China's Private Equity Boom

Includes: MS, YUM
by: Shaun Rein

The following article by Shaun Rein of the China Market Research Group originally appeared in BusinessWeek:

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With the current credit crunch roiling financial markets, private equity firms in the U.S. and Europe are finding it hard to tap the credit they need to fund their acquisitions. According to Dealogic, the value of buyouts dropped almost 90% in the U.S., from $216 billion in the second quarter of 2007 to only $22.1 billion in the final quarter. In contrast, private equity in China continues to boom. China received $12.8 billion in private equity investment in 2007. In 2005, investors allocated only $5 billion to the country. Capital under management hit $20.5 billion last year, an increase of 40% over 2006, according to Beijing research firm Zero2IPO.

My firm, the China Market Research Group, conducted interviews with managers at several dozen leading private equity firms in the U.S. and China to see if China is likely to remain a hot market for private equity, or if the credit squeeze will hit the region, too. Our findings showed optimism for investment in China. The vast majority of respondents felt that U.S. private equity investing will remain flat or drop in 2008 while China will post 30%-plus annual growth for the next three years.

In recent years, China has been a tough market for private equity, with too much money chasing too few deals, a booming local share market causing sky-high valuations, and regulatory hurdles hindering investment in certain sectors. Moreover, investors are also worried about the lack of financial transparency at many Chinese companies. While some of those obstacles remain serious, successful exits recently by Softbank and GGV from Alibaba, and Morgan Stanley (MS) and Crescent Point from footwear manufacturer Belle International show returns can be had for the savvy investor.

Growing Middle Class Fuels Growth

The surge in private equity funds in China is supported by four pillars: the continued optimism and growth of China's middle class in spite of inflation and the global downturn, the increasing global competitiveness of domestic Chinese firms that need expertise and capital to expand internationally, the tightening of credit from Chinese banks, and the decline of China's stock market.

Investments in companies that target China's emerging 250-million-strong middle class will continue to pay dividends as the group remains optimistic. As I wrote recently (, 4/2/08), the vast majority of Chinese middle-class youth expect to spend considerably more money in 2008 than 2007. The continued optimism of households earning between $6,000 and $15,000 drives compelling investment into companies that target them.

A case in point is the fast-food market, growing at 20% annually, as increasingly busy Chinese families lack the time to prepare their own food or prefer to socialize with friends in restaurants than cook. China Capital Today, a private equity firm based in Shanghai that has foreign limited partners and closed a new $600 million fund last month, in October led a group to back Kungfu Catering. A fast-food chain that operates 261 restaurants with a $40 million investment, Kungfu's goal is to carve out a slice of what will be a $50 billion fast-food industry in China in the next five years. Kungfu has carefully fostered a clear brand message, something that just five years ago most Chinese companies were unable to do.

As one 25-year-old Shanghai woman told us, "I like eating at Kungfu because I know I'm going to get healthy, steamed food quickly every time."

Emerging Stronger from the Tainted Food Scare

Chinese companies that need capital and international expertise to take their companies global also make attractive investments for private equity firms. One example is China Minzhong, a producer of processed vegetables. To help in its global expansion, China Minzhong took funding from Olympus Capital Holdings Asia and a consortium of other investors. New York-based Olympus, which has allocated $1.2 billion in middle-market private equity investments in Asia since 1997, saw that Minzhong had lower costs than competitors in the developed world yet had implemented quality-control standards to ensure the safety demanded by Western consumers.

Bulwarked by additional capital and expertise, Minzhong has more than doubled profits in the past two years and now exports to 22 countries. Following China's tainted food scare last year, Minzhong has emerged stronger. It has consolidated market share as smaller, less well-capitalized players cannot compete in ensuring food safety.

During the Chinese stock market's bull run in 2006 and 2007, many companies demanded higher valuations. If they did not get them from private equity firms, companies decided to raise money in the public markets instead, where initial-public-offering prices regularly doubled on the first day of trading. The drop of China's market—down more than 50% since November—has changed the situation. Many entrepreneurs who could previously demand huge valuations for their companies in the public markets now are turning to private equity investors for reasonable valuations.

Changes in China's banking system also bode well for private equity. Although relatively unscathed by the subprime debacle, Chinese banks can no longer loan as much money because the government has moved to combat rising inflation by increasing the bank reserve ratio to 17.5% from 16% earlier this year. What money banks do lend tends to go to state-run enterprises first or to large private companies, leaving even very profitable private smaller companies unable to get funding from traditional sources. They are turning more to private equity to get the capital they need to grow.

The sinking stock market and the ongoing credit squeeze create a great opportunity for private equity firms to provide capital and get more reasonable valuations from fast-growing companies than has been possible in the last few years.