Talk of China's private equity boom is rife. Such talk is also loose. A goldmine to some, a landmine to others – China offers riches and ruin in equal measure. It just depends on which side of the fence you're sitting. The restructuring of investment group London Asia is a compelling illustration of one firm's determination to sit on the right side.
Rewind to 2002, and London Asia launched with the intention of investing in Chinese companies and then listing them overseas. While having a substantial Chinese presence from the get-go, London Asia opted to be headquartered in the UK. From 2002 to 2006, relates London Asia CEO Simon Littlewood, times were good. The firm oversaw 12 listings of Chinese companies in London during that period amid burgeoning appetite for high-growth Chinese stocks from UK-based institutional investors.
Everything changed in the second half of last year. Determined to develop its own financial services market, part of China's new M&A rules were designed to stop Chinese businesses from listing overseas, as well as encourage local investors by putting obstacles in the way of foreign competition (specifically by demanding they seek not just local but central government approval for new deals). Second, market sentiment towards Chinese stocks in London took a major turn for the worse. Investor attention was being grabbed by larger stocks and corporate governance fears were beginning to surface amid concern that, in the words of one source familiar with the recent history of Chinese listings in London, a “due diligence-lite” approach towards these companies had taken hold.
Having seen the writing on the wall, London Asia had already been preparing for some time for a major restructuring of its activities. This process reached fruition last month when the firm announced that it had split into two core divisions: comprising an investment division based in a new head office in Hong Kong and an operational business located in mainland China. During the course of last year, the firm launched 25 new offices around China, hiking the total from 7 to 32. In London, meanwhile, just two members of staff remain in situ, providing administrative support to the companies listed there.
The relocation means London Asia is able to avoid the restrictions placed on foreigners' investment activities. What is more, the timing of its move appears highly opportune. The main Chinese stock markets of Shanghai and Shenzhen are booming as liquidity escalates. Littlewood comments that, on international markets, P/E multiples of between 7 and 15 are common; on China's markets, they are typically between 30 and 50. Consider also, he says, the estimation that around $1 trillion currently resides in private Chinese bank accounts. “What happens when a decent portion of that capital gets shifted into China's 2,500 listed companies?” he asks. It's a rhetorical question.
For resident investment firms, stock markets offering runaway valuations obviously have their attractions when it comes to exiting portfolio companies. Significantly though, stock markets are not the beginning and end of the Chinese liquidity story. PEI was told of one GP with a 20 year track record of investing in China that has sold a succession of businesses to other private equity firms and has virtually stopped contemplating any other type of exit.
“Because of the lack of alternative deal flow combined with pressure to invest, financial prudence appears to have flown the nest.“
Seeking an explanation for this takes us back to the restrictions being imposed on foreign investors. Many of them have raised large funds for investment in China and find that the new rules make it extremely time consuming to invest in new deals (central government approval can sometimes take years). They have a few alternatives – none of them particularly attractive. One is to hand the money back to investors. A second is to dabble on the stock market. A third is to buy assets from local private equity firms (as the legislation demanding central government permission does not apply retrospectively – only to new deals). Because of the lack of alternative deal flow combined with pressure to invest, financial prudence appears to have flown the nest. Says one local VC currently benefiting from the trend as a vendor (and scarcely able to believe his good fortune): “Due diligence is really slack and the valuations are crazy”.
Back at London Asia, Little-wood says his firm is “making the most of the liquidity”. And so it should. After all, it might not last forever. There's talk of a market correction and at least some of the foreign players might end up cutting and running. But for now, it's a good time to be a domestic private equity firm in China. As such, you're on the right side of the fence.