This article is taken from our Buiness Magazine, China Economic Review.
Investing in firms in central and western China offers lower costs, faster growth and bigger risks
Investing in firms in central and western China offers lower costs, faster growth and bigger risks
In 2009, as the US auto industry appeared to be going through its death throes, an unlikely savior appeared out of the Sichuan basin. An obscure company by the name of Sichuan Tengzhong Heavy Industrial Machinery announced that it intended to buy General Motors' (GM) Hummer marque, a brash symbol of American excess.
But Tengzhong's US$150 million bid was widely ridiculed – the company had no experience with passenger cars, and the ongoing financial crisis made brash excess less marketable. Nor were central planners in Beijing, preoccupied with promoting environmental sustainability, excited by the prospect adding a notorious gas-guzzler to the national portfolio.
"We hope Chinese companies can learn more about international rules and make prudent investments," a Ministry of Commerce (MofCom) spokesman said pointedly after the bid was launched.
GM officially announced the sale on October 9, 2009, but it remained subject to government approval. Approval never came – MofCom insisted it had never even received an application – and in February 2010, the deal fell through. In a last-ditch effort to salvage its bid after banks backed out, Tengzhong set up an offshore private equity fund to woo private investors.
That didn't work either, but it did at least show Tengzhong's management was capable of creative thinking when it came to financing. The bid may have been ill-conceived, but it was nevertheless an indication of both the growing confidence and financial acumen of inland Chinese firms.
This increased sophistication is in turn attracting private equity (PE) and venture capital (VC) investors to hunt for investment opportunities in the hinterlands. Investors – both domestic and foreign – are journeying west, basing themselves out of rising urban centers in Chengdu and Chongqing, and looking for promising local companies operating nearby. What is emerging is a very different animal from its counterparts on the eastern seaboard, but it is a beast with an appetite for growth.
Going upstream
"It's developing differently," said Derek Sulger, partner at Lunar Capital Management, a PE firm that maintains offices in Kunming and Chengdu. "If you look at what's driven successful private equity in eastern China ... generally speaking, they could be companies like Alibaba, Baidu, Focus Media, Trina Solar." Many of the highest-profile deals in eastern China, Sulger notes, have tended to target startup technology or export-oriented companies.
In central and western China, such targets are relatively rare. "Obviously what's driving the economy in those areas is not startup tech deals or dot-coms or media deals. It's certainly not exporters because they're not positioned well for exports," he said. "It's more upstream primary industries like cement, steel production, domestic manufacturing, heavy manufacturing."
Such upstream industries, already enjoying significant growth in central and western China, and bolstered by reconstruction efforts following the devastating Sichuan earthquake in May 2008, received a further shot in the arm when Beijing introduced a US$586 billion stimulus package to counteract the effects of the global downturn.
While there is some debate over whether the stimulus created new projects, or simply accelerated existing and already-planned ones, the result was a infrastructure boom as workers laid road and rail into China's interior. This investment supplemented Beijing's long-standing western development policy, launched in 2000, to stimulate economic development away from traditional economic centers.
In the following 10 years, Sichuan more than doubled the length of its transportation networks, and similarly more than doubled the per capita income of both urban and rural residents. Official figures also showed an urbanization rate of just over 38% for the province in 2008 – below the national average, but six percentage points higher than before the western development policy package kicked in. Blistering growth has been the order of the day in neighboring Chongqing municipality as well – it recorded year-on-year GDP growth of 17.1% over the first nine months of 2010.
In an official interview in early 2010, Sichuan Governor Jiang Jufeng expressed strong confidence in his province's future: "Given the achievements ... of [the] western development drive, we are confident and resolved that Sichuan province will march into a new stage in the next 10 years and be the first in the western region to develop into a well-off society."
In early March, the central government set the scene for the next 10 years with the State Council's approval of a "Chengdu-Chongqing Economic Zone." Covering more than 200,000 square kilometers, the zone is intended, in the official parlance, to become China's "fourth pole" of economic growth. Following on from the Bohai Bay, the Yangtze River Delta and the Pearl River Delta, Beijing wants the Chengdu-Chongqing zone to become a modern industrial base as early as 2015, with a focus on equipment manufacturing, automobile accessories, IT and aviation.
Rebalancing act
The announcement of the zone came just before Beijing officially adopted its 12th Five-Year Plan, a major theme of which is restructuring and rebalancing – in contrast with earlier plans, which tended to favor expansion. It emphasizes the need to continue to build roads, irrigation systems, urban utilities, transport hubs, fuel pipelines and to expand the electricity grid in central and western China, as well as developing natural resources in the region.
Zhang Fang, a lawyer at Chongqing-based law firm Jingshen and a professor of commercial law at the Law School of Chongqing, highlighted the plan's potential to draw attention to that city in particular.
"[Chongqing's] development has a very strong future in terms of the central government promoting and developing western parts of the country," Zhang said. "Chongqing will continue to grow and this will be very helpful to the financial development of the PE and VC industry."
The establishment of Chongqing's Liangjiang New Area – an inland counterpart to Shanghai's Pudong district – was a notable milestone in the municipality's attempt to transform itself into a financial center.
"[Liangjiang] is one of the biggest steps the Chongqing government has ever made to attract global PE giants to register local renminbi funds," said Frankie Fang, China representative for LGT Capital Partners. "Playing a national country-wide card is too ambitious. But I think if they want to play a regional card ... it's very likely [to succeed]."
In a major coup for the Chongqing government, San Francisco-based PE firm TPG Capital announced in August 2010 it would use the Liangjiang financial district as a base to launch the US$761 million TPG Western China Growth Partners I fund. The announcement came a day after the firm launched an equally large investment fund based in Shanghai.
And TPG is not alone: The list of global PE giants with their sights on China's inland regions is increasingly distinguished. In addition to TPG's fund, the Carlyle Group was said late last year to be planning a US$761 million PE fund in Chongqing, though few details emerged regarding potential targets.
Carlyle declined to comment to China Economic Review when contacted for this story. If established, however, the fund would mark a triumphant return to the west for the firm, which had its 2007 bid for a 7.99% stake in Chongqing Commercial Bank rejected for not meeting "current relevant rules and regulations."
Changes to those rules and regulations – including simplifying the requirements for foreign investors to enter into PE joint ventures with domestic partners – have played a significant part in attracting more investment. In March 2010, Carlyle and Fosun Group – parent of Hong Kong-listed Fosun International – set up a US$100 million fund in Shanghai under new rules that allow JVs to apply for permission from local authorities rather than the central Ministry of Commerce. For investors, there is a meaningful difference.
"Of course the provincial government is easier to deal with," said James Zhao, partner at Vivo Ventures, a health care-focused PE firm that recently set up a joint venture renminbi biotech VC fund in Chengdu together with Chengdu Yinke Venture Capital, a local government-backed firm. "I think the central government ... they're very big-picture. For a single case, if you apply to the central government, you're just a tiny drop in the ocean."
Some local governments in the region go beyond simply supporting VC and PE activity. Jingshen's Zhang notes that while Chongqing has been happy to provide what he calls an "organic" environment for start ups and investors, Chengdu is taking a more active role. "In Chengdu, they are quite focused on promoting VC investment and have formed a platform for startup companies," he said.
Other government policies are more specific: Sichuan has said it intends to build IT into a US$152 billion industry in the province by 2015, and it has already enticed major international tech firms such as Intel to relocate. Industry observers said such government direction can be a useful indicator of potential targets – PE funds sometimes accept "guidance" from local governments. Following the government's lead may also help in securing support for investments.
"It helps fundraising, because when the government commits as an anchor investor it brings credibility," said Roman Shaw, managing partner at Shanghai-based DT Capital Partners.
Government involvement is not always beneficial. In other parts of China, foreign PE investors have complained that inexperienced domestic renminbi funds run on behalf of local officials are causing bidding wars by offering outrageous multiples for stakes in Chinese companies. But this is less of a problem out west, where targets tend to be more reasonably priced and competition for deals is less intense. At the same time, government encouragement is only part of the picture.
"The preferential policies to attract PE and VC are important, but what is more important is for these funds to make a profit. The chances of gaining a profit are high because western China is growing quickly," said Jingshen's Zhang.
Certainly, TPG's investments into western China have proven successful even under the old, more complicated rules – and further west than Chongqing and Chengdu. Starting in 2006, it made three investments into China Grand Automotive, an auto parts and retail venture it established in a US$430 billion deal with Xinjiang Guanghui Industry Investment, an Urumqi-based developer. By the end of 2010, China Grand Auto claimed to be China's largest auto retailer, with annual revenues of US$7.61 billion, and TPG was reported to be seeking a Hong Kong listing to raise as much as US$1 billion.
"A company based in Xinjiang, you would think, wow – it's so far away," said Fang at LGT Capital Partners. "But you can still become a national and then a global champion."
For the foreseeable future, the focus for most companies in central and western China will be on regional and national ambitions, rather than global ones. This domestic emphasis has led to one notable trend: Funds targeting central and western China increasingly are denominated in renminbi rather than US dollars.
"Five years ago, when renminbi funds were almost nonexistent, people were very willing to take any kind of currency they were able to attract," said Fang.
Today, however, renminbi funds have significant advantages: "They can be quicker, the approval process is easier, and they can do domestic listings." Renminbi funds may also have an easier time investing in certain strategic sectors, such as health care.
The appeal of domestic listings is especially strong given the more traditional industries that investors are courting in the region. DT Capital's Shaw notes that more traditional companies often perform poorly on international markets.
"On NASDAQ, they pay a higher premium for certain sectors – specifically, money-losing sectors," he laughed, pointing to the example of video-sharing site Youku.com.
There are also more practical concerns: "These companies, they are not as sophisticated as those in coastal areas ... they don't have an overseas structure ready. In order to be listed overseas, you need to have an overseas structure," Shaw said.
The rise of the renminbi fund is not coming at the expense of all dollar-denominated investments; several fund managers contacted by China Economic Review noted that they maintained both US dollar and renminbi funds in the interests of flexibility. Fang at LGT Capital argues that the currency a fund is denominated in is increasingly irrelevant.
"Entrepreneurs are getting more shrewd and sophisticated. They actually look behind the capital itself," he said. "Green paper is green paper, renminbi is renminbi – but what's behind you? What can you bring to the table? Be it US dollar, be it RMB, you have to be a value-added capitalist."
The precise definition of value-added varies from investor to investor and fund to fund, but it typically involves some level of technology and management expertise.
Amir Gal-Or, managing partner of Infinity Group – which in 2004 received the first license for a foreign-managed onshore renminbi fund – emphasized the comprehensive approach of his firm, which comes from a VC background. "We have our own IP sources, and we are experts in technology transfer, in creating joint activities with cross-border deals," he said.
Sulger of Lunar Capital drew attention to his firm's long-term outlook, in contrast with what he calls the "pre-IPO perspective" of most PE investment in China. A forestry venture that harvests fast-growing pine trees in Yunnan province to make plywood and woodchips is hardly the stuff of dramatic earnings multiples, but nonetheless has excellent long-term potential, he said.
"I very much look forward to building that business, making it generate more cash flow and just being involved – watching how it grows and maybe helping it to grow better."
For its part, Beijing is also concerned about management and healthy growth – but of the private equity industry itself. That could pose some difficulties for investors as policy makers, struggling to tame inflationary pressures, look unkindly upon the emergence of new forms of financing. Of particular concern are those forms with the potential to contribute to so-called "hot money" inflows as foreign investors flock to take advantage of a rising renminbi. Thus in mid-March, the People's Bank of China (PBoC) announced it would extend its regulatory oversight to cover PE.
The relatively low levels of private equity investment in central and western China may help to insulate the region from regulatory meddling for the time being, but investors should be aware that there are some good reasons why most PE still sticks to the coast.
"The west has an advantage that prices are still competitive when it comes to industrial locations – the land is less expensive, and [so are] salaries. So you do have a 'Going West' mentality when it comes to large cost structures," said Infinity's Gal-Or. "But the question that always comes to mind is talent, or middle management, which is in shortage in China in general, in the west a bit more."
Particularly given this difficulty of securing talent, some observers are more skeptical of the utility of basing funds in Chongqing and Chengdu instead of Beijing and Shanghai when targeting inland areas. "I personally don't see any advantage because you still need to get on the plane," said Rocky Lee, head of the Asia practice of law firm Cadwalader, Wickersham & Taft in Beijing.
Other fund managers and industry observers confirmed that despite small differences in specific policies – in January, Shanghai launched a Qualified Foreign Limited Partner scheme to allow certain overseas investors to make PE investments in China – there is little practical difference in the economic incentives given to foreign or domestic investors in the different cities.
But in part because private equity is still a new phenomenon in the region, others remain convinced of the importance of physical proximity – and Lee admits that cultural familiarity could be a real advantage.
Zhao notes that the majority of Vivo Ventures' deal flow comprises proprietary deals brought by its local partner and local governments. Being on the ground, he says, is key: "It gives you access to the company, and to sit down with the company's CEO, talk about the investment opportunities."
Fang concurs: "If you can roll up your sleeves and walk into these fourth- and fifth-tier cities, you can find good deals."
Even if Chongqing and Chengdu are not the final destinations, with their relative nearness to new booming markets in China's rapidly urbanizing central and western areas, they remain enticing platforms for private investors looking for growth opportunities as opportunities in first-tier markets dry up.
"I think that a good sign of whether you're needed is whether the market is flooded with competition or capital," said Sulger of Lunar Capital. "And it's been very clear to me that central and western China are flooded with neither."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.