Cai Lei of JD Capital: The “1+N” Model of Consolidation-Oriented Investment Has Dominated China’s PE


On June 3 and 4, the 2017 Tsinghua PBCSF Global Finance Forum was held in Beijing,hosted by Tsinghua University (THU),organized by the PBC School of Finance (PBCSF) and the National Institute of Financial Research of THU. The forum brought thousands of participants together, including leading figures from the political, business, and academic communities across the world. They shared their views on “economic globalization and financial stability”.

At present, China is accelerating its pace of entering the new era of asset management. For one thing, due to the rising wealth of Chinese people, wealth management businesses are enjoying faster growth, as a pivotal force in solving decreasing high savings rate and enhancing the development of direct investment market. For another, China’s economy currently stands at a critical juncture featuring slowing pace and structural transformation. Hence PE investors are facing both opportunities and challenges.

In this context, a sub-forum with the theme of “Prospect of Private Equity Funds” was held. President Cai Lei of JD Capital had a discussion with other guests about the current development status, difficulties and future prospects of private equity (PE) funds and delivered a keynote speech.

Below are extracts of President Cai Lei’s speech on the 2017 Tsinghua PBCSF Global Finance Forum, with certain revisions: 

Good afternoon! Today, I’d like to talk about private equity industry, i.e. PE.

PE, as a special form of investment, has a short history – it’s only decades since its birth in America. Compared with traditional financial sectors like banks, securities and insurance, PE is just a small subsector. Despite that, with its own features, it is playing an increasingly important and unique role in economic development. In America, “barbarians at the gate” used to have profound impacts on industry dynamics, and PE can be found in a lot of boom stories in China as well.

This speech includes two parts, the theoretical issues and practices of PE in China. Why? For one thing, people in THU and PBCSF always focus on practices; for another, theories, arising from practices, can guide practices as well. Hence I will talk about both of these two sides. 

A Universal Rule in PE Industry: Duality

I will start with theories. The history of PE is not long on a global scale, even shorter in China. Although it’s been only 20 years since PE emerged in China, we have found a lot of theoretical issues worth studying, among which the most critical one is how to understand PE.

In my view, the nature of PE lies in its duality. It has been connecting finance and industry ever since its birth, and it will also follow the pattern in the future. PE is the abbreviation of the term “private equity”, and “private” means that funding is raised through private placement. In this way, PE is thus a financial term. Then, how to make use of the funding? As we know, instead of stocks, PE investors will get equity, mostly equity of unlisted enterprises. Obviously, PE must get close connection with real economy, which makes it a prominent part of industry as well.

Basing on this, we can see that PE all over the world, both the original form in America 50 years ago and the current form in China, has an essential feature, namely its duality – it can span both the sectors of finance and industry. How come? In terms of finance, the sources of funds are all (pan-) financialized. Although PE in its earliest days used to rely on private placement, there are also PE funds which operate through public placement. For example, subsidiaries to some public funds are also engaged in direct investment. Hence both public and private placement have been financialized by their nature – they are all financial products and activities.

Meanwhile, the investment is part of the industry as well. The biggest feature of PE lies in that PE investors invest in only brick-and-mortar enterprises by purchasing their equity. All PE practices, in both narrow and broad sense, shall follow this rule. For instance, venture capital (VC), a form of PC in a broad sense, is aimed at the equity of brick-and-mortar start-ups. 

To understand PE, the first fundamental concern is to make out that PE is capital with duality which can span two sectors, which is also PE’s unique value. If PE was merely financial capital, it could never compete with banks. Similarly, if PE was purely industrial capital, it could not compete with brick-and-mortar enterprises, either. The operation of PE always involves two sectors, featuring the financialization of funding and industrialization of assets.

Distinctiveness of PE: Localization

All PE practices across the world involve two sectors, which is a universal rule in the industry. However, PE models may vary among different economies, as they are strongly localized.  

As a matter of fact, localized PE practices stem from duality as well. Since the funding in PE is financialized, it must be highly correlated with the financial systems of the countries where the businesses or agencies work. Meanwhile, the financial systems in different countries are strongly localized. As PE is targeting brick-and-mortar enterprises and their equities, and enterprises and their businesses vary greatly among regions. PE, in terms of assets, is thus also localized. 

Due to its localized practices, PE has different development models. There are two fundamental ones. The first one is called American model, or “A model”. PE was conceived in America, which boasted an advanced financial system and a mature environment for the real economy. PE began to develop against that backdrop, starting with leveraged buyouts—these people are “barbarians at the gate” I have mentioned before. This is the A model.

The second one is China Model, or simply C model. PE first appeared in China 20 years ago. At that time, the status in China was completely different from those in America: China was developing rapidly, with a premature financial system, and the facilities for leveraged buyouts were yet to be made; meanwhile, the first generation of entrepreneurs were still in their positions, so it was hard to acquire those enterprises. Therefore, different from A model, C model started with shares investment in growth-oriented companies, instead of M&As.

The development and progress obtained by China’s PE industry through practices are highly correlated with the theoretical issues mentioned above. PE agencies will get more opportunities if they have deeper understandings of critical theoretical issues. For example, some state-owned enterprises, with net assets of some ten trillion yuan in China, are waiting for mixed ownership reforms, and the Belt and Road Initiative is about to facilitate overseas M&A worth trillions of yuan – PE will play an important role in all these fields. Meanwhile, various strategies, including promoting the supply-side structural reform, industrial transformation and upgrading, as well as preventing investment from being diverted out of the real economy, cannot be implemented without PE. All this will provide a larger stage and more opportunities for PE investors. Therefore, PE agencies equipped with solid theoretical foundations are able to meet the challenges and seize the huge strategic opportunities.

Three Stages in China’s PE Industry: Growth, IPO, and Consolidation

Next, let’s talk about practices.

Over the past 20 years, China’s PE industry has experienced various stages: the first stage from 2000 to 2008 is; the second stage from 2009 to 2013 is; the current stage as the third one.

As I have mentioned, the first stage featured C model, during which PE investors were engaged in shares investment in growth-oriented companies. It was the introduction stage for PE in China. Most market players were foreign-backed, with a few Chinese agencies competing with them. They made investments by buying into shares of leading enterprises with excellent market performance and rapid growth. This was the core profit model in PE industry: PE investors chose leading enterprises, especially enterprises like Mengniu Dairy, Yili Group, and Shuanghui, and they managed to become their shareholders to obtain a share of their high-growth dividends.

The advent of the second stage was directly related to the development of China’s capital market, especially as the reform of non-tradable shares in A shares was completed and the Growth Enterprise Market was officially launched. From 2009 to 2013, the growth-oriented investment model in China’s PE industry was optimized to some extent, and it began to include the businesses of IPO. Hence it was transformed into the so-called pre-IPO model, which featured the core profit pattern of “growth + IPO”. During this period, mane China-based PE agencies including JD Capital enjoyed their growth. From then on, PE agencies were involved in the operation of many pre-IPO companies, and investments made at that time were all delivering decent returns for PE agencies. 

The time of pre-IPO model has passed as well. People are no longer engaged in PE practices in this way in China. Since the year of 2013, dramatic changes have taken place in the external environment for China and its domestic economic growth mode. Hence the current PE model in China is different from the previous one as well.

Since 2014, the period of high-speed economic growth for China has been over. Both typical growth-oriented investors and pre-IPO investors could no longer dominate the industry. China’s PE industry has entered the third stage, which is dominated by consolidation-oriented investment. In my view, it features a core model of “1+N”. To be more specific, the investors will help the leading companies or quasi-leader (i.e. “1”) in a subsector to perform industry consolidation by acquiring other enterprises (i.e. “N”) and become a leader in the region and China, even all over the world. Right now in JD Capital, we conduct the “Emerging Industry Leaders Program” to support the strategy, with the “1+N” model as its core. Actually, in many industries, we can take the initiative to create a leader, namely to create the “1” by consolidating the “N”. This is the dominant model in China’s PE industry at present. 

If any of you would like to be engaged in PE businesses, I believe that the “1+N” model is exactly what we shall turn to. Moreover, if you are unable to promote industry consolidation, just quit PE. Actually, the theories I have mentioned before are strong enough to support the progress of China’s PE industry at this stage. The consolidation-oriented investment model requires both more industrialized PE and a wider range of financial approaches.

In the future, China’s PE industry may be gradually transformed into the A model dominated by leveraged buyouts. With further decline of China’s economic growth, the financial system will be more mature. There will be more financial approaches, and a number of first-generation entrepreneurs will retire from the leadership, for which China is quite likely to embrace the era of leveraged buyouts. Nevertheless, I believe this would happen in five or even ten years. At present, instead of leveraged buyouts, the sector is still dominated by industry consolidation, namely to promote industry consolidation with the “1+N” model and create industry leaders.

That’s all for my views and summaries of the PE industry. I hope it could be some help to you. Thank you!

About the 2017 Tsinghua PBCSF Global Finance Forum

Hosted by Tsinghua University (THU) and organized by the PBC School of Finance (PBCSF) and the National Institute of Financial Research of THU, the Tsinghua PBCSF Global Finance Forum is a distinguished academic gathering for renowned scholars at home and abroad. From a global perspective, the forum orients itself as a high-end, prominent and leading-edge event, it integrates situation analysis, policy interpretation, proposal discussion, and academic research together, and seeks to be the most powerful and influential financial forum in China.

As a representative of the world's emerging economies, China has been in the spotlight especially since embarking on a new round of economic reforms after the Third Plenary Session of the 18th CPC Central Committee. The forum focuses on the new thinking, new trends, new practices, and new dynamics of China's financial reforms. It features three major themes: China and the world, reform and practice, and academic research and practical work. Moreover, the most prominent professionals all over the world are invited to the form to analyze, interpret, and predict the financial development in China and the world, so as to figure out the future path of China’s economic reform and development.