Big Foreign Private Equity Performing Badly In China?
I do not have any first hand knowledge to support the title. I am basing it on a post I just read (and on related past experience) entitled, "Private Equity in China: Blackstone & Others May Grab the Money But Miss the Best Opportunities" from the China Private Equity blog. This blog is written by Peter Fuhrman, "Chairman of China First Capital, Ltd., a boutique investment bank based in China and the USA. China First Capital works exclusively with China’s most innovative and high-growth private Small & Medium Enterprises (”SME”) companies, providing strategic financial advice and pre-IPO capital-raising."
Peter's post talks about how some of the large US private equity (PE) firms are creating reniminbi funds for China investment:
Blackstone, the giant American PE firm, is now trying to raise its first renminbi fund. Its stated goal is to provide growth capital for China’s fast-growing companies. Blackstone isn’t the only international private equity firm seeking to raise renminbi to invest in China. In fact, many of the world’s largest private equity firms, including those already investing in China using dollars, are looking to tap domestic Chinese sources for investment capital.Dollar-based investors are increasingly at a serious disadvantage in China’s private equity industry: investing is more difficult, often impossible, and deals take longer to close than competing investors with access to renminbi.
Blackstone enjoys a big leg up in China over other international private equity firms looking to raise renminbi. Its largest institutional shareholder is China’s sovereign wealth fund, CIC. Knowing how to get Chinese investors to open their wallets is a skill both highly rare and highly advantageous in today’s global private equity industry.
Peter sees US private equity going to renminbi funds because some of China's best investment opportunities are purely domestic and because China is where the money is right now.
Despite their "very long track records of successful deal making," Peter is skeptical of big foreign PE being able to do China well:
The international PE firms have more experience picking companies and exiting from them with fat gains. They also do a good job, in general, of keeping their investors informed about what they’re doing, and acting as prudent fiduciaries.So far so good. But, there’s one enormous problem here, one that Blackstone and others presumably don’t like talking about to prospective Chinese investors. Their main way of making money in the past is now both broken, and wholly unsuited to China. They’re trying to sell a beautiful left-hand drive Rolls-Royce to people who drive on the right.
The basic US PE model is just not well suited for right now in China:
Blackstone, Carlyle, KKR, Cerberus and most of the other largest global private equity companies grew large, rich and powerful by buying controlling stakes in companies, using mainly money borrowed from banks. They then would improve the operating performance over several years, and make their real money by either selling the company in an M&A deal or listing it on the stock market.* * * *
It can be a great way to make money, as long as banks are happy to lend. They no longer are. As a result, these kinds of private equity deals – which really ought to be called by their original name of “leveraged buyouts”, have all but vanished from the financial landscape. It was always a rickety structure, reliant as much on access to cheap bank debt as on a talent for spotting great, undervalued businesses. If proof were needed, just look at Cerberus’s disastrous takeover of Chrysler last year, which will result in likely losses for Cerberus of over $5 billion.
* * * *
On their backs at home, it’s no wonder Blackstone, Carlyle, KKR are looking to expand in China, All have a presence in China, having invested in some larger deals involving mainly State-Owned Enterprises. But, to really flourish in China, these PE firms will need to hone a different set of skills: choosing solid companies, investing their own capital for a minority position, and then waiting patiently for an exit.
There’s no legal way to use the formula that worked so well for so long in the US. In China, highly-leveraged transactions are prohibited. PE firms also, in most cases, can’t buy a controlling stake in a business. That runs afoul of strict takeover rules in China.
These PE funds will raise the money, but end up either being able to do the big deals they want, or will have to settle for much smaller ones:
I have little doubt Blackstone, KKR, Carlyle can all succeed doing these smaller, unleveraged deals in China. After all, they employ some of the smartest people on the planet. But, these firms all still have a serious preference for doing larger deals, investing at least $50mn. This is also true in China.There are few good deals on this scale around. Very few private companies have the level of annual profits (at least $15mn) to absorb that amount of capital for a minority stake. Private companies that large have likely already had an IPO or are well along in the planning process. As for large SOEs, the good ones are mostly already public, and those that remain are often sick beyond the point of cure. In these cases, private equity investors find it tough to push through an effective restructuring plan because they don’t control a majority on the board seats.
My guess is that Peter will likely be right in the short term, but in the long term, I see the big PE firms thriving in China. I have always been fascinated with the difference in how massively well funded firms go into a foreign country as compared to how small and medium sized businesses go into a country. Simplifying considerably, I think the following generally holds true:
The massive firms go into a foreign country to go into a foreign country and to learn about the foreign country and to eventually start making massive profits in that foreign country. In other words, the goal is not usually to profit right away, but to get set up so as to build a strong work force and so as to learn and to adjust so that long run big profits can be realized. Mistakes abound, but ample funding makes up for them. Getting in fast and building up a strong presence trumps focusing on expenses.
Small and medium sized companies typically cannot afford mistakes, particularly big ones. They are expanding into a foreign country not to build up a presence and from there figure out how to make money, but to make money as fast as possible. Sometimes the goal is to make money from day one. Other times the plan is to be profitable within a year. Rarely is it longer than that.
I compared big and small companies because from what I have seen of the big private equity firms going into China is that they are doing so somewhat along the standard big firm model. Though their goal is no doubt to make big profits as quickly as possible, I would bet that they are admitting to themselves that they would be satisfied with less than that so long as they position themselves well for the future. A few months ago, someone I know at a leading PE fund confessed to me that he was "worried" about how slow his company was moving in terms of China and he feared that if it did not step it up, it would be getting in too late to compete. He said that they were focusing too much on building up their expertise, rather than on "just going in" and building up expertise "on the fly." Of course, one conversation with one person at one PE firm is not a measure of the industry as a whole, but I do think that in combination with everything else, it is not a bad measure.
The top PE firms are going into China in a big way and many of them will eventually get strong bearings there.
What do you think?
Comments
First of all PE firms do not borrow much money from banks to do leveraged buyouts. They get their money from hedge funds, pension funds, and other investors PE firms use investment banks as matchmakers to investors, but normally they don't (and in fact in a lot of situations are legally prohibited) from using bank money. This matters a lot, because if the investment goes bad (and most PE investments will go bad), it makes a big difference who eats the loss.
This also works in China because you have investment trust companies that basically do the same thing that hedge funds do in the US.
Peter: In most cases, can’t buy a controlling stake in a business. That runs afoul of strict takeover rules in China.
The takeover rules aren't that strict for SME's and you can fund start ups. If you work with the government and direct money at what the government considers national priorities (green technology is a big one), you'll find a lot of those rules relaxed (and I don't mean wink, wink relaxed, I mean you get a piece of paper with a chop saying that you are allowed to do something).
The big problem is that PE in the US runs on preferred shares which means that the PE investors get their money before anyone else does. This is not possible in China, but there are ways around that.
The other thing is that if you go to any big PE firm, you see tons of Chinese people working in them, so most of PE isn't "alien investment" but rather something of a "homecoming." It's really, really blurry exactly who is a "Chinese company."
One final thing, who said that PE firms were only going to only invest Chinese money in China?
Peter: Private companies that large have likely already had an IPO or are well along in the planning process.
In the US. Not in China. In China is much, much more difficult for a private company to go IPO than in the US. In particular, you need three years of profits, before you can list, and there is horrendous bureaucracy that you have to go through. That creates a niche for larger deals in China than in the US.
Also the main exit strategy for SME's in China isn't to IPO. It's to get bought out by an SOE.
The rules *are* different, but different isn't necessarily bad.
Posted by: Twofish | November 12, 2009 9:54 AM
Just to point out an important fact, which is that the big PE firms are direct competitors to the commentator. That doesn't invalidate what he says, but as with everything you read (including the stuff that I write) you need to take things with grains of salt (since you have no idea what my financial interests are).
Posted by: Twofish | November 12, 2009 10:01 AM
One other thing. The big guys are already in China have have been there for about a decade.
Posted by: Twofish | November 12, 2009 10:08 AM
Big PE doesn't have any choice, they have to make big deals to generate the returns on their Funds. If I have a 5 billion dollar fund, what was the point of making a deal for 50m?
Management fees alone it up more than that.
Conversely to a small PE shop, lets say a 150m fund, a 50m is great.
The only advantage size confers, I think, is the prestige/power of the fund. But even that is suspect. Check out what happened to KKR: http://www.forbes.com/2009/07/09/kkr-tianrui-cement-china-private-equity-asia.html
The idea that PE can just sit there passively is problematic as well; their whole premise is to go into a company, shred all the dead weight and then pull out within 5-7 years with a relatively successful and functioning company. How can they do that as a minority investor in a country where shareholder rights are pretty...iffy?
There is a reason why PE didn't take off in America until the Delaware courts started to seriously enforce shareholder rights.
Posted by: Dennis | November 12, 2009 10:15 AM
Heard of Jim Chanos?
http://www.politico.com/news/stories/1109/29330.html
Posted by: casual observer | November 12, 2009 10:49 AM
Dan, thanks for your comments on and digesting of my post. Let me start off with correcting "Twofish". We don't compete with the Big PE firms. In fact, we work with them, quite happily and successfully. I wish them success, but raise questions about their approach to what is a unique PE environment in China.
Other matters: no, SMEs don't get sold to SOEs. That is rarely, if ever, the exit route. The exit is via IPO, and these days, every week, PE-backed Chinese SMEs are going public in China, HK and elsewhere, earning their PE investors returns that regularly exceed 5X.
In general terms, scale is not terribly important in PE in China. If all the best investment opportunities are to put in $10mn-$15mn in a fast-growing SME, and your minimum investment is $50mn, then you can't invest. Simple. The PE industry in China, I stress again, has aspects that are unique to China. These can and do thwart a business model that has succeeded elsewhere.
Posted by: Peter | November 12, 2009 3:54 PM
Nnot sure if my previous post didn't get posted or just wasn't processed yet.
But anyway -- one of the problems any PE deal will face is, if they are not allowed to assume majority control, is corporate governance.
KKR, the oldest if no longer the largest, PE company ran into some pretty serious trouble here: http://www.forbes.com/2009/07/09/kkr-tianrui-cement-china-private-equity-asia.html
And to bring this back to the legal perspective, we must remember that PE took off in the United States for several reasons, junk bonds definitely was one of them, but also thanks to corporate governance norms that evolved by the time Kravis Roberts and Kohlberg started making their push.
And also I would just like to note, big PE deals are necessary for big firms. If they have a 5 billion dollar fund, the 2% annual management fee alone will add up to huge numbers, add to that the 20% of any upside on a deal and you see why big PE needs big deals, otherwise its clients will not get return on their investment. [and as the KKR article shows, even the biggest PE firms will run into a hurdles in China that size won't be able to solve].
Posted by: Dennis | November 12, 2009 4:08 PM
"just going in" and building up expertise "on the fly."
That is very true. In many fields you cannot become an expert without trying first.
Emilie
Posted by: vpn in china | November 12, 2009 11:54 PM
Dennis: There is a reason why PE didn't take off in America until the Delaware courts started to seriously enforce shareholder rights.
I think it's something of a coincidence since lots of things happen in the 1980's. The big thing IMHO, is that you could start using the capital markets to raise cash for buyouts which you couldn't do in the 1970's. There were also cultural changes.
Also in some ways American corporate law is less friendly to shareholders than Chinese law. What ended up happening is that American corporate law for large companies is very board of director centered, and once people figured out how to use "poison pills" then its almost impossible to get control over a company without the approval of the board of directors.
About the Fortune 500 article about KKR, other than the CFO getting beat up, I can't see anything in that article that is special about China. These sorts of deals can be headaches in the US.
Also big firms can try a large number of small deals. There are reasons why this may work badly, but it can be done.
Peter: The PE industry in China, I stress again, has aspects that are unique to China. These can and do thwart a business model that has succeeded elsewhere.
China is unique, but it isn't uniquely unique. What I mean by that is that the things that make China different from the US are similar to the things that make Peru different from Germany. This is important for big firms because they have to deal with lots of different countries, and have to adapt business models for each country.
The issues that you have to face in China (i.e. cultural differences, legal differences, financing differences) etc. require you to adapt, but not in ways that are different than you would have to adapt if you do things in Peru.
Posted by: Twofish | November 13, 2009 7:17 AM
The Chinese game is completely different than the American game for PE firms.
First, the American game is to snatch up an established company that has hit a rough patch and is down on its luck for whatever reason, and turn that around by trimming cost, waste, and putting in good management, and maybe develop some new products. The Brand is preserved and leveraged to get them back to their market and regain profit in a relatively short time, then sell the now profitable enterprise (or IPO it) for profit. None of that is at play in China.
With a few notable exceptions, Chinese companies are generally relatively young, have grown very fast, and do not have a great brand marking. The markets are generally very fragmented with local players having a lot of hidden advantages and leverage with the local political establishment. Few of the players have a built a good inter/national brand.
There’s two ways to play this game if you have to equate it to American terms, one is venture capital silicon valley style, and the other is Warren Buffett style of buy and hold for decades. I think the PE firms will go to the VC model fairly quickly, but the ones to look out for will be the Warren Buffets, they will be globally dominant players in 20 years time.
Posted by: Ethan S. | November 13, 2009 7:49 AM
Ethan S: The Chinese game is completely different than the American game for PE firms.
There isn't one American game. Pretty much every private equity fund and firm does something somewhat different, and the big firms have often use multiple strategies.
Ethan S: First, the American game is to snatch up an established company that has hit a rough patch and is down on its luck for whatever reason, and turn that around by trimming cost, waste, and putting in good management, and maybe develop some new products.
That's one game. There are others. There are firms that look for second stage companies that need extra capital. There are firms that take successful companies that are publicly traded, take them private, and then keep them private and continue off of the profits. There are "vulture" companies (and I mean this in a positive way) that take failed companies and then try to restructure them to get something useful.
Etc. Etc.
The term "private equity" is like "mutual fund." There are a dozen strategies I can think of off hand, and probably others that someone has come up with.
Also I think that people are missing what's new. Having US private equity firms invest in China isn't that new. It's been done for about a decade. What is new is US private equity firms being allowed to take RMB investments. So people that think of PE as investing in China I think are missing the point. The big new game is PE firms taking Chinese money and investing it in other places such as the US.
China is sitting on $2 trillion in foreign exchange reserves which are invested in US Treasuries and Mortgages, and that $2 trillion has to be matched by sterilized RMB. The interest in private equity is partly so that Chinese savings are no longer backed by US Treasuries and mortgages, but by investments in US companies.
So it's not the US investing in China, the big story is China investing in the US.
Posted by: Twofish | November 13, 2009 2:49 PM
Another interesting discussion on ChinaLawBlog. The current rumor is that the CIC slated $4B for overseas investments. Will be interesting to see how it turns out.
Paul
Posted by: Investment Banking Real Estate | November 21, 2009 11:17 PM