Hony Capital: Navigating US-China trade tensions

Hony Capital’s experience with Jushi Group shows how Chinese firms can thrive in the US, regardless of the current political climate, says John Zhao

This article is sponsored by Hony Capital

At a time when many nations are withdrawing into themselves, private equity firms must still look internationally for growth. Hony Capital is one such firm. The Beijing-headquartered company specialises in buyouts and the marketisation of state-owned enterprises, providing growth capital to high-growth Chinese enterprises.

Over a period of 13 years, Hony transformed fibreglass manufacturer Jushi Group from a domestic, state-owned player to a multinational heavyweight accounting for over 20 percent of the global fibreglass market share. It is currently the largest fibreglass manufacturer in the world.

Hony’s second period of ownership – having exited and later reinvested  – saw the firm navigate frayed US-Sino tensions to establish Jushi as a North American producer in the heartland of the US. Not only did the investment deliver strong results for Hony, it serves as an invaluable blueprint for growth in a tricky diplomatic environment and an important reminder of why countries must resist the temptation to look inwards. Hony Capital’s founder and CEO, John Zhao, tells us what the experience taught his firm.

State-owned enterprises are a distinctly Chinese phenomenon. What is the appeal of such an investment?

John Zhao

When we started Hony in 2003 we positioned ourselves as a creator of value. We chose to invest in state-owned enterprises and make them more competitive through mixed-ownership, which allowed us to bring improved governance and introduce new strategies.

The Chinese government advocates mixed ownership of state enterprises, believing that an external market force coming into the company would be able to enhance the governance and deliver more competitive results. Corporate restructuring is one of our specialties and the investment into Jushi Group in 2006 was a prime example.

At the time, government policy called for marketisation and the modernisation of SOEs. Jushi was a fibreglass manufacturer and the second-class subsidiary of a centrally owned SOE, China National Building Material Group. It was growing very quickly but had limited resources and global reach, so we decided it would be a meaningful project.

How did you invest in that particular SOE?

We initially deployed $75 million from our $580 million USD Fund III to become the third-largest shareholder, after the state and the founder. The company later went public and Hony’s share was diluted before fully exiting.

In 2016, the founder decided to become a multinational by launching a new factory in the US. We opted to invest alongside him from our separate account of USD Fund VIII as the sponsor, while Jushi remained controlling shareholder. Our second time around we initially deployed $45 million, and, as we neared production, market demand indicated that we could add another $15 million to enlarge capacity.

How do you approach value creation in a Chinese manufacturing business?

During our initial ownership, there were three pillars of value creation: newly invested capital which enabled rapid expansion of capacity; restructuring to ensure the company had the most efficient supply chain; and investment into engineering R&D. Fibreglass making is very process-driven and it very much depends on the engineering. It requires a lot of experimentation, both on the lab level and on the production level, which needs investment and resources.

What obstacles did you need to overcome?

We got a bit of a storm in 2008 and many companies found themselves in terrible overcapacity. That also hit us and we had to do a lot of restructuring to sharpen our focus so we did not get harmed by the recession and could emerge stronger.

The founder is very entrepreneurial and he was initially spread pretty wide by producing a lot of other products in addition to the fibreglass. A lot of the restructuring we did was realigning the focus onto fibreglass and advising him to sell companies that were not relevant to that part of the business.

What is Hony’s secret sauce when it comes to value creation in China?

Our secret sauce is investing in people.

It does not matter whether it is a private entrepreneur or an SOE business leader, we want to build deep, trusted relationships with that person so we can become a long-term partner. China is still developing and its history of business practice is short, so very often it is the case that success depends on individuals. You need to find a business leader who is able, trustworthy and has integrity.

Even when a company looks great, we will not invest if the business leader does not meet our standards. Likewise, if the industry is not sexy or a company has lots of problems, but the business leader and team is of a certain calibre, we will consider investing. We have always done well when that was the case, and been hurt when it was not.

How does the SOE angle play into value creation?

The number one difference was the governance. As a major shareholder and board member, we ensured the company had transparent governance, which in turn enabled the management team to focus solely on global expansion. We were the market force that made a huge difference for the company by helping it not only produce consistent results but also ensure that capital markets, both private and public, would actually recognise that and provide efficient financing for M&A and its IPO.

For the second phase, when we jointly invested in this US greenfield project, governance continues to be something that all parties expect us to deliver. That is why the shareholder structure is similar to the original one; it is very balanced between the state, the management team and Hony.

What results have you seen?

The number one difference was the governance. As a major shareholder and board member, we ensured the company had transparent governance, which in turn enabled the management team to focus solely on global expansion. We were the market force that made a huge difference for the company by helping it not only produce consistent results but also ensure that capital markets, both private and public, would actually recognise that and provide efficient financing for M&A and its IPO.

For the second phase, when we jointly invested in this US greenfield project, governance continues to be something that all parties expect us to deliver. That is why the shareholder structure is similar to the original one; it is very balanced between the state, the management team and Hony.

How do you turn a Chinese SOE into a successful multinational?

As the company grew in size, capacity and international exposure, Jushi’s founder became more interested in becoming a multinational. The company was selling to the US in large quantities and it became very inefficient to serve so many North American customers from China. Like many global multinationals, we wanted to have more balanced involvement outside of China to manufacture and serve its customers locally.

In our second tenure as owner, we sponsored a new factory in South Carolina – the heartland of the US – to service the North American market. The manufacturing process of fibreglass is mostly automated and the US has the best-trained skilled workers, so we are comfortable being based there.

Although the production costs are much higher than China, the work ethic and legal environment really supported much higher productivity. The project is expected to create 500 local jobs, so this is good for us and good for the area, as well.

For this US project, our investment thesis is slightly different. This one is less risky than our first investment and it has been a more obvious decision, because Jushi was already selling to the US in large quantities and the customers loved the project.

From our reading of sales marketing and customer satisfaction, this looks like it will be a winner. We have slightly lower financial targets because there is less risk associated with it, so we are looking at this being something that will return a net IRR in the mid-teens.

What are the implications of the trade war for Chinese multinationals?

The challenge, since we started the multinational project, was growing concern about globalisation and the resulting trade war. Before we could ever anticipate the trade dispute turning into a full trade war, we sensed growing protectionism and knew it would help to have local production, even if just for tax benefits.

We got luckier than some other manufacturers because as the tariffs started and the threats became more real, we found ourselves having more demand for the US factory as customers stopped trying to buy from China.

We happen to benefit if President Trump continues with these tariffs because we are manufacturing locally, employing locally and using local services. That is why we invested more capital to increase capacity.

However, it is certainly still a challenge, because the trade war has no winners; today you can be on the lucky side but you can easily fall on the other side tomorrow. We are still in the middle of this and it is a very severe, ongoing challenge.

History is marching on and it is meaningful for a Chinese company like Jushi to become a multinational. While this is a reasonably successful investment project for Hony, it is also a model investment for a much larger trend, especially at a time when the world is rethinking globalisation.

I have seen how the world has benefited from globalisation and, even though it exposed severe problems like the wealth gap, the solution to those problems is not going back to a nationalised economic system.