China’s economic slowdown is prompting private equity firms to change their tactics to maintain returns in the country, with one suggestion being to push banks to provide more leverage, finance recapitalisations and to take more control of portfolio companies themselves to push through changes.
“With the slowdown in economic growth, being a passive minority investor in an unlevered company is a pretty hard way to make private equity level returns,” said Stephen Peel, co-head in Asia for US private equity firm TPG, at the SuperReturn Asian 2013 conference in Hong Kong last week.
KKR announced its first majority-owned investment in China on Tuesday. The US firm said it will invest $140 million over the next 18 months to build two dairy farms in China alongside CDH Investments and milk producer Modern Dairy. KKR, CDH and Modern Dairy will hold 61.5%, 20.5% and 18.0% stakes respectively. KKR will be making the new investment through its China Growth Fund.
There have been very few cases where private equity have been able to secure control of a company in China nor conduct leveraged buyouts in China. Private equity firms have made most of their money taking small stakes and piggybacking off economic growth spurring revenue growth. That model is now looking increasingly flawed.
“We need to find deals where we can get greater control than we have historically and where we can use more leverage to drive down the cost of capital and push up equity returns,” said Peel.
The challenge private equity firms face is that, in China, onshore acquisition finance is not permitted. Instead, funds have to find financing offshore, which is tricky when most of the companies' assets that can be used as collateral are on the mainland.
“It’s a long way off the efficient buyouts you see in North America or Europe,” said Peel.
Another method is to find a company that is already levered. TPG invested in Shenzhen Development Bank, which as a bank already has a highly geared balance sheet because it makes loans as a business. TPG still owns a leasing company called Unitrust, which is levered about 8:1 said Peel.
“We are looking more and more for businesses that inherently have leverage,” said Peel.
Carlyle’s co-head in Asia, X.D. Yang, who started in the private equity business in 1995, sees the Chinese buyout market evolving rapidly, spurred by the Chinese banks.
“I see evolution happening quickly in the next three to five years,” said Yang during the conference. “Once one or two of model deals get done then the rest of the market will follow.”
Yang was speaking after Carlyle recently completed China’s largest ever leveraged buyout, the $3.7 billion privatisation of US-listed Focus Media Holding.
Carlyle Group and China-based FountainVest Partners helped the display advertising company’s chairman Jason Jiang take the firm private and own 19.7% each.
“Lining up financing for the deal took quite a while,” said Carlyle’s Yang.
It was complicated by the fact that the financing vehicle was offshore and the cashflow from the business was onshore in China. “That took some education.”
“In the end the Chinese banks provided the majority of the financing,” said Carlyle’s Yang.
The banks providing the $1.5 billion loan included China Minsheng Bank, Industrial & Commercial Bank of China and China Development Bank, alongside Western banks. They then parceled out $1.08 billion of the loan to other banks.
“The Chinese banks clearly viewed leverage finance as a business that they have been studying for years and this was a test case,” he said.
“The next step is to educate the Chinese banks how to do a dividend recap,” said Carlyle’s Yang. “It’s a tried and true model in other markets, but Chinese banks need to be convinced that the shareholder can take capital out of the company while the banks stay put.”
A dividend recap adds more debt onto the company in order to pay its shareholders a dividend.
Ming Lu, regional head for Southeast Asia, KKR agreed that private equity’s minority investment model in China is looking increasingly flawed due to the economic slowdown. However, much as KKR would like to take control of top-tier businesses in China and lever them up, it is not always possible.
“High-quality businesses are not for sale in China, particularly for control,” said Lu.
Therefore he thinks: “Minority growth equity investment will remain the mainstay for the forseeable future.”
