Cracking China’s buyout code

Weijian Shan, one of TPG's top dealmakers in China for more than a decade before leaving to chair PAG Group, talks with Private Equity International about the Chinese market.

Weijian Shan left TPG last year to become chairman and chief executive of PAG Group, whose private equity arm held a $1.7bn first close this summer on its debut Asian buyout fund, targeting $2.5bn. Although Shan declined to discuss fundraising, he talked with Private Equity International about China’s macroeconomic climate, its developing private equity industry and the pleasure derived from working on successful turnarounds.

PEI: When you left TPG many people expected you to launch an independent private equity firm; why join PAG instead?

WS:  For me it makes little difference. The key is that PAG is a leading regional platform in alternative asset management and as chairman and CEO of this group, I have the complete freedom to do exactly what I set out to do: build a best in class private equity business with a regional platform. The advantage of doing this under the umbrella of PAG is that we have a well established infrastructure, so we don’t have to build everything from scratch.

PEI: PAG’s private equity focus is on buyouts, particularly in China. But a lot of people would say that strategy is quite difficult to employ in Asian markets.

WS:  Well, you know swimming is also difficult depending on whether or not you are a good swimmer, right? China is a more difficult market for private equity in general – regardless of what you do – largely because Chinese economic growth does not necessarily translate into profitability or performance by companies.

Comparing China’s economic growth in the past 10 years with stock market performance during the same period does not necessarily show a positive correlation; in fact, if anything, there seems to be a negative correlation. For some reason the Chinese stock market has underperformed substantially and I think that makes China quite different from almost any other markets that at least private equity players are familiar with.

I think that’s because China’s growth is very much driven by capacity expansion, or what China calls fixed asset investments, which have a tendency of creating over-capacity in almost every major industry in the country – which depresses the prices of finished products, which erodes profitability. So that kind of market, by and large, is difficult in comparison with other markets to identify investment targets which will be profitable in the long term or will be able to sustain their profitability.

When it comes to buyouts I think it requires some specific and special skills because unlike the so called pre-IPO type of investments, for buyouts, typically the investor will need to be long-term, you need to work with the company and therefore the current shareholders of the company will have to trust you and trust your reputation. So your track record, your credibility and your reputation become critically important in the courting process. They will have to trust that this is a long term partner that they can work with and therefore many of the players especially in China, where there are so many new players, would not even qualify in this particular space.

And then on top of that, of course, you really have to have the capability to help structure deals, turn around a difficult situation, create value by providing operational value added or capabilities. So you have to have a full set of capabilities to persuade the other side that you should be the partner of choice and that’s not something that every private equity firm has.

PEI:  Firms that take minority stakes might argue they, too, provide some of that expertise without needing to be the controlling shareholder.

WS:  Well, we prefer control whenever possible because in my mind, no matter how good the business is, we are dealing in an uncertain world and sometimes things just go wrong. And if you have control you will be able to fix things. I strongly believe in the ability of the management to fix things – if things go wrong and you have control, you can fix the management as well.

Secondly, if you are serious about adding value, improving the value of the company, you really can’t do that without control. And thirdly, if you look at the track record of some of our partners you would find that if you do have control, when you exit from the investment, you will be able to command a so called control premium – that is, you can sell at a higher price than the market for your assets.

So for all those reasons, control is very important. But on the other hand, we are interested in non-controlled deals as well, except that in those situations the risk is higher, because if anything goes wrong there is not much that you can do. Therefore you have to structure the deal in such a way that you are much better downside protected.

PEI:  Why is China your main focus?

WS:  There are a number of things going for China at the same time. There has been rapid economic growth as we all know in the past 20, 30 years which is expected to continue for the foreseeable future. There is also a very powerful structural change in China’s growth model. I just mentioned that China’s growth so far has been driven so much by capacity expansion or fixed asset investments. China is making a consistent  effort to shift away from that growth model into a growth model more driven by domestic consumption, and in this process of transition many opportunities present themselves to private equity investors. For example, I would say that consumer/retail is very attractive as more domestic consumption is represented in the GDP going forward. Thirdly, much of the Chinese economy remains dominated by the state-owned firms, many of which remain rather inefficient. The reform in privatisation of the state-owned firms will be a continuous theme of Chinese economic reform, which also creates very interesting opportunities for us.

PEI: Do you think the number of Chinese buyout opportunities will increase?
As the Chinese economy grows, the scales of these firms become much more meaningful and significant. Therefore you will find that many interesting opportunities present themselves as large buyout opportunities; five years ago these [would have been] very rare to find in the Chinese market.

PEI:  RMB funds have proliferated in China and an increasing number of regional and global firms are also operating there. Is that contributing to a bubble?

WS:  Well it depends on how you look at it. There is certainly no bubble where we focus, on buyouts and structured investments. But when you talk about pre-IPO-type investments, where the only thing that matters is the price you pay … that’s where most RMB funds focus and there is a lot of competition, a lot of intermediation. I think that is where you likely will see a bubble if there is too much money going after the same deal.

PEI: But you don’t see a bubble forming now?

WS: I think it is a function of whether or not there is a bubble in the stock market in the first place because a pre-IPO [deal] can’t be priced more than post-IPO valuation. If there is a bubble in the stock market then you are likely to see the valuations for pre-IPO deals to be similarly high. Now that the market has sharply turned down, many who invested in pre-IPO deals in the past 12 months are likely to find many of their investments to be underwater as they probably paid more than the current market valuation.

On the other hand, money [has been] particularly tight in China in the past 12 months and is continuing to be so. I think in the past year the Central Bank has raised the reserve ratio numerous times and has increased interest rates a number of times and the leadership has also restricted the Chinese banks from lending to particular sectors or at particular pace. Therefore money today in China is quite tight, contrary to the perception outside of China. So some of the opportunities that we are looking at, the valuation actually is quite compelling.

PEI: New private equity firms seem to sprout up in China every day. Is that a good thing or does it concern you?

WS:  It doesn’t concern us because, yes it seems that a lot of capital is flowing into private equity especially for China, but if history is any guide not everybody with capital will be able to make a lot of money for investors. I think experience and discipline are critically important. I think that in five years – like what happened in some other markets – you will find a great differentiation between the winners and losers. I am sure there will be a lot of losers as well as some winners.

PEI:  What are your thoughts on how global firms are able to compete with domestic firms, both for talent and for deals?

WS:  Global firms have a lot of advantages on their side: they have the scale, they have the resources, but more importantly they have experience and over time have adopted many of the best practices and processes that we see in the industry today. On the other hand regional platforms, local firms, are probably almost by definition better connected in the local markets and more nimble when it comes to decision making process. So I think the key is to find the way to combine the best practices with the advantages of being a regional and local platform; and that’s exactly what we are trying to do here at PAG.

PEI:  During your time at TPG you were involved with some highly successful FIG sector turnarounds, Shenzhen Development Bank and Korea First Bank. Are those the deals of which you are most proud?

WS: With regard to deals like Shenzhen Development Bank or Korea First Bank, it is not so much the money that we have made for LPs that makes us happy. We are happy we are making money for LPs, but [also very proud of] the way we helped turn around the institutions and the small contributions that we made in the process to help reform the banking system in those countries where the institutions are located.

If you look at Korea First Bank and Shenzhen Development Bank they were both very weak when we made the investment. Take SDB, for example. When we made the investment, the reported capital ratio of that bank was only 2.3 percent – the actual was probably much worse. Its bad loan ratio in 2004 was 11.4 percent, also reported, when the actual number was probably much worse because the bank at that time classified many bad loans as normal loans. And so it was, by the definition of almost any country, an insolvent bank. After five years we improved the capital ratio largely through organic growth from 2.3 percent to more than 10 percent, and the bad loan ratio from 11.4 percent to 63 basis points. And our profitability went from $40 million in 2004 to probably more than $1 billion dollars last year.

So I think, without regard to how much money that we have made by making this investment, if you just look at the financials and the operations of this company, you will find that we fundamentally turned around a weak bank into a very strong bank. In this process we built a credit culture and we built an institution that embodied this credit culture to ensure its long term health. That is what I refer to as our contribution to the reform of the Chinese banking system in a very small way. We did the same thing with Korea First Bank, which failed in 1998 in the wake of financial crisis in Asia, and in five years we substantially turned around that operation, built a credit culture and made it a very profitable bank. I think it is this process that is extremely rewarding to those involved in the work.

PEI:  Do you think there will be more of those sorts of turnaround opportunities in Asia, or were those deals simply the product of a particular point in history?

WS:  History always repeats itself but in a different form. Sorry to give you a philosophical answer, but we do see a lot of interesting opportunities, some of which are even more exciting than the deals that we did before.

PEI:  What have you found surprising in watching the industry develop in recent years?

WS:  Five years ago, I think very few people would have expected China to be such a significant market for private equity because the Chinese market is difficult. It requires specific local knowledge, the regulatory regime is complicated and five years ago the Chinese banking system was weak and Chinese firms were relatively small in scale. But today that has almost completely changed. China has, by and large, a healthy banking system; the Chinese economy has created some companies of meaningful scale by international standards; and China’s entrepreneurs have proven to be very receptive to the idea of working with new investors for the purpose of growing their business and expanding their operations.