As private equity investors eye China more enthusiastically, they need to review and augment their due diligence criteria, according to consultant firm Cambridge Associates. “The private equity market in China is attractive,” says CA’s Managing Director of International Private Equity Research, Miriam Schmitter. “The pace of change, the dynamism of the market and the entrepreneurial spirit are astounding. But it’s important for investors not to get blinded by this excitement,”
From an institutional investor’s perspective, Schmitter suggests the focus on private equity in China is on small but growing companies, “whereas elsewhere in today’s markets, it’s now mostly on distressed companies having trouble staying afloat.” Investors need to be especially careful to ensure the PE managers have a positive exit track record: “Private equity managers in China have spent years trying to prove they can profitably exit investments. Some firms now have a sufficiently long track record.”
Consultant firm Towers Watson has just issued its own report on private equity. In answer to the question ‘Why Asian private equity now?’ it suggests there are a variety of reasons why Asia currently appears compelling:
“First, the regulatory environment has significantly evolved over time. Both China and India have been improving their business partnership laws to make them more practical for both local and international private equity investors. The key issues being addressed are limited partners’ liability and taxation. China has somewhat relaxed restrictions on local financial institutions investing capital in onshore private funds, which is likely to further stimulate growth of the domestic private equity market in China.
“Second, the role of the Asian segment within the context of global private equity has experienced a meaningful change since 2008. In the absence of both leverage and growth in developed markets, financial sponsors in developed economies are struggling to find deals which would allow them to achieve their required rates of return. Long term growth, together with different valuations being placed on private versus public companies, present a compelling investment backdrop for private equity managers. In 2009 we saw a demonstration of this trend, with many private equity managers running global funds with a flexible investment mandate turning their attention to Asia.
“Third, the growing capital markets of 2005 to 2008 created a robust exit environment for private equity. In that period, Asian managers distributed almost US$9 billion on US$3 billion of invested capital. Whilst the exit market is more challenging today, as it is in all markets across the globe, the trend of increasing liquidity that China and India have experienced in the recent past is likely to help financial sponsors find appropriate exits.
“Fourth, the use of debt in Asia is not as common as it is in the West. As such, the capital structures of Asian businesses do not necessarily face the same challenges as some over-leveraged balance sheets in developed markets. In addition, local banks prefer to lend to established companies or those with government backing. Therefore, access to growth capital for smaller companies has been very challenging. As a result, there is a meaningful role for private equity to play before a company has reached a level of maturity where other sources of financing become available.
“Fifth, many growing sectors in Asia, such as healthcare or industrials, are not well represented in the public markets. Private equity provides a better route for investors to gain a meaningful exposure to these sectors.
Investment opportunities in venture capital
According to the TW report, “Most of the opportunities would appear to be in industries in which venture capital funds are especially well entrenched - for example, IT, healthcare and alternative energy. This positions them very favourably to take advantage of some important global trends.
Another opportunity comes in the form of the globalisation of venture capital. Entrepreneurship (some of it exported from the US) has begun to take solid roots in important economies like India and China and venture capital managers have taken note. According to Deloitte and Touche’s 2009 Venture Capital Report, more than half of respondents stated that they are investing outside their home country, whereas five years ago, when the survey was first conducted, only a fraction of respondents showed interest.