The theme at this year’s Boao Forum for Asia, an annual nexus of politicians and businessmen sponsored by the Chinese government, was the pro-market reforms outlined last year during the leadership’s ‘Third Plenum’.
Private capital was given a high-profile role at the conference, given its potential to both help private companies move up the value chain and to modernise the management of state-owned enterprises.
But according to both private equity executives and former government officials, the current reality is that overweening regulation is hampering the evolution of Chinese private equity.
A panel discussion at Boao on the shift of private equity to buyout strategies, moderated by Jame DiBiasio, FinanceAsia’s editorial director, generated passionate pleas for more freedom.
The central government has claimed that it would regulate the private equity industry “moderately”. But the statement sounds vague and there is no clear definition of what “moderately” means, said Shao Bingren, president of China Private Equity Association and a former vice-director of the State Economic Reform Commission, an organ of the Communist Party.
Shao was once also vice director of the State Electricity Regulatory Commission. In other words, he has managed powerful SOEs.
To Chinese private equity general partners, or GPs, the current regulation is better described as stiff rather than moderate.
For example, one new requirement by the China Securities Regulatory Commission is that private equity firms are not allowed to undertake any investment unless they register with the regulator’s sub-entity Asset Management Association of China by April 30. “It’s bullshit,” Shao said.
Another rule is that GPs must now publicise quarterly reports, which not only creates an extra burden but seems to contradict the very spirit of letting private investors get on with their business, Shao said.
“There are many restrictions in investments, such as size of deals, type of target companies, qualification of buyers and percentage of shares,” Richard Zhang, a partner with UK-based private equity firm Apax, complained.
For Shao, the Chinese authorities regulate too much because they don’t want to give up power and the rent-seeking this power encourages.
GPs are worried that policymakers meddle in everything and leave little freedom for them. “President Xi said ‘put power in a cage’ but I see now the regulators may probably put enterprises in a cage,” Li Jiange, vice chairman of Central Huijin Investment and chairman of Shanghai-based Shenyin Wanguo Securities, said.
Li, who was also former CEO of Capital Investment Corporation of China (CICC), has overseen some of China’s most important financial groups and was former premier Zhu Rongji’s right-hand man in enterprise restructuring.
“We are private companies, invest with our own money and take risks by ourselves. We want more room in investing freely,” said Wu Ying, chairman of China Capital Group, which specialises in the telecom and technology industries.
Let it be
Part of the problem is that China has no laws specifically written for private equity. The closest thing is the recently enacted Law of Securities Investment Funds, which, as the name suggests, focuses on securities. There are also laws and related regulatory agencies for mutual funds or other products that aren’t quite relevant for private equity.
This leads to arbitrary regulation. “We see a lot of notices, documents, even memos that we need to follow. And there are more unwritten or unsaid rules,” Zhang said.
GPs and finance experts believe that the government needs to step back and let private equity evolve more naturally, so that it can adopt longer time horizons and business models that emphasise adding value to companies rather than just piggybacking on entrepreneurs in high-growth industries.
To date, Chinese private equity activity has been dominated by investments in companies set to be brought to market via an initial public offering of shares -- so called pre-IPO investments -- and minority stakes in companies with high-growth prospects. Local funds, in particular, have maturity structures lasting only a few years.
This strategy has worked for many investors as long as the acquired companies could then list, which is how the first generation of GPs thrived.
But a combination of a slowing Chinese economy (GDP growth, though still impressive, has decelerated significantly in the past three years) and an IPO market closed by regulators for nearly two years, has burned many GPs. They have either swallowed losses or are begging their investors for extensions.
This is recasting the way private equity can add value. “With the slowdown of economic growth and some sectors going overcapacity, private equity firms have to focus on efficiency,” said Wu Yibing, senior managing director at Temasek International, which invests both directly in Chinese companies as well as in third-party GPs.
On the supply side, intense competition leads to fewer attractive target assets and higher prices to buy them. The existing model is not going to deliver the same high internal rate of return as before, although it still works for smaller GPs.
On the exit side, the fact the Chinese A-share IPO market had closed for over a year and is still waiting for further regulation updates leaves some pre-IPO investors in trouble and forces them to figure out alternative ways.
“Private equity should focus on value-based investment and take a long-term view; it’s the nature of investment,” Wu Ying said.
Buyouts are an important strategy to realise this. The title of the panel discussion was “From pre-IPO to buyouts”, reflecting the Boao organiser’s desire to see private equity mature in order to help Chinese companies at a time of economic transition.
In the West, buyouts are standard practise. By taking control, GPs can leverage their operational experience to help companies adopt new technology, raise quality and standards, boost market positioning or consolidate, enhance brands and develop customer or supplier relationships overseas. But such activity is rare in China, where private equity has mostly been about subordinating itself to entrepreneurs.
That’s partly because China lacks a professional class of managers, said Guy Hands, chairman and chief investment officer of Terra Firma Capital, and the one non-China specialist on the panel.
He said he has replaced management in 80% of the companies bought by his firm in the US and UK – to which Zhang responded that it could take 10 more years for Chinese private equity firms to achieve that.
The dearth of managerial talent in a country where ambitious people prefer to own their own companies is a trend beyond the control of private equity firms or regulators. It compounds a more addressable shortcoming, however: the lack of leverage, which GPs in the West deploy in large transactions where companies are more impacted by efficiency gains. It is a critical ingredient in deals in which private equity takes control of a company.
China’s first buyouts have already begun to take place but as take-private stories, in which Chinese companies listed overseas (usually in the US, where they have suffered reputational issues) are delisted with the aim of being restructured for a listing in China or Hong Kong. This year’s expected IPO from Focus Media is a leading example. It went through a $3.7 billion leveraged buyout last year.
These deals have used debt, or leverage, but only for the offshore aspects of these deals. The lenders may be international or Chinese banks but only involve their offshore branches.
“China’s domestic debt market is still young and cost for debt financing is too high, so leveraged financing is not easy,” Li explained.
Also, in China bank loans can’t be used to finance acquisitions. Local companies, especially smaller, privately owned ones, struggle to obtain financing for buyouts – or, for that matter, to obtain bank loans at all.
Buyouts are rare also because it’s hard to build professional and well-trained management for the acquired companies. “In a privately owned company the boss is like a pope, while in a state-owned company the [Communist] Party has the ultimate say. No one can be easily replaced or controlled,” Zhang said.
Western private equity firms would like to restructure large target companies and change their management, according to Hands.
This raised another important issue, one the panel didn’t have time to address: whether China can accept US or UK-style private equity, which really exists for shareholders alone. It is not designed to help labour or other parties in a company’s supply chain – or government.
The obvious answer is 'no', China is not ready for such a narrow approach. But as the government looks to private capital to help it either advance the private sector or help reform the public one, it is a question that will soon become less philosophical and more urgent.