Riding the China buyout wave

Adapting a US buyout model to China requires patience, local know-how and a willingness to learn from mistakes, says Yichen Zhang, the founder of CITIC Capital

CITIC Capital, the winner of Firm of the Year in China in the 2017 Private Equity International Awards, pulled off a string of notable deals last year including the acquisition of the McDonald’s franchise in China and Hong Kong. Founder Yichen Zhang and senior managing directors Eric Xin and Boon Chew tell Carmela Mendoza how the Hong Kong-headquartered firm is reaping the dividends of early mover advantage in China’s booming buyout market.

How has your China buyout strategy evolved?
Yichen Zhang: We started our buyout strategy in 2002. In retrospect, that was too early – we were left trying to force a strategy onto a market that was not quite ready for it. We did deals that were challenging, but persevered to strengthen our team and build an operating talent pool. Now, everyone is talking about doing buyouts in China and we have an early mover advantage as it takes at least one fund cycle to build a team.

Yichen Zhang

GPs in China are shifting to buyouts as fund sizes increase. How do you position yourself in the market?

Boon Chew: The market for China buyouts is not yet that competitive. Pan-Asian players compete, but if it’s a China asset, we are much better resourced locally. All our operating partners are China-focused and we have a much bigger footprint than any of the pan-Asian firms.

Eric Xin: The Chinese buyout market is large enough for a lot of players but needs more players to educate it. We are privileged as we have a long history and more buyout experience than our peers. We know how to control companies, make money and deal with difficult situations. We have also made mistakes, learnt so much and accumulated a lot of unique experience. Moreover, in the last 15 years, we have recruited close to 100 executives for the companies we controlled – the pool becomes a base for our operating partner programme. More importantly, we have built a team that is consistent in evaluations of companies and know the right time to exit. This is a critical success factor in private equity.

How has your experience helped?
We look at deals from a totally different angle from growth, venture or minority shareholding deals. With McDonald’s, for example, we needed to know how to incentivise the management team. We helped them grow stores and we implemented digital payment systems.

YZ: It always comes down to brands and people. With each of our deals, you can see the trust and comfort that our team has developed with the portfolio company. There are a number of Chinese players that have a good brand, but I’m not just talking about the language. It is more about how to run an international business professionally.

What’s the secret to adapting a US or European buyout strategy for China?
Buyouts make up over 80 percent of overall deal value in the US and Europe. The number is much smaller in China but as the economy matures there’s no doubting the direction it is going in. And because we’ve been focused on buyouts all along, the wind is behind us. We are taking a lot of the Western know-how around buyouts, localising it and adapting it to China.

Boon Chew

Successful buyout groups in the US and Europe know how to evaluate management teams and change them, how to dictate strategies, monitor their portfolio companies and bring operating resources to bear. They also have the expertise to execute more complicated strategies like corporate carve-outs and roll-ups. Not many private equity firms have the resources to do all those things, but I think our firm is already at that point today. We have the people who have the mindset, the confidence, comfort level and support system internally – we don’t need to be reliant on others to dictate the strategy or direction of the business. That’s what we are continuing to build within the firm.

How do you add value to your companies?
It’s all about China. If you look at CIBTvisas, for example, it is by far the largest B2B visa processing business in the world. CIBT processes over 1.3 million visas a year. The entire American market – CIBT’s largest – processes eight million visas a year. CIBT had no presence in China until we invested in it in May 2017. Today they do and the Chinese market now is almost six times larger than the US.

The opportunity in China is so large and prominent that CIBT management wanted an investor who could give them access. That’s where we add the most value in our cross-border acquisitions – defining the right strategy and bringing in the right resources and relationships.

EX: Before we invested in the leading mattress manufacturer King Koil, it was pretty much a B2B business: 65 percent of its business came from hotels and retail only accounted for 35 percent of revenue. When we invested, the company was struggling and growth was slowing. Our team turned it into a retail player, opened 200 stores in two years, streamlined its supply chain, created a retail brand on shopping website Taobao and built a new strong team driving retail sales. When we exited, retail business accounted for 65 percent of revenue, EBITDA had doubled in two years and we exited at much higher multiples.

How do you get the best deals overseas?
First, it’s down to the brand. In the case of McDonald’s, for example, they wanted to continue the business and find the right partner for the franchise. The negotiation was not about pricing – we put in a very reasonable bid and in the end EBITDA grew by 36 percent, so we actually paid an even lower multiple. The company did not negotiate with us on price, they just wanted the right partner, and they wanted CITIC Capital. That was very clear.

Deal certainty is also a concern. Each of these deals goes through anti-trust reviews in China and other regulatory reviews. With us the deal certainty is a lot higher. For McDonald’s, we promised within six months of signing we would close the deal, and we did exactly that.

You put all that together, and that’s a huge advantage for us. That is why we get the deals and we don’t overpay.

Has CITIC Capital experienced any challenges with the acquisitions made overseas?
Not really as we’re not looking to do deals in sensitive industries. Our deals in the US and Europe are mainly in consumer-related businesses.

For us the main challenge is finding assets that suit us, where we feel that there is a viable and tangible China value creation opportunity and where our involvement is a real differentiating factor in the deal.

The key challenge is filtering through that dealflow and identifying deals where we truly believe we have the network and resources to be a differentiated buyer for that asset.

What’s behind the cross-border strategy for your third fund?
A lot of the deals we did in Fund II were deals where we had control but were partners with existing owners. In Fund III, we are doing a lot more “China buyout 2.0”-type deals, where we take 100 percent of the company. A big part of that strategy over the last 12 months has been corporate carve-outs. We have signed or closed five corporate carve-outs in this fund, four in the last 12 months. For McDonald’s, Wall Street English, Global Marketing Intelligence Division and LifeStyles, these were buyouts of China businesses from multinational companies. One of the things we found is that there’s an international element to a lot of the deals we are doing now, either where we are dealing with a multinational company when we are buying their China businesses, or, for example, with condom manufacturer LifeStyles, most of the EBITDA comes from China although the company operates in many countries.

We realised that to have the full suite of capabilities and to go after deals like these, we don’t only need the China know-how, we also need the international presence and team who can work with management teams outside of China. I think that’s a key synergy that we saw from the combination of our US and China teams.

Tell us more about integrating your US and China deal teams
YZ: We thought the combination of the teams was a natural move, that putting the team together makes sense because the China team is more sector-focused, and the US team more transaction-driven. We said that if we combined the two, we will have a deeper understanding of the investment opportunities. The two teams merged seamlessly together and now look at deals jointly from due diligence to strategy execution and exits.

BC: We combined the US and China teams formally when we raised Fund III but that process started a couple of years earlier. If you take a look at what CITIC Capital has done in the US historically, we have done a lot of roll-ups. For us, taking that know-how and expertise from our deals in North America (where it is quite common) and applying it to the China market is another synergy we are starting to see. I think the buyout market is going to continue to evolve and become more complex in the next couple of years and we need to make sure we invest in the right resources to be able to go after those more complex strategies.

How did your LPs respond to this?
I think LPs have been happy with the integration. If you take a look at the deals we have done for Fund III, we have built a compelling portfolio. Four China carve-outs from listed MNCs in the last 12 months is sizable even by US and European standards. And we are not buying them for big multiples. If you take a look at our current portfolio and blend it together, we are buying assets for single digit EV/EBITDA with double-digit top line growth and EBITDA growth of over 20 percent. These are all cashflow generative, market-leading businesses in high-growth sectors in China – it’s a pretty compelling portfolio.

Eric Xin

Yichen Zhang, founder, chairman and chief executive of CITIC Capital, established the firm in 2002. Under his leadership, CITIC Capital led a number of landmark deals, investing in some of China’s leading companies, including Alibaba, Sina, Harbin Pharmaceutical, SF Express, AsiaInfo and Focus Media.

Eric Xin is CITIC Capital’s senior managing director and managing partner, responsible for private equity investments in China. Prior to joining the firm, he was a management consultant at McKinsey & Company.

Boon Chew is a senior managing director and managing partner at the firm. Prior to joining the firm, Chew worked for Morgan Stanley, Whitney & Co and UK private equity firm Charterhouse Development Capital.

This article was sponsored by CITIC Capital and first appeared in the China supplement which accompanied the May edition of Private Equity International.