CHINA'S HIDDEN SECRET

Consider the following quote from an unnamed US fund manager that prefaces the latest version of China Watch, a quarterly business report distributed by Mahon China Investment Management, a Chinese growth capital investor: “We will not invest in China now. The economy is growing out of control and there is too much money chasing too few deals.”

This sounds as though one of the most tired phrases in Western private equity has now also reached the new frontier of the East. But the basic assumption lying behind the quote is roundly challenged by Mahon's report.

One of its central arguments is that foreigners' perceptions of the Chinese economy are skewed. For example, it alleges: “Some foreign investors have the mistaken view that it is they who are the major force transforming the Chinese economy and driving ongoing economic reform.”

In reality, the authors argue, such an opinion could not be much further from the truth. It reveals that fully 95 percent of all investment in China is accounted for by domestic sources, most of which comprises municipal authorities injecting capital into infrastructure projects and banks lending to large state-owned enterprises. Foreign groups, meanwhile, account for just five percent of the total: hardly enough to place them in the vanguard of economic change.

Another reason why foreign investors are failing to see the big picture, maintains the report, is that they tend to congregate en masse in the seven coastal provinces. This is a tendency also found among local groups to an extent. In 2005, 50 percent of total domestic investment went into the coastal zones – which include cities such as Beijing, Guangdong and Shanghai – with the remaining half divided up between the remaining 24 provinces.

But, when it comes to foreign investors, the mismatch between coastal and inland preference is more striking still. Over the last five years, 72 percent of all foreign investment has been ploughed into the coastal provinces and just 28 percent into the interior. The report says that, because price wars are raging in the coastal areas, putting pressure on margins, foreign investors have formed the false impression that all of China is now overheated.

There are indeed some signs of froth and they should not be readily dismissed. The clearest indication of this is to be found in the profusion of pre-IPO funds that have sprung up in China in recent years as bandwagon jumpers have sought to replicate a few stunning early successes achieved by first movers. In this context, the report concedes, there really is too much cash going after too few opportunities. After all, qualifying for offshore listings is difficult and China's own capital markets are “possibly still five years away from being efficient mechanisms to facilitate exits for foreign investors”.

But this is a mere sub-plot in a much bigger story, if you believe Mahon China. It argues that while there may be little to excite investors on the over-populated coasts, head to the overlooked provinces in the centre and north of the country and you will find a multitude of private and small state-owned enterprises hungry for capital. Requirements vary from capital and expertise for restructurings, to the need for good corporate governance to help retain or assume sector leadership. What many of these companies have in common, it would seem, is a willingness to consider what private equity can do for them – just as long as they can find a private equity firm to talk to, that is.

China is surely too big a market to have matured this fast.

The interior provinces have a number of apparent advantages over the coast. Not only are land, utilities and labour all cheaper, but valuations are typically lower. On the latter point, the report says that businesses in these parts of China are still typically valued in the traditional manner, which is to say on a net asset basis rather than taking into account ‘market-defined’ values such as product margins, market share, brand recognition and goodwill. The upshot of this is, in many cases, a low entry multiple.

As a final point worth considering here, the report notes speculation that an increasingly stringent tax regime applied to private equity firms in the coastal regions will not necessarily be extended to the inland, where the government is keen to give investment a boost. Taken as a whole, the report gives the impression not of too much money chasing too few deals, but too much money chasing certain types of deal in certain places. After all, China is surely too big a market to have matured this fast.

CARLYLE REDUCES XUGONG STAKE TO GET APPROVAL
Global buyout firm The Carlyle Group has acquired a 50 percent stake in Xugong Group Construction Machinery, a Chinese construction equipment maker, for about $220 million (€175.6 million), instead of the previously agreed 85 percent for $375 million, according to Bloomberg. The decision to scale back its investment was aimed at winning approval from the central government, a year after Carlyle entered into talks with the firm. Carlyle's acquisition of Xugong was subject to government approval because of the size of the investment and the fact that it would involve foreign ownership. Carlyle pulled out of a race for China's Guangdong Development Bank in early September because the size of stake it could get approval for was too small for the buyout group, according to a source familiar with the auction.

ACTIS PUSHES INTO MALAYSIA
Actis, an emerging markets-focused private equity firm, has held the final close of a vehicle targeting South East Asia on $130 million (€102 million). The ASEAN Fund represents a geographic expansion of the Actis Malaysia Fund, which raised $60 million in 2004. Alun Branigan, partner responsible for Actis' activities in South East Asia, said the Malaysia fund “was a successful concept but we felt there was a bigger opportunity across the region, so we expanded the fund size and its remit”. To date, the fund has completed two deals: an $11.3 million buyout of personal care company Unza; and the MBO of Distri-Thai, a Thai distributor and retailer of foreign language books and magazines, for an undisclosed sum.

CHINA DEBUT FUND RAISES $280M
Capital Today, a Shanghai-based private equity firm, has received $280 million (€223 million) in commitments for its first China-focused growth capital and expansion finance vehicle. The fund was launched last year with a $200 million target. Capital Today was founded by Kathy Xu, a former investment professional at Baring Private Equity Partners Asia. Investors in the fund include pension funds, endowments, funds of funds, family offices and foundations in the US, Asia, Europe and the Middle East. C.P. Eaton Partners acted as placement agent for the firm. Paul, Weiss, Rifkind, Wharton & Garrison provided legal advice.

PRIVATE EQUITY FIRMS VIE FOR TELECOM STAKE
Silver Lake Partners, Bain Capital and Texas Pacific Group are competing to acquire a stake in H3C, the networking joint venture company of Huawei Technology and 3Com in a deal worth up to $1.5 billion (€1.19 billion). Huawei is a Chinese telecoms equipment maker, while 3Com is a US networking systems company. 3Com holds a 51 percent stake in H3C.

Under an existing agreement, 3Com and Huawei have the right, starting on 15 November, to bid for each other's equity interest in the joint-venture, according to several media reports.

CITIC CAPITAL PARTNERS TO MANAGE THIRD PARTY MONEY
CITIC Capital Partners, the private equity affiliate of CITIC Capital Holdings has raised $220 million (€175.3 million) in a first close of its debut China private equity fund, just below its final target of $250 million. The fund marks CITIC's evolution to raising and managing third-party money after having invested its own capital since it was founded in 2003. The CITIC Capital China Partners fund will focus on buyout and privatisation investments in well established Chinese companies. The fund has so far attracted less than 10 investors from the US, Japan, and the Asian region, according to a company official.

INDIA PE INVESTMENT TO HIT $7BN IN 2006
India has drawn $5.4 billion (€4.3 billion) in private equity investments for the first nine months of the year, and could surge past $7 billion for the whole of 2006, according to a study by Venture Intelligence India, a local data provider. The latest statistics come as a surprise in light of a recent forecast by management consultant Bain & Company, which predicted that the value of Indian deals would grow from $2.2 billon in 2005 to $7 billion by 2010. India, apparently, is ahead of schedule.

CERBERUS POISED FOR AOZORA WINDFALL
Cerberus Capital Management, the US alternative assets investor, is planning to re-list Japan's Aozora Bank in November, selling half its stake to raise at least $3 billion, according to Reuters. Cerberus, which controls 61.84 percent of Aozora Bank, bought a 49 percent stake in 2003 for ¥101 billion ($850 million). The planned IPO of Aozora Bank values the business at $10 billion to $12 billion.

WL ROSS ENTERS INDIA WITH TEXTILE PURCHASE
WL Ross & Co has made its first investment in India, acquiring textile manufacturing business OCM for $37 million (€29.2 million). WL Ross made the acquisition through its $300 million India Asset Recovery Fund, co-investing alongside its $1.1 billion WLR Recovery Fund III and the Housing Development Finance Corporation, WL Ross's partner in India since October 2005. Initially founded as a manufacturer of handmade carpets and carpet yarn, OCM is a worsted textile manufacturer supplying fabrics to more than 60 wholesalers and 1,200 retailers in India as well as global markets.

CVC COMPLETES CHINESE MBO
CVC Asia Pacific has backed the management buyout of Plantation Timber Products, a Chinese manufacturer of fibre panels and laminated flooring. No financial terms were disclosed for the deal, in which CVC acquired the business from New Zealand wood products company Carter Holt Harvey. However, reports in the Chinese press suggest a transaction value of approximately $100 million (€78.5 million). CVC was advised by ABN AMRO and Clifford Chance, with debt financing for the transaction from ABN AMRO and Royal Bank of Scotland. CVC Asia Pacific has also recently agreed to acquire DCA, an Australian healthcare business, in an all-cash offer that gives DCA an enterprise value of A$2.7 billion (€1.58 billion; $2.03 billion).

SUN CAPITAL TO PURSUE TURNAROUNDS IN JAPAN
Sun Capital Partners, a Florida-based turnaround private equity firm, is opening an office in Tokyo. The firm has hired Shigeru Utsugi to head up Sun Capital Partners (Japan). Utsugi was most recently executive director with Basic Capital Management, a private equity affiliate of Mizuho Banking Group. Before that he worked with EastPoint Capital, a spin-out from Connecticut-based private equity firm Whitney & Co. Sun Capital also has offices in New York, Los Angeles, London and Shenzhen, China.

ISTITHMAR HIRES SENIOR EXECUTIVES
Dubai-based private equity firm Istithmar has hired former Lehman Brothers veterans Felix Herlihy and John Amato as co-chief investment officers and managing directors. Both have taken up residency in Dubai. From 1986, Herlihy spent 18 years at Lehman Brothers after a stint as senior portfolio analyst at Fred Alger Management. Amato spent ten years at Lehman Brothers, where he worked in the M&A and merchant banking groups, before joining Banc of America Securities as head of financial sponsors M&A. David Jackson, chief executive officer at Istithmar, also previously held senior positions at Lehman Brothers in New York, including senior vice president and head of mergers and acquisitions, Asia.

BAIN CAPITAL TO RAISE ASIA FUND
Bain Capital will raise a separate fund to pursue private equity opportunities in Asia, according to sources close to the Boston-based GP. The firm's senior partners have not yet decided on the timing and target size of the vehicle. Bain Capital announced its intention to offer an Asia-only vehicle at its annual limited partner meeting this past summer. Bain Capital currently manages two dedicated European private equity funds, which invest alongside its core global vehicle in European deals.

AUSTRALIAN VENTURE FUND REACHES A$100M
Southern Cross Venture Partners, founded at the beginning of this year by three Australia-based directors and one Sillicon Valley-based director, has held a first close on A$100 million ($75 million; €60 million). The fund was launched with a A$200 million target to focus on early-stage investments in Australia. Spokesman Gerard Reilly said the fund is expected to reach its target by the end of the year. It has drawn support from Australian institutional investors including Macquarie Fund Management, a fund of funds manager.

SARATOGA FUND STARTS ROAD SHOW
Saratoga Capital, with bases in Singapore and Jakarta, has embarked on a road show to raise $300 million to $500 million for a new private equity fund that will be invested three key Southeast Asian markets. Due to the fund partners' prior experience in Indonesia, at least 50 percent of the fund will be invested there, Kay Mock, one of the four partners, said. Two other markets on the fund's radar are Singapore and Thailand. Twenty percent of the fund will be set aside for investments outside Southeast Asia, though these will have some link to Indonesia.