Performance room: Growing pains

IRRs in China are comparable with those in US and Europe, but a maturing economy is forcing funds to work harder to generate returns.

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In China, declining growth is not a sign of a weakening economy but a maturing one. China’s GDP growth rate halved from a peak of more than 12 percent in 2008 to below 7 percent in 2017. But rather than negatively impact private equity deal-making, this shift appears to have spurred on a new wave of activity.

According to Bain & Company’s Asia-Pacific Private Equity Report 2018, there were 569 deals in greater China in 2017, 28 percent more than the 2012-16 average, transacted for a total value of $73 billion, 56 percent up on that four-year average.

“What’s changed is that first rush of growth is coming to a stage of maturation. Lots of private businesses are now focused on addressing the unmet needs of the burgeoning middle class – something state-owned companies have done poorly or not at all, but competition is fierce,” says David Pierce, managing director and head of Asia for HQ Capital.

Private equity firms are being forced to take a more hands-on approach to value creation.

“The previous stage of private equity activity in China was about macro growth and fundamentals. It was quite easy to make a return when the overall market is growing as fast as it was. A lot of the time, say five years ago, investors just left the company alone and it grew,” says Kiki Yang, a partner in Bain & Company’s Hong Kong office and its regional practice co-leader for greater China.

“But as the macro environment goes down, private equity investors are moving from a reliance on top-line growth to a focus on value creation, performance improvement and driving margin differences after acquisition.”

High entry multiples also require a focus on operational skills, says Yang. “China deals are more expensive so funds have to have the ability to work with the portfolio team.”

Pierce says a challenging exit environment – “exits have been difficult to come by in Asia generally and China in particular” – is driving greater openness on the part of Chinese business owners to accept private equity investment. “Expertise such as helping get listed in the US or Hong Kong is one of those value-added elements that companies are looking to private equity for,” Pierce says.

HQ Capital’s David Pierce says the dispersion of returns between the top and bottom quartile is much greater than in the US or Europe. “However, when we look at our average returns from China they are consistently comparable with European or US funds.” Data from eFront confirms this, showing Chinese funds recorded an average IRR of 10.03 percent from 2011 to 2017, with US funds generating 9.51 percent and Western Europe funds clocking a 12.89 percent IRR.

The growing popularity of buyouts is, in turn, changing the nature of the exit environment. “Exit activity is less reliant on IPOs as the number of control transactions is increasing and these tend to be exited through trade sales,” says Mingchen Xia, managing director on Hamilton Lane’s fund investment team.

With dry powder at record levels, stalled capital has crowded the space. This has led to high entry multiples, which is creating opportunities for secondaries buyers. “Many funds raised in the 2000s were invested on the assumption that there would be an IPO exit but if that didn’t happen there was no Plan B. Such funds are coming to the end of their lives with a significant portfolio remaining. So yes for our secondaries strategy we can get great discounts to NAV,” says Pierce.

But he says these sorts of deals are not a one-way bet: “What is the NAV based on? It may not be achievable or based on a realistic time frame. It’s not easy pickings but there are opportunities to work with GPs and investors.”

While more activism from private equity managers is key in a crowded, high-priced, maturing market, some investors say GDP growth of nearly 7 percent means the macro story remains the growth driver – and that this doesn’t necessarily translate to higher returns.

Despite more buyout deals and increased capital deployment, being the stand-out growth country in Asia means China has drawn in a lot of private equity money. There is now a significant capital overhang. Bain estimates that overall Asia-Pacific funds are sitting on record amounts of dry powder – $225 billion, or around 2.2 years’ worth of future investment. Yang says the amount of unspent money has created a steep entry barrier to potential newcomers. “The space is very crowded already and look at the dry powder. Unless you acquire a team with experience, it is very hard to get a foothold (in China).”

“In China fundamentals are still the main drivers,” says Guido Justen, head of alternatives at multi-billion German fund investor Helaba Invest. “And in terms of realised IRR and multiples, I’m not sure the outcome is that different from established markets because firstly there are fewer experienced managers and so they don’t deliver performance far above average: they tend to be swimming in the mainstream of 5 to 6 percent growth. And secondly, it’s easier to have a 1.5 or 1.7 multiple because you can make mistakes without losing the fundamental speed of growth happening at the macro level.”

For Yang, despite the still robust macro growth, activism and outperformance are entwined. “The better performing funds take an activism approach to portfolio management. Whether it’s organic, add on, or performance improvements, we are going to see more activist investors as the ones driving value.”