Private Equity With Chinese Characteristics (Part 3)

Just as they are getting started, foreign private equity firms are finding significant barriers to entry in cracking the China market.

First, a lengthy government approval process for major transactions has stalled or killed deal after deal. Second, the inability to obtain majority ownership in any reasonably-sized, state-owned company means that foreign private equity firms are not able to exercise management control as they do in their home markets. Finally, embryonic capital markets and the lack of debt financing to leverage equity investments has forced a departure from time tested investment models that generate outsized returns based on the availability of cheap debt.

As if this weren’t enough, another impediment to deal making has popped up from an unlikely source–China’s booming stock market. Normally, a robust stock market is an ally of private equity investing because it provides attractive exit opportunities. In the case of China, however, where many listed companies are trading at valuations reminiscent of the dotcom era, the stock market has essentially priced most deals out of the market.

Private equity deals, or leveraged buyouts (LBOs) as they were commonly referred to in an earlier time, became a big business in the 1980s when the U.S. stock market placed low values on most industrial assets. High inflation, interest rates and unemployment in the United States depressed equity prices. In this environment, LBOs became an attractive and lucrative way to unlock the underlying values of publicly traded companies. The game was to buy assets cheap on the stock market using large amounts of debt; restructure the companies; pay down debt; and then re-package and sell the same assets in the public markets at a higher valuation at a later date. These deals depended for much of their gain on a stock market which undervalued bricks and mortar and other corporate assets compared to their intrinsic value.

The experience of the major U.S. oil companies in the merger-frenzied decade of the 1980s provides a good example of how this worked in practice. Despite several oil shocks in the 1970s, as well as handwriting on the wall which indicated that energy assets would become increasingly scarce and dear, stock market valuations of oil companies languished. Astute corporate raiders soon realized that it was cheaper to drill for oil on the New York Stock Exchange than it was to actually go out and do the hard work of discovering and developing oil fields. As a result, one major oil company after another changed hands, with LBO and private equity firms being some of the largest beneficiaries.

With PetroChina trading in the Shanghai market at a price to earnings multiple near that of Google, however, the reverse is true in China today. It is likely more cost effective to drill for oil in the Arctic than it is to buy shares of PetroChina at current share price levels.

This phenomenon is not limited to hot industries like oil. Share prices for even ordinary, run of the mill industrial companies have risen so much so that their valuations have become much too rich for private equity buyers.

Take the case of Fuyao Group, China’s largest glass company.

In November, 2006, Goldman Sachs agreed to take a 9.98% stake in Fuyao by buying 111.28 million shares at a price of 8 yuan per share. In August of this year, nine months later, the Ministry of Commerce finally approved the transaction. At the time, Fuyao’s shares traded at a price which was approximately 10% higher than the price being paid by Goldman.

But then Fuyao’s shares surged to more than 30 yuan per share, nearly four times the Goldman price. On November 5, the China Securities Regulatory Commission rejected the Goldman Sachs offer and the deal was called off. This was not the first time that Goldman has had a deal derailed by the bull market. In August, China’s securities regulator also blocked a separate plan by Goldman Sachs to buy a 10.7 percent stake in Midea, one of China’s top home appliance makers, for about $96 million.

The lesson in the Fuyao case is that China’s approval process for purchases of stakes in Chinese companies by foreign investors, and a booming stock market, have combined to form a lethal one-two punch for foreign private equity firms in China. Even when a private equity firm manages to obtain state approval, as Goldman did in Fuyao, there can be no assurance that the deal will not be struck down by yet another regulatory body based on valuation. Of course, Goldman could agree to pay a price which is closer to Fuyao’s public share price today, but my guess is that Goldman’s analysis is that Fuyao is more than fully valued at current levels.

Prior to making an investment decision, foreign private equity firms spend an enormous amount of time, money and resources doing financial and legal due diligence. Additional money is spent dotting all of the i’s and crossing all of the t’s on the volumes of legal documentation which accompany each transaction. Faced with a gauntlet of regulatory approvals and a soaring stock market, the prospects of getting to the finish line are lower, not higher, than they were a year ago. Perhaps a reassessment of the role of foreign private equity in China is in order?

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