Privately Speaking: John Zhao, Hony Capital

John Zhao certainly knows how to make an entrance. 

Sitting in his personal conference room at Hony Capital’s headquarters, you might expect the firm’s chief executive to enter through the same doors you used.  Instead, he suddenly appears behind you through a door that looks like it’s part of the wall (which turns out to lead directly to his office). Perhaps he installed it just to wrong-foot private equity journalists; if so, it works. 

Laughing at the double take prompted by his ‘surprise’ arrival, Zhao sits down to talk about Hony’s own entrance onto the Chinese private equity scene – and the dramatic growth it has enjoyed since.

Beijing-headquartered Hony started life in 2003 as a captive private equity platform for Legend Holdings, the influential government-backed conglomerate that is also the largest shareholder in computer manufacturer Lenovo. The private equity firm is now China’s largest, having raised more than $6 billion in the past five years alone across a suite of RMB and US dollar funds, according to the 2012 PEI 300, our ranking of the world’s largest private equity firms. While competition has skyrocketed since Hony’s founding – there’s no scarcity of capital in China – the firm is one of a handful of domestic and foreign managers focused on larger buyouts and restructurings. 

It will need to be even more focused on large-cap deals with its latest investment funds. Both of Hony’s recent fundraising efforts – which concluded in December 2011 – resulted in oversubscribed funds substantially larger than their 2008-vintage predecessors. Its fifth US dollar-denominated fund raised nearly $2.4 billion (Fund IV closed on $1.4 billion), while a second local currency fund collected RMB 10 billion (€1.1 billion; $1.5 billion), nearly double the size of its predecessor.
How does Zhao think the step-up in fund size will change Hony’s strategy?

“First of all, the world is changing. China is changing. And as you mentioned, the size of our fund is changing,” responds Zhao. “But another factor to add that’s no small matter is our team’s becoming more experienced and more mature.”
In addition to an increase in size – Hony now has 65 investment professionals, versus just 27 back in 2008, according to a 2008 University of Michigan document – it has also ramped up its focus on operational improvements. “Along the way we started to really practise what we claim: value adding. So over 10 years we’ve built a team, practised the art and we actually now have a lot of operational capabilities,” says Zhao.

In 2008, after a year of trialing the concept, the firm established an operationally focused consulting group similar to Kohlberg Kravis Roberts’ Capstone division, called Hony Consulting. This group, which has around 28 professionals,  currently works with the deal team as and when needed, but the plan going forward is to fully integrate the two, Zhao says. “Now we’ve had enough experience to be convinced that our value-adding service is the way we get oversized returns,” he says. “We want to restructure so that Hony Consulting are just part of the flow.”


A boost in operating capabilities allows Hony to pursue larger, less obvious deals that require a certain vision and skill set the firm didn’t always possess, says Zhao. “When we were small, we would do deals that were ‘there’: the obvious SOE [state-owned enterprise] that was suffering from the restriction of the system, for example. We’d work to unleash that restriction by prioritising it, and then all the heat of that would just quickly get released and you’d get a return. We have a lot of deals like that – like China Glass.” 

In January 2004 the firm bought a stake in state-owned Jiangsu Glass Group, a deal which was explored in-depth by Roger Leeds of the School of Advanced International Studies at Johns Hopkins University and INSEAD’s Lily Fang. “Once in control,” they noted in a case study, “Hony rapidly orchestrated a major growth-oriented restructuring of the company, a successful IPO on the Hong Kong Stock Exchange (with a new name, China Glass), and the acquisition of seven Chinese glass manufacturing companies. As a result, in the time span of about three years China Glass was transformed from a relatively obscure, mid-size glass manufacturing company to one of the largest, most efficient producers in China.” The case study concluded that Hony was “poised to exit with an enviable financial return on its original investment”.

While there may have been a good deal of heavy lifting needed to turn around China Glass, and indeed a good return to be had, Zhao indicates those sorts of deals were still simply capitalising on the more run-of-the-mill or obvious opportunities.
Now, he says, “since we are a lot more capable, we not only go after deals that have an obvious proposition … we are a little bit bolder … we also create deals our way. We’re a lot more proactive and we generate a lot of ideas.”

Is that another way of saying Hony has proprietary deal flow? Zhao chuckles and says: “Proprietary to me doesn’t mean exclusive. Proprietary means sometimes a company, in the eye of competitors, is not a deal … but in my eyes, it’s a deal.”
The firm’s focus on SOE restructuring and large-scale capital investment requires a great deal of work, operating skill and good reputation to effectively carry out in China, says Zhao. Hony, he asserts, has built that track record over the past nine years. 

However, the firm’s accomplishments to date notwithstanding, it will surely still be a challenge for Hony’s team to write larger equity cheques than it has in the past, in a private equity market characterised by smaller deals. In the fourth quarter of 2011, for example, Ernst & Young noted that the median deal size was $20 million, and that while larger deals were increasing in size and volume, only 29 out of 143 deals that quarter had values greater than $50 million.
Is the challenge of spending larger funds in such a market in part why the firm has started to look at more in-bound and out-bound M&A opportunities?

“Oh, no,” Zhao says quickly. “First of all, the landscape is littered with smaller deals, bad or good – larger deals are fewer, but I think there happens to be plenty. It’s not necessarily harder to cover larger deals. In fact to some extent, it’s slightly easier; not all PE firms are looking at bigger deals because they’re a smaller fund size.”

Larger deals can also be more efficient in terms of where and how resources are spent, he continues. “If you can write a $100 million cheque and do high-level operational improvements with one portfolio company, versus putting ERPs [enterprise resource planning schemes] together for three smaller companies and writing three $30 million cheques, I’d rather write the $100 million cheque. So that’s why I said our increasing size has caused us to change. But these are changes we proactively anticipated; and the overall efficiency, as we grow in size, is actually improving.”

Any increasing focus on in- and out-bound cross-border opportunities has less to do with Hony’s larger fund sizes and more to do with Chinese companies’ growth opportunities coupled with the rise of China as a consumption market, he says. 

“For outbound, it typically relates to one of our portfolio companies’ expansion plans,” he says, noting that often Hony’s foreign-based limited partners will facilitate introductions to potential partners in foreign markets. 

And for inbound? “The idea is this: China is one of the world’s most attractive consumption markets,” says Zhao. “Every global company is paying more attention to becoming a player in this market. And we feel, for a lot of businesses, having a board meeting in New York or Rome is just not the way to do things here.”

“The existing model even still for multinationals is to get a Chinese division, find a Chinese manager, but the more important decisions are still made somewhere outside China. For some companies, maybe the best way to explore the Chinese opportunity is having a Hony, or a very local but financial investor, to invest in your China portion of the business. So we sit on the board and when something happens in China, you know that we’re with you in terms of our interests being the same.”

Hony’s approach to such inbound deals has tended to stay within its sector focus or strengths, Zhao adds. “We typically only work with international companies [where] we know for a fact we can offer a lot more for them to become very big in China, in addition to capital.”

He speaks confidently of the firm’s ability to execute such transactions based on prior “experiments”, a term Zhao uses frequently to explain how Hony has tested and rolled out various initiatives. 

“Recently, we finished the ‘experiment’ that started three years ago … based on an investment called Biosensors. It’s a US-headquartered company listed on the Singaporean stock exchange. It really wanted to move into the Chinese market but couldn’t on its own for five or six years.”

Hony studied the company and its sector and felt the Chinese market potential was there. “The management team’s observations were correct – the way they went about it was wrong,” he recalls. “If you want to get into China people know they need to get a local partner, do a JV. So they did that, but then they fought with their JV partners on day-to-day business practices that weren’t very localised. We decided to become the foreign parent company’s controlling shareholder to be able to play a role on that company’s management of the governance. Now, we work with the same Chinese partner and everything is a different story.”  

Hony’s $2.4 billion Fund V wasn’t raised with a predetermined allocation to cross-border plays. “The global LPs were a little concerned that I would start to invest in New York in a domestic company which has nothing to do with our core strategy. So we explained to them our strategy is still China; we’re all about China. That put a bit of comfort in their minds.” 

It helps that the firm hasn’t deviated from its strategy during the past decade, he says. “We didn’t detour into pre-IPO arbitration when there was a lot of temptation out there. We simply just used 10 years to practice the same thing over and over and over again,” Zhao says. “We are focused on China, focused on our two models, focused on a few sectors, focusing in few regions, and just keep beefing up the team and keep adding capabilities beyond the capital, and build our reputation as such.”

In any case, it’s still early days for cross-border investing. “I don’t think we’re going to do a lot because despite the fact that we’ve done experiments before, we’re still at an early stage in developing this model.” 


The investor concerns Zhao acknowledges wouldn’t have been the only ones requiring discussion when marketing its most recent funds. The substantial increase in capital being raised and evolving strategy prompted some LPs to think twice about investing – either because the new strategy, predicated on doing larger deals, was simply yet to be proved out by Hony or because it no longer fit the investor’s portfolio requirement. 

Indeed some institutions, such as the California Public Employees’ Retirement System, did not re-up. The US pension’s latest publicly available private equity performance report shows it committed just over $12 million to the firm’s prior Fund IV via an emerging markets fund of funds, which it noted was still in its J-curve but showed as having a 1x multiple as of 31 December 2011. The private equity report does not list a commitment to Fund V. 

Other equally influential investors, however, did re-up, such as the California State Teachers’ Retirement System (CalSTRS), which committed $75 million. (CalSTRS had committed $50 million to Fund IV, which as of 30 September 2011 CalSTRS showed as having a 10.33 net IRR since inception.) An even bigger vote of confidence came from the Canada Pension Plan Investment Board, which committed $200 million to Fund V, having committed $75 million to the prior fund. 

“When we started to fundraise, we tended to want to work with scalable institutional LPs out of each and every major economy. We are lucky we get to somewhat select our investors because our fundraises have been oversubscribed, so we make sure the ones we take commitments from are able to scale with us so that we don’t have to get too many LPs and we don’t have to switch them all the time,” says Zhao. 

“That’s what we started to do eight years ago when we first went outside China to fundraise. That has paid off very nicely. Temasek, CPPIB and the Stanford endowment are among the foreign institutional investors Hony has attracted. All these large institutions can scale with us and are so big they typically have a wider array of strategies that they can support. So, so far, we haven’t seen many LPs that decided to drop us because we’ve changed. They actually are welcoming our newer strategies and starting to take advantage of them.”

Another investor-related issue the firm has had to face is particular to China: many domestic LPs have shorter time horizons, in part due to having become used to rapid distributions from pre-IPO strategies. Some Chinese managers, for example, have considered structuring private equity funds with shorter lives to appease domestic investors. 

“That pressure is there,” admits Zhao, “except that Hony sort of anticipated the fact that the Chinese LP community is in the absolute early stages, not very mature, and really good LPs are very few and far between. Knowing that, from the beginning we started to focus on large institutions, and I [initially] didn’t worry about concentration. 

“So in our Fund I, which raised just over RMB 5 billion, we have seven LPs that included two or three individuals, but the rest were all very large institutions like the social security fund. Fund II raised RMB 10 billion from 11 or 12 LPs, and again there were large institutions like the Chinese social security fund, CIC, Bank of China and then a few high-net-worth individuals. We are extremely careful in selecting whose money we want to manage because we insist on the GP/LP governance structure, which includes that the money here is long-term money. If you have a shorter term expectation, we’re not your GP.”

Fund sizes and structures aren’t the only things on investors’ minds, of course. “I was in the US last week and the questions that were coming my way most were: ‘Is China really slowing down? What does that mean? Is the power transition going to be smooth? What’s the impact?’” says Zhao.

“I’m going to leave the power transition thing to politicians. So I won’t comment on that. The Chinese so-called slowing down is something that I’m concerned with, but then I think it’s a healthy thing, it’s a necessary thing. You can’t have the economy running at super high speed when you want to change its ways; you need to slow down for better reflection.”
That sort of reflection is currently taking place inside Hony, which Zhao says has slowed its investment pace in light of global volatility. “Being as conservative as we are, I wanted to make sure that on a macro level, we have a view that we feel comfortable before we started to write cheques,” he says. “So we’ve been studying global impacts for the Chinese economy and the Chinese political and economic change.”

China, he says, is in a very critical and challenging period in terms of its economic growth slowing alongside a transition to a new socioeconomic system. “The overall educational level of the population … is still in the early stage. There are still a lot of people that just left the poverty line. As a country we are still learning what is law and order, what’s the benefit to being a law-abiding citizen instead of getting ahead on your own. So it’s really very critical to keep a lot of people employed even at relatively low level so that we don’t get into social unrest – if the country gets into that, nobody is going to worry about economic development. And Chinese history is laden with unrest-caused bloodshed.”

The consensus among most in China, he believes, is there is a need to take things slowly and keep growth stable. Though anything less than 8 percent GDP growth may feel like recession – a comment Zhao first made to PEI several years ago – that 8 percent figure still “is projected to just create enough new jobs to take in the ever-growing labour pool”.

China’s growth rate dropping to, say, 7 percent,  “is still relatively fast compared with what’s going on globally”, Zhao continues. And it’s effectively a blended rate, he adds, meaning there will still be sectors recording phenomenal growth and others negative growth where restructuring will become vital.

“There will be a lot of restructuring and shuffling, and guess who likes that most? Private equity. Slower growth will put pressure on companies to do something. And it will clearly illustrate to global LPs the value of a good Chinese GP – because when things get complicated it is the local knowledge, local expertise that matters.”


It’s clear that Zhao’s and Hony’s ambitions are big, and go beyond being just a brand-name private equity firm in China. 
“We’ve always looked at how Hony Capital might develop itself,” agrees Zhao. “Our goal is to be the absolute leader in the marketplace in China and we also, one day, aspire to have some global influence.”

Hony will continue to focus on Chinese private equity for the near-term, but is studying other related alternative asset classes including real estate, infrastructure, mezzanine or debt. “We’re also looking at how our industry is changing: 2008 changed the world including private equity from a regulatory perspective, from a practitioner perspective, LP perspective … everything is changing and we’re monitoring and studying these factors,” says Zhao. “I like our strategy – I want it to be simple and solid and really meet the market requirement – but at the same time we want to be one step ahead of the curve.”

The question now is: have the bold steps taken by the firm so far positioned it so that its exits will turn out to be just as dramatic as its entrance has been?  



Hony closes debut $38m fund


Fund II closes on $88m


Fund III closes on $580m


Hony raises an RMB 5.3bn fund, anchored by China’s social 
security fund
Fund IV closes on $1.4bn
Hony Consulting launches
Hong Kong office opens


Shanghai office opens
Fund V closes on $2.4bn
RMB Fund II raises RMB 10bn
Source: Hony Capital


US dollar-denominated funds in China, as well as RMB funds managed by foreign firms, are still subject to restrictions on investment and long and unpredictable approval processes, while local RMB funds have fewer obstacles. As such, China’s most established fund managers with both fund types have found they have access to deal flow with their RMB funds that they might not be able to touch (at all, or anytime soon) with their USD funds. How to avoid conflicts of interest between firms’ onshore and offshore investors has long been a talking point in the industry, with no perfect solution to be found. 

“That’s another thing that Hony has been experimenting with: how to handle this tough issue of having two funds,” says Zhao, noting he prefers the term ‘co-existing’ to ‘parallel’ funds. 

“A parallel fund is a somewhat defined term, where you have onshore/offshore pari passu – we don’t do that. The reality is we’re a country manager and need to have domestic currency funds in addition to our global funds. We raise those funds concurrently but we don’t regulate them to be simultaneous. We use the same team, same strategy. We allocate with some predetermined standard but it’s at the GP’s discretion … whatever we do, we communicate with our LPs clearly.”

Hony has meanwhile been leading the charge on various initiatives related to the development of the asset class in China and currency conversion issues, including Shanghai’s Qualified Foreign Limited Partner conversion programme (it was the only firm to execute a deal under the programme, which is now essentially defunct), as well as an experimental financial hub being established in Qianhai, outside Shenzhen, as a testing ground for more liberal currency flows.

“As China continues to grow, the currency conversion and the gradual internalisation of currency is coming, and we wanted to make sure that Hony is positioning itself right in the middle, or at the forefront, of this trend,” Zhao says.