December was a typically busy transactional month for our China team with the end of the calendar tax year looming. We were brought onto a China acquisition by one of our PE clients mid-month, and we closed before the end of the year.
This cyclical frenetic pace of closing deals has caused me to reflect on various forces that motivate VC and PE fund managers to make deals. All fund managers are responsible to identify market opportunities, research acquisition targets, deploy capital, and ensure that the investment criteria fit within the fund’s focus and life cycle. Most funds have a 10-year horizon, but most investments do not perfectly track that timeframe.
Hunting for Deals in Asia
Smart fund managers continue to watch the China and greater South Asia (India) and Southeast Asia markets. In the VC space, it is clear that China’s unique and economically destructive way of dealing with Covid-19 had a significant negative impact. While government data from China is always suspect, we have alternative data sources that provide helpful indicators.
According to Pitchbook and Preqin, VC investment into China last year was less than half of the amount invested in 2021. India, a much smaller VC market compared to China, took an approximately 50% hit in 2022, as well, while Southeast Asia, a much smaller market compared to India, lost only about 25% in venture funding.
But Nikkei Asia reported that looking ahead into 2023, VCs are hunting for deals in Asia. PwC’s report on prospective investment by U.S. PE firms confirms that the amount of PE “dry powder” (funds yet to be deployed) reached $1TT by November 2022, the largest number in a decade.
Continued Hesitancy Regarding China Investment
Smart fund managers understand the global environment, which is one reason why that dry powder has not been employed en masse. China is reeling and will continue to reel from the abrupt discontinuation of its zero covid policy and the current social chaos that has caused.
Southeast Asia will continue to try to absorb companies that are diversifying from or leaving China, continuing uncertainty in global manufacturing. Russia’s actions in Ukraine will continue to drive energy and food insecurity, and a mildly contrite (or at least more thoughtful) Beijing continues to need to assert itself against U.S. “hegemony.”
So early 2023 is the time for venture capital and private equity funds to do their research and update their internal metrics for what constitutes a good deal in China. Although many company valuations took a significant hit in 2022, which is great for bargain-hunters, that is not the only criteria that should be used.
Preparing a China Exit Plan: The VC Fund List
A China exit strategy should be top of mind, and VC term sheets should incorporate a planned exit based on several types of potential events. This strategy will vary somewhat for VCs, who are often a minority investor, compared to PEs, who are typically acquiring entire companies and is discussed more in the following section. For instance, a good VC term sheet should include:
- Broad termination criteria. The option to terminate the deal pre-closing due to any force majeure events. This can be written as broadly or as narrowly as desired. Pandemics are top of mind for everyone and will be for decades, but governmental intervention, always a convenient scapegoat for Chinese companies, has never been more likely to apply to U.S. firms who will probably face outbound investment restrictions in 2023 and beyond.
- Comprehensive due diligence. Due diligence the past few years has largely been limited to document review and videos rather than in-person diligence of China assets or assets based in other Asian locations. This should not be continued as a practice, but due diligence will still be difficult while covid continues to rage in China this winter. Both Chinese- and expat-owned QC firms are available and should be utilized. For the foreseeable future, we will all feel the effects of the expat exodus from China. Many expats are still located in adjacent countries such as Japan, South Korea, Vietnam, Thailand, and Singapore. Finding QC companies that can be trusted with personnel already in China will be more and more difficult. Term sheets should hinge on the VC firm’s (and its international due diligence group) satisfaction with due diligence. Be as nitpicky as you want here.
- Other triggering criteria to exit the investment. Virtually every Chinese company is craving investment right now, which means it is a buyer’s market. Do not be shy about including more normal trigger events that require the Chinese company to buy out all or a portion of the fund’s investment or set aside funds for this purpose. A breach of minority investor information rights or debt or equity payment obligations should be on this list.
- Control rights. Control rights or triggers to change control are always hotly negotiated, and often a non-Chinese fund will not want to exercise these rights except in the most extreme circumstances. But as China’s economy continues to open up, partly by design and partly by economic necessity, VC funds should keep a close eye on how the regulations surrounding control rights will change. This will be important to industries that are removed from the negative list and also for industries that are important to China’s Made in China 2025 plan.
Preparing a China Exit Plan: The PE Fund Considerations
PE firms need their own unique exit strategy because they are typically buying entire companies with established market footprints and not prospecting on startups like VC funds. However, the first two points above relating to VC funds apply equally to PE funds.
Many of the PE deals we have been involved with were completed at the U.S. to U.S. parent company level. For many PE groups, the most likely purchaser for overseas assets is another PE group. This means that the management team needs to clearly understand the key macroeconomic and policy factors in play that will benefit or undermine the value of their overseas portfolio.
Reading the tea leaves is always fraught with difficulties and uncertainty, but as long as the PE group can find at least one interested buyer for the assets, they have a good shot at making a timely exit from that investment. A diversified customer base and supply chain across multiple international jurisdictions will help, even with geopolitical tensions and energy limitations affecting almost the entire globe in 2023. For this group, there is no substitute for continual research to stay up to date to ensure you can exit at the right time for an acceptable price.
For more information on China M&A, check out the following: