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Private equity in changing. But, from what and into what? This is a question not only foremost on the minds of the publicly-traded PE firms Carlyle, Blackstone and KKR, but also at big investment banks like Goldman Sachs and Morgan Stanley, where principal trading provides a steady, sometimes large, source of profits.

Over the last week, I had an email discussion with a managing director in China of one of the world's five largest private equity firms. He wrote to tell me about the fund's recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China. I'll share an edited version here. I've taken out the firm's name and any references that might make it identifiable.

The PE industry in China has grown from basically zero a decade ago into the world's second-largest based on capital raised and invested. What happens to private equity industry in China will impact not only the traded PE firms, but large institutional investors, sovereign wealth funds and US pension funds that have also poured bucket-loads of money into China.

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn't just reply, "sounds fine to me".

Here's my view of it, after a day's thought. If I didn't know it was from [your firm], or didn't focus on the larger check size, I'd say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys - you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that's your opportunity, to be the " thoroughly professional, experienced, global, proper fiduciary" version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group, can gain an IPO in next two years. The English idiom here is "making yourself a hostage to fortune". In other words, the only way a PE could consistently achieve the goal of "IPO exits within 24 months" is based more on luck than planning and deal execution.

If you asked me, I'd think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It's kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can "free ride", to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn't change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don't cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can't be faulted. In a nutshell, it's "Get in, get out, get carry and get new capital allocations from one's LPs."

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don't see them. I'm just one guy feeling the elephant's tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically, to raise outside PE money from a dollar fund at a discount to public markets. Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That's the part I'll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you're someone who looks at deals through a special, somewhat contrarian prism. Your firm's new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We're finishing up now a "What's ahead in 2014″ Chinese-language report that we'll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database. I'll send a copy when it's done. You'll see we're basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors. Your role: supply the fuel, supply the ammo.

Source: Private Equity In China: It's Changing, But From What? Into What?