China dealflow strained as dry powder rises

In April, data emerged suggesting that the levels of dry powder in China had reached an all-time high.

It’s no secret that dealflow has been slow in China. A recent EY report suggested that private equity firms closed 16 transactions worth $10.8 billion in the country last year, an 18 percent decline from the $13.1 billion invested in 2012. Throw in some overzealous fundraising in 2010 and 2011, and the industry was left sitting on about $65 billion in undeployed capital as of the end of 2013, according to recent research by Bain & Company – an increase of about 20 percent from 2012.

Some argue that things are finally looking up. In a survey conducted for the report, EY found that around

90 percent of China GPs are expecting deal activity to increase in China over the coming months.

“The government’s 12th five-year plan, announced in late 2013, offers some clarity around future policy as the economy transitions from export-driven to one characterised by consumption,” the report said.

The government has always been tinkering with regulations in a way that should be helpful to private equity firms, says Steve Xiang, a partner at Weil, Gotshal & Manges.

For example, in March, China’s Ministry of Commerce (MOFCOM) came up with a provision allowing certain qualified transactions to be deemed ‘simple cases’, i.e. they can be cleared in 30 days. This would substantially shorten the process private equity firms have to go through to get deals approved in China – which can currently take up to six months, in some cases.

“If that can be implemented, the closing mechanics would be a huge benefit to private equity,” says Xiang. “A lot of funds have been quite concerned about the long clearing process from the anti-monopoly bureau, so this makes the deal more predictable.”

But there’s a caveat, he adds: despite the high-level regulatory changes, it’s still not clear which deals would qualify under the new rules.

“[It] is great news, but we are still waiting for the implementation rules to come out. There is no [example of a] ‘simple case’ fast-track approval that has come out yet.”

Moreover, many people are skeptical about the extent to which regulatory change can really influence the investment environment in China; even Xiang admits these changes “would not drive the market”.

Brett Tucker, partner at Baird Capital China Growth Equity Fund, argues that dealflow will only pick up in China if some fundamental perceptions about buying and selling start to change.

“There are a staggering number of private equity deals [from which] LPs should have their money back by now,” he says.

To boost exit volumes, he argues, GPs must start doing secondary buyout transactions and entrepreneurs must start ceding more control. However, managers have historically been reluctant to buy from other private equity firms in China, usually because they’re worried that any assets up for grabs must by definition be lower quality, Tucker explains. Equally, many entrepreneurs have shown little sign of loosening their grip on their businesses. “If you can break that logjam, that will significantly increase deal velocity.”

But until these attitudes start changing, dealflow in China will continue to suffer – exacerbating the dry powder issue and putting some LPs off altogether. As one industry source puts it: “How much longer are LPs going to say ‘I’m going to put money into China’ if it is not going to come back?”