Private equity: spanning the culture gap

At the beginning of March, Providence Equity Partners, one of the large international buy-out firms, sent a note to investors to announce that Sean Tong, one of its Hong Kong-based managing directors, was leaving the firm to launch a China-focused private equity investment platform. Mr Tong is just one of many locals leaving western firms to set up his own shop, adding to competition that was intense even before the defections.

“With the growth of domestic private equity firms in China, the major international firms are losing their competitive edge,” says a China lawyer at one of the big US law firms in Hong Kong.

So today, if they are to flourish in the Chinese market, private equity firms will have to reinvent themselves once more. Buy-out firms have already had to adapt their model to the reality of the Chinese market several times, because the formula that has worked so successfully in the US does not travel particularly well.

For one thing, there is now a lot of money in the country. Having capital is no longer something unique or differentiating. As the example of Mr Tong shows, there are no barriers to entry on the mainland. In addition, there are virtually no control deals. It is hard to use masses of borrowed money. Aggressive restructuring and cost cutting is difficult. That means many of the deals involve minority stakes in companies that are either about to go public or have already done so.

However, there is still money to be made on such small stakes. Carlyle Group’s minority holding in China Pacific Insurance is likely to be among the most profitable deals any buy-out firm has done anywhere to date. Similarly, TPG, the US private equity firm, made billions on its stake in Shenzhen Development Bank.

It is likely to make even more on its China Grand Auto deal, which gives it a stake in car dealerships all over China but effectively is also a property play, since the dealers sit on land that is increasing in value. Indeed, in 2010, TPG’s Asian funds performed far better than its flagship US funds. Its Asian funds were up between 40 per cent and 50 per cent for the year.

But those kinds of returns are likely to fall in the future. “The gravy train of buy low and sell high is over,” says the head of Asia for one major private equity firm. “Perhaps the market opportunity is growing, but the money is growing faster.”

Now, as the competition for deals becomes more intense, private equity firms are having to adapt again. One sign of that change is their willingness to raise local-currency funds in China in the hope that the country’s wealthy entrepreneurs will be the source of both funds and deal flow.

Many also hope that a template that was pioneered when Lenovo, the computer vendor, bought IBM’s computer business can be replicated on a bigger scale in the future. Lenovo turned to TPG and General Atlantic, another private equity firm, for help in running the US technology operation. That should be a natural role for the private equity firms to play, as they can serve as a bridge between two cultures. They can ease political and regulatory concerns, or advise on the practicality of the process as partners rather than paid advisers.

“The value-add is what the private equity firms know outside China,” says Joe Gallagher, head of mergers and acquisitions, Asia-Pacific, at Credit Suisse in Hong Kong.

But so far there have not been many such deals. When Haier, the white-goods maker based in Qingdao, was looking to bid for Maytag, the US appliances maker, it teamed up with Bain, the management consultancy, and Blackstone, the private equity group, for help in what was ultimately an unsuccessful bid. Blackstone is also helping China National BlueStar, a consumer company in which it has a stake, make overseas investments.

As Chinese companies become more interested in making acquisitions in the developed markets of the west, the private equity firms can potentially do much to help. That is because one of the main fears of domestic companies, even the biggest state-owned enterprises, is about integrating differing cultures. Their lack of experience in the international arena represents an opportunity that does not exist in a market such as India, where executives have far more confidence about their ability to manage multinational companies.

That is one of the principal reasons there have not been more deals, bankers say. Only where deals involve heavy engineering skills or natural resources do the Chinese have the confidence that they can manage the companies they acquire.

Private equity can also help ease fears of overpaying, a fear that has paralysed many Chinese companies and kept them from closing on deals they desperately want – as was the case when Bank of China tried to buy Bank Internasional Indonesia several years ago.

That reluctance to pay up also helps explain why many China bankers hate domestic deals. “The China advantage should be cheap financing, but because they drip-feed the price, that cheap financing doesn’t mean automatic success,” says the head of M&A at one large international firm.

There are many other reasons for frustration. Virtually everything in the country is government directed, so when deals come up, a key task for bankers is to figure out who will get Beijing’s blessing to bid.

One of Credit Suisse’s great success stories was in selling local Wing Lung Bank in Hong Kong to a Chinese bidder in the form of second-tier China Merchants Bank, despite the fact Beijing was backing Industrial and Commercial Bank of China, the largest of the country’s state-owned banks. But such upsets are rare.

Meanwhile, there is another template that private equity firms hope does not get repeated.

Last month, China’s Wanhua Industrial Group gained full control of Borsodchem, a Hungarian chemicals manufacturer, for €1.2bn ($1.7bn). Wanhua first bought a stake in the distressed company by acquiring the debt at bargain prices after a poorly timed purchase of Borsodchem by London-based private equity firm Permira in 2006. Chinese companies love such bargains, but private equity firms are not rejoicing when the deals come at their expense.

Beneath the surface: a fishing trip to China

In July 2010, Carlyle Group, a Washington-based private equity firm, put almost $200m into China Fishery Group, giving the buy-out firm a 13.6 per cent stake in the world’s largest fish processor. Except it obviously was not a buy-out at all. But then very little private equity activity in China actually involves true buy-outs. Doing deals in the country is not easy: valuations are high, and most entrepreneurs are still young and have little desire to sell their companies and retire.

Instead, international private equity groups such as Carlyle are reduced to taking minority stakes in companies that are private, about to go public or already listed. Indeed, as many as 70 per cent of all China-related listings and secondary offers involve private equity players, according to data from UBS, the Swiss bank.

That is not to say the upside cannot be as good as – or far better than – the true leveraged buy-out deals that these big investment firms with tens of billions of dollars under management undertake in the US. Indeed, in 2009, after China Pacific Insurance, the country’s third-largest insurer, went public in Hong Kong (one of the top 10 listings that year worldwide), Carlyle began to sell down its minority stake. That deal will probably prove to be one of the most profitable private equity transactions to date, and earned the Hong Kong-based Carlyle deal team hundreds of millions of dollars collectively. Thus are fortunes made in China.

Because China Fishery is already public, it will not prove as lucrative as Carlyle’s insurance deal. But because the fishery was founded by a Hong Kong entrepreneur and is listed in Singapore, happily the investment is not nearly as risky as deals in China itself. On the mainland, regulators are constantly changing the rules, and concerns about local protectionism and potential xenophobia are never far from the surface.

Indeed, China Fishery was just what Patrick Siewert, managing director at Carlyle in Hong Kong, was looking for when he joined the group several years ago after running the Asia-Pacific region for Coca-Cola, the US beverages group. He wanted investments in companies that would be plays on the growth of domestic consumption in China, and believed food prices would rise as hundreds of millions of people in Asia became integrated into the world economy.

But, concerned with the reputational risks that are often an issue in the country, Mr Siewert wanted reassurance that the company’s practices were appropriate. (Carlyle had already ploughed money into a dairy company after careful due diligence to ensure there was no possibility of another melamine-in-the-milk scandal.) Moreover, he had heard that Ng Joo Siang, managing director of China Fishery, had been talking to UBS about a secondary listing in Oslo (Norwegians understand fish), suggesting the company was looking for additional funds.

Mr Ng, meanwhile, wanted to expand and upgrade. He had arrived in Hong Kong in 1992, a “negative millionaire”, he recalls, fleeing creditors from the family business in Singapore. In Hong Kong, he began processing and selling fish. While his competitors were selling to Japan, he ranged further afield to Europe and Russia where the competition was less intense.

Today the company’s sales total HK$11bn ($1.4bn), Carlyle has helped it comply with best environmental compliance, and the business has operations from China to Chile.