How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital's latest research note. An abridged version is available by clicking here. Titled, "Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity" the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.
This new report is, like the two preceding ones (click here and click here) the result of China First Capital's path-breaking research to measure the scale of the problem of unexited PE investments in China, and to illuminate strategic alternatives for GPs investing in China. China First Capital will publish additional research reports on this topic in coming months.
As this latest report explains, "these [hold period and investment return] models tend to support the thesis that "Quality Direct Secondaries" currently offer the best risk-adjusted opportunities in China's PE asset class." Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.
"Until recently," the China First Capital report points out, "private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year. Those assumptions on valuation differentials as well as hold period are no longer valid."
There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China's still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:
- Trade sale / M&A
- Secondary sale
- Buyback / recapitalization
Our conclusion is the current exit crisis is likely to persist. "Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals."
Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only, option available for a PE firm with diminishing fund life. "Buyers of these direct secondaries will not avoid or outrun exit risk," the report advises. "It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund's hold period. "
The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China "Quality Secondaries" offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.
Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.
Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure, are not available in the abridged version.