Derek Sulger from Lunar Capital on investing in China

Lunar Capital is an investor in off-the-beaten-track, high-growth companies in China. Founder and partner Derek Sulger explains the strategy and why he coined a Grand Hyatt rule.
Derek Sulger
Derek Sulger

What is your background?
I left my career as an executive director in investment banking with Goldman Sachs in 1999 to move to China. I wanted to be part of the China boom. My thesis was quite simple – I believed I could successfully launch a business which catered to the very nascent but emerging Chinese middle class. I decided to specifically focus on the mobile telecommunications boom. In 1999 China had 15 million mobile phone users and I was convinced this number was set to grow exponentially.

I set up three businesses focused on telecoms -- Linktone, Intrinsic Technology and SmartPay -- with my own capital, some capital from co-founders and some external funding. Linktone was among the first in China to develop and market value-added data services, which led to ring tones, virtual pets and other wireless content online. Intrinsic writes a software that allows mobile operators to receive, transmit and bill for data. SmartPay is a new way to pay bills, linking users’ bank accounts to their mobile phone numbers, enabling them to pay via text messaging.

We did an IPO of Linktone shares on Nasdaq in 2004 and all our investors cashed out with a multiple of the money they put in. We sold Intrinsic in 2005 and are still nurturing SmartPay.

Why start three companies?
Linktone and Intrinsic were based on splitting a business plan we developed for one business into two separate companies. SmartPay grew out of necessity so I’d say the businesses came out of both design and necessity.

How did you come to run a private equity fund?
I came to China as an entrepreneur but somewhere within me I think I always knew I would morph into an investor. In 2007 I felt I could use the knowledge and operational expertise I’d accumulated in the China market to identify Chinese companies which need growth capital. The investors who had backed my businesses agreed and we closed a private equity fund of $60 million. That fund was invested in six companies.

We are now raising our third fund with a target amount of $150 million. Around two thirds of this has already been committed.

Why the fascination with China?
If you think back to 1999, China was out of favour with investors post the events of 1997. At the time, investing in private enterprises was almost unheard of and there was a very limited investor community. But I was convinced that the fundamentals of China would prevail and that this was where the future was.

Who are your investors?
Initially, all my investors were people who seeded my first three companies, but over time we have grown more institutional. Currently, our investors include family offices and multi-family offices in the US and Europe, universities and endowments in Europe and funds of funds.

What is your target investment size and holding?
Our sweet spot is between $20 million and $40 million and the investment must buy us at least 20% of the target company as this gives us the control we need to effect change. We don’t have a ceiling and we own majority stakes in some of the companies we’ve invested in. But we never see ourselves being a passive minority stakeholder.

What differentiates Lunar Capital from a host of other growth capital funds?
I’d begin by saying the situation today is very different from when I moved to China. Today people want to invest in China so money is no longer lacking -- what is in short supply is sweat equity. And that is what we provide. A majority of our senior management has run businesses at some stage of our careers. We are not staffed with people with pure finance or banking backgrounds.

Also, we are a very local fund – of our 25-strong team, only myself and one analyst are non-Chinese.

How do you identify investee companies?
We are very focused. We seek out businesses in central and western China which are driven by domestic demand. One oft-voiced criticism of private equity firms operating in China is that they tend to be generalist in their approach. We are convinced the central and western China regions will benefit from a potential rebalancing of the Chinese economy. Within these regions, we look to leverage our connections within entrepreneur, industry, and government circles to source deals. Specifically, we have a focus on companies in agriculture, food and food processing, basic consumer necessities, and materials which go into infrastructure development. We see commonality of themes driving demand in these industries.

How do you approach an investment?
We try to integrate ourselves into the operations as early as possible. We begin with auditing the financials -- specifically, we spend a lot of time understanding what drives revenue and profitability for the company. Once we’ve secured these, we second some operating personnel to the company.

How do you ensure you’ve done adequate forensics?
We believe we do due diligence better than many, because our team comprises many people who ran businesses. Our investment memorandums have a section called fraud. We sit down as a team and ask ourselves, 'If we ran this company how would we commit fraud?' On average it takes us between 12 and 18 months from identifying a company to closing an investment.

How do you ensure the valuation is reasonable?
By definition, some sectors have become sexy and there is too much money chasing opportunities in these sectors. We differentiate ourselves by valuing things in an old-fashioned way – we ask ourselves how much a business is intrinsically worth. We look at replacement cost and book value. We also use DCFs [discounted cash flows] but are nervous about using multiples – we don’t believe in using relative value arbitrage.

What is your exit strategy?
We seek out businesses that can be sold to strategic investors rather than businesses which would be best sold in a secondary deal to another PE firm. Sometimes the very fact that a company is in play makes it an attractive IPO candidate, although IPOs do not drive our exit strategy – we find too many people speak too cavalierly about IPO exits.

How do you spend a typical day?
Shanghai has been my base since 1999 so generally I could either be in our Shanghai office or Chengdu office working with the team. But I still like to get dirt under my fingernails and am not someone who spends my life at my desk. I spend at least one-third of my working life interacting with companies in which we’ve made an investment or are thinking of investing in. That means travelling to Yunnan, Shaanxi, Inner Mongolia or wherever good potential investments take us.

I’ve coined something called the Grand Hyatt rule -- if there is one within 100 kilometres of one of the companies we are evaluating an investment in, we don’t pursue the deal. What this means is we seek to identify companies which may not be on the radar screen of our competitors and which it may not be easy to reach. They require extensive travel time and effort. One of our investee companies, a forestry business, was nine hours from the airport when we closed our investment. And, of the nine hours, the last few entailed driving on dirt roads. We got lucky with that one -- a super-highway came up and now it’s only two hours from the airport.

What do you see yourself doing in the long-term?
I will ultimately retire in China. I’m lucky that the China bug hit me when I was young enough to transplant myself. Infrastructure in China is developing rapidly and it is much easier to live here than it was when I first moved. I learnt Mandarin on the job so my use of the language still sometimes provokes chuckles, but I can make myself understood. I cannot see myself ever doing anything else except what I’m doing right now -- or living anywhere except China.

 

This article first appeared in the September 2010 issue of FinanceAsia magazine.

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