Private Equity With Chinese Characteristics (Part 4)

Piggy Bank Part 2 of this series on Private Equity in China, posted on November 3, described how a newly-created Chinese private equity firm, majority-owned by a large state-owned bank, had raised funds from state-owned financial institutions and had then made its first investment in a state-owned company in Tianjin. I thought this was pretty interesting because it showed how fast the Chinese have caught on to the private equity game and how determined they now are to make it a purely Chinese affair—at least as far as state-owned companies and assets are concerned.

Thinking this was a one-off occurrence, a sub-headline in the September issue of ASIAMONEY CHINA caught my eye: “Beijing builds buyout funds as protectionist policy.” (Since there is no online version of the article, we have created a link.)

Essentially, the article states that Beijing has created a number of private equity funds to allow domestic companies to reduce their dependency on bank loans and to keep state assets from falling into foreign hands. It goes on to report that the State Council has approved the creation of four private equity funds, each with a regional and industry focus, and each capitalized with Rmb 20 billion (US$2.65 billion) of funds from local and national state-linked institutions. The Bohai Industry Investment Fund, which made the investment in Tianjin referred to earlier, was created in late 2006, before the approval of the four additional funds and was also capitalized with Rmb 20 billion ($2.65 billion). (Interestingly, Standard Chartered was interested in investing in the fund, according to the ASIAMONEY CHINA article, but its participation was vetoed by the National Development and Reform Commission which oversees the fund and reportedly wants to maintain its Chinese heritage.)

The four funds approved by the State Council are: The Shanghai Financial Fund, which will operate much like a traditional private equity firm; The Guangdong Nuclear Power and New Energy Fund which will invest in nuclear technology firms and “clean” energy sources like wind and solar power; The Shanxi Coal Fund which will focus on local mining and smelting assets; and The Sichuan Mianyang High Technology Fund, which will invest in new technology and IT firms.

What this means essentially is that the option of investing in China’s state-owned companies by foreign private equity firms has been taken off the table in three ways. First, a lengthy government approval process for investments by foreign players in state-owned companies, with a strong bias against the sale of majority stakes, makes it extremely difficult to get these transactions approved. Secondly, a red hot stock market has priced many deals out of the private equity market (see Part 3 of Private Equity in China). And finally, the creation of government-controlled private equity funds with inherent advantages for getting deals done in China represents almost unbeatable competition.

What’s a private equity firm to do? There are only two choices: focus on private companies which are outside state control, or build companies from the ground up.
The Carlyle Group has already started down the path of looking at private companies. On November 20, The Wall Street Journal reported that Carlyle is negotiating to buy a minority stake in a Chinese hotel chain for $40 million to $50 million, New Century Tourism Group.

As the article points out, deals with private companies, although smaller in size, face fewer regulatory hurdles, and represent bets on the ability of Chinese entrepreneurs to realize the large potential afforded by China’s vast markets.

Even deals with private firms, however, will have to compete with the high valuations that may be had in the public equity markets, both inside and outside China. In a recent conversation with the representative of a large U.S. buyout firm, I was told how negotiations with the owner of a private company in China were being complicated by the fact that the owner was considering an A share listing. China shares are also hot outside China. As noted by The Wall Street Journal, shares of NASDAQ-listed Chinese budget hotel chain, Home Inns & Hotels Management Inc., have soared since the company listed in October 2006.

In the end, the only way to create a truly proprietary deal flow in China may be to develop a business model which focuses on building businesses in China. This is a model which is closer to traditional venture capital investing than it is to private equity investing as now practiced in the United States and other developed markets, but it may be the only one that is practical given the realities of China. In a similar vein, multinationals interested in growing their businesses in China may have to forget about acquisitions as a strategy, and instead focus on building from the ground up.

For corporations and private equity firms alike, China’s rapidly growing markets represent an ideal opportunity to build tomorrow’s large, world-class businesses, but there are no easy answers and no shortcuts. It will take time, patience and an emphasis on developing good local management. In the end, this is what it always comes back to in China.


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