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A decision by private equity firm Carlyle to sue its own portfolio company in China, ATMU, for $369 million after the latter missed a four-year IPO deadline is a striking example of growing problem in China – how to get out.
Private equity firms are wrestling with ways to whittle down a record overhang of companies due for sale by thinking up new and creative ways to sell out.
Funds are seeking to harvest a bumper crop of investments they made when China was growing at break-neck speed. But they are finding it no easy task as the country’s regulators tightly control the spigot of IPO supply to investors in the wake of a local stock market crash in 2015.
The unrealised value of private equity firms’ portfolio companies has risen to whopping $300 billion across Asia Pacific as of June last year, from $66 billion in December 2008, according to data compiled by investment bank Nomura. Funds usually prefer to invest, boost the value of the company quickly, then swiftly return the capital to their own investors, known as limited partners LPs.
Carlyle bought ATMU, an automated teller machine operator in China, via its Carlyle Asia Growth Partners IV fund back in 2010. The fund made four investments that year totalling $140 million. A Carlyle spokeswoman declined to comment further.
The Cayman Islands’ Grand Court has listed the hearing for January 20 according to a spokeswoman for the court’s Financial Services Division.
To be sure, some funds are managing to thread the needle. Bain Capital had a record year of exits in Asia in 2016; it created about $1.2 billion of liquidity for its LPs by selling five companies– half of its portfolio in China.
“There’s a virtuous circle – you build great companies then exits are much easier,” Stephen Pagliuca, a managing director at Bain Capital, told FinanceAsia in an interview.
It is not that other private equity funds have been lazy; active portfolio management has nudged down the average age of portfolios in Asia from their peak in 2014 of 4.8 years to 4.4 years in 2015, according to Nomura’s analysis of data.
Break-ups, dividend recaps, sale of a minority stake pre-IPO, back-door listings and share-backed margin financing are among the routes increasingly travelled by funds to exit. While these types of transactions are commonplace in more developed M&A markets – they are often ground breaking in Asia, where private equity is still relatively new.
“Private equity sponsors are being a lot more creative and using a lot more tools in their arsenal in terms of achieving realisations and returning capital to their LPs,” said Lindsay Chu, head of the financial sponsors group Asia ex-Japan at Nomura. He was speaking during FinanceAsia and Merrill Corporation’s webinar: “China Private Equity Comes of Age: How to cut the exit backlog”.
Backlog
The backlog in private equity’s portfolio of companies for sale has been building up steadily over recent years. That's largely because mainland Chinese stock markets, driven predominantly by retail investors, are so volatile that windows for IPOs rapidly open and close.
China’s onshore stock market crash in June 2015 exacerbated the problem. In an attempt to even out the swings in prices, the China Securities Regulatory Commission banned IPOs for several months after the crash, the ninth time it has done so, and has drip fed investors a slow supply of issuance since. The queue to IPO is hundreds of companies long.
The number of private equity-backed companies who completed an IPO in 2016 sunk to just five from 15 in 2015 and a recent high of 43 in 2010, according to data from Dealogic.
Regulators’ overweening presence in China’s financial markets has also thrown up roadblocks across exit routes and created uncertainty for would-be buyers.
If a foreign investor is deemed to have decisive influence over a Chinese subsidiary then the portfolio company will be treated as a foreign company. This is very pertinent for an offshore structure known as a variable interest entity (VIE), which is commonly used by private equity firms to control companies in restricted sectors such as ecommerce and education.
“Today as things currently stand this structure is tacitly tolerated by the authorities in China, but when the Foreign Investment Law is enacted this structure will be called into question,” said Andrew Whan, a partner and head of the Asia-Pacific private equity practice at Clifford Chance.
A draft version of the Foreign Investment Law was issued in January 2015 and was slated to be promulgated by the end of 2016 by China’s Ministry of Commerce of China (MOFCOM); but most pundits predict the law will take effect in 2017.
The law is unclear on whether grandfathering will be allowed.
However, given the sheer number of companies affected, several lawyers said they believed some kind of approval system would be allowed to prevent chaos. Even listed companies such as ecommerce giant Alibaba would be affected.
“The most likely approach we believe is that there will be some sort of a validation process following the implementation of the law,” said Whan.
Another new law that has impacted private equity is the Announcement 7 tax law that was enacted in February 2015. It allows tax authorities to more widely apply capital gains tax and apply a withholding tax obligation on the buyer.
“This very much incentivises both the buyer and the seller to address the tax issue to agree who bears responsibility and who needs to file on a transaction. It complicates transactions,” said Whan.
Technology could speed up exits, but virtual data rooms have largely been limited to use in cross-border large mergers and acquisitions.
The average due diligence period for an M&A transaction has been two to five months this year, shorter than the 12 to 18 months over five years ago according to Merrill Corporation.
“Technology actually helps the seller to be more efficient in their exit,” said Nancy Yu, regional managing director Asia Pacific at Merrill Corporation, a sponsor of the webinar.
Trade sales & other exits
Private equity firms have increasingly sold their companies to other companies in what is known as a trade sale to a strategic buyer, instead of taking the more arduous IPO avenue.
In recent examples, Blackstone sold Pactera to China’s HNA for $675 million in October, while FountainVest, CrestView and CPPIB made a fast exit from Key Safety Systems in a sale to Shanghai-listed Ningbo Joyson Electronic for $920 million.
“A lot of the listed companies in China have been using their publicly listed equity as frankly acquisition currency,” said Nomura’s Chu, who has been involved in over two dozen leveraged buyouts, recaps, M&A and IPOs worth over $37 billion.
Chinese strategics are trading at an average price to earnings multiple in A-share markets of around 49 times. Looking ahead into 2017, this trend could accelerate.
“With some of the headwinds and recent curbs on money transfers out of China we may see heightened interest from Chinese buyers domestically,” said Whan.
To maximise value, private equity firms have increasingly been breaking up companies and running auctions targeting different universes of buyers for separate parts of the portfolio company.
“PE firms will continue to try to find ways to be more efficient to handle that exit process because the pressure is very real,” said Yu, who in a previous role was vice-president of portfolio management for CITIC Private Equity.
There has also been a rising number of sales to other private equity funds, known as secondary buyouts. To date secondaries have been a mainstay of M&A activity in Europe and the US where funds frequently own the majority of shares in their portfolio companies but have been relatively rare in Greater China where funds have often settled for minority stakes.
Bain Capital sold its stake in China-focused call centre provider VXI Global Solutions to Carlyle in a leveraged transaction in 2016, while TPG told HCP Packaging to Baring Asia in December 2015.
“We’re seeing much more activity with private equity clients across the region. There’s a lot more willingness by private equity funds, both on the buy side and sell side, to look at secondary exits,” said Chu. “It’s certainly an activity that is picking up.”
Lenders, keen to earn a bit more yield on their capital, have helped support private equity-led acquisitions and exits in Asia.
Permira acquired Hong Kong-based Tricor for HK$6.47 billion, equating to a steep valuation of about 15 times Tricor’s Ebitda of $55 million in 2015 and approaching seven times debt. CVC and Wharf Holding’s sale of Wharf T&T to MBK and TPG was struck at about 6.5x total leverage, according to a market source.
Private equity has also been loading companies up with debt and paying the owners a dividend across the region. Carlyle followed up the purchase of Focus Media just five months later with a $500 million dividend recap in 2013.
“The banks have been very accommodating in supplying capital for these dividend recaps,” said Chu. “Leverage multiples available to private equity funds are increasing.”
Another development has been private equity sponsors’ use of debt in the form of share-backed financing, which means putting leverage against publically listed equity stakes in Hong Kong.
The push to extract cash will continue to grow, not least because funds have raised even more capital in recent years to deploy in Asia. Before investors give them even more cash to spend, they want to see exits.
- To listen again to the webinar “China Private Equity Comes of Age: How to cut the exit backlog” and view the slides please click here.
