Privately Speaking: Frank Tang of FountainVest Partners

In late 2012, when China’s GDP growth was clearly easing, when regulators had frozen the IPO market, when mainland fundraising was about to show a 50 percent annual drop, FountainVest Partners closed its second fund – oversubscribed on $1.35 billion. Total time in market: nine months.

External conditions weren’t the only challenges. FountainVest had “very few realisations to point to in its debut fund”, one LP source says. And as a growth capital investor, the firm is strategically not particularly differentiated from peers like Hony Capital, CITIC Private Equity and CDH Investments.

Yet three big-name LPs that anchored the first fund re-upped and did the same for Fund II: Ontario Teachers’ Pension Plan, Canada Pension Plan Investment Board and Temasek Holdings. Their commitments helped create some real momentum for the fundraising, which resulted in the vast majority of Fund I LPs re-investing in Fund II.
“It was helpful for us to have three anchor investors on day one,” says Frank Tang, chief executive officer and managing partner of the Hong Kong-based firm. “That lends a lot of credibility to like-minded institutional LPs.”

A PEDIGREE TEAM

Why did the North American LPs in particular choose to re-invest? It used to be that quick commitments to a large China fund were predicated on excitement around China’s growth story. But these days, when there’s a lot more caution and skepticism in evidence about that story, expressions of confidence by big institutional investors tend to rest on more solid ground. 

FountainVest’s main pull, according to several LP sources interviewed, is the people at the heart of the firm. FountainVest was founded in 2007, when a team of four Chinese nationals spun out of Singaporean sovereign wealth fund Temasek, where they’d worked on China investments. Tang, Terry Hu, George Chuang and Chenning Zhao today make up the core of FountainVest. Prior to Temasek, three of them were together at Goldman Sachs (Hu was at Credit Suisse).

The result is differentiation through pedigree. China has (by some estimates) 3,000 fund managers, but only a handful of these firms operate with an institutional-type structure. Among them, FountainVest is the newest – and, according to some LP sources, the most crisply-defined Western model. The firm uses the sort of familiar methods and practices institutional investors would expect from GPs in North America: a clear investment strategy, meticulous due diligence, transparent investor communication and – notably – no political angle. 

Tang says that while his firm has a wide network for deal sourcing and partnerships, it doesn’t have any “special political affiliation”, as he puts it. “We’re not focusing on state-owned companies, so we don’t need it and doesn’t affect our strategy.”

“We want to build an institutional firm that can last,” he continues. “We focus on maintaining a disciplined process and we have proper checks and balances in the decision-making process. This approach helped us to attract many large institutional investors.”

On the other hand, other LPs prefer to rely on performance data. “The FountainVest story so far is mainly about reputation,” says an LP from a family office, which chose not to invest in the fund.

FountainVest, therefore, offers a trade-off to investors. According to one US pension fund source who has looked at FountainVest: “It’s quality of execution [in exchange] for a few percentage points on IRR. Better protection, longer duration of due diligence – but an avoidance of deals a little risky. That’s what LPs would be assessing when forming a judgement.”

BEING CONSISTENT

Tang was born and raised in Shanghai, before moving to the US to study for his MBA at Columbia University. By the standards of most private equity professionals, he had an unusual upbringing, something that emerged in early 2012 when he was pitching Fund II to the board of the San Diego County Employees’ Retirement Association. Veering from the standard talking points, Tang spoke about his early life in Shanghai – recounting how he had to sleep on the floor of his family’s apartment until he got his first bed at age 15, and how he had to barter on the black market to make sure his little brother had enough to eat. 

Much to Tang’s astonishment, the talk was videotaped and put on SDCERA’s website. And it’s possible that this experience has made Tang a little more guarded: his answers and explanations are always intelligent and well-articulated, but matter-of-fact: you get exactly what you ask for, with no padding.

Nonetheless, LPs suggest that his cross-border background has given Tang certain qualities that are also reflected in his firm. In particular, he seems to understand the interplay between Chinese and Western cultures and why their perceptions sometimes don’t match. An interesting observation from one LP is that both sides tend to view Tang as one of their own. “Frank is well-liked and well-understood by the LP community,” the source says.

Tang is most talkative on the subject of China. And he’s not shaken by the task ahead, despite the country’s sputtering growth and ongoing economic reformation. 

In 2012, private equity deal value in China was down 12 percent to $12.4 billion, according to Dealogic data. This year looks set to be even bleaker: to mid-July, the figure stood at $4 billion. The IPO market didn’t reopen in April as expected, and officials haven’t announced when listings will resume. This impacts the entire ecosystem, from deals through to exits.

China’s economy is changing fundamentally. After decades of 8 percent-plus annual GDP growth, the rate is now sliding; Hony Capital’s CEO John Zhao recently said it could stabilise at 6 percent annually. Some LPs have started to switch their attention from the PRC to Southeast Asia, which is increasingly seen as the new growth story.

As such, FountainVest has to invest more than $1 billion in China at a time when deals continue to be scarce and exits difficult. But Tang remains undeterred. “We’re now in a stage where the overall tone about China is negative. But we won’t be influenced by bullish or negative sentiment. We’ll just focus on what we’re doing, have patience and be consistent.”

FountainVest’s investment strategy is based around three core themes: the rising middle class, urbanisation and sustainable development. 

“These are the key trends for the next 15-20 years for China. By taking a thematic approach, we’ll find companies that will benefit from them, regardless of near-term market volatility. We’ll stay focused on that. We wouldn’t jump into manufacturing for export, for example, which doesn’t fit into the three themes.”

Tang also likes industry consolidation plays. China’s industries remain fragmented and the biggest companies in the sectors may have less than 5 percent market share, he says. “Gradually industries will consolidate and large scale players will gain advantages. That’s the next stage of economic development.”

Deal size is $50 million-$150 million enterprise value on entry. “This size is very attractive because the company has already passed the early-stage risk and is still several years away from becoming a billion dollar company … We can play a role in helping them get there.”

FOCUS ON DEALS

Some of the firm’s 14 investments to date in China include a pharmaceutical distributor, a large fashion retailer, a high-end car dealership focused on second-tier markets, a housebuilder, a pollution monitoring and treatment business and a clean energy company (Tang declined to name the firms).

The firm also completed a $64 million privatisation of jewelry supplier LJ International from the NASDAQ in July.
But its most ambitious deal to date was leading a team of investors – including the Carlyle Group, CITIC Capital and China Everbright – to delist digital advertising company Focus Media from the NASDAQ, a deal that was completed in May. The $3.7 billion transaction remains China’s largest ever buyout.

A lot is riding on the Focus Media deal, and in some circles there’s an argument that it carries outsized risk. In 2011, research group Muddy Waters claimed that the Shanghai-based company overstated assets and overpaid for takeovers to disguise losses. Focus said in a statement that the allegations lack credibility, but its share price was hammered nonetheless. 

Tang adds that Focus is a well-established company that generates strong cash flow and that debt financing for the company has been well received in the credit market – a further vote of confidence.

A key element of the Focus deal is that some FountainVest partners, including Tang, met Focus founder Jason Jiang back in 2003 when they were at Goldman (which made an early investment in Focus). Several partners now at FountainVest, including Tang, had also been part of the Goldman team that initially took Focus public in 2005.

The relationship they developed over the years was clearly a factor in the recent deal: the FountainVest partners believe they have a keen understanding of Focus’s inner workings, and as a result, they see it as less risky than public market investors perceive it to be.

Tang is mulling over a future re-listing for Focus on the Hong Kong stock exchange. Even though dozens of Chinese companies have been delisted from the NASDAQ, not one has ever been relisted in Hong Kong. “There is no such precedent yet, but I don’t see any technical difficulties. It all depends on the quality of the company.”

Adds an industry source based in Hong Kong who has knowledge of the deal: “It’s a shot at a big win for FountainVest, which wrote a big cheque across two funds.”

MEANINGFUL INFLUENCE

FountainVest raised its first fund in 2007, at a time when LPs were throwing money at China. It is still early years for the $950 million vehicle: Washington State Investment Board, which committed $50 million to Fund I, reported interim estimates (as of December 2012) of a 1.1x multiple and a net IRR of 6.85 percent.

Most LPs interviewed for this article said performance was reasonably good for a young debut fund. Generally, expected returns from a China fund are in the 2.5x-3x range, and Fund I seemed to be heading in that direction, according to PEI’s fund of funds source.

The source added: “[FountainVest] couldn’t point to distributions and obvious success [in Fund I]. But it was clear that good companies were in the portfolio and the firm had done a reasonably good job with no disasters. It’s a downside-focused firm. They would rather not lose money than hit a home run.”

Tang would not comment on Fund I specifics. But he says his team’s “extensive due diligence” honed during the Goldman days, has helped avoid any blow-ups.

“On every deal, we go through the whole supply chain and talk to everybody involved – suppliers, customers, competitors, distribution channels. It’s the depth of due diligence, getting to the right people to look at the same company from different angles.”

FountainVest has an operational team that works on value creation together with the investment team. However, the work seems closer to ongoing guidance than anything more radical.

“Although we have a majority stake, we allow existing managers to manage the company,” Tang says. “We don’t typically go in and try to change management. If the management team is not good then normally we won’t invest. We try to pick companies where we can have significant influence. It’s not about outright buyouts, it’s about a meaningful stake that management feels comfortable with.”

He adds that China’s entrepreneurs rarely ask for operational value-add work, because they typically think their own efforts and vision are good enough. “For any changes we try to bring into the company, if on day one the chairman or founder buys into it, feels it is his own idea and feels ownership of it, we are half-way there already. It’s a gradual process, through patience and persuasion.”

For Fund II, the emphasis will continue to be on influence rather than buyouts. “It’s too early to brand ourselves as a buyout fund. China is not a buyout market yet. Focus Media, for example, involves private investors holding the majority stake. But is it really a buyout in the North American sense? We don’t really try to run the business and replace the existing team – although we may seek to help strengthen the team. Our focus is on transactions that allow us to have meaningful influence on an investment target.”

Some sources pointed out that FountainVest’s appetite for growth capital investing is not much different from that of peer firms. CDH, Hony and Primavera share more similarities with the firm than differences.

However, differentiation will become more evident over time, Tang says. “We believe that out of thousands of PE firms in China, there will be a handful of GPs that will succeed. And we believe we’ll be one of them. At the end of the day, it’s all about execution.”

TOO INSTITUTIONAL?

FountainVest’s approach is arguably an illustration of private equity’s next stage of maturation in China. After a frenetic (and under-regulated) start, change is in the air. The new leadership that came in March is trying to build a more sturdy financial industry. Officials froze the IPO markets to revamp the listing system, introducing tighter standards. Pre-IPO deals, often oiled by high-level connections, are fading fast. Domestic funds concerned about longevity are starting to embrace operational work and figure out how to attract offshore capital. In business sectors, market share growth – the really hard work – is now often more important than expansion.

“The GDP slowdown means the easy money is gone,” Tang says. “Surely we need to differentiate between better and poorly run companies – so it’s the international-style private equity funds with careful due diligence who will succeed in the long run.” 

It is clear that the FountainVest model represents a counterpoint to old-school, politically-connected private equity firms, which “use political connections in an institutional way”, as one European LP source puts it.

However, as the source emphasised, the latter approach is not necessarily a bad one. LPs interviewed separately for this article brought up Boyu Capital as a counter-model, and marvelled at the early performance of the firm’s first fund (it has plans to raise a new $1.5 billion vehicle). Boyu has a professional team (some of whom are ex-TPG), but it also has the grandson of former president Jiang Zemin as a partner.

Another is New Horizon Capital, which was founded by the son of China’s former prime minister Wen Jiabao. As most China investors admit, political connections prudently used can really benefit a fund.

But the blue-chip LPs who have provided the bedrock for both of FountainVest’s funds suggest changing expectations for China. If the speed of its fundraise is anything to go by, LPs clearly value gaining access to China via a country fund that follows a transparent and methodical approach to investment.

Washington State, for example, cited FountainVest’s “high institutional quality, the team’s prior tenure at Goldman Sachs and Temasek, discipline in deal sourcing and pricing, and investment focus” as reasons for tripling its re-up commitment (to $150 million) in Fund II, according to public documents.

Is FountainVest “too institutional” to flourish in an extremely competitive industry, against a multitude of local players who are better connected in government circles? Which model is likely to access the best deals and deliver the highest returns? 

It will be a few years yet before we have enough fund performance to answer these questions definitively. But for now, it seems that investors like what they see.