Private Equity in China

The Journal of Private Equity 1999.2.2:7-13. Downloaded from www.iijournals.com by David Ahlstrom on 10/31/13. It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

Private Equity in China: Differences and Similarities With the Western Model GARRY D. BRUTON,MANEKSH DATTANI, MICHAEL FUNG, CLEMENT CHOW,AND DAVID AHLSTROM

GARRYD. BRUTON is an assis-

he private equity industry has been widely examined in the U.S., tant professor at the and in Europe as well. But in Asia, M.J. Neeley School private equity remains largely of Business in the unexplored despite the rapid growth of Asian department of management at Texas capital markets in recent years. Even during Christian University the economic downturn of 1997, the indusin Fort Worth. try in Asia added approximately $8.3 bdbon in capital. Nevertheless, it cannot be assumed MANEKSH that the Asian industry is comparable to the DATTANI is with U.S. industry. Situational and cultural factors Phildrew Ventures in London. in Asia have created a private equity industry with its own unique characteristics. MICHAEL FUNG is Over the last two decades the Chinese with the department economy has been one of the fastest growing of decision sciences at in the world. China (includmg Hong Kong), Chinese University in Hong Kong. home to approximately 25% of the world’s population, now has the second largest CLEhlENT CHOW k amount of private capital under management with the department of in Asia. This comprises approximately onemarketing and intemathird of all capital under management on that tional business studies continent. Given the continuing growth and at Lingnan College in Hong Kong. increasing importance of the private sector, there exists an opportunity for substantive DAVID AHLSTROM investments with high returns for the private is with the departequity industry. The gateway for these funds ment of management historically has been Hong Kong, second at Chinese University in Hong Kong. only to Japan in the number of private equity firms based in Asia. To date, most research on Asian venture capital has examined Japan. But given the size and rapid rate of growth and change in the private equity market in China, this article will focus attention there. First, we WINTER1999

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detail the history of the development of private equity in Chma. One factor that has dlfferentiated t h s private equity market from others in Asia and elsewhere is that China has retained a socialist economy with some capitalist characteristics. Thus, private equity firms in China face distinctive problems and situations unknown in mature economies such as the U.S. or other Asian economies (e.g., Singapore or Japan). Second, this article will examine these unique characteristics as they apply to the private equity fundmg cycle from the initial funding decision, to follow-up monitoring, to eventual exit. Finally, recent changes and future trends withn the Chnese private equity industry will be dlscussed.

METHODOLOGY To develop t h s understanding of the Chinese private equity industry, we conducted twenty semi-structured, in-depth interviews with leading private equity fund managers and other experts on private equity in Chna. These interviews were undertaken in Hong Kong and in other areas of China. The cases and insights provided by each interviewee were tested against established U.S. models of private equity.‘ One of the co-authors of this article drew on his four years of private equity lending experience in Asia, as a fund manager for one of Europe’s leading banks, to direct the THEJOURNAL OF PRIVATE EQUITY

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development of ths model of private equity investing in China. The model was sent to a number ofleadmg private equity h n d managers in China for their comments, and it was subsequently mohfied. Through these iterations, we ultimately refined the model and then contrasted it with counterparts in the U.S. and Europe.

HISTORICAL BACKGROUND

Early 1990s Chna’s economic reform to a more market-oriented system was initiated in the 1970s. Yet economic liberahation in Chma has been a slow step-by-step process. Initially private ownerslup of almost all property was fi-owned upon, and it was virtually unheard of for foreigners. But after t h s initial aversion, a series of economic measures eventually made it possible for foreign investors to invest lrectly in Chna. During the 1980s, private equity professionals’ pioneering efforts to enter the China market began. Jardine Fleming, Sung Hung Kai & Co., and American International Group were such pioneers. However, the pace of economic reform l d not encourage sigruficant numbers of firms to enter the market until 1992, when reforms were accelerated. The principal vehicles for market entry during those early years were China Direct Investment Funds (CDIFs). Typically, these funds were listed on the Dublin, London, or Hong Kong stock exchanges in order to attract funds from institutional investors. The stock exchanges recognized these funds as investment companies and thus restricted investment types. For example, the London Stock Exchange (the most common listing for CDIFs) required that such funds invest only as minority investors, taking less than 49% of stock of any target investee firms. Adltional listing regulations required that the finds not play a significant role in management of these overseas ventures or place more than 20% of the funds in any one investment. The CDIFs generally were invested in state and township/village enterprises throughout China rather than in businesses of inlvidual entrepreneurs. The township/vdlage enterprises are organizations owned and operated by local governmental units, as opposed to the state-owned enterprises controlled by the central government. CDIFs were not usually industry-focused; rather they provided mezzanine financing for a wide variety of 8

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industries as they sought to expand with the rapidly growing marketplace. The strategic plan of most CDIFs was to build relationships with large state enterprises and have those organizations help source good investment opportunities for them. For example, Sino-Chem is the firm designated to build external import and export relationships for the chemical industry in Chna. In such a relationship, a Western CDIF would bring both money and managerial expertise to the table. Large !state firms like Sino-Chem would locate deals and provide the “guanxi,” or connections, to government officials necessary for business success in China. Thus, such firms would be able to provide CDIF access to the tlest chemical-related funding opportunities in China. To fund this prospect, the CDIF would create a joint venture between itself, the funded firm, and the large si:ate enterprise that had sourced the deal. In spite of rapid growth in Cluna over the past two decades, the performance of CDIFs has not been as good as one might expect. The large state enterprises typically promoted deals with other state enterprises of lesser quality. As a result, large amounts of CDIF capital were never invested.2Funds that did pursue an aggressive grow-and-build philosophy suffered significant losses due to the poor quality of the venture. The original intended exit strategy for CDIF investors was to list the firms on the stock exchanges within China (Shanghai, Shenzhen, or Hong Kong). But exit even from successful ventures has proven to be problematic. The selection of firms to be listed on a stock exchange in China is still principally a state decision. Consequently, firms that have funds from international sources such as CDIFs often are not permitted to be listed. The state believes that these firms already have financial resources and therefore should not need the additional capital that a stock; offering provides. Rather, the capital available through a stock listing is saved for state enterprises that are in desperate need of restructuring. As a result, the only viable exit strategies available to a CDIF once an investment is made are 1) for the firm itself to buy back the stock held by the CDIF, which is problematic, or 2) to locate a strategic buyer. Such a buyer is commonly a Western firm that needs a local partner in China. For example, a CDIF was able to exit an investment in China when a major Western firm purchased its investment in a paper plant. Tlus Western firm supplied machinery and certain necessary raw materials such as chemical-related items. This partnering allowed

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the Western firm to sell more of its wares upstream whde also entering the Chinese market. However, finlng strategic partners to exit an investment can be difficult. Also, such strategic partners generally want a majority stake in the venture. Thus, for the CDIF to exit, it must not only sell its own stock, but also convince the Chinese firm to sell a portion of its share and become a minority owner in the venture.

Today Many funds now active in China are stdl organized as CDIFs. But other funds and ways of investing are tahng root and are likely to replace CDIFs in the future. Most new investment funds are not listed as such on stock exchanges. Rather, they are limited partnerships established in a manner simdar to U.S. venture capital funds. The result is that these newly organized investments have fewer operating constraints than do the CDIFs. For example, investments today are less likely to be du-ect investments in Sino-joint ventures where only a minority position can be held by the private equity fund. Instead, current new ventures create an offshore corporation where they partner with the local Chnese firm. The private equity fund takes absolute control of t h s corporation with the fund often holdmg 80%-95% of the stock, the remainder being in the hands of the Chinese partner and managers. The level of managerial input by the private equity professional into this sort of firm is greater than it is for a CDIF, but s t d less than generally associated with U.S. or European venture capitalists. The China-based venture will rely extensively on the local partner to provide managerial expertise, with general management and financing input &-omthe private equity fund when necessary. In part, this lstribution of responsibdity can be explained by the continued tendency in China to invest, not in start-up firms, but in mature firms requiring expansion or mezzanine financing. However, it is also a result of cultural lfferences in Chma, where undue reliance on outsiders for guidance is not a generally accepted practice.

DIFFERENCES IN CHINESE PRIVATE EQUITY In recent years, private equity in China has moved away from the older CDIF model to one with modest simdarities to the U.S. venture capital model. Yet interesting and significant differences persist. These WINTER 1999

hfferences manifest themselves throughout the investment process, from the initial investment decisions, through the monitoring of the investment, to exit. Each of these distinct stages, and some of the lfferences found, are examined below.

The Initial Investment Decision One of the difficulties for private equity firms in China is determining the viability of a proposed investment. In the U.S. the most important aspect of an initial investment evaluation is the person who leads the target firm. It is said that U.S. private equity investors fund the person, not the project. This advice holds sway even more strongly in China. Guanxi, or relationships among business people, are considered essential both for Westerners doing business in China and among Chinese doing business with each other.3 Such relationships are critical for private equity investors in China, since the usefulness of financial data provided by a potential investee may be questionable, if not downright unreliable. This is due in part to the fact that accounting practices in Chna differ from international standards. Also, most state firms prepare business plans and projections for state agencies that often are more concerned with maximizing outputs rather than profitability. Thus, the business plan presented to a private equity investor may not be designed in a manner that is useful for a sound financial analysis of the proposal. Another problem is that market research is not well developed in China. As a result, the only marketing factor that a private equity investor can rely on is the business sense and connections of the partner. Thus, most deals undertaken by private equity firms in China hinge on the people with whom the firm has some prior relationship. Even more than in the West, private equity firms in China fund the individual, not the venture. But guanxi does not ensure good private equity investments. Most private equity firms attempt to conduct, as best they can, a Western-style due diligence process. For example, a full audit by an international accounting firm generally will be required. There is an effort to bring the firm’s financials into a more readily understandable and monitorable form. Additionally, an effort d be made to obtain market information. Finally, firms may seek to validate the credit history of the inlvidual with whom they are dealing. Although the ability to gather information and conduct due diligence in China is rapidly improving, the importance and conTHEJOURNAL

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nections of the indwiduals in charge of-the investee firm can not be overstated.


Monitoring the Relationship The model of investing initially established by the CDIFs embraced a “hands-off’ style of monitoring the investee firm. Western investors held a seat on the board and received periodic financial data. But the degree of direct involvement with the firm varied from limited cursory contacts to moderate input to the firm’s management. This model was consistent with the unknown nature of China in the early 1990s, when private equity investment there was just heating up. Private equity represented a new financial product with whch most Chinese were u n f a d a r . Due to the long hstory of abuse Chnese business people have suffered at the hands of outsiders, many have been hesitant to cede any measure of control to non-Chmese financiers. Even if the investing private equity firm is run by ethnic Chmese (whether born in or outside of China), Chinese managers hesitate to share control with individuals outside of their inner circles, or with anyone with whom they lack long-standing relationships. Over time, many unique problems arose ddemmas that &d not typically occur in funded firms in the West. These included flagrant breaches of contract and non-competition agreements, significant overstaffing, and interference from myriad. government ministries. The early CDIFs sought to protect themselves from abuses by having extensive minority protection clauses in their agreements. However, it was difficult to anticipate all the potential problems, and the enforcement of these protective agreements was often problematic. For example, a CDIF would fund a venture with a state or townshlp enterprise; arid quite mysteriously an extra 150 workers from some unrelated business would appear on the payroll. Following a local company’s layoff, the government would simply move the newly jobless quietly over to the funded venture. Clearly, the extra workers and padded payroll are unacceptable; but the foresight to develop specific minority protection clauses to prevent such personnel maneuvers in a timely manner is rare. Government-owned enterprises are not the only firms to present unusual challenges to private equity investors. Firms owned by private entrepreneurs in Chma offer up their own set of dlfficulties. For example, one private equity fund financed the expansion of a 10

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private paper products firm producing a high-quality paper output. After a short time, the ownedmanager of the funded firm d d not believe that he, personally, was earning enough from the venture. So he set up a competing paper products company next door to the existing firm. He sold the same product line, with lower quahty, and with the same product name as the funded venture. Such activities clearly violated both his contract and all norms of business practice. But legally, it was difficult to compel this individual to stop in a timely maimer. The level of managerial sophistication in funded ventures in China is often surprisingly low. In one successfully funded beer company, the firm’s local management was looking to sell the firm to another company. However, the price they contemplated was based solely on the firm’s asset valuation. They gave no value to the established product name, dstribution system, on-going cash flows, or customer contracts. The fund manager had to educate the senior managers about valluing their firm. The result of such enigmas is that the time investment by private equity firms with their investee firms has risen significantly. A recent survey found that the time spent is approximately threefold that required for U.S. funded ventures. The focus of private equity investors has generally zeroed-in on gently moving management in the desired dire~tion.~

Exiting As noted before, the vehicle by which most initial private equity investors in China had e.xpected to exit was an IPO, whch has proven difficult. Many firms have found that their exit returns were not as high as expected. The targeted annual return typically anticipated is 20%-30%, although the actual returns for many funds have been sipflcantly 10wer.~This occurs for several reasons. First, most investments in China are with mezzanine-type firms looking to expand operations; the fundlng of new startups is rare. Such firms are lower risk, with consequent lower returns than those of private equity-backed start-up firms predominant in the U.S. Addltionally, the lower returns are due in part to the fact that private equity investments in Chma lack investment-enhancing opportunities that typically arise in the U.S. One constraint on value appreciation is that there are few other debt funding mechanisms available to firms. Once a private equity firm invests in a Chnese venture, the reliance of that company on the investor for any additional funding d likely be higher than what is

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experienced in the U.S. Another reason for lower returns lies in the nature of China’s capital markets. In the U.S., a firm can be listed on the Nasdaq without having actual earnings. For example, many Internet firms recently have been listed, although it may be years before they turn a profit. The stock’s price reflects expected future earnings, and multiples paid on such potential streams of income can be quite high. Venture capitalists provide such firms with the funlng needed to get started. The capital raised fi-om an initial public offering amplifies that investment by supplymg additional capital for expansion of the firm while in turn increasing the value of the original private equity investment. When private equity investors exit an IPO investment, they will have been able to leverage their initial investment for a greater return. In contrast, the exit for private equity investors in China is far more lfficult. The best exit option for a private equity firm is to list the venture on the Shanghai, Shenzhen, or Hong Kong stock exchanges. But before listing on any of the China stock markets, a firm must show several years of positive income. Since most of these firms are mature, lower technology firms, the multiples paid in such situations are fairly low. But, as noted, actually getting a listing for such a firm may be problematic. Alternatively, if a local strategic partner buys the firm, the multiple paid on the revenue stream is reduced even further. There are few vehicles for a d l n g value to one’s ownershp position by incurring outside debt. The overall result of these factors is that the return on a private equity investment is reduced.

FUTURE OF PRIVATE EQUITY IN CHINA Private equity in Chna is likely to continue its growth. Chma is a nation with 25% of the world’s population and is undergoing economic expansion that offers abundant opportunities for investors. As international institutional investors seek to diversifjr their investments, they will need to consider China in their portfolio of investments. After the initial euphoria of recent years, the rate of growth in private equity will likely slow, due in part to the lfficulties of managing private equity investments in China. Additionally, the low rates of return some firms are experiencing will &scourage some investors. Chma needs time to build a legal infrastructure and adltional market mechanisms to further improve its climate for private equity. WINTER1999

Clear understanding of China, its practicalities and its pitfalls, is critical, as market growth and variety of investment opportunity never guarantee success. Until recently, funds argued that they could cherry-pick investments in a rapidly growing economy and financial success would arrive automatically, as they were able to exit the growing investee firms. But as noted earlier, success is far from automatic. State-owned and township enterprise partners vary greatly in quality, legal institutions are underdeveloped, commercial norms are inconsistent, and exit is often problematic. But after being active in the market for at least five years, most funds have established a fairly clear track record. The result is that some funds have demonstrated consistent success and have had little difficulty in attracting investment. Less successful funds and those with unproven management will have increasing lfficulty, particularly in an unsettled market environment. Therefore, in the future China-specific funds simdar to the large regional funds such as HSBC Private Equity 11, which closed its subscription in January 1998 at $525 d o n , and Prudential Asia Private Equity 11, which closed its subscription recently at $540 d i o n , can be expected to dehne the norm. Those firms with demonstrated success and proven management are likely to grow larger, whde the overall number of funds active in the market may shrink. China investors’ future is likely to be modeled more closely on that of the U.S. or Europe than it is on Chma’s own earlier version of venture investing. For example, several large funds are now structuring their due dihgence actions in a manner comparable to those in more mature private equity markets. Where Chnese market research may not have been avadable or reliable in the past, the sophistication of recent data collection has greatly increased due in part to the presence of major consumer products firms. Additionally, closer investigation of the nature of an investment opportunity, beyond what is touted by a local inlvidual, is far more common. These trends are likely to both continue and expand. Perhaps the greatest change lies in the monitoring of the investee firm. Increasingly, private equity investors do not accept the notion that Chma is unique and that they are unable to provide relevant active advice to the firm. Instead, these investors have learned to view an investment as an investment, whether it is in the U.S. or in China. W e the manner in whch the advice is delivered may lffer, the private equity investor brings more than simply money to the table. The insight, aid, and direction that a private equity investor can provide THEJOURNAL

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to the investee firm often proves quite valuable.6 Investors have learned that their investment in China needs to be monitored and its best interest always promoted. This closer involvement is demonstrated by the upswing of foreign investors tahng a majority control of their firms than has occurred in the past. Still, it is rare that private equity investors provide as much advice in Chma as they do in the U.S. The Chnese themselves are quickly gaining business knowledge and sophstication - Western style business education is one of the fastest growing academic sectors in China. They increasingly recopze that private equity investors no longer d be passive providers of money. The most sophisticated of the Chnese firms now actively seek out advice and input from their investors. Related to the changing nature of the advice given to Chinese firms is a change in the nature of the advisor. Originally, private equity professionals were actually old China hands hired to cobble together funds and firms, only later learning about private equity. The ability to draw on high-level connections to source quality deals was considered the most important s a . Thus, an indvidual such as Henry Kissinger easily established private equity funds. However, it is increasingly recognized that while private equity financing in Chma is impacted by cultural and situational factors, it remains private equity financing. Understandmg of the industry and the associated financial and managerial skills are just as important as having connections or finlng a partner who has them. And consequently, in the future the private equity industry in China will become more professionalized. An additional trend in Chinese private equity that merits attention is the changing nature of the funded firms. In the past, nearly all private equity firms in China sought to invest only in ventures requiring mezzanine financing. However, increasing numbers of funds are locating high technology investment opportunities in Chma. A unique aspect of these investments is that several private equity firms now look to exit by listing the investee firm on a stock exchange, not in China, but lrectly in the U.S. Adhtionally, studes are now underway to establish secondary listing boards in Schenzen and Hong Kong that will be targeted to technology firms includmg private equity funded firms. While these trends are still small steps, they w d result in expandmg the sidarities between the private equity markets in Chma and those of established markets such as the U.S. 12

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CONCLUSION Over the past decade, private equity investmen: in Chna has grown alongside the robust national economy. The future is likely to offer even greater opportunity, as state-owned enterprises are sold, en:repreneur-shp increases, and capital markets become more efficient. However, there will be a period of transition as the market continues to mature and as new legal structure!; and favorable commercial arrangements develop. Currently, private equity in China has many interesting differences from Western private equity, but the impact of these differences is not always clear. For example, in the U.S. venture capitalists and other private equity professionals commonly retain some interest in the venture capital funds they invest. Thus, they have strong financial motivation to pursue the best interest of the fund and its investors. W e the benefit of such control of agency costs has been widely dxussed in the U.S., most venture capitalists in Asia do not hold an interest in the private equity funds they manage. Instead, due to the large institutional presence among parent firms of private equity funds, most fund managers are salaried employees. They commonly receive a bonus based on performance, but such bonuses are based as well on the entire firm's activities, which represent a wide range of financial-related activities. As noted before, to date the financial performance of most Asian private equity funds has been both lower than anticipated and lower than that of the average U.S. or European fund. It is estimated tha.t the average return across Asia has been as low as -1% to only 5%.7 The role of compensation differences in these returns is not immediately clear. However, practitioners and academics need to be aware of such dfferences and seek to better understand their impact in the future. Overall, Chma represents one of the: principal future economic powers of the world and one of the great potential markets for private equity. Improved market research and valuation of firms, more legal protection for investors and contracts, and easier exit strategies all need to be developed if the market is to mature to its full potential. The promise for private equity professionals appears great, but it can be achieved only with clear understandmg and commitment to the market itself.

ENDNOTES The authors thank Vance Fried, Tim Meade, and Kathleen Ng for insightful comments on an earlie:: version of

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thls manuscript. ‘This model of investigation is called replicative logic (Eisenhardt [1989]). The methodology relies on in depth intervies in which a model of managerial action is tested against information provided for vahdation or adaptation. In this case the model of American venture capitalists was used to explore ifventure capitalists acted similarly in China. During these interviews the insights provided by each interviewee were tested against the established U.S. model of private equity. At each stage of the process the model was changed as deemed necessary based on the information provided and then presented to the next interviewee for validation. Thus, over the course of the interviews a consistent picture of venture capital in China began to develop. This process is the same as that used by Fried and Hisrich [1994] when they examined venture capital decision makmg in the U.S. 2See Fannin [1995]. 3Some private equity investors stop at the first step of only evaluating the individual. They believe no other types of information from China can be believed or relied on. So the evaluation of the individual is where they begin and end. 4See Bruton, Sapienza, Fried, and Manigart [1998]. ’ 5“Great Expectations.” Asia Pac$c Private Equity Bulletin, June 1998, pp. 1-4. Rock [1987]. 7“Great Expectations.” Asia Pacijc Private Equity Bul-

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letin, June 1998, pp. 1-4.

REFERENCES Bruton, G.D., HJ. Sapienza, V.H. Fried, and S. Manigart. “U.S., European and Asian Venture Capitalists’ Governance: Are Theories Employed in the Examination of U.S. Entrepreneurship Universally Applicable?”Working paper, 1998. Eisenhardt, K.M. “Building Theories from Case Study Research.” Academy of Management Review, Vol. 14 (1989), pp. 532-550. Fannin, R.A. “The Great Capital Gap.” Asia, Inc., December 1995. Fried, V.H., and R.D. Hisrich. “Toward a Model of Venture Capital Decision Makmg.” Financial Management, Vol. 23 (1994), pp. 28-37. “Great Expectations.” Asia Pac$c Private Equity Bulletin, June 1998, pp. 1-4. Rock, A. “Strategy vs. Tactics from a Venture Capitalists.” Haward Business Review, Vol. 65 (6) (1987), pp. 63-67.

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