JD Capital: PE Fund in China Enters M&A Era


Source: Tsinghua Financial Review

Private equity fund did not enter the Chinese market until 2000. Despite its late start, PE fund in China was quick to catch up. In just more than a decade, it has gone through the first two eras of growth-oriented investment and listing-oriented investment, and is now marching into the third era, the M&A era.

Born in the US after World War II, PE fund is a combination of physical economy and financial system. The global economic reorganization in the 1970s laid bare the problem of low asset efficiency, giving rise to a large demand for M&A among companies. Able to pool together a large amount of capital and to be part the development strategy of the industry, PE firms were known for their strong overall operation abilities and thus participated in the M&A of many companies. From then on, PE firms have been regarded as the financial asset most deeply involved in physical economy.

Pre-M&A Era of PE in China

From 2000 to 2008, PE industry in China was at its primary stage of growth, with growth-oriented investment as the main strategy. The period coincides with China’s golden age of high-speed development, with an average GDP growth rate of 10.4%; from 2005 to 2008, China saw an over 20% value increase in its mining, construction, wholesale and retailing, financial and real estate industries; with booming macro-economy and fast developing industries, many high-quality companies in China saw their average annual revenue increase by over 50% or even double. Against such backdrop, as long as they invested in the right companies, PE firms could see their revenue multiply in just 3 to 5 years. Therefore, most successful PE investment were made on such industry bellwethers as Belle International, Yurun Group and Mengniu Dairy Company, whose growth rates of average annual net-profit within the first 5 years of foundation were respectively 158.23%, 74.67% and 56.3%.

During the first development stage of PE fund in China, or PE1.0 era, PE firms profit from a simple model, that is to invest in high-quality companies at their growing stage. These fast-growing companies could bring return bonus to PE firms within 3 to 5 years, quadrupling the original PE investment. In the 1.0 era, PE firms were “picking up money”.

Before 2008, growth-oriented investment dominated PE investment in China. According to data by Zero2IPO Group, in 2008, growth-oriented investment in China amounted to USD 6.624 billion, representing 69% of total PE investment, while M&A-oriented investment amounted to USD 356 million, representing only 3.7% of the total. At this stage, China’s financial industry was lagging behind its western counterparts with an immature financial system and financing environment, resulting in low competitive strength of Chinese PE firms. Therefore, most leading PE firms in China at that time were those with foreign investment, such as wholly foreign-owned organizations like the Carlyle Group, Goldman Sachs, Morgan Stanley, and some Chinese companies whose initial funds came from foreign investors, like CDH Investment and Hony Capital.

The 2008 global financial crisis put a brake on China’s economic growth, leading to economic reorganization in China and putting an end to the 1.0 era. Nevertheless, China’s capital market reform gave many companies the opportunity to go public, which proved China’s PE industry as a new driving force. From 2009 to 2013, by exploiting the pre-IPO system bonus, PE firms entered into a new turn of fast growth.

In 2005, China initiated the reform of non-tradable shares and determined to abolish the categorization of tradable and non-tradable shares on A-share market by the end of 2006. In 2009, China opened the Second-board Market, which helped smooth the way for PE firms to exit through going public at home instead of on foreign markets, which used to be the only way of exit before 2009. Listed companies could have considerable liquidity premiums at the Second-board Market. At this stage, successful PE firms had high market sensitivity of physical economy and financial market. They were quick to spot promising companies and knew how to help these companies go public. Therefore, at this stage, i.e. the 2.0 era, PE firms developed a new profit model, the “2×2” model: despite the slowing-down growth of national economy and companies at this stage, high-quality companies managed to achieve an average annual growth rate of 15%~20%, with their revenue doubled in merely 3 to 5 years; meanwhile, thanks to system bonus, companies that went public on A-share market doubled their PE ratio. For example, in the second year after the opening of the Second-board Market, the average PE ratio of companies listed on the Second-board Market reached 69.85, thus bringing institutional investors an average return of 11.34 times. 

The two-factor profit model in the 2.0 era was more complicated than the single-factor one in the 1.0. In the 1.0 era, PE firms focused on the fundamentals of the economy and companies. In the 2.0 era, PE firms should not only focus on physical economy and companies, but also be equipped with the ability to operate on the capital market, and be familiar with rules of China’s stock market. Competition in China’s PE industry underwent tremendous changes in the 2.0 era. As loosened policy brought abundant finance, local PE firms more familiar with Chinese market emerged in large quantity and high quality. At the same time, high-quality private companies in China went public in large numbers. Among all companies went listed in 2008, only 35 of them were invested by PE/VC firms, and the figure soared to 171 in 2011.

However, the fast development of PE industry in China began to slow down in 2012. With new policies being unveiled by the China Securities Regulatory Commission, the number of IPO plummeted and the macro-economy and capital market fell short of expectation. Therefore, investment and return on investment of PE firms showed signs of decline. Since the stock of quality companies in China emerged over the past decades had been invested in by PE firms and other institutional investors, companies worth investing were hard to find. Internal and external factors conspired to put an end to the 2.0 era, with PE firms starting to make more M&A investment. In 2013 M&A market in China expanded enormously, with the total value of M&A supported by VC/PE firms surging to 6 times of that in 2012. PE firms swarmed into M&A market for new growth point.

PE Industry in China Turns to M&A Investment Under the “New Normal”

In 2003, China entered the “new normal”, under which growth must change from factor-increase-driven to factor-efficiency-driven. That is to say, economic growth must be driven by the improvement of efficiency of production factors only. This is also the background for the current supply-side reform.

Under the “new normal”, growth-oriented investment opportunities are on the decline, but the advantages of M&A investment begin to emerge. As their assets belong to both physical economy and financial industry, PE firms in China are equipped with strong ability of resource allocation and can promote industry development through M&A. By driving M&A in mature industries, PE firms can help establish industry-leading companies and promote industrial upgrading; they can also invest in potential emerging industries to optimize the industrial layout. Besides, temporary difficulties faced by many promising companies due to gloomy economy may cause the undervaluation of these companies, proving large room for M&A.

Economic slowdown may turn out to be a blessing in disguise for PE industry as shown by international experience. For example, the first booming age of PE industry in the US happened to be the period from the mid-1970s to 1980s, when the post-war golden age had passed. At that time, PE firms purchased many companies through leveraged buyouts, junk bonds and other tools, and improved corporate efficiency through asset reorganization and management reshuffle, reinvigorating a large number of American enterprises. Many famous American PE firms like KKR realized fast growth during this period.

There are, of course, differences between the “M&A Era” in China and that in the US, the most notable one being the economic growth rate. The American economy in the 1970s is “steady economy” with a relatively low growth rate. While China’s economic growth rate during the “M&A Era” has always been above 6%, much higher than that of developed countries, despite its slowing-down growth. Therefore, although the driving force from growth-type investment and listing investment has declined, but it has not disappeared. In another word, China has not completely entered the typical M&A era; instead, the country is now at the 3.0 era driven by the combined force of growth, listing and M&A.

The triple-factor model in the PE 3.0 era is called “Three 1.5s Model” or “1.5×1.5×1.5”. In the 3.0 era, the endogenous growth rate of enterprises in the investment period slows down from “making 2 out of 1” to “making 1.5 out of 1”. Besides, the price difference between the primary and secondary market narrows, and the conservative estimate of valuation multiples is reduced to 1.5. M&A has become a new driver of investment returns. Through M&A and integration, PE firms can reorganize industrial and corporate resources, and achieve enterprise growth with a higher efficiency. In this model, with the three factors combined, investment institutions are still able to get a return of 3 to 4 times in 3 to 5 years. For instance, JD Capital invested in U-Tour, an undervalued outbound travel service provider in 2010. The scale of U-Tour then was not large and it operated only mainly in Beijing. JD Capital aimed at helping U-Tour to go public, and at the same time conducting M&A and integration in the industry. U-Tour purchased Zhuyuan International Travel Agency, Uzai, an online platform, Club Méditerranée and Huayuan International Travel Agency. Through a series of acquisitions, U-Tour has become a leading enterprise in Chinese outbound tourism market, with its valuation raised by nearly 100 times in five years. JD Capital also earned remarkable returns from its involvement in the operations.  

It is obvious that in the 3.0 era, the requirements of the market for PE have been further raised. PE firms have to do their job well and “make money” instead of “pick up money” without much effort. On the investment side, as M&A often involves integration of a number of enterprises and even industries, the scale of investment in a single object will be expanded accordingly. In 2015, there were 30 cases of investment exceeding RMB 2 billion among China’s PE firms, accounting for only 1.1% of the market. But the amount of these cases occupied 32.5%, nearly one third, of the total amount of investment in 2015. On the capital side, PE firms are supposed to have greater ability of raising funds so as to support large-scale investment. Therefore, PE firms will pay more attention to the role of institutional investors and overseas investors, and improve their capability of managing large funds.

Key Factors in Developing China’s PE Industry in the New Era

The profit model of the 1.0 and 2.0 eras was rather simple, but the window phase was also short. In the M&A-led 3.0 era however, PE firms have to reach higher expertise standards, and the duration of investment is longer. In this era marked by a bigger market and higher threshold, China’s PE industry should focus on improving the following abilities:

Capital Raising Ability

In the past, the scale of PE firm’s investment was on the 10-million level. However, in the 3.0 era, the scale of an M&A project may be on the 100-million or billion level. PE firms thus must enhance their capital raising abilities and do it fast. Meanwhile, M&A investment requires strong timeliness. The project proponent will conduct a comprehensive investigation on the resource integration and capital raising capabilities of PE firms. If PE firms fail to reach the target amount in the shortest possible time, they may lose the trust of the project proponent. Therefore, strong PE firms tend to select global institutional investors as their sponsors. These investors are more far-sighted and not sensitive to the funding period, making it easier for PE firms to coordinate capital. Meanwhile, their good reputation and publicity is an endorsement for the comprehensive strength of PE firms, conducive to the capital operation of PE firms. Mature international PE firms such as Blackstone, Carlyle and KKR, all get support from large institutions, including sovereign wealth funds, pension funds, university endowment funds and family funds. Some successful Chinese investment institutions, such as Hillhouse Capital, CDH Investments and Hony Capital, have already begun to search for overseas institutional clients, and at the same time seek support from large domestic institutions like social security funds.

It is notable that apart from PE firms, other Chinese financial institutions are also very good at raising funds. Recently, Baoneng Group purchased Vanke for tens of billions of yuan with only a little of its own money and a lot from insurance products and wealth management products of banks. The M&A model is in fact an American-style leveraged buyout. The leveraged buyout wave in America is closely related to the fact that pension and enterprise annuity have entered the PE industry. M&A needs a large amount of money and has a relatively long return cycle, but the income is very attractive, thus more suitable for institutional investors and long-term fund providers. In the M&A era, competition in fund raising capability is not just among PE firms, but also all types of financial institutions. Meanwhile, regulators should provide more convenience for institutional funds to enter the PE industry, and encourage institutional funds, including insurance funds and social security funds to enhance their proportion of PE assets. 

Industrial Integration Ability

In the “pre-M&A era”, PE firms make profits by passive investment. The growth and profits of the enterprises invested mainly depended on the macro environment, regulatory policies and business decisions, while PE firms rarely take the initiative to intervene in the business process. The value of PE firms purely lies in providing capital for enterprises, and value-added services to improve enterprise operation are not common. In order to avoid investment losses caused by operation risks, PE firms are inclined to sign terms of gambling. The investment management is relatively extensive on the whole. However, equity investment is essentially different from borrowing capital and stock investment on secondary market in that it is active financial capital. In the 3.0 era, equity investment will often act as a major shareholder. It is qualified and necessary to take the initiative and get involved in making development strategies and operation decisions. Of course, this does not mean that PE firms need to really run enterprise entities. It means that PE firms should give full play to the advantages of their own amphibious capital, so as to help enterprises integrate resource allocation, optimize industrial shape, build excellent management teams, and proactively enhance the competitiveness and profitability of enterprises.

Against the background of China’s supply-side reform of cutting overcapacity, destocking, deleveraging, reducing corporate costs and shoring up weak spots, a large number of enterprises are in the middle of reorganization. Traditional enterprises need to catch up with the “new economy” through expanding business territories. Enterprises need to achieve integration and extension of industrial chain with sensible M&A solutions. PE firms shall also grasp the opportunities in the 3.0 era, and enhance their industrial integration abilities to stand out in the wave of supply-side reform. In fact, in the 3.0 era, PE firms should not only be more capable of “finding money”, but also be more competent in “spending money”. This is an important criterion for outstanding PE firms in the new era. With the deepening of the reform, regulators should first standardize the M&A behavior, and then further streamline the administrative approval process for normal M&As, encourage listed companies to enhance their competitiveness through M&A, and lift the policy restrictions for M&A funds and PE funds in the spirit of “eased regulation and strengthened supervision.”

Overseas M&A Ability

Since the beginning of the 21st century, with the deepening of the global industrial restructuring, Chinese enterprises are faced with new opportunities and challenges both at home and abroad. In the increasingly fierce international competition, Chinese enterprises need to “go global”, absorb foreign advanced technologies and integrate high-quality assets to achieve leapfrog development. Currently, overseas M&A of Chinese enterprises is not uncommon. Apart from large central enterprises, private industry groups and financial institutions have come to play an important role in the sixth global M&A wave. In the process of cross-border M&A and integration, enterprises can resort to experienced PE firms to help them select M&A targets, and dock with overseas resources to achieve strategic integration and collaborative development more efficiently. It is an opportunity as well as a challenge for PE firms. Chinese PE firms will be confronted with more intense international competition, and fight with each other on a global scale. Therefore, Chinese PE firms can only become world-class large institutions by grasping the overall development trend of global economy, constantly enhancing their abilities to acquire and operate resources in overseas markets, and realizing the globalization of capital, investment and partners.

Currently, the “One Belt, One Road” initiative and a series of national policies support enterprises to “go global” and actively participate in international competition and resource integration. The Silk Road Fund and Asian Infrastructure Investment Bank (AIIB) also provide more diversified financing services for overseas M&As of Chinese enterprises. Policy makers should focus on promoting the “going global” of financial capital, and thus encourage Chinese corporate entities to “go global”. They should also introduce more facilitation measures on overseas M&A, including further simplifying the administrative approval process for overseas M&As, and providing more policy support in foreign exchange settlement and sale. Besides, the government should stick to the established objectives and further internationalize its currency, so as to create more room of development for Chinese enterprises in overseas markets.