Calling The Shots: Private Equity In China

Following the lead of their US counterparts, China’s private equity funds are angling for bigger ownership stakes and a louder voice in the country’s corporate sector.

When Yuanfudao wanted to grow its business, the Chinese online-education services company bypassed traditional financing options such as banks and the stock market in favor of deep-pocketed, well-connected private equity (PE) funds.

Yuanfudao raised more than $3.5 billion last year by tapping PE-led investor groups in three waves between March and December. Contributing to these financing packages were several small firms tagging along with the likes of Chinese PE giant Hillhouse Capital; Temasek Holdings, a Singaporean sovereign wealth fund; social-media behemoth Tencent; and Alibaba founder Jack Ma’s PE fund, YF Capital. The flurry of fundraising for Yuanfudao, which is now one of the world’s most valuable online-education companies, points to the rapid rise of PE as a major source of company financing in China. It also underlines PE’s expanding role as a corporate influencer, with investors who are keen to provide specific managerial direction, alongside cash, to companies that want to expand, adapt and compete.

PE in the past five years has been especially busy introducing digital business strategies to investment-target companies that were founded in the 1980s, during the early years of China’s economic “reform and opening” movement, according to Winston Ma, adjunct professor at New York University School of Law, former managing director of the sovereign wealth fund China Investment Corporation and the author of several books on financing in China. PE funds have learned how to work closely with well-established companies long controlled by aging founders or their family members, helping them finance modernization drives—and sometimes complete overhauls.

“The founders are getting old,” Ma says, “and the second generation either doesn’t want to take the company or doesn’t want to go through a digital transformation.”

But adapting to the digital age is practically a matter of survival for these older companies, which Ma calls “the backbone of the Chinese economy.” So “they have become interesting targets for private equity,” he says, since top executives recognize the value of PE financing and managerial support.

Growth Spurt

This new receptivity and other opportunities for involvement in corporate decision-making are fueling a growth spurt in China’s PE sector. The Asset Management Association of China recently reported that the value of private equity under management grew by 2.17 trillion renminbi ($335 billion) between December 2019 and November 2020 to total more than 15.91 trillion renminbi. Most of the estimated 27,000 investment products tied to PE funds now on the market in China are relatively small, although the association says the top 184 funds are each managing more than 10 billion renminbi in assets.

To date, China’s most enthusiastic PE supporters have been investors living in a handful of big cities with robust financial sectors. The association report said about 70% of the country’s private equity managers are registered in Shanghai, Beijing, Shenzhen, and two provinces—Zhejiang (excluding the city of Ningbo) and Guangdong (excluding Shenzhen). Last fall, Shanghai for the first time surpassed Beijing as the city with the greatest number of PE fund managers; Shanghai now counts 4,663 managers overseeing funds worth a combined 3.7 trillion renminbi.

The investors are attracted by healthy returns. A January analysis by China’s Securities Daily newspaper found that the average, 12-month return on investment in 2020 for a sampling of 15,000 PE products exceeded 30%.

Foreign investment firms have also gotten in the game. UBS opened China’s first foreign-owned PE fund in 2016. Another nine firms from abroad, including BlackRock, arrived within the next year. Today, according to Securities Daily, 32 foreigners including Allianz and Bridgewater Associates are operating PE funds on the mainland.

PE’s rapid growth recently raised red flags at the China Securities Regulatory Commission (CSRC), a government watchdog that last fall enacted more than a dozen new rules covering fund registration, legal liability, investment disclosure and fund manager practices. CSRC cited a concern that illegal fundraising was creeping into the PE sector.

But the new rules were accompanied by a CSRC circular praising the PE sector for playing “an important role in promoting” China’s economic development at a difficult time due to Covid-19, as well as encouraging “scientific and technological innovation” while “optimizing the capital market investor structure.” CSRC thus affirmed government support for PE investors and the deals that have injected funds into companies without banks or the stock market—and yet, in many cases, not without strings attached.

Rising Influence

The fundraising strings are underscored by the fact that China’s PE managers are gaining corporate sector influence through bigger deals, according to an August report by McKinsey & Company. In some cases they are emulating their larger US counterparts by stepping beyond basic financing to secure a majority stake or even de facto ownership of their investment targets.

“As investments in China have grown, so have the sizes of PE deals,” the McKinsey report says, noting that the average deal was worth $75 million in 2019, more than twice its magnitude in 2009. “The same trend toward scale has played out at the other end of the market: Both the share and the number of deals over $500 million have increased in the last decade.”

McKinsey expects “funds operating in China to increasingly seek deals where they purchase a controlling interest in an asset. Such deals give investors direct management control of capital allocation, talent and exits. Where investors hold minority stakes, it has proved difficult to sufficiently influence their portfolio companies.”

Typically, PE managers with big takeover ambitions must earn the trust of the investment target before executing the deal—much like a traditional suitor seeking a parent’s trust before winning the daughter’s hand, Ma says. Exactly that happened in 2017, he notes, when Hillhouse led a $6.8 billion takeover of the shoe retail chain Belle—the largest deal of its kind that year for a Hong Kong–listed company—before engineering a transformation of the company.

More Stable Support

Companies that obtain PE financing can expect support for longer than in the past, when Chinese private investors often focused on quick and profitable exits by means of initial public offerings (IPOs). The trend in recent years has been toward “fewer, larger exits,” McKinsey says. “The total number of exits in the China market had declined to 112 by 2019 after peaking at 229 in 2014, while the average deal value climbed to $267 million from $96 million over the same period.” IPO exits for PE investments fell to about 5% of exit deal value in 2018-2019, down from 40% to 60% in 2010-2014, McKinsey calculated.

As exemplified by last year’s Yuanfudao deal, says Ma, “abundant PE capital also means that a promising startup can stay private much longer before going IPO.”

The emergence of Chinese PEs as a financial powerhouse has attracted a variety of investment partners, reflected in Temasek’s stake in Yuanfudao. The participation of multiple PE-led investment groups with diverse interests and investment goals has been welcomed by companies seeking financing, and has also garnered the kind of broad support from the investor community that fosters competitive strength. Certainly, Tencent’s involvement bodes well for the online-education company.

From an investor’s point of view, McKinsey found that these PE-led groups performed much better than individual funds during the relatively slow period for economic growth between 2009 and 2013, suggesting good potential for success during the current business crunch tied to the Covid-19 pandemic.

PE firms that have embraced the challenge are motivated by the search for growth and by their increased confidence that they can help China’s corporations to achieve it, benefiting themselves in the process. “Control-seeking investors want to control their destiny,” says Ma. Moreover, the PE sector has the government’s blessing. The CSRC circular voiced support for “increasing the proportion of direct financing” by PE investors, as well as “supporting entrepreneurial innovation, serving the real economy and managing citizens’ wealth.”

“Clearly, there is still a great deal of opportunity for PE firms operating in China,” McKinsey says. “Perhaps more than ever before.”