asia private equity institute (apei) private equity …private equity insights, september 2013 asia...

Private Equity Insights, September 2013

Asia Private Equity Institute (APEI), SMU

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Asia Private Equity Institute (APEI) Private Equity Insights Q3 2013

Contents

• An Introduction to the APEI • The Private Equity Deal Landscape in China by Lily Fang and Melvyn Teo • Update on the Institute’s Activities

An Introduction to the APEI The vision of the Asia Private Equity Institute is to be the premier research and knowledge hub for private equity and venture capital activities in the Asia Pacific region. According to Preqin, “Asia PE funds raised $62 billion in 2011, double the $31 billion raised in 2010. This 100% growth rate was approximately twice that of the global PE fund raising market, and Asia funds have now taken over Europe as the 2nd largest fund-raising market after North America.” Despite the surge in interest for private equity in Asia, most academic and practitioner research on private equity remains focused on US and Europe. As the first Asia-focused academic research centre on private equity and venture capital, APEI seeks to fill this knowledge gap. To do so, APEI will be an integrated platform that (i) conducts high quality academic and applied research on private equity and venture capital (ii) educates practitioners and disseminates new ideas and methods, thereby raising the standards and level of professionalism in the industry (iii) elevates the profile of the private equity and venture capital industry in Singapore and Asia. Some of the activities of the institute include a quarterly private equity insights newsletter that parlays academic findings into key lessons for general partners and limited partners, a closed door quarterly investment roundtable which facilitates an exchange of investment ideas between key industry players in an intimate setting, and an annual private equity conference where academics, general partners, limited partners, and industry experts discuss and debate topical issues that resonate with the industry.



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The Private Equity Deal Landscape in China Lily Fang and Melvyn Teo1 Executive summary We explore the private equity landscape in China using a large transactions database with 17,585 transactions and US$367.50bn total capital flows. Private equity activities increased rapidly in the last two decades, from virtually non-existent in 1991 to a peak of US$92.59bn in 2011. Initially, entry transactions are driven by growth capital, although in the more recent years, we see a surge in venture, pipe, and buyout activity. Exits have concentrated in 2006, 2010, and 2011. General partners tend to invest in companies in finance, machinery, services, mining, food, and real estate. The average investment multiple for deals in China is an impressive 5.58 but the performance distribution is highly skewed. On one hand, 66.23 percent of the deals are either write-offs or have yet to deliver distributions to their investors. On the other hand, 21.38 percent of targets acquired deliver multiples in excess of three times initial capital. Moreover, the average deal multiple when weighted by initial investment falls to 1.39 suggesting that the larger deals substantially underperform the smaller ones. Significant variation in performance exists between industries, with machinery and finance outpacing mining and real estate for the average dollar invested. Finally, the duration of Chinese private equity investments has changed over time. The mean time to exit for deals initiated between 2001 and 2005 is less than two-third that for deals initiated prior to 2001. However, the investment cycle appears to be lengthening again after 2005, which is indicative of a more difficult exit environment. Introduction In recent years, China has been one of the hottest destinations for private equity funds. According to Washington-based EMPEA (Emerging Market Private Equity Association), for example, China accounted for 45% of all private equity fund raising for emerging markets in 2011. China’s rise in the global private equity scene is perhaps inevitable, given the country’s rapid economic development, vast population, burgeoning middle class, and steady transformation from an investment and export driven economy to one that is driven more by internal demand and consumption. Against this macro-economic backdrop, private equity investing in China has focused more on growth than on harvesting efficiency gains or unlocking shareholder value, as is often the case in mature markets like the U.S. or Europe. The data presented in this newsletter bears out the growth-centered theme of Chinese private equity investments. However, in recent years, deal sizes have become bigger and more buyout type deals have taken place. Another critical factor behind the rise of China’s private equity industry—one that is perhaps less obvious or discussed—is the incomplete and underdeveloped nature of China’s capital markets. In China, banks (most of which are state-owned) are still the biggest allocators of capital, and capital is allocated overwhelming to the state-owned sector. While the private sector now generates over 60% of the country’s GDP and over 70% of total employment, it still gets only about 20-30% of the credit from banks. There is a vast funding gap working against China’s small and medium private sector firms, which are the key drivers of China’s

1 Lily Fang is Associate Professor of Finance at INSEAD. E-mail: [email protected]. Phone: +65-6799-5376



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economic growth. By providing capital to these enterprises, and in many cases, by providing expertise as well, private equity has played a significant role in capital allocation and wealth creation in China. Anecdotally, virtually every private sector “success story” from China that one can think of—Haier, Alibaba, Focus Media, etc.—all have benefitted from private equity backing. In the long run, private equity in China can do extremely well by filling in the gaps in China’s capital markets. However, these long-term factors underpinning the growth of China’s private equity market are, in the short-term, challenged by a number of adverse conditions. One of the key challenges for China’s private equity industry is that it has been easier to raise and invest money than to exit and realize returns. This is a point that is clearly borne out by our data. In our dataset, we observe 11,724 private equity transactions2 made over the past two decades. Overall, the total dollar amount of investments is 168.93 billion in our sample, which spans 1991 to 2012. The total dollar amount of exits is 198.57 billion. Thus the industry has, on aggregate, just about returned all the capital to LPs. This overall statistic however masks a huge amount of heterogeneity in performance. In particular, over 60% of the investments are either capital losses or unexited. At the same time there is a long (and thin) right tail in the performance distribution. Out of the total sample of deals initiated before 2010, 23.54% of them have multiples between 3 and 100. The extreme heterogeneity in deal performance presents a significant challenge to an “average” LP who might be grappling with capital allocation and manager selection decisions regarding China private equity. The challenging exit environment may not have any quick fixes. It is driven by a confluence of factors: the continued uncertainty in the global economic outlook, the IPO ban in China since Oct 2012, and the relatively small M&A market. Thus in some sense there is a lot of money “stuck” in the private equity ecosystem. Ultimately, exit conditions will only improve if the domestic A share market recovers, foreign investors increase their appetite for Chinese listings, or the M&A market for Chinese firms grows. Thus it can be said that the overall performance of China’s private equity has been lackluster, especially in contrast to the rapid GDP growth over the last decade. Raising funds have been relatively easy while exiting from deals have been relatively difficult. This has resulted in the huge asymmetry in deal performance with a large mass density at capital loss and a small right tail. Ultimately, this suggests that one of the key bottlenecks in China’s private equity is also a lack of human capital: talented, experienced private equity managers with the right skills. When investors are enticed by China’s growth prospects, capital flowed into China’s private equity funds. Without sufficient talent and investment expertise, the “money-chasing-deals”3 dynamic played out on a market-wide scale, hurting aggregate performance. In the last two years, private equity activity in China has cooled relative to its 2011 peak. In the long run, we think that a slower, more moderate pace of fund raising and investing could be the start of a healthier cycle for the industry. A slower pace of growth will allow human capital, market infrastructure, and capital markets time to develop and catch up. Data and Analysis The data used in our analysis comes from the VC/PE database compiled by ChinaScopeFinancial. The VC/PE database covers more than 3,000 LPs, more than 5,000 GPs, and 6,000 funds. After data cleaning, such as removing funds for which we have no investment information, we are left with 2,140 funds and 11,724 deals in our sample, from 1991 to 2012. For many of our deals, we have cash flow information, 2 In our sample, a transaction is a fund-target firm-time triple. Later we also present statistics where we aggregate investments into “deals”, defined by a fund-target firm pair. By definition we have fewer deals than transactions due to multiple entries and exits for each deal. 3 See Gompers and Lerner (2001).



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namely, when investments were made (including follow-on investments), and when partial and full exits took place. Although our sample period starts in 1991, for much of the analysis we focus on the more recent 2000 to 2012 period. In this analysis, we aim to take a first look at this rich dataset. Thus most of the statistics presented below are either at the aggregate level (industry wide sums), or distributions of performance at the deal level. There are other interesting issues to examine, for example, fund or GP level performance, and performance persistence; but we have left these issues for future work.

A. The Aggregate Picture – Investments and Exits To begin, we graph in Figure 1a, the total number of entry and exit transactions each year, and in Figure 1b, the total value of entry and exit transactions each year. The first observation from Figure 1a is that there have been more entries than exits in terms of deal counts. This pattern holds for every single year in the sample. Second, 2011 is a peak year in terms of both entries and exits. In that year, there were 2,580 entry transactions or transactions with flows into portfolio companies and 1,467 exit transactions or transactions with flows from portfolio companies. These numbers imply about 10 entries and 6 exits per business day. Turning to dollar figures, Figure 1b shows that while in most years entry dollar amounts also exceeded exit dollar amounts, there has been notable exceptions. In 2006, 2010, and 2011, exit values easily surpassed entry values. Take 2011 as an example, at US$62.62bn, the value of exits in this year outpaced that of entries by US$32.65bn. Not surprisingly, these are also the years that the Chinese stock market showed relative strength compared to other years in the last decade. In the aggregate, this figure reveals that the total dollar amount returned is roughly equal to (or slightly exceeding) the total dollar amount invested. Figure 1a: Total number of entry and exit transactions in deal database

Figure 1b: Value of entry and exit transactions in deal database



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To facilitate a comparison between outflows from and inflows into private equity portfolio companies, we graph in Figure 1c the ratio of exit versus entry transactions, by number and by value. The darker bars in Figure 1c indicate that based on the number of transactions, between 2000 and 2012, exits have increased relative to entries. This reflects the gradual maturation of the private equity industry in China during that period. The lighter bars in Figure 1c show that the ratio of the value of exits versus entries displays significant time series variation however. It ranges from a low of 0.07 in 2001 to a high of 2.78 in 2006, and fluctuates significantly from year to year, suggesting that the market for exits is highly cyclical in the Chinese private equity industry. Figure 1c: Ratio of exit versus entry transactions in deal database

To dig deeper and to understand the driver (or drivers) of the cyclicality in the value of exits, we break down the transactions by investment type. Entry transactions fall into four categories: buyout, growth, pipe, and venture. We group venture series A, B, C, and D transactions into the same category to facilitate inferences. Exit transactions also fall into four categories: buyout, dividend, listing, and trade sale. Figure 2a depicts the number of entry transactions by investment type. One immediate observation is that Chinese private equity deals are dominated by venture investments. In every year of the sample, venture deals far outpaced the other deal types. The second most prevalent deal type is growth capital. Thus clearly China’s



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private equity—at least so far—has focused more on growth than on harvesting efficiency gains or unlocking shareholder value, as is often the case in mature markets like the U.S. or Europe. This is clearly a reflection of the very fact that China is the largest and fastest growing economy in the world. The overall growth bias is still evident from Figure 2b, which looks at dollar figures. Another interesting observation from this figure is the prominence of PIPE deals after 2008. In fact, between 2009 and 2011, PIPEs account for the largest fraction of dollars invested. This is no doubt related to the fall of public equity valuation after 2008, creating buying opportunities for investors as well as funding needs among newly public firms. The surge in Chinese PIPE activity post-2008 is reminiscent of the increase in US PIPE deals after collapse of the US tech bubble. Figure 2a: Number of entry transactions by investment type

Figure 2b: Value of entry transactions by investment type



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Figures 2c and 2d turn our attention to exit patterns. The number of exit transactions by investment type shown in Figure 2c reveals that the Chinese private equity market is highly dependent on listings as an exit strategy. The number of exit transactions via listing dominates exits via other routes over the entire sample period. Between 2000 and 2008, secondary buyout was the second most common way of exiting from a deal. Starting in 2009, there was a significant increase in the number of trade sales to the extent that the number of trade sales outpaced the number of secondary buyouts in 2010 and 2011. Clearly this is driven by the dearth of Chinese domestic IPOs starting from 2010, forcing GPs to seek alternate exit routes. The value of exit transactions not via the stock market is still much smaller than exits from listings and dividends, as can be seen in Figure 2d. Exits via buyouts and trade sales amounted to US$1.38bn and US$1.23bn, respectively, in the typical year. In contrast, the value of exits via listings was on average US$7.95bn per year, and increased to an impressive US$25.22bn and US$23.73bn in 2006 and 2010, respectively. This suggests that the cyclicality in the value of exit transactions (see Figure 1b) is driven primarily by the cyclicality in the market for Chinese IPOs. Figure 2c: Number of exit transactions by investment type

Figure 2d: Value of exit transactions by investment type



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B. Industries

How do the number and value of private equity transactions in China vary across industries? We classify the portfolio companies in our data into 18 industries based largely on the 17-industry classification used by Fama and French (1997). The 18 industries include food, mining, oil, textiles, consumer durables, chemicals, drugs, construction, steel, real estate, machinery, cars, transportation, utilities, retail, finance, services (i.e., non-financial services), and others. According to the pie chart in Figure 3a, three industries account for most of the number of transactions, namely food (5.86%), machinery (27.60%), and services (27.52%). All the other industries account for less than five percent of the transactions each. The transactions values (as opposed to the transaction numbers) are more evenly spread out across industries. Six industries are each responsible for at least five percent of the total transaction value: food (5.50%), mining (6.02%), real estate (5.38%), machinery (16.78%), finance (28.96%), and services (12.72%). Clearly, the value of each transaction in mining, real estate, and finance is higher than that in other industries.



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Figure 3a: Total number of transactions by industry

Figure 3b: Total investment amount by industry

We also present in Figure 3c – Figure 3f, the industry distribution for entry and exit transactions. Private equity firms are most likely to deploy capital in finance (28.21%), followed by services (13.70%), machinery (10.05%), mining (8.58%), food (6.55%), and real estate (6.15%), in that order. At the same time, they are most likely to receive distributions from finance (29.60%), machinery (22.50%), services (11.91%), real estate (4.71%), and food (4.60%). Portfolio companies in machinery and finance appear to punch above



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their weight when it comes to distributions per dollar invested. Conversely, portfolio companies in services, food, and real estate appear to deliver below average distributions per dollar invested. Figure 3c: Total number of entry transactions by industry

Figure 3d: Total entry investment amount by industry



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Figure 3e: Total number of exit transactions by industry

Figure 3f: Total value of exit transactions by industry

C. Capital Calls and Returns

To understand the characteristics of private equity deals in China, we group the private equity transactions into deals. In our data, a deal denotes a unique general partner and target pair. Co-investments by multiple general partners in the same target within the same time period are classified as multiple deals. We plot in Figure 4a, the distribution of the number targets by initiation year. Initiation is defined as the first time a general partner invests in a particular target. We find that the number of deal initiations has surged to a



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high of 2,262 in 2011 corresponding to the phenomenal growth in the private equity industry in China during the period. The average number of deal initiations per year between 2000 and 2012 is 876.38 deals. Figure 4a: Number of targets by initiation year

To understand the timing of capital calls and distributions for the average deal, we plot in Figure 4b the total cash flows from target by year after initial investment. We find that, over the entire sample most of the distributions occur during the five-year period post initial investment. The total initial investment amount in year zero is US$153.99bn. Within a year (i.e., in year 0), deals return US$24.92. In the five-year period post initial investment, the average net distribution is US$27.64 per year. Net distribution peaks in year 3 with a total capital outflow of US$45.49bn from portfolio companies to general partners. Figure 4b: Cash flows from target

The timing of distributions varies significantly with the vintage of the deal. Figure 4c and Figure 4d reveal that deals initiated at or before 2000 distribute cash slower than deals initiated between 2001 and 2005. As shown in Figure 4c, for deals initiated at or before 2000, the majority of the distributions tend to occur after the five years post initiation. Indeed there is a spike in net distributions seven years after deal initiation. In contrast, as shown in Figure 4d, for targets acquired during the golden era of Chinese private equity, from 2001 to 2005, the majority of the distributions occur with five years of target acquisition. Indeed, we observe a sharp increase in net distribution as early as one-year post deal initiation. The swift exits observed for deals initiated between 2001 and 2005 may be driven by the buoyant IPO market for Chinese companies



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immediately following that period. By comparison, we do not witness a surge in net distributions so close to the deal initiation year for targets acquired between 2006 and 2010. To put things in perspective, the mean time to exit for deals initiated prior to 2006 is 3.87 years. The average time to exit number masks significant variation over the 1990 to 2005 period. For deals initiated prior to 2001, the mean time to exit is 5.22 years. In contrast, for targets acquired between 2001 and 2005, the mean time to exit has decreased close to a third to 3.42 years, reflecting the compression of the private equity investment cycle during that period. We do not calculate the mean time to exit for deals initiated after 2006, as general partners may not have fully exited from some of those deals by 2012. Figure 4c: Cash flows from target for deals initiated at or before 2000

Figure 4d: Cash flows from target for deals initiated between 2001 and 2005

Figure 4e: Cash flows from target for deals initiated from 2006 and 2010



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D. Performance

How have Chinese private equity deals performed over the last twenty years? We calculate the investment multiples for all deals initiated at or before 2010. On average, every dollar invested in a private equity deal yielded 5.58 dollars. However, the average investment multiple of 5.58 masks significant variation in performance across deals. Over the full sample, 66.23 percent of deals are either write-offs or have yet to exit by 2012, consequently the investment multiple for these deals is zero. At the same time, 13.18 percent of targets generated investment multiples between 3 and 10, and 7.41 percent of targets delivered investment multiples between 10 and 100. Moreover when we weight investment multiples by initial investment, the average multiple falls to 1.39 indicating that the larger deals substantially underperform the smaller ones. Figure 5a illustrates the distribution of investment multiples for our sample of Chinese private equity deals. Figure 5a: Distribution of investment multiples for all deals initiated at or before 2010

Is the preponderance of deals with zero investment multiples (66.23 percent of the deal sample) driven by deals initiated close to 2010 that general partners have not yet been able exit from? We report in Table 1 the distribution of investment multiples for deals initiated in the early, middle, and later part of the sample



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period. We find that even for targets acquired at or before 2000, 56.27 percent of such targets have yet to distribute any capital back to their investors. A similar picture emerges for targets acquired between 2001 and 2005. There is some variation in deal performance over time. In line with buoyant conditions in 2006 and 2007 for Chinese equity listings, we find that the average investment multiple of 11.13 in the 2001 to 2005 sub-period was more than double the average investment multiples for the pre-2001 and post-2005 sub-periods. Table 1: Distribution of investment multiples for deals initiated at or before 2010

There is also substantial variation in deal performance across industries. As shown in Table 1, equal-weighted average investment multiples (where all deals are given equal weight) are highest in mining and machinery, and are lowest in finance and non-financial services. The high equal-weighted and value-weighted investment multiples of 8.53 and 2.78, respectively, for machinery accords with the relative size of the pie slices in Figures 3d and 3f. The low equal-weighted average investment multiple and the high value-weighted investment multiple for finance (relative to those for the other industries), suggest that the finance deal landscape is characterized by a few mega successful deals and many smaller unsuccessful ones. For mining however, the average multiples reported in Table 1 indicate that while smaller mining deals have generated impressive multiples, the larger mining deals have largely disappointed private equity investors. Conclusion We provide a first look at the private equity deal landscape in China using a comprehensive dataset covering private equity transactions. The value and number of private equity investments have grown rapidly in China, but exits have been relatively more elusive, and concentrated in years when public equity markets were buoyant. Perhaps the most striking and salient feature of Chinese private equity deals’ performance is its binary nature: either a capital loss or a significant upside. There is clearly substantial cross-sectional heterogeneity in deal performance. In the aggregate, the industry has just about returned investors’ capital. We will leave determinants of fund-level performance for future study. The statistics furnished in this study portray a cautionary tale for investors—especially for the relatively new investor who is just starting to allocate capital to China’s private equity industry.



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References Fama, Eugene, and Kenneth French, 1997, Industry costs of equity. Journal of Financial Economics 43 (2), 153-193. Gompers, Paul, and Josh Lerner, 2000, Money chasing deals? The impact of fund inflows on private equity valuation, Journal of Financial Economics 55 (2), 281-325.

Update on the Institute’s Activities Networking The APEI held our second annual private equity and venture capital symposium on 24th September 2013. The theme for this year’s symposium is The Evolution of Private Equity in Asia. The conference keynote speakers and panelists included Alan Thompson (Temasek Holdings), Ming Lu (KKR), Mathieu Perfetti (Credit Agricole), Meng Ann Lim (Actis), Ludovic Phallippou (Oxford) and Lily Fang (INSEAD). 337 people had registered for the conference. For more information regarding the Asia Private Equity Institute (APEI) at SMU and our upcoming activities, please contact Ms Karyn Tai, centre coordinator (Tel: +65-6828-0933, E-mail: [email protected]). We look forward to receiving your suggestions and comments.

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