Is 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 post talks about how some of the large US private equity (PE) firms are creating renminbi 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.

Per the post, US private equity is 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.

Yet despite their “very long track records of successful deal making,” the writer of this post 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 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.

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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.

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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 the above will likely be true in the short term, but in the long term, I see big PE firms doing just fine 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 to figure out how to make money. SMEs go into a foreign country 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 compare big and small companies because from what our China business lawyers have seen of the big private equity firms going into China, 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 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. I see it as too soon to write them off.

What do you think?

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