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— Private Equity —
Even in the global financial slump, "the Chinese market has well outperformed the rest of the world," says Terrence Mullen, a managing director with New York private equity firm Arsenal Capital Partners. In the third quarter, China's government said gross domestic product expanded nearly 9%, compared with 3.5% in the U.S. and 0.5% in Europe. There is a wide variety of private equity shops operating in China, from Blackstone Group LP -- which recently launched its first renminbi-denominated private equity fund -- to midmarket shops looking for low-cost manufacturing for their portfolio companies. They employ a variety of strategies. Arsenal does not seek standalone deals, but half the investments of its current fund, the $500 million Arsenal Capital Partners II LP, have meaningful operations in China. One of its U.S.-based holdings, Novolyte Technologies Inc., is looking to make an add-on acquisition in China, Mullen says. The Independence, Ohio, electrolyte materials maker, which Arsenal bought for $60 million last year, has production plants in Baton Rouge, La., and Suzhou, China. Arsenal is relying on its Shanghai office to help guide Novolyte's effort. "To be really successful, you need to be out there searching for good companies," says Mullen, as navigating the risks on the ground is imperative from quality and regulatory standpoints.
Sun Capital Partners Inc., a midmarket private equity firm in Boca Raton, Fla., doesn't directly invest in China either, but it has "sourcing" offices in Shenzhen and Shanghai to help improve -- and protect -- the profitability of its portfolio. The only way to weed out "the good and the ugly" of manufacturing in China is to visit the facilities, says David Stokoe, Sun Capital's head of sourcing. Slick catalogs and well-designed Web sites can be deceiving: He recalls arriving at one factory, where "you could literally see they fastened the sign on the wall 20 minutes before I got there." Once inside, the red flags continued to rise. The person claiming to be the owner didn't seem to know his way around, he says, getting lost on the way to the restroom. On-site due diligence may also prevent a serious run-in with the law. While touring a Chinese factory, one private equity investor discovered that at the end of its production line hand tools were being stamped "Made in Vietnam." The violation, known as trans-shipping, was an attempt to avoid paying stiff tariffs imposed by the U.S. Once solid production facilities have been identified, big payoffs can ensue. In October, Sun Capital made 15 times its money in the sale of Japanese fruit-flavored jelly product maker Tarami K.K. In some cases, sponsors have found opportunity despite problems. Faced with product safety concerns in the Chinese dairy industry -- six infants died and 300,000 were sickened last year from melamine-tainted milk -- the Chinese government has been pushing to modernize the country's fragmented sector. Private equity has become a welcome part of that effort, with a string of deals in recent months. In June, Kohlberg Kravis Roberts & Co. said it completed a series of investments in Chinese dairy farm company Ma Anshan Modern Farming Co. Ltd. According to a source close to the deal, the New York buyout house sank $150 million in the company, known as Modern Dairy, to help it build 20 to 30 large-scale dairy farms and back acquisitions over the next few years. The following month, the dairy sector realized this year's largest private equity deal in China, according to research firm Dealogic. China National Cereal, Oils & Foodstuffs Import & Export Corp. teamed with homegrown private equity firm Hopu Investment Management Co. Ltd. to buy a roughly 20% stake in China Mengniu Dairy Co. Ltd. for a combined $790.7 million in July. In September, Carlyle Group said it bought a 17.3% stake in Guangdong Yashili Group Co. Ltd., one of China's biggest makers of infant formula. It said it planned to appoint a new head of quality control at the company. While Beijing has been promoting private capital to improve its economy, it's not always easy to obtain regulatory approvals for deals. In 2005, Washington-based Carlyle tried to buy a majority stake in Chinese machinery maker Xugong Group Construction Machinery Co. Ltd. for $375 million, in what would have been one of the largest foreign investments in the province of Jiangsu. But the government is wary of foreign takeovers of state-owned companies and the deal faced considerable resistance. Carlyle sweetened terms and offered to buy a minority stake, to no avail. The firm's patience ran out in 2008, and it scrapped the effort after three years in regulatory limbo. But with plenty of opportunities to invest in privately held businesses, the regulatory environment is no longer the biggest impediment to doing deals in China, argues John Breckenridge, a managing director at Good Energies Inc. (pictured above), a renewable energy-focused private equity shop. Instead, cultural differences regarding how people think about selling their businesses have become the greatest challenge. For Chinese entrepreneurs, the "ultimate sign of success" often lies in filling a long-term position of chairman and CEO, whereas in the U.S. it is signaled by turning a "great profit." Based in New York, Breckenridge travels to China at least once a month, and is responsible for Good Energies' largest Chinese investment: a 35% stake in the Nasdaq-listed Solarfun Power Holdings Co. Ltd., a Qidong-based photovoltaic module maker. "The Chinese PV industry has grown with astounding speed," he says, arguing it will become one of the top three or four players in the world for solar installations over the next several years. Private equity's interest in China remains evident despite the global downturn in private equity fundraising. So far this year, 12 pools solely targeting China have raised about $3.5 billion, according to industry data tracker Preqin Ltd., while a further 54 funds are on the road, looking to amass a combined $24.56 billion of capital. Many of them are homegrown. "There's been an absolute explosion in wealthy Chinese," Breckenridge says. This has helped give rise to dozens of local private equity funds. New York-based Blackstone unveiled in August its Rmb5 billion ($734 million) Blackstone Zhonghua Development Investment Fund, which will concentrate on investment in the Shanghai region. Blackstone has invested in China in the past, buying a 20% stake in chemical producer China National BlueStar (Group) Co. Ltd. for $600 million in September 2008. Investing with a renminbi fund, however, could carry certain regulatory advantages, including, for instance, helping to get around Chinese accounting rules that make it difficult to take money out of the country. It's a "complicated and arduous" process to take capital back to the U.S., says Frank Marinaro, an attorney with Loeb & Loeb LLP. There's a lot of interest among sponsors to set up renminbi funds, he adds. Arsenal Capital is one of them. "We don't need to do it now," says Mullen, but "it's something we'd consider." |
The low cost of doing business in China and the potential for growth continue to attract private equity investors. Its economy and local enterprises have expanded so quickly that sponsors can often achieve high returns without any leverage. But they have been forced to get comfortable with risks and regulatory hurdles of investing in the evolving market there.
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