Cai Lei from JD Capital: From Model C to Model A – 16 Years’ Development of PE in China


From October 6 to 8, 2016, sponsored by Zero2IPO Group and, and co-hosted by Lenovo Capital, the 16th China Venture Capital & Private Equity Annual Forum was held. Elites in equity investment gathered here to analyze the trends, strategies and industry development of this era.

On the forum, Cai Lei, President of JD Capital, delivered a speech themed “From Model C to Model A: 16 Years’ Development of PE in China”, sharing his idea of China’s PE development.

The following is the speech, compiled and edited by 

Thanks for your inviting. Today I’d like to talk about China’s PE development since 2000. Though we all take investment business, we have not yet set up a unified definition of PE. PE investments mainly go to unlisted companies, but sometimes also the listed ones. We can either control or hold shares of a company; we can invest in either industries or real estates... In my opinion, there are three core features of PE investment: first, it is an active capital investment; second, it is an amphibious capital connecting with both finance and industries, with characteristics of the two fields.

The third feature of PE investment is its reliance on environment. As society keeps evolving, the humankind has gone through a path marked by agricultural age, industrial age and information age successively. Financial investment has always been a dominant factor in this path. However, we have to recognize that the financial sector is as susceptible as agricultural sector to the environment.

Two classical PE models: 

Model A (Buyouts Capital) and Model C (Growth Capital)

So what is the environment for PE investment? Actually, it is the real economy, industrial pattern, and financial market. Different PE models are created under different growing environments. 

Based on this understanding, we can say that there are two classical PE models. One is the original PE: Originated in American, PE at its early period was processed through acquisition. Therefore, I definite this kind of buyout-oriented model as the Model A (America), or the PE model of mature economies. These economies, though at a low growth rate, have gone through a century-long industrial consolidation, thus boasting developed financial systems and abundant financial tools. PE in such an environment is mainly conducted through “buyout”, that is the Model A I’ve just mentioned. 

However, can we say that Model A is the only authentic PE model? I don’t think so. Every country propels agricultural development. And the crops in America may not as productive in other countries. Only those crops that can best suit local environment grow the most profusely. So we can never ignore the local conditions. 

It is the same case with investment businesses. China also has developed a PE Model, which I definite as Model C (China). This model features growth investment. As China’s economy keeps grow rapidly, a majority of traditional industries are also developing at a fast pace. However, since the industries have not yet been well consolidated and the capital market is rather under developed, plenty of opportunities exist for growth investment. This is the typical PE model in emerging markets.

Let’s just give a brief conclusion that PE investment is highly related with conditions of the real economy and the development level of the financial market, and thus demonstrate the characteristic of “industry+ finance”. There are two classical PE models: Model A – the one for western economies; and Model C – the one for China. 

But the above-mentioned two models both represent extremeness. In fact, there is also growth investment in America and acquisition investment in China. A great deal of investment cases cannot be classified as going with neither of the two models; instead, they are conducted at an intermediate or mixed state. With the fast changing of China’s economy, industry and finance, PE investment in China has been faced with the rapid transition from Model C to Model A over the past decade.

This transformation from Model C to Model A is an inevitable trend. It represents the growing path and the future trend of China’s PE investment. 

Four phases and four investment models during the transition from Model C to Model A

The first transition phase, with the keyword as “growth”, is represented by the classical China Model. We may have all experienced this period. From 2000 to 2008, when the financial crisis had not taken place, China’s economy witnessed a golden age, the overall economic growth rate reaching double digits. At that time, the capital market was less developed. Although there were also consolidation and acquisition, they are mostly for the purpose of growth.

At this period, the key to investment success lies in the identification of industrial bellwethers. The investment to an enterprise with 50% or even higher growth rate, whether it is listed or not, would bring satisfactory returns to PE firms. This is the path-breaking period of PE investment in China, when active investors were mainly foreign institutions. It was also at that time that some Chinese institutions, like CDH Investments and Hony Capital started their businesses. Both domestic and foreign PE firms worked in an aristocratic style, doing business in five-star hotels instead of struggling in a bitter way. This period can be called a “Aristocratic Phase” of PE in China.

However, shortly after the outbreak of the financial crisis in 2008, the “Aristocratic Period” for PE investors came to an end. PE in China got into the second phase, which I define as the “listing investment phase”, or the Pre-IPO Phase. With the keywords of “getting listed” and “IPO”, this period lasted from 2009 to 2013. How did this phase come into being? I think the root cause lies in the weakening of economic growth driving force in the aftermath of the financial crisis, which in turn intensified competitions among enterprises, especially private ones. Their competition involves not only personnel, products, and sales channels, but capital, and equity capital in particular, hence the need to go public.

The opening of ChiNext in 2009, a landmark of the rapid growth of China’s capital market, conforms to the development demand of the national financial system as well as a large amounts of private enterprises. 

Though practiced in almost every economy, the Pre-IPO model is the most characteristic in China. Getting listed in China is very difficult, but the company, once getting listed, would have a high valuation. The Pre-IPO model is simple: finding an enterprise with a high growth rate and judging the possibility of getting listed. The profits model is also simple: 2*2, which refers to the doubling of its performance and valuations (price earnings ratio), hence a realization of turning 1 into 4. Actually, the results are even more satisfactory. 

In China, it is impossible for “aristocratic” investors to find a large amount of enterprises qualified for application and to judge the possibility of it to get listed on the A-share market. During this period, China’s domestic PE firms sprang up and grew rapidly. The expression “Wilderness Phase” can best describe the features of this period. However, due to the simplicity of this model, professional as well as non-professional firms all flooded into PE investment, making it a cause for the whole people. In China, Model A for all means Model A with the least revenue opportunity. 

Since 2013, although there are still some PE firms engaging in Pre-IPO, actually they are in a withdrawal period of their investment. Now China has entered the third phase during its transition from Model C to Model A. 

So what is the third phase like? I have kept thinking about this and there also have been analysis and conclusions made by professionals in JD Capital. We think we have entered a “Consolidated Investment Phase” with the keyword of “consolidation”. So why do we consolidate? Our economy growth has decreased from 8% to 6%, but the capital market keeps growing steadily. In order to secure sustained growth and success for enterprises, we have to take the tail wind of capital market and consolidate our industries.

There are thousands of enterprises listed on A-share market, including many industrial bellwethers, small bellwethers, and bellwethers-to-be. Although the relative valuation of these enterprises are very high, with a P/E ratio of 50 to 100 times, the absolute valuations are only USD 1 to 2 billion, or RMB 10 billion. Many of these enterprises are in an extremely dispersed industry, equaling to the situation in America 100 years ago. And the status of these enterprises in their own industrial chain stands in stark contrast. With a rather low level of internationalization, they mainly conduct businesses in China. 

Enterprises in this phase are also faced with bottlenecks. Should they make breakthroughs through elaborate management or grow on the basis of a consolidated industry? The latter, in my view, is a wiser choice. A horizontal consolidation in the industry would increase the market share; a vertical consolidation along the up-stream and down-stream would unblock the industry chain; a consolidation targeting at foreign market would extend the business scope; a consolidation by the traditional offline enterprises or by online enterprises would also be a good choice. All of these consolidation approaches are expected to improve the competitiveness of these enterprises significantly, and deliver a synergistic effect to boost corporate revenue and market value.

Adding “consolidation” the element to the growth and listing achievements gained in the second phase, we can have the profit model of consolidated investment. Enterprises can maintain a sustainable growth by relying on China, an economy with the world’s fastest growth speed, and gain a premium of consolidation amidst capital market bubbles. Besides, the key of this model is to giving full play to the synergistic effect of consolidation. The combination of the three elements can bring forth investment opportunities that help turning 1 into 2 and even 3. 

There are two specific models of consolidated investment: one is to consolidate the existing industrial bellwethers, the other is to create bellwethers through “roll-ups” for industry consolidation. Both industry capital and financial capital from domestic or foreign institutions can play an active role in the consolidation process.

After massive industry consolidation, I believe that, in the coming 5 to 10 years, the patterns of most industries in China will settle. The emergence of a large amount of industry bellwethers is expected to prompt the emergence of excellent PE firms. In that “Heroic Phase” for PE investors, we all have the opportunity to gain returns through investment. 

The last phase of the transition from C to A is represented by typical American acquisition investment. I call it “Acquisition Investment”, and the keyword is “leverage”. Now some investors have already been acting like “barbarians at the door”, attracting attention from both the common people and regulatory departments. 

However, in my opinion, China has not yet entered the “Acquisition Investment Phase” featuring leverage acquisition and management improvement. 

The first reason: the first generation entrepreneurs are still at the helm of lot of Chinese enterprises, like Vanke and Gree. As long as the enterprises operate on a good condition, the helmsmen can have hundreds of followers for his acquisition decision. It is hardly possible to conduct a simple acquisition or to make any improvement after an acquisition. 

The second reason: It is mainly pure financial institutions who acquire listed companies. The most and only advantage of these institutions lies in their abundant capitals. It is unrealistic for them to be a largest shareholder and to have an operation and decision-making capability that surpasses the startup team before they acquire experiences from hundreds of industrial transactions. Therefore, these financial institutional had better to be financial investors even they had become controlling shareholders. A “barbarian” way is not welcomed under such a condition.

Though a group of Chinese PE firms have the capacity to hold controlling shares of a company, we still do not need to be a “barbarian”. So does JD Capital. All of you take transactions almost every day, so you must know that every transaction is made upon repeated communications. We better not be “barbarians” who do not even “knock the door”. Depending purely on capital is unwise. Therefore, I suggest that powerful financial institutions be financial investors or LPs of quality PE firms. 

Looking into the future, Chine will undoubtedly enter the Acquisition Investment Phase, and there will be a group of PE aristocrats, even global giants. They are calm and firm, extraordinary in their professions, influencing and even determining the future of industries worldwide.