China GPs hopeful on exit routes

Pressure for alternative exits is building despite the recent IPO thaw.

The Chinese private equity and venture capital industry is facing tremendous pressure to exit, and is entering “an era of divestment”, according to a recent report from China-based research group Zero2IPO. 

In China, private equity and venture capital firms have made a cumulative 15,000 investments to date, but have exited only about 3,000 deals, the report said. For funds established after 2008, about 90 percent of LPs haven’t got back their principal investment. 

Exiting investments continues to be a problem, even though China’s domestic listings have been restarted. The backlog of 700-odd companies will create a long waiting period for exits through IPOs, according to a recent survey report by Ernst & Young.

However, sentiment toward trade sales and secondary transactions in China is increasing. In the E&Y survey, 81 percent of respondents expected trade sale opportunities in China to increase in 2014, compared to 74 percent for IPOs and 69 percent for secondary sales.

Trade buyers have always been active in China, with $262 billion in overall M&A done in 2013 across 3,749 deals, according to Thomson Reuters data. However, private equity was only involved in $8.5 billion of the M&A activity (157 deals). 

Private equity finds it challenging to compete with deep-pocketed corporate acquirers, particularly on control deals. But that may be changing as corporates are increasingly viewed more as acquirers of private equity assets. In E&Y’s recent study, only 40 percent of respondents found competition from corporate buyers challenging compared to 79 percent the year before. 

Sentiment toward secondaries, likewise, continues to rise, but there are obstacles. Derek Sulger, partner at Lunar Capital, believes 70 percent of China's domestic private equity deals are fatally flawed for various reasons. The remaining good assets hold promise, but the difficulty in acquiring them is due to tension between the founder and minority shareholder, who is often private equity with a guaranteed IRR. 

“There’s often a conflict between a private equity investor who paid too much yet has some preferential rights that act as enormous roadblock to the founder,” Sulger said, speaking at a recent industry event in Hong Kong. 

“The private equity firm wants its guaranteed IRR. The founder probably holds the majority, but if he goes forward with the deal he gets a minority of economics. The deal can go forward without the founder’s support, but that’s not a good position to be in.”

He said his firm was approached by founders who would like to sell their businesses, which they believe have plateaued and have little prospect of going public. If the founder is bought out at a specified price per share, he would then see to it that the minority investor sold out at a smaller amount per share. 

“At least five brand name transactions have approached us with that pitch. It’s a sign were driving toward freer flow of secondary transactions,” Sulger said.