage the knowledge and skills we have learned from investing in Italy in order to find investment opportunities in China. At the moment we are evaluating one pre-IPO financing opportunity. We are also considering another opportunity to expand in an industry in which we are already invested in Italy.”
The most interesting investment opportunity for private equity funds, he says, is a company which has reached a certain size and can be targeted for an IPO within a few years. This is a strategy that many private equity companies are pursuing.
Having a local presence, he says, is a must for anyone managing a private equity fund which hopes to invest successfully in China.
“You have to be local to understand the people and their way of thinking and the rules of the game. To approach good quality deal flow, you need good connections, both with government authorities and with the local entrepreneurial community. Such connections can only be developed by maintaining a presence on the ground,” he explains.
The importance of conducting thorough due diligence on a deal opportunity cannot be overstated, says Mr Mazzarese.
A new perspective
Pointing out that accounting practices within Chinese companies can be opaque, he jokes: “To do business here, you have to remove completely the base assumptions you hold in doing business at all – logic and fairness. One plus one does not always add up to two!
He warns also that a lack of transparency makes equity acquisitions in China “dangerous”
He explains: “M&A tends to be done through an asset acquisition involving the purchase of the physical assets of the target company. The Chinese do not want to discuss equity. They are more comfortable with physical assets which are tangible.”
Dealing with Chinese entrepreneurs can be a challenge, contends Mr Mazzarese, because many are wary of private equity funds.
He observes: “The entrepreneurs are mostly blue-collar; they work very hard and are making money – but the Chinese way. We avoid companies like this.”
By contrast, when he comes across an entrepreneur with a good education and sometimes international experience, the ratio between deal flow and deal execution improves.
Talks with entrepreneurs can be fraught with sensitivities, contends Mr Mazzarese. You do not ask them about expected profits. You ask instead for the industrial cost plus labour and then you make “an assumption” about profits based on that information.
Major risks
According to Bain & Company, governance and fraud are major risks for private equity funds investing in China. Other high-risk factors include a lack of local market liquidity which restricts exit options, the recruitment and retention of strong management talent, limits on holding a majority stake and a lack of access to debt.
Emphasising that making money from private equity investment depends on the rigorous sourcing and screening of deals, Bain says the fund must be able to walk away from a potential transaction when the valuation is not supported by the underlying potential.
Bain also highlights the importance of linking portfolio companies to a wide network of customers, suppliers and advisors to ensure sustained long-term value.
Natexis-Cape plans to raise a new private equity fund in Italy in the second half of 2007. The fund, which will total around e150m, will have an allocation of €10m-€20m for private equity deals in Chinese.
Mr Mazzarese says the fund will focus on expansion capital and buy-out rather than venture capital deals.
“While we will not invest in Chinese start-ups, however we might fund our own enterprises,” he adds.
