Playing the long game in China

The next decade will favour thematic investors that focus on China’s evolving mid-market, says Chris Lerner, head of Asia for Eaton Partners

China is in the headlines daily making its presence felt on the world stage. If the globalisation of the renminbi, trade tariff retaliations, increasing spend on military and aerospace and surprise diplomatic moves with North Korea are not enough to convince you, then Xi Jin Ping’s removal of term limits for the presidency should at least remind us that China is playing the long game. Our lens for investing in private equity should be no different.

Chris Lerner

The traditional private equity toolkit has become something of a commodity in most markets. The buzzwords change but the core approach to mid-market buyouts remains the same mix of strategic planning, new sales and marketing initiatives, new hires, operational improvement, better financial and accounting systems, and balance sheet optimisation.

The yearn from overseas investors for buyout strategies and good old-fashioned value add in China is constant. The strategy is proven in the US where PE returns have been on a tear. Distributions have outpaced capital calls for the past few years, with consistency valued above all else – a stable team with a repeatable formula for success. How much longer and at what levels that will persist in the US is the subject of another discussion.

Starting point
While savvy fundraisers in China are happy to sell you this buyout dream, China is different. The starting point is different. The pace and depth of change is different. The skill sets to succeed therefore must also be different. Indeed, the definition of insanity in Chinese private equity is doing the same thing over and over again, and expecting the same results.

Different does not, however, imply greater uncertainty (or associated risk). Past and future are discernible and almost visibly tangible in China. Technology and the new economy are gradually replacing and transforming every industry while addressing China’s unique social and demographic needs. As investors, we therefore need a different framework for assessing opportunities across the lifecycle of an industry and its participants.

Only within that context may we then better understand how venture capital and private equity firms are adapting best practices and applying technology to drive growth and create new market leaders. Therein we may also understand why to date distributions have taken longer and been lumpier; why buyouts and control in the China context won’t necessarily in itself lead to better DPI; and, most importantly, how the next decade of outperformance and value creation in private equity will depend less on a front-end consumption-led growth story (for which one has to pay up anyway) and more on building the next generation of middle market businesses that remove inefficiencies through intellectual property driven productivity improvements.

Misleading measures
The notion that private equity in China is a winner-takes-all game is only partially correct and should not be considered a constant. A common derivative of this notion is that China has too much money chasing too few deals. There is no doubt the market has been incredibly competitive. Still, penetration rates in private equity and relative measures of capital raised can be misleading. For example, the reported numbers for venture capital appear astronomical. However, a closer look at the more than $40 billion of RMB assets under management reveals that this money is not really focused on venture capital but rather on policy and subsidies to support and transform SOEs and promote the upgrade of the manufacturing sector – a long-time bedrock of the Chinese middle market.

In reality, these funds do not compete much with the traditional venture capitalists. They no doubt have an impact. Government-led direct investment has always been a major factor in GDP. However, over the past decade, it’s been the traditional private market funds that we have seen build China’s new platforms premised on digital infrastructure and mobile technology. The BATJs (Baidu, Alibaba, Tencent and are the pillars of this backbone.

Alongside these internet giants, new ecosystems inclusive of start-ups and strategically important SOEs, and corresponding physical infrastructure have also been built. Today China already claims over one quarter of the world’s unicorns. And by no means is this stage of development over.

Most traditional VCs in China still take a B2C perspective scanning the market for new platform opportunities. The so-called TMDs (Toutiao, Meituan-Dianping and Didi Chuxing) are among this next wave of winners. In fact, in 2017, half of the largest private financing rounds globally took place in China, according to Pitchbook. This trend should continue.

Playing catch-up
Naturally, funds focused on such investments tend to result in longer holds with value drivers for performance centred on one or two key investments. However, as we look ahead, the core private markets opportunity set is shifting and arguably will expand. While it is true that consumption-led rebalancing has been in full swing and China has cut its reliance on exports by almost half in the last decade, the middle market still has a lot of catching up to do.

A comparison between the US and China is helpful in forming a clearer understanding. On the surface, both segments represent similar contributions to overall employment and economic output. However, in China the focus and composition of companies in the middle market account for a far lower percent of business services and consumer-focused business. The last 20 years have supported the rise of the private enterprise. Still, the next 20 years will see considerable turnover among those legacy companies, both stated-owned and private. Next-generation companies will be technology driven and service-oriented. Moreover, as the aforementioned new platforms and digital infrastructure take hold, new solutions and systems are being created to help adapt, organise, process and connect these pillars.

Big data, cybersecurity, mobility services, new energy solutions and business-to-business exchanges are all examples where companies are filling gaps and entering a cycle of continuous improvement. This will become the core focus for the next generation of theme-focused middle-market private equity firms.

Recasting its reputation
Additionally, the Belt and Road initiative is creating new pathways for growth beyond lower-tier cities and across 65 countries on three continents for Chinese companies to export its IP and recast its reputation from exploiters of copyright in China to influencers in copyright from China. It’s not only about new business models or products like Xiaomi, ViVo, Castbox and Kuaishou but also companies like TransferEasy that offer solutions for problems such as overseas settlement in RMB that didn’t exist before mobile payments and cross border e-commerce.

Given the persistent structural financing imbalances from the state-led banking sector (which has its own issues to resolve), private equity will play an instrumental role in reshaping the leaders in every sub-sector and region across China.

At the same time, consolidation in the old economy will continue to take place. Annual M&A transaction volume quadrupled and the number of transactions more than doubled between 2013 and 2016 when there were more than 1,600 deals totalling $212 billion. In 2017, similar levels of M&A continued with over 1,400 deals totalling $214 billion, according to Zero2IPO.

Interestingly, during the same period the number of USD domiciled private equity firms with a true middle market growth strategy and fund size have decreased both on a relative and absolute basis. The number of China private equity firms managing RMB or USD denominated funds of between $500 million and $2.0 billion are still only a little over one-third of those in the US, according to Preqin. All else equal, this vacancy in the middle should benefit private equity performance in China over the next cycle.

This article is sponsored by Eaton Partners and was first published in the China supplement that accompanied the May issue of Private Equity International.