The deal was supposed to be a high point for foreign capital investing in China.
On one hand was The Carlyle Group, the world’s largest private equity firm, eager to put its billions in capital to work; on the other was Xugong Group Construction Machinery Co Ltd, China’s largest manufacturer and distributor of construction equipment and machinery, a massive state-owned enterprise in need of fresh capital to strengthen its balance sheet, foreign management expertise to bring it up to date with what the outside world is doing.
This deal, officially announced in October 2005, involved Carlyle putting in US$375 million in cash for an 85% stake in Xugong. The other 15% remains in the hands of the original owner, the city government of Xuzhou -- a city of more than 9 million just north of Shanghai.
However, even after the deal was inked and announced publicly, it soon ground to a halt. While the Xuzhou city government was a willing seller, authorities higher up did not take quite kindly to the fact that Xugong - a strategic entity by most measures - was to be majority-owned by a foreign company. According to local media reports, regulators posed questions like Carlyle’s motivation, exit strategy, how the agreement came about between the two parties and so on. The players involved were also asked to assure that following the completion of the deal, Xugong will not be in too powerful a position that it will dominate the market.
Facing this stronger than expected resistance, Carlyle tried to make the deal more acceptable by lowering its proposed stake - at least twice – to as low as 45% from the original 85%. Yet, after three years of wait and prolonged scrutiny, the deal was eventually called off, as regulators remain unconvinced that the floodgates should be open for foreign capital to come in gain majority control of large state-owned enterprises, such as Xugong.
From the perspective of Yong Kwek Ping, a 12-year veteran of the private equity market in China, Carlyle’s appetite in this particular deal was a tad too large and too ambitious in its undertaking. Yet, by playing their cards right, private equity players in China can certainly find good deal-making opportunities. Yong, CEO of Inventis Investment Holdings (China) Co Ltd, was speaking at a recent seminar “Navigating the Private Equity Market in China” organised by the China Capital Market Research Centre (CCMRC) at Singapore Management University.
“Private equity players in China have generally maintained a low profile until now,” said Practice Associate Professor Tan Kim Song, Director of CCMRC. “This will be an increasingly busy field, as recent success stories have shown Chinese companies that cutting a deal with private equity investors gives them access to more than just fresh funds. Private equity firms are also getting more skillful and gaining more experience operating in China.”
With more than US$1 billion of capital under management, Inventis is one of the larger private equity firms focusing on greater China. The firm divides its capital into five funds of US$200 million each, and from each fund, put in between US$20 million to US$60 million into individual portfolio companies.
3i’s Little Sheep
Private equity firms, briefly, differ from venture capitalists in that they invest in the later stages of a company’s business. Rather than coming in during the start-up stage, private equity firms look for businesses that are already up and running, yet in need of that extra capital to help lift them to the next stage of growth.
Investments by private equity firms tend to have a lower failure rate compared to bets made by venture capitalists, as the risks taken are lower. Just like any investor, private equity firms aim to “exit” someday. Their usual investment horizon is between three to ten years, and a return of at least twice the original capital is expected for an investment period of three years.
But despite Carlyle’s less-than-palatable experience with Xugong, this is by no means the end of its presence in China. In fact, even as Carlyle and Xugong were seeking regulatory approval, Carlyle has forged ahead, investing in a string of other Chinese companies. Between 2006 and 2008 alone, the firm invested more than US$1.3 billion in some 30 companies.
Carlyle’s investments, according to its announcements, include: US$50 million invested in Hao Yue Education Group; US$87 million put into Sinorgchem, one of the largest Chinese producers of a chemical additive used in rubber products, and US$21 million into DIO F&B Group. More recently, in March 2009, the firm invested US$20 million into Shenzhen-based Ellassay, a high-end women’s fashion house.
Of course, there have been some high-profile success stories already. For example, 3i, a UK-based private equity firm, took a stake in Little Sheep, a fast-growing hotpot restaurant chain. Three years after its US$20 million bet, 3i helped to shepherd Little Sheep’s listing in Hong Kong. It also sold its stake in Little Sheep to Yum Brands, a company that runs the KFC and Pizza Hut franchise. The whole exercise generated a five-fold return for 3i.
Rainmakers in a grey area
To Yong, navigating the private equity market in China means more than a mastery of corporate finance. It is also about “politics, macro-economics, and everything else. You need a wide-scope of knowledge. Sometimes, certain deals are positioned as a sweetener for something bigger,” he said.
There are currently no specific laws governing the private equity market and investments in China, which adds fluidity to the situation. While foreign investment is not explicitly banned, approval is needed for each and every deal. Meanwhile, recognising the growing trend of private equity investments, Chinese regulators have not been napping. The first draft of the legislation is expected by end of the year. But for now, private equity in China remains a grey area, said Yong.
Despite the relative-murkiness of this sector, the potential pickings are sufficiently rich enough to attract a stellar cast of high-profile names to jump into the action.
For example, Anthony Leung, Hong Kong’s former Financial Secretary, is now with Blackstone, another leading global private equity firm, where he holds the title of senior managing director, as well as chairman of Blackstone Greater China. A growing list of well-connected names, sons and daughters of current or former high-ranking officials, are also in on the action. They include Levin Zhu, son of former premier Zhu Rongji, who is the CEO of China International Capital Corporation, a firm that also provides investment banking and advisory services
Clearly, what these names (often described as “rainmakers”) bring to the table are not merely their skills, but also their connections to get things done. Not all private equity players have the benefit of enjoying such high-level connections to open the doors to mega-deals involving state-owned behemoths. “The larger companies are mainly state-owned, and potential investors must be prepared for many tricky issues,” said Yong.
But, certainly, there are still many opportunities to do medium-sized deals involving privately-held Chinese companies with no government links. With China’s private sector economy gaining greater weight, there is a growing number of these entrepreneurs around. They may be living an entrepreneur’s dream, yet, many find themselves in need of an extra dose of capital and management expertise that outside investors (like these private equity firms) have, to bring their companies to the next level.
Soft touch
While there is not as much political sensitivity for private equity firms dealing with these privately-held companies, they come with their own set of issues to be addressed. “Private equity firms can’t take outright control. They have to exercise control via other mechanisms,” said Yong. This includes putting in money in various stages - subject to the successful attainment of certain targets based on a schedule agreed upon.
Yong suggests that in China, there is no point trying to use legal documentation like contracts, to protect business interests. According to him, the legal system in China is good, but any legal proceeding or process tends to take very long. “A 200-page legal document in America can be a two-page agreement in China. Mutual understanding and trust matters more,” he said. In other words, a soft touch needs to be used when dealing with the Chinese entrepreneurs.
During his talk, Yong also addressed some questions raised by the audience. For example, he was asked if he, as a Singaporean, had any difficulties changing his mindset to fit into the China’s business culture. “When we do business, we still do it in the traditional, Western way. However, I’ve developed a mechanism, a knob, that I can turn wherever I am. I can adjust myself to whichever city I am at,” said Yong, who travels frequently between Shanghai, Tokyo, Singapore, as well as various smaller Chinese cities, where people from each location behave and think differently. To Yong, the way to deal with the rapid changes is not to confine himself to just one type of behaviour. “It is important to have a global mindset and adjust, like an auto-pilot.”
“Delicious”
Yong was also asked about another widely-held concern of businessmen outside China: accounting issues. With a dozen years of doing businesses in China, Yong is clearly unfazed. “Accounting in China can be a tricky issue, as the accounting and auditing framework is still in its infant stages,” he said. He went on to suggest that many companies declare lower revenue than they have actually earned so as to lower their tax obligations. Lest such issues deter one from attempting a business career in China, Yong added: “I don’t really see this as a short-coming; I see this as a way of life, everybody is doing it this way for now. We need to give the business community (in China) some time to change.”
As for worries over corporate governance standards and practices in general, Yong agrees that more can be done. “We do require them to be transparent in terms of accounting, we do checks every quarter. We certainly want them to be more transparent. It is impossible to be 100% transparent,” he said. Thus, some allowance could be given, “as long as everything is not too far off,” he added. If the owners of the target companies differ too much from investors like Yong, either party can just walk away.
Despite all these seemingly tough challenges, Yong is optimistic that private equity in China is something that will be rewarding. With the exception of certain sectors like technology and telecommunications, his firm is open to investment opportunities in all other sectors of China’s economy, whose population of some 1.3 billion gives this market a lot of potential. “Everything else makes sense, everything is opening up. There are many opportunities to capture growth. Every sector looks good and delicious,” he said.
Last updated on 27 Oct 2017 .
