June 25, 2014
Interviewed by: David Snow
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China’s IPO-Challenged Private Equity Market

Three veterans of the Chinese private equity market discuss the current state of play, including how GPs can no longer rely on the IPO market as a creator of value.

Three veterans of the Chinese private equity market discuss the current state of play, including how GPs can no longer rely on the IPO market as a creator of value.

China’s IPO-Challenged Private Equity Market

Private Equity in China

David Snow, Privcap:

Today, we’re joined by Rob Petty of Clearwater Capital Partners, Ben Fanger of Shoreline Capital, and Bob Partridge of EY. Gentlemen, welcome to Privcap. Thanks for being here.

All of you are participants in the Chinese private capital market. It’s a huge market, huge opportunity, so I’m thrilled to have you here.

I’d love to hear what is going on from your boots-on-the-ground perspective, starting with Rob Petty. You invest across Asia, but you have a huge practice focusing on China. Let’s start out at a 1,000-foot view: how would you characterize today’s private equity market in China?

Rob Petty, Clearwater Capital Partners:

Thanks, David. Pleasure to be here. It’s so hard to characterize China in short sentences but it’s worth saying that, from our perspective, the industry’s in its second generation. It now has a seasoned group of experienced GPs who are Fund Two and Fund Three, so we have hit the maturation point in terms of the development of the industry.

At the same time, part of that reality and the biggest topic is the difficulty around exits. As the markets have been difficult, particularly for equity exits to the past three years, who are mature managers able to manage through that? We are excited about the fact that the market’s gotten to be that second stage, but we should recognize that exits and development and creating liquidity are the dominant question marks in what is also a difficult economy for the past episode in China.

Ben Fanger, Shoreline Capital:

Rob makes a very good point, which is what was planned to be the channel of exits has not for the last few years and that’s the IPO market. Some strategies don’t rely on the IPO markets as their exit. We certainly don’t and we have returned capital to our investors, but none of it has come from the IPO market.

There are strategies within the private equity space that work in an environment where the economy is decelerating. Certainly ours is not the only one and it’s not only distress debt or credit. That’s a strategy that works but there are strategies within the equity side of things that could work in that environment, too. But it’s requiring managers who can do something other people can’t do and actually add value to the investments they make.

Bob Partridge, EY:

Certainly, this year the market’s been fairly robust. We’ve been involved in exit planning from a value-creation standpoint, but the new investments are coming on very strong this year. Year to date, the first four months, we’ve been involved in over 70 private equity deals in China. Now, many of those haven’t closed yet, but the investment appetite’s very strong, though part of that’s because there is the belief that the exits are coming.

Even though the public markets have really curtailed the number of exits, the confidence levels coming in this year have been strong.

On top of that, we’ve had two years of a lot of the principles focused on value creation. While you’ve got the overhang of investees out there on the portfolio, they’re now starting to turn the corner and with the confidence levels in the broader market, we’re starting to see a more positive environment in terms of flexibility of exits.

Petty: In that second generation, people really have developed operations teams and there are some great case studies of building value within businesses, building management teams and the like. Also, value investing, right?

For those of us who think contrary in whatever our strategy might be, there’s a large number of well-capitalized GPs taking advantage of the tough economic environment that is the reality on the ground and putting money to work. Both of those points are very well said.

Partridge: Rob, I would add, it’s the first time in 15 years that I’ve been in China that I’m seeing GPs feel confident to tell LPs “Let’s hang onto the investment a bit longer. The value’s there.” There’s an opportunity to exit perhaps at a lower valuation, but that path they’ve created for value creation is starting to come to fruition and we’re seeing a lot of confidence from GPs as well.

Snow: In the period leading up to the economic slowdown, how important was the IPO market as a place to monetize one’s investment? Did the robustness of that market tend to downplay the need to do anything operationally smart with these companies? Anyone?

Petty: There’s no question IPO was the dominant exit plan and, again, not being that classic-growth PE guy, I think the focus on operational growth of your business has been De minimis until the most recent past. Historically, that strategy has changed and changed rather notably in the past five years, if not three years.

Fanger: At this point, nobody knows what’s going to happen to the growth rate of private equity managers because we haven’t been through a period where they actually had a difficult environment. The last couple of years have and they can, like Bob said, tell their LPs, “Actually, we should wait to exit later.” But that could also be they can’t exit right now, at least not at the three “X” that they told the LPs they were going to be getting, for sure.

It’s an environment where everyone was doing the same thing; there were a ton of R&B investors. You hop in a taxi these days and the taxi driver has an R&B fund. It was an environment where everybody was doing that. So, on the entry side, the valuation—we’ve never done a deal where there’s competition in China because it just erodes the terms you can negotiate.

Snow: Bob, without naming names, do you detect there are groups that are waiting for the good times to return and maybe have not sharpened their focus?

Partridge: I think there are. Ben’s comment about consolidation is occurring. There are going to be more players that fall out. We’ve certainly seen some challenges in the fundraising efforts by what I would call “unseasoned” PE teams. There are a lot of PE professionals out there who might have had a good track record at a house they were at who have been out there, raised the fund a couple of years ago, haven’t deployed it or deployed it and haven’t returned it yet, and are much more challenged with the shutdown in the IPO markets. We’re starting to see those players not able to raise additional funds and more pressure from the LPs to cut back on those opportunistic new PE funds that are formed. Even exclusive of the taxi-driver RMB funds, which are starting to slow down a bit.

Over the next two to three years, we’ll continue to see some smaller players that really don’t have not just track records of returns but, as Rob said earlier, the ability to differentiate themselves from an operational standpoint and create value because you need to sustain when IPO markets suddenly go away.

I’m from the U.S. I always believed IPOs were an opportunity. You get to China and it turns out it’s a strategy. The last couple years have really helped people turn that around. It’s very opportunistic and the players who will survive the consolidation are the ones who are really focused on operational improvements and long-term growth enhancement, not short-term flips.

Expert Q&A

With Bob Partridge of EY

How does EY help private equity firms invest successfully in China?

Partridge: With private equity in China, EY really helps deliver superior returns, whether it’s helping originate deals at the front end or helping execute from a diligent structuring standpoint, to value creation once investments are made, to exit readiness, to audits of the investees, to tax and consulting advice, we’re there from the front end of the landscape to exit and beyond, helping private equity deliver superior returns.

One thing about EY that differentiates us is we’re very passionate about private equity in China. Certainly, others are too. But, if anything, we’ve overinvested in this space. Having worked on about 200 deals last year, and 70 in the first four months of this year, the ability to predict what we’re going to see next and help GP’s get through the execution landscape quickly, assess what kind of things they need for day-one readiness, and start to put their eyes, for those deals that are going to close, on value creation—that’s what sets us apart from our competitors.

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