Private Equity in China

Introduction to Private Equity• Private Equity: Funds

and/or investors that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity.

• Capital is raised to expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet

Private Equity1) Private Equity firms

seek out undervalued or underperforming companies. Unlock significant value by:

1) Improving business strategy

2) Injecting managerial expertise

3) Advancing production technology

4) Expanding distribution

Issuers-New Ventures (Start-ups, early stage)-Public Company (Turnaround, Buyout)

-Private Company (Turnaround, Expansion, Replacement Capital)

Private Equity Firm

Investors-Pension Funds-Endowment Funds

-Banks-Wealthy Individuals

Private Equity1)Mostly consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. (i.e. pension funds, insurance companies, rich people, etc..)

2)Private Equity firms sometimes pool together funds to take public companies private.

1)Private Equity firms often conduct LBOs (Leveraged buyouts): Large amounts of debt are issued to fund a large purchase.

1) Will then improve company in hope of reselling it to another firm or cash out via an IPO.

2)Investments often demand long holding periods for a turnaround of a distressed company or a liquidity event (IPO or sale to a public company)

China• China has seen tremendous growth the

past 2 decades stemming from economic reform to general ways of doing business (laws, practice, standards, etc.).– China: East Asian growth model.

• Export-led growth that exploits its labor cost advantage.

• Have improved infrastructure, human capital, labor mobility & urbanization of the population since 1978.

– Large labor pool, high savings (more than 45% of GDP) and rising FDI have led to rapid capital accumulation.

– Succeeded in all manufacturing segments with high labor and capital/infrastructure intensity and is in the process of building multibillion-dollar electronic and heavy industrial plants.

Risks of Doing Business in China

• GENERAL RISKS:

1) Economical

2) Geopolitical

3) Societal

4) Environment

• IDIOSYNCRATIC RISKS:

1) Making Investments

2) Government Restrictions

3) Inadequate Legal Environment

4) Managing Investments

5) Exiting Investments

Private Equity in China• Chinese Private Equity firms are not as

rigorous in their investment analysis and tend to rely more on their gut instincts and local knowledge of the country when investing in China.

• A Chinese Private Equity firm will not spend the time and money that an international Private Equity firm will spend on due diligence, but will instead rely on its own network of contacts to form opinions.

• The fact that Chinese Private Equity firms do not spend as much time on due diligence enables them to act much faster than their international counterparts, making them extremely competitive when it comes to making deals in China.

Differences between Western and Chinese Buyouts

Western ChinesePublic-to Private

In the West, buyouts involve the outright purchase of public listed firms

going private.

In China, the seller has been the state (i.e. privatization) and in most cases the new

controlling shareholder is a local, and not a P/E entity.

Leverage In the West, buyouts are highly leveraged (60%-80% of debt financing)

In China, little or no debt is involved. But this might change over time as credit markets

deepen and legal framework might adjust to permit more leverage.

Transaction Size

In the West, buyouts run into the hundreds of millions, maybe billions of

dollars.

In China, very few companies exist of that size and P/E transactions are far smaller.

Politics and Foreign Ownership

-Political sensitivity to foreign investors gaining control of large, high visibility

enterprises has begun political backlash in China.

China’s 12th 5 Year Plan (2011-2015)

• The targets for the Twelfth Five-Year Guideline in 2011 were to grow of GDP by around 8%, 7% annual growth of per capita income, spend 2.2% of GDP on research and development by 2015.

• Sectors Poised to Benefit:– Health Care

• Biotechnology

– Energy and Environment• Nuclear and Hydropower

– Technology• Want to transition from “Made in China”

to “Designed in China”.

• Strategic Emerging Industries: China is shifting from “The World’s Factory” to develop seven SEI’s.– Biotechnology,– New energy– High- end equipment

manufacturing– Energy conservation and

environmental protection – Clean- energy vehicles– New materials – Next-generation IT.

China’s 12th 5 Year Plan (2011-2015)• Implications for Foreign Business

– Foreign business should monitor China’s SEI policy closely and look for opportunities to inject comment and input into its development. Foreign firms may also consider the use of partnerships with local companies to better access the significant funding opportunities available.

• Changes to Business Environment– Negatives

• Increased costs could result from proposed minimum wage hikes

• Value-added tax hikes • Raw materials resource price reforms

– Positives• The government will continue to focus on

opening up China’s service sectors.– Further developing its talent

recruitment through education reform and strengthening the country’s IP regime.

Hony Capital & China Glass Holdings Case Study Overview

• Hony Capital, a recently created Chinese Private Equity fund at the time, bought out state owned Jiangsu Glass company in 2004. • Restructured company to create

successful IPO on the HK Stock Exchange, now known as China Glass. With the acquisition of seven Chinese glass manufacturing companies, CG has transformed into one of the largest glass producers in China.

• Since the Buyout (2003 to 2007):

– Daily Production Capacity• 2003: 900 Tons• 2007: 5,320 Tons

– Revenues• 2003: $44.5 mil• 2007: $250 mil+

– Exports• 2003: 10% of Sales• 2007: 30% of Sales

Hony Capital Opportunities and Differences

• Opportunities for Hony:

1. China’s traditional industries (i.e. construction material, textiles, food & beverages, etc..) have limited risk and very fast growth. This makes it perfect for Private Equity investment.

2. Private enterprises in China lack resources, while Private Equity can stimulate quick, qualitative change.

3. Private Equity is a good tool for China to reform state-enterprise ownership and management-incentive systems. • This allows state enterprises to

reform in a more acceptable fashion.

• Ways in which Hony’s deal differs from US Buyout Deals:

1. Focus on privatizations of state owned enterprises rather than publicly listed private-sector companies.

2. Leverage is not a significant factor

3. Don’t do deals that involve significant asset stripping or major layoffs

4. Do an enormous amount of due diligence on management, as to not interfere with daily operations.

5. Hony could capitalize on investment opportunities because of its local knowledge

Big Players in the China Glass Transaction

• Three Major Shareholders in the Transaction:

1. Seller: Municipal Government • Trying to privatize company quick

2. Company’s Senior Management

3. Buyer: Private Equity Fund (Hony) • Wanted to execute buyout strategy

that would capitalize on privatization opportunities.

• Introduced new incentive-based compensation to motivate management.

• An alignment of interests:

1. Company owner: • Wanted to reduce the

government’s financial burden and strengthen the private sector’s role in the economy.

2. Company’s Senior Management: • Jiangsu Glass needed capital in an

industry that would increasingly favor larger players.

3. Hony Capital : • Believed in Jiangsu Glass’s

management team. The country was growing at a 10% annual rate.

China Glass Deal Structure• Establishing post-investment objectives:

– CEO would work for Jiangsu full-time and relinquish position as official of Suqian City.

– Preparations to list on the HKSE would begin as soon as legally possible. • Proceeds from the IPO would be

used to build additional production lines and expand production via acquisitions

– Immediately start looking for acquisition targets.• Would look to attract a world-class

glass manufacturer as a shareholder and strategic partner.

• Structuring and Closing the Deal

– Wanted to list on HKSE to demonstrate to international investors that the company satisfied the highest standards of financial reporting, transparency and corporate governance. • Stipulated there must be no

material change in company ownership for at least one year prior to IPO.– Throughout that year, the

accounting and financial reporting systems were revamped & a new Board of Directors was established.

• Hony acquired Jiangsu Glass for 93 million RMB (13 million USD).

China Glass IPO• Preparing for the IPO

– Hony Restructured the Board of Directors • Hony CEO became chairman of

the board.

– New accounting and audit standards• Immediately establish

accounting standards that comply with the GAAP required by the HKSE.

• Would also perform an annual independent audit, for the first time in company history.

• Executing the IPO– In June 2005, 7 months after

the buyout, China Glass Holdings Ltf issued 90 million new shares on the HKSE, raising $25 million in capital.

Future for China Private Equity• The Rise of RMB Funds

– There are two types of RMB funds:

1. Domestic RMB funds are fully owned by Chinese investors

2. Foreign-invested RMB funds may be partially or fully owned by non-Chinese investors. – Both types of RMB funds are

organized under Chinese law and use RMB to invest in Chinese companies.

Future for China Private Equity

• "China is going to set the tone for private equity because a large number of their sovereign wealth funds are going to be investing large amounts of money outside of China, and they're going to be setting the rules and the patterns for what some of those investments are going to be." - David Rubenstein, co-founder of Carlyle Group

• Example: China's national investment fund, China Investment Corp. (CIC) - revealed in a filing with the U.S. SEC early this year that it owned $9.63 billion in equity stakes at more than 60 U.S. companies, including American International Group Inc., Apple Inc., News Corp. and others.

Presentation Notes

Presentation and additional following points

Private Equity• Private Equity: Funds and/or investors that make investments directly into private

companies or conduct buyouts of public companies that result in a delisting of public equity.– Capital is raised to expand working capital within an owned company, make

acquisitions, or to strengthen a balance sheet. – Mostly consists of institutional investors and accredited investors who can commit

large sums of money for long periods of time. (i.e. pension funds, insurance companies, rich people, etc..)

– Investments often demand long holding periods for a turnaround of a distressed company or a liquidity event (IPO or sale to a public company)

– P/E firms sometimes pool together funds to take public companies private. – P/E firms often conduct LBOs (Leveraged buyouts): Large amounts of debt are issued

to fund a large purchase. • Will then improve company in hope of reselling it to another firm or cash out via an IPO.

– P/E firms seek out undervalued or underperforming companies. Unlock significant value by: • Improving business strategy• Injecting managerial expertise• Advancing production technology• Expanding distribution

Private Equity in China• Chinese P/E players are not as rigorous in their investment analysis and tend to

rely more on their gut instincts and local knowledge of the country when investing in China. A Chinese P/E firm will not spend the time and money that an international PE firm will spend on due diligence, but will instead rely on its own network of contacts to form opinions. The fact that Chinese P/E firms do not spend as much time on due diligence enables them to act much faster than their international counterparts, making them extremely competitive when it comes to making deals in China.

• China has seen tremendous growth the past 2 decades stemming from economic reform to general ways of doing business (laws, practice, standards, etc.).

• China: East Asian growth model.– Export-led growth that exploits its labor cost advantage.

• Have improved infrastructure, human capital, labor mobility & urbanization of the population since 1978.– Large labor pool, high savings (more than 45% of GDP) and rising FDI have led to rapid capital

accumulation. – Succeeded in all manufacturing segments with high labor and capital/infrastructure intensity

and is in the process of building multibillion-dollar electronic and heavy industrial plants.

Opportunities & Risks (1/2)– Risks

» General• Economical

• Increase of input prices, failure to execute reforms, financial or fiscal crisis, fall of consumer spending, reduction in FDI.

• Geopolitical• Increased terrorism and political tension

• Societal• Social unrest, protectionism

• Environmental• Pandemics, natural disasters, pollution

» Idiosyncratic• Making Investments

• Difficulty to conduct proper due diligence• In China, financials can be unreliable and market data may be limited.

• Important to conduct rigorous and creative outside-in due diligence, allocating stronger emphasis on verifying financials in China.

• Government Restrictions• Since China’s admission to the WTO in 2001, it has opened up an increasing number of sectors to foreign investment.

• Caps in communications, airlines, airports, and transportation sectors. • Approval needed for controlling shares in construction or public facilities.

• Inadequate Legal Environment • As China progresses to the “rule of law”, government officials have been known to meddle with court decisions, law

enforcement is less rigid, and fraud events have been reported in the local press. • International pressure is mounting to encourage China to improve its legislation and administration of

intellectual property rights and reduce inequalities in bankruptcy laws.• Companies planning investment in China should include clauses in contracts that allow for international arbitration. • China’s State Administration of Foreign Exchange has issued a policy closing a loophole for P/E firms that set up off-

shore intermediate companies to avoid paying capital gains tax upon sales of assets.

Opportunities & Risks (Continued) (2/2)

• Risks (Con’t)– Idiosyncratic (Con’t)

• Managing Investments – Lack of appropriate management skills

» China has limited middle management pool with international-standard skills and knowledge of English. • P/E firms also should consider hiring US management with solid track records to improve operations or employing

senior professionals to spend considerable time to train locals in China. – Limited access to domestic capital markets

» China has limited access to debt.• Chinese banks are wary of foreigner, whom they view as predators. • International banks are limited in their capacity to lend Chinese currency.

– Currency volatility» China’s currency has been pegged to the dollar until managed float was introduced in 2005.

• Important to consider proper currency hedging with export-led businesses. » Exiting Investments

• Exit option limitations:• In China, local market liquidity is limited. • Shares on the Shanghai and Shenzhen exchanges are inefficiently priced because of poor disclosure and the

overhang of untraded state shares. • Restriction on repatriation of funds

• Exiting Investments– Exit option limitations:

» In China, local market liquidity is limited. » Shares on the Shanghai and Shenzhen exchanges are inefficiently priced because of poor disclosure and the overhang of

untraded state shares. – Restriction on repatriation of funds

» China allows payments out and foreign exchange progressing within a reasonable time frame, although paperwork requirements vary.

Hony & China Glass Case Study (1/4)

– Hony Capital, recently created Chinese P/E fund, bought out state owned Jiangsu Glass company in 2004. • Restructured company to create successful IPO on the HK Stock Exchange, now known as China Glass.

With the acquisition of seven Chinese glass manufacturing companies, CG transformed into one of the largest producers in China.

» Trust was key in tis case, and accelerated the company to a new higher level.

• New board of directors was established, revamped governance practices and acceptable accounting and financial reporting standards were also implemented.

» This enhanced the company’s credibility with investors.» P/E and Company management must share the same vision for the company.

• Since the Buyout» Daily Production Capacity

• 900 tons (2003) to 5,320 tons (9/2007)» Revenues

• $44.5 mil (2003) to $250mil+ (2007)» Exports

• 10% of sales to 30%

• Three Major Stakeholders in Transaction– Seller: Municipal Government

» Trying to privatize company quick– Company’s Senior Management– Buyer: P/E Fund (Hony)

» Wanted to execute buyout strategy that would capitalize on privatization opportunities. » Introduced new incentive-based compensation to motivate management.

Hony & China Glass Case Study (Continued) (2/4)

• Opportunities for Hony:– China’s traditional industries (i.e. construction material, textiles, food & beverages,

etc..) have limited risk and very fast growth. This makes it perfect for P/E investment. – Private enterprises in China lack resources, while P/E can stimulate quick, qualitative

change.– P/E is a good tool for China to reform state-enterprise ownership and management-

incentive systems. • This allows state enterprises to reform in a more acceptable fashion.

• Hony’s deal differ in a few ways from US buyout deals:– Focus on privatizations of state owned enterprises rather than publicly listed private-

sector companies.– Leverage is not a significant factor– Don’t do deals that involve significant asset stripping or major layoffs– Do an enormous amount of due diligence on management, as to not interfere with

daily operations.• Hony could capitalize on investment opportunities because of its local knowledge

Hony & China Glass Case Study (Continued) (3/4)

• Hony-China Glass Transaction– An alignment of interests

• Company owner: Wanted to reduce the government’s financial burden and strengthen the private sector’s role in the economy.

• Company management: Jiangsu Glass needed capital in an industry that would increasingly favor larger players.• Private Equity Investor: Believed in Jiangsu Glass’s management team. The country was growing at a 10% annual rate.

– Establishing post-investment objectives• CEO would work for Jiangsu full-time and relinquish position as official of Suqian City. • Preparations to list on the HKSE would begin as soon as legally possible.

– Proceeds from the IPO would be used to build additional production lines and expand production via acquisitions

• Immediately start looking for acquisition targets. – Would look to attract a world-class glass manufacturer as a shareholder and strategic partner.

– Structuring and Closing the Deal• Wanted to list on HKSE to demonstrate to international investors that the company satisfied the highest standards of

financial reporting, transparency and corporate governance. – Stipulated there must be no material change in company ownership for at least one year prior to IPO.

» Throughout that year, the accounting and financial reporting systems were revamped & a new Board of Directors was established.

– Hony acquired Jiangsu Glass for 93 million RMB (13 million USD).

– Executing the Value Enhancement Strategy• Creating Financial Incentives for Key Management

– Hony gave 4% of it’s 100% share ownership to the seven most senior managers at the same price they bought it for.» Gave 8% after the IPO came out, at the IPO price.

• Attracting a World Class Strategic Investor– Pilkington, a UK flat glass producer, wanted a better foothold in China. – Pilkington initially got 9.9% of China Glass shares at the IPO price, and agreed to buy the rest of the shares from Hony.

Hony & China Glass Case Study (Continued) (4/4)

• Preparing for the IPO– Hony Restructured the Board of Directors.

• 3 senior members of management, 2 Hony representatives and 3 unrelated independent directors. Upon the IPO this would include two representatives from Pilkington.

• Hony CEO became chairman of the board

– New accounting and audit standards• Immedietly establish accounting standards that comply with the GAAP required

by the HKSE. • Would also perform an annual independent audit, for the first time in company

history.– Executing the IPO

• In June 2005, 7 months after the buyout, China Glass Holdings Ltf issued 90 million new shares on the HKSE, raising $25 million in capital.

China’s 12th 5 Year Plan (1/3)• A full proposal for the plan was released and approved by the National People’s Congress on March 14,

2011, with the goals of addressing rising inequality and creating an environment for more sustainable growth by prioritizing more equitable wealth distribution, increased domestic consumption, and improved social infrastructure and social safety nets.

• Foreign business can expect a changed cost structure during the 12th FYP period. – Increased costs could result from minimum wage and value-added tax hikes, raw material resource price reforms,

and environment-related taxes. – On the positive side, foreign business can expect the government to continue opening up China’s services sector,

to further develop talent recruitment through education reform, and to strengthen the country’s intellectual property (IP) regime.

• Strategic Emerging Industries: Shifting from “The World’s Factory” to develop seven SEI’s. Doing this by including several preferential tax, fiscal and procurement policies in order to develop the SEI’s. Planners hope these industries become the backbone of China’s economy in the coming decades.– The seven industries are biotechnology, new energy, high- end equipment manufacturing, energy conservation

and environmental protection, clean- energy vehicles, new materials, and next-generation IT.• The targets for the Twelfth Five-Year Guideline in 2011 were to grow of GDP by around 8%, 7% annual

growth of per capita income, spend 2.2% of GDP on research and development by 2015.• Among the other highlights of draft plan distributed to the media prior to the opening of the Fourth

Session of the 11th NPC are:– Inviting of foreign investment in modern agriculture, high-tech, and environment protection industries– Value-added output of emerging strategic industries accounting for 8% of GDP– Moving coastal regions from being the "world's factory" to hubs of research and development, high-end

manufacturing, and the service sector.

China’s 12th 5 Year Plan (Continued) (2/3)

• Sectors poised to benefit from 12th FYP:– Health Care

• Biotechnology: Will be one of China’s key SEIs, most likely due to the sector’s potential for large productivity gains and its ability to solve health problems associated with China’s rapidly aging society. The plan will support the development of innovative biotech products, high-end medical devices and patented medicines. The government will reportedly put forth a spending package of more than RMB 12 billion for R&D of new drugs from 2011-2015.

– Energy and the Environment• In terms of energy sources, China’s overall energy objective during the 12th FYP will be to maintain coal as the dominant

source of energy, while steadily increasing the proportion of renewable energy.• Nuclear and Hydropower: The government has announced that it will structure new energy policies around hydro and

nuclear power. China’s 11 nuclear power reactors currently account for 1 percent of the nation’s total power capacity, but by 2015 will double, with 25 nuclear power plants in operation. Hydropower’s capacity will increase by 50 percent by 2015.

• Three of the seven SEIs are devoted to the energy and environment sectors: – Energy Efficiency and Environment:

» The focus will be on waste recycling and clean coal technologies– New Energy:

» China aims to develop advanced technology in the nuclear, solar and wind sectors– New Energy Vehicles:

» China is focused on battery cell technology and is also aiming for an annual production of 1 million electric vehicles by 2015.

– Technology• Want to transition from “Made in China” to “Designed in China.”

– In order to achieve this goal, the government plans to heavily invest in science and technology education and R&D, further develop China’s intellectual property rights system and support “Next-Generation IT” as an SEI. China’s indigenous innovation drive will also continue to play a central role in this sector throughout the 12th FYP period.

– Next Generation IT: » Next-generation IT has been selected as one of China’s SEIs. China is particularly interested in accelerating the creation of next-

generation information networks, mobile communication and the Internet. In addition, the government plans to invest in R&D of the "Internet of things" and cloud computing, and develop digital and virtual technologies.

China’s 12th 5 Year Plan (Continued) (3/3)

• Implications for Foreign Business– Foreign business should monitor China’s SEI policy closely and look for

opportunities to inject comment and input into its development. Foreign firms may also consider the use of partnerships with local companies to better access the significant funding opportunities available.

– Changes to Business Environment:• Increased costs could result from proposed minimum wage hikes, value-added

tax hikes, raw materials resource price reforms, as well as the implementation of potential environment insurance plans, carbon markets and other environment-related taxes. However, there are benefits to foreign business embedded is this plan, as well. Foreign companies can expect the government to continue its focus on opening up China’s service sectors, further developing its talent recruitment through education reform and strengthening the country’s IP regime.

Future for China Private Equity• Future for China P/E

– "China is going to set the tone for private equity because a large number of their sovereign wealth funds are going to be investing large amounts of money outside of China, and they're going to be setting the rules and the patterns for what some of those investments are going to be." • To take just one example, China's national investment fund -- China Investment

Corp. (CIC) -- revealed in a filing with the U.S. Securities and Exchange Commission early this year that it owned $9.63 billion in equity stakes at more than 60 U.S. companies, including American International Group Inc., Apple Inc., News Corp. and others.

– When competing globally, for example, Chinese companies turn to private equity firms because they are inexperienced in managing intellectual property and brands. But this can be problematic because the firms themselves may be ill-equipped for the job, as many of their employees hail from finance backgrounds.• It’s critical to be invested in sectors that have the strong support of the

government and are in line with its goal of providing a better quality of life for its people.