When
News Corp. decided to launch a subsidiary of MySpace.com in China, it
chose not to go it alone. This April, the global news conglomerate
announced it was teaming up with two financial investors that are also
local heavyweights: IDG, which has racked up a 15-year operating
history as the first foreign VC fund in China, and China Broadband
Capital Partners, another venture fund headed by the influential Edward
Tian, former CEO of landline titan China Netcom.
MySpace declined to comment on the alliance, the value of which one
press report pegged at nearly $100 million. But Kathleen Ng, managing
director of the Hong Kong-based Centre for Asia Private Equity
Research, says the social networking site "stands to gain from two
known names in the domestic market. They can offer lots of local market
knowledge that's quite important."
Tie-ups like the MySpace deal highlight some of the novel approaches
being tested out by corporate investors in an increasingly complex
landscape in China. Strategic dealmakers are working with -- and
sometimes competing against -- a growing array of financial investors.
This marks a shift from the investment template that held true in
China for the past few decades. Not long ago, direct investments in
China were done largely by multinationals willing to joint venture with
a Chinese company. Venture capital made a limited appearance in the
early '90s, but investors backed off during the Asian crisis. Buyouts
didn't really show up in a big way until recently.
But now money is pouring in from both camps. The amount of private
equity funds dedicated to China rose to $4.8 billion in 2006, up 37%
from the prior year, according to the Centre for Asia Private Equity
Research. Venture capital is surging, too: last year VC investors spent
$1.8 billion on China, up 52 % from 2005 levels, according to research
firm Zero2IPO. On top of this, corporate venture outfits, notably Intel
Capital, have stepped up their presence. Then there are the domestic
players. China already has a couple of local PE houses with
dollar-denominated funds -- CDH Investments and Legend Hony Capital --
and new regulations passed in June will make it easier for Chinese
entities to set up their own private equity funds denominated in
renminbi.
All this is taking place in a shallow and at times highly
politicized deal market. It should come as no surprise that in this
fluid and fast-evolving investment landscape, the usual rules of
Western dealmaking are being swept away. On one hand, the situation in
China has given rise to innovative investing models linking corporate
and financial interests, such as the MySpace alliance and the $180
million investment fund set up last fall by IBM Corp. and Lehman
Brothers Inc. In other cases, the situation has created outright
rivalries between the different camps that would be highly unusual in
developed markets.
"You could have a three-way competition for the same deal with all
three investors taking part. In the U.S. that would rarely happen, but
in China it happens a lot," says Rocky Lee, Beijing-based partner and
head of China venture and private equity practice at DLA Piper.
Consider activity in the unsexy construction equipment sector. The
highest-profile bid so far has been the two-year old attempt by PE firm
Carlyle Group to buy Xugong Group Construction Co., the nation's
biggest construction firm. As of March Carlyle had resubmitted the deal
for bureaucratic approval for the third time, having dropped its
planned stake to 45% from an initial 85%. Officials had objected to the
buyout on grounds that Xugong is the leader in a strategically key
industry. Last year Caterpillar Inc. also ran into roadblocks when it
tried to buy Xiamen Xiagong Group Co. Ltd., another leading machine
company. By some accounts, the deal stalled because Caterpillar wanted
to jettison Xiagong's brand name.
But Volvo Car Corp. won approval for the purchase of 70% of Shandong
Lingong Construction Machinery this February, and this June Deere &
Co. said it would acquire the Ningbo Benye Tractor & Automobile
Manufacture Co. Ltd. business, a small tractor manufacturing concern.
Also last November, H&Q Asia Pacific managed to buy a 43%, $45
million stake in Yuchai Engineering Machinery, a light construction
equipment producer.
To understand the tangle of interests that can give rise to such a
free-for-all, it's important to recognize a key feature of the mainland
market: The traditional distinctions between different categories of
investors are far less applicable in China. Start with the VCs, who in
the developed markets typically fund technology startups with small
stakes. In China, where it's hard to find truly disruptive
technologies, VCs are not averse to plunking money into later-stage
companies with appealing but unproven business models -- a market
that's also of interest to private equity.
Or take private equity, which in the U.S. is often
synonymous with buyouts. In contrast, private equity houses operating
in China usually have to settle for minority stakes, either because
it's the only way to get regulatory approval or because Chinese
entrepreneurs are famously reluctant to give up control. Private equity
is also willing to do deals on a more modest scale in China than in
developed markets, often from $25 million to $100 million.
It's easy to see the potential for competition. At the same time,
there's also reason to expect a growing amount of collaboration.
"Strategics are looking at this as, 'We can help lay off some of the
risk to the private equity guys,' and private equity guys are saying,
'It's difficult to source deals as financial investors only, so this is
a way to put our money to work.' It's an idea that works from both
parties' perspective. I think you'll see more of that," says Jon
Christianson, Beijing-based partner at Skadden, Arps, Slate, Meagher
& Flom LLP.
Giving spiraling prices, offloading some risk to a financial partner may increasingly look like a sensible option.
"The size of required investment to make deals work in China has
increased tenfold in the last 10 to 15 years," points out Christianson.
"Before we would have had someone come in and put up $30 million or $50
million, and that would be pretty significant. Now you have strategics
having to put up $600 million or even $1 billion." Notably, several of
the big pre-initial public offering investments in Chinese banks over
the past couple years have featured combos of both corporate and
financial investors. And in 2005 the Carlyle Group joined up with
strategic investor Prudential Financial Inc. for the $410 million
purchase of just under 25% of China Pacific Life Insurance Co. Ltd., a
leading insurer.
In a more recent pairing, IBM and Lehman set up a $180 million China
investment fund last October, with each fronting half the capital. The
alliance draws on IBM's insights into China and Lehman's banking and
private equity expertise. In June the fund announced its first
investment, taking a 7.7% stake in Kingdee International Software Group
Co. Ltd. for a total of $16.9 million.
The jointly run fund has an eight-person staff, including three investment professionals each from IBM and Lehman.
"This is a unique model for IBM, which has never set up any kind of
investment vehicle for direct strategic investment, let alone partner
with another firm," says Charles Wu, Beijing-based managing partner of
the China investment fund. "We can provide information systems and
technology to help our clients accelerate their growth. But we believe
we can also help them by becoming a strategic investor, not only
helping them with business know-how and processes, but also with
internal structure, helping them transform their business."
Rather than focus on startups, the fund will invest in mid-stage and
mature companies -- what IBM's Wu calls "the sweet spot, where we can
make the biggest difference." IBM also has a separate, U.S.-based
venture arm, which focuses on working with VCs to help them make
investments aligned with Big Blue's strategy. Both it and the China
investment fund report to a centralized investment committee at Big
Blue's corporate headquarters.
While the IBM-Lehman fund may look a lot like private equity in
terms of its acquisition targets, Wu points out that it will only take
minority stakes, much like a VC firm. In this case, it's to avoid any
conflicts with IBM's own clients. "We don't want to gain a controlling
interest; we want to be a strategic partner," Wu says.
Also, the China investment fund won't limit itself to Chinese
technology firms, aiming instead at a broad portfolio of industries,
not including real estate. Contrast IBM's approach with that of another
strategic investor in China, Intel Capital, the VC arm of chip giant
Intel Corp. Intel Capital focuses solely on investments in technology
companies. One of its main goals is to build out technology ecosystems
-- helping sell more PCs and other digital devices -- so its parent can
get more of its silicon to market.
Intel's venture team, which launched a $200 million China Technology
fund in 2005, usually collaborates with financial investors. But that's
not for any lack of interest in other corporates.
"Most of the corporate investors don't have a formal
organization to do minority equity investments, so normally they're
more reactive than proactively going to source deals," says Cadol
Cheung, Hong Kong-based managing director of its Asia-Pacific
operations. But he adds: "If we think that certain investors can bring
value into the company, we will definitely go to invite them and see
whether they're interested."
In a deal announced this May, Intel teamed up with Warburg Pincus
and another corporate investor, Synopsys Inc., a Silicon Valley-based
vendor of chip design software, to invest in Chinese chip play Phoenix
Microelectronics (China) Co. Ltd. (No deal value was disclosed.) Cheung
calls Synopsys "a significant company in terms of chip design. With
Synopsys as an investor for Phoenix we could help them out with their
chip development and share expertise with them."
Financial investors don't just allow corporates to spread their
risk. Some of the more experienced players can also offer useful
insights into the market. Lehman is an attractive partner for IBM
partly because it was one of the first global investment banks to enter
China, setting up a representative office in Beijing in 1993, and one
of a relatively small group of foreign institutions allowed to invest
directly in China's equity and bond markets.
Or take Hong Kong-based boutique private equity house Orchid Asia.
In over a decade of investing in China, it's teamed up with industrial
investors including Trane, a subsidiary of U.S.-based American Standard
Cos. that makes and sells air conditioners on the mainland, and Lafarge
Gypsum Asia, a unit of Lafarge SA of France that distributes
plasterboard in China. "Multinationals will work with us because we
have a lot of local knowledge," says managing director Gabriel Li.
"Whereas MNCs fly in from U.S. or Europe who don't know anything about
China. They don't know which companies are good, who to talk to, they
don't know about management teams."
In contrast to longer-tenured financial investors, the global
private equity shops, which are relatively new to the scene in China,
are still finding their place. PE dealmaking has a very brief history
in China. "We didn't really see major PE deals until the last 24
months," says Clarence Kwan, the New York-based national managing
partner of Deloitte & Touche's Chinese Services Group who was based
in China from 1995 to 2002.
Carlyle ranks as an old hand among major fund houses, though it just
opened its first office in Shanghai in 2004. Kohlberg Kravis Roberts
& Co. didn't even have a Hong Kong office until the beginning of
2006, while Blackstone Group LP announced plans this year to open an
office in Hong Kong -- two years after it set up its first Asia shop in
Mumbai. Not only are most big PE houses relative greenhorns, but their
political standing is somewhat in question. That could play to the
advantage of corporates.
To be sure, the state investment company's recent decision to take a
$3 billion pre-IPO stake in Blackstone was viewed by some foreigners as
encouraging to private equity. Blackstone is also negotiating for a
minority stake worth $400 million in state-owned chemical firm China
National Bluestar Group, The Wall Street Journal reported in July.
That's a big deal in dollar terms in China, where most fall below $100
million. Beijing remains sensitive to criticism that it's selling
assets on the cheap to foreign speculators. In practice, the official
stance toward private equity has veered between grudging acceptance to
outright regulatory stonewalling.
In contrast, foreign corporates are perceived to have a fair amount
of sway with Beijing. With their know-how, they can help the government
advance toward a prized goal: transforming China from a reliance on
commodity manufacturing to one geared toward more innovative,
higher-margin goods and services. "China doesn't want foreign money
involved unless it's bringing in technological or management expertise.
You've got to position yourself that way in order to be favorably
looked on," says one person who's worked on deals in China. "It's been
a watershed event over the last two years, the change in attitude over
that issue. For the last 20 years, it was, 'We want your cash, cash,
cash, and a little technology.' Now it's, 'We want your technology and
maybe a little cash.' It's flipped."
The onus is on the private equity firms to show they aren't merely
out for a quick buck. It's no coincidence Carlyle referred to itself as
an "international strategic investor" in a 2006 press release
announcing its $25 million investment in private credit guarantor
Credit Orienwise.
When IBM and Lehman announced the formation of their joint
investment fund last year, the press release made sure to note it would
help support the China central government's policy of encouraging
business innovation.
As a corollary, some financial investors in China find it
worthwhile to act more like their corporate counterparts, taking up
advisory roles. That's especially true for investments in financial
firms. For example, in January 2006 a consortium of investors including
Goldman Sachs Group, Inc. (as well as Allianz Group and American
Express Co.) plunked down $3.78 billion to buy 8.5% of shares in
Industrial and Commercial Bank of China. As part of the deal, Goldman
agreed to help the bank develop its corporate governance, risk
management and internal controls and offer training in corporate and
investment banking and disposal of nonperforming loans.
"Goldman in a sense is [acting like] a corporate investor, in that
they're offering strategic advice," says Ng of Asia Private Equity
Research.
But since many bureaucrats remain skeptical of private equity
motives, adding corporates to a deal might sweeten relations.
"Certainly the government is generally responsive to multinationals
that bring in a lot of operational value," says Orchid Asia's Li. "Not
that they don't pay attention to financial investors; they do. But when
the two are teamed up together it's even better. Your skills sets are
different and complement each other."
Already, partisans of both groups are having to decide whether to
form alliances or compete. As dollars pour into a still-shallow deal
pool, investors will be called on to rethink their approach to China's
changing landscape, where the old rules are being rendered obsolete.
The A-share factor
Corporate investors must now factor in yet another phenomenon that's
shaping the investment landscape: the startling ascent of China's
domestic stock market. After rocketing up 130% in 2006, the Shanghai
Stock Exchange Composite Index was up another 50% between January and
mid-June.
The stock market's rise could mean one of two things for foreign
corporates. On the one hand it may make it tougher to buy into Chinese
companies, since the fittest can raise money via a public listing
instead, partaking in the fat multiples now accorded by the bull
market.
But the stronger stock market could also benefit foreign investors
because for the first time, a domestic listing is starting to look like
a conceivable exit strategy. Indeed, some Chinese entrepreneurs are
more favorably inclined toward a domestic initial public offering than
one in the U.S.: The renminbi-denominated A market is more familiar and
doesn't impose any language hurdles or Sarbanes Oxley-like regulation.
Admittedly the legal picture remains fuzzy and there may be currency complications for foreign investors.
"There's no clear regulatory path for a foreign-invested company to
list on a Chinese exchange, and for the foreign shareholder of the
listed company to exit and repatriate its money. But there's no
prohibition, either," says Rocky Lee, Beijing-based partner and head of
China venture and private equity practice at DLA Piper.
"We have a couple of portfolio companies considering an A-share
listing, though it's just a discussion at this point," says Cadol
Cheung, Hong Kong-based managing director of Asia-Pacific operations
for Intel Capital.
The Nasdaq market is still Intel Capital's preference, though. After
all, the A-share boom is a very recent phenomenon -- and to some
observers, even has the look of a bubble. - K.C. Swanson
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