Asia Private Equity Institute (APEI) Private Equity Insights Q4 2012 Contents An Introduction to the APEI The Rise of RMB Funds in China and Their Challenges by Jerry Cao 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 2 nd 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. 1
The Rise of RMB Funds in China and Their Challenges Jerry Cao 1 Executive summary In China, the market has witnessed rapid development, largely due to the abundance of entrepreneurial activities, ample liquidity and attractive exit opportunities. Despite its huge success, the private equity market is highly divided and faces many challenges. This paper documents the recent trends and describes the market structures. The analysis covers the characteristics of RMB funds such as fund raising, investment, exit and industry concentrations and compares RMB funds with US dollar funds. We highlight some structural challenges that may impede the future development of the private equity market in China. Introduction Private equity investment offers an important source of growth capital in emerging markets since credit is often rationed and firms face financing constraints. Different from the buyout model, many private equity funds in emerging markets are targeting underdeveloped, credit-constrained firms, and their core focus is to help them grow faster. This is highly relevant in the sense that in many developing countries family-managed businesses are dominant business organizations [see, e.g., La Porta, Lopez-de-Silanes, and Shleifer, 1999; Bertrand and Schoar, 2006; Villalonga and Amit, 2009]. For family firms, the main obstacle to growth is the lack of managerial and financial expertise that is critical for taking advantage of great growth opportunities abundant in fast growing markets. Control or majority buyout is often not encouraged since many firms have concentrated ownership structures. China offers a perfect setting to examine the private equity industry s growth and challenges. In the study, we look at private equity funds that are active in China. The government has long recognized the need for longterm growth and has devised numerous policies to promote private equity especially venture capital investment in China. As a result of many such policies, China s private equity industry has experienced tremendous and dynamic growth in the past twenty years. Currently, it is the second largest private equity market including venture capital in the world. Over 600 PE-backed Chinese firms are currently listed in the major capital markets around the world with the majority listed in domestic equity markets. Although anecdotal evidence reveals that private equity investment is playing an increasingly important role in both Chinese high-tech entrepreneurial firms and the global market, research on this market is at an early stage. The focus of the study is on the RMB funds and US dollar funds in China, two types of funds that are currently active in the market. China s research and development is a focus of attention nationally and internationally since it may determine the sustainability of China s growth and can also fundamentally affect international markets. This study will thus contribute to both policy-making and business practice. Data We collect the data on private equity investment deals by combining two datasets. The deal or investment information on PE-invested transactions and PE firms are collected from the Zero-2IPO database and Asia 1 Jerry Cao is Assistant Professor of Finance and Co-Director, Asia Private Equity Institute (APEI) at the Singapore Management University. E-mail: jerrycao@smu.edu.sg. Phone: +65-6828-0273. 2
Private Equity Insights, December 2012 Venture Capital Journal database. The two databases contain information of private equity firm or fund s basic information such as age, asset under-management, location, currency of capital, as well as information of investee firm s name, age, amount of investment, stage of financing, ownership stake, firm s post-money valuation and exit information such as investee firm s IPO or M&A. The sample period is between 1990 and 2011 and our whole sample covers 4925 transactions, involving 3225 PE firms. We first divide all PE firms into two groups: RMB funds and US dollar funds. Since prior to 2002, there were not many RMB and US dollar funds, in most of the analysis we will provide summary statistics for the PE funds and PE investment transactions between 2002-2011. For example, in 2011 alone, 382 new funds weree started and 28 billion USD amount of capital were committed in total, more than doubling the number of 158 new funds and amount of 11 billion USD capital raised in 2010. The trend shows a strong overall growth of PE fund raising in spite of the recent financial crisis. In terms of capital raised by those new funds, the annual rate of growth exceeded 100 percent in the period from 2011 to 2012. Figure 1: New fund raising activity Among the two types of PE funds, RMB funds have shown a greater increase in the fund raising activities. As shown in Figure 2, in 2010, 351 new RMB funds raised capital while merely 31 new USD funds were started, partially reflecting the deepening of global financial crisis that affected institutional investors based in the U.S. and Europe. In retrospect, RMB fund raising activities accelerated in the past 6 years while USD fund raising remained relatively subdued. A noticeable development is the size of USD funds (251 million USD), which increased substantially while RMB funds average size remained quite small (58 million USD). This difference partially reflected the consolidation and economy of scale in the USD funds that used to be dominantly managed by foreign GPs. 3
Private Equity Insights, December 2012 Figure 2: New fund raising activity of USD and RMB denominated Funds Figure 3: Top 10 USD funds in 2010 Not only the size but the composition of USD funds showed changes. In Figure 3, we report the top 10 USD new funds that were raised in 2010. The top three funds were all from domestic fund management companies: Hony Capital Fund V, CDH China Fund IV, and New Horizon Capital IV. Among the top ten funds, two real estate foreign funds are managed by foreign fund management companies: CapitaMalls China Development Fund III and Macquarie Chinese Real Estate Fund II. There are several driving forces behind the recent rapid developments in the PE industry. First, the establishment of two new exchanges: Shengzhen SME Board in 2003 and ChinaNext Board in 2009. The two new exchanges enable PE funds to easily accesss the onshore public secondary equity market for liquidity. The easy onshore exit opportunities provided by lucrative listings through the domestic IPO markets affected PE fund behavior. First, PE funds have strategically shifted to domestic listing for small and medium firms from 4
Private Equity Insights, December 2012 international listing such as on the NASDAQ. Secondly, pre-ipo investments have become a dominant strategy for many RMB funds. In contrast, USD funds in China relied heavily on offshore IPO markets which weree adversely affected by the global financial crisis and European debt problems. Since in China the IPO listing process is heavily influenced by political connections, many PE funds are starting to establish political connections by hiring GPs with government background. According to the data collected, approximately 40% of GPs in domestic market have government or state-owned enterprises (SOEs) as the controlling shareholders. Figure 4: The RMB/US PE Funds Investment Activity Panel A: RMB/US PE Funds Invested Amount Figure 4 showss the investment amount of both RMB and US dollar funds from 1997-2011. US funds used to dominate the market with most deal flows prior to 2009. The investment amount for RMB funds was twice that for USD funds in 2010 and 2011. The trend for RMB funds is likely to continue in the future. Panel B of Figure 4 shows the deal number for RMB and US funds. It reveals that both types of funds are nvesting in similar number of deals each year. In terms of IPOs, RMB funds fare much better than US funds, partially reflecting its sheer larger number of funds and easy access to domestic secondary IPO markets. In particular, there has been a spike in the number of IPOs in 2007-2009, due to the establishment of the two new exchanges. In contrast, IPOs done by US funds are almost close to zero in 2010-2011, reflecting the deteriorating international IPO markets due to the global financial crisis. 5
Private Equity Insights, December 2012 Panel B: RMB/US PE Funds Invested Deal Number in China Figure 5: The IPO Number of US/RMB Funds in China 6
Second, the market witnessed a tremendous growth of domestic LPs. One important characteristic of Chinese RMB funds is that their LPs are mainly rich individuals, families or corporations. In contrast, most USD funds have institutional investors as LPs. In a typical private equity fund, investors invest in PE funds as limited liability partners (LPs) and their liability is confined to the capital committed to such funds. However, this legal and organizational structure was not permitted by the Partnership Enterprise Law of China promulgated in 1997. The law also stipulated that only natural persons were eligible to be partners. In addition, there are double taxation on both partnership enterprises and personal incomes. The inflexibility of the Partnership Enterprise Law greatly impeded the incentives of domestic LPs. In 2007, a new Partnership Enterprise Law was enacted with the introduction of limited liability partners and a single income tax on domestic LPs. Such favourable legal emendation however, did not apply to the foreign LPs. Since 2011, the Chinese government started to allow limited amount (3 billion USD) of foreign LPs to invest in RMB funds as qualified foreign limited partner (QFLP) in Beijing and Shanghai. Such policies largely prevented foreign LPs from tapping the exit opportunities offered by domestic IPO markets that are dominated by RMB funds. Empirical analysis Table 1 provides a summary of the PE transactions in China by industry. As the table shows, PE investors favour the Traditional industry with 879 PE-invested deals and an average transaction size of 13 million USD. Machinery, Pharmaceutical and E-commerce are the next three active sectors, followed by Software, Semiconductor and Hardware. In terms of deal size, the IT services and Energy industries are the two industries with the largest amount of investment per transaction. In terms of exit, the Machinery and Energy industries have the highest ratio of IPOs among all transactions (approximately 20 percent). There are not many PE-backed M&As in China. Table 1: Industry Distribution for PE deals and IPOs Industry Number of PEinvested transactions Amount of PE invested (Million USD) Number of PEbacked IPOs Number of PEbacked M&As Traditional 879 13.18 72 22 Machinery 451 12.32 78 8 Pharmaceutical 206 21.01 19 8 E-Commerce 158 11.27 17 7 Software 153 2.84 9 6 Semiconductor 125 13.28 13 3 Hardware 110 12.66 10 0 Environment 100 10.62 9 3 Chemicals 98 7.28 4 3 Online gaming 93 4.29 8 6 IT services 92 112.15 6 3 Energy 91 87.22 25 6 Real estate 88 27.45 8 1 Table 2 summarizes the multivariate analysis of performance for RMB funds and US dollar funds via exit through future IPO. The regression utilizes the probit regression which sets the left-hand side variable to one if an investee firm has a future IPO after the private equity transaction. We also report the probit regression that analyzes the exit via acquisition. The left-hand side variable is set to one if an investee firm is acquired in the future after the private equity transaction. The left-hand side variable of interest is a dummy if a fund is RMB fund. The regressions control both year and industry fixed effects. In the regressions, we also control for investment size (logarithm of deal investment amount), investee firm size (logarithm of post-money valuation), 7
PE fund s ownership after the capital injection, PE firm s age and PE firm s capital under-management. Robust t-statistics are reported in the parentheses. The result shows that RMB fund dummy is positively and significantly associated with investment performance. The regression coefficient of the RMB fund dummy is 1.39 in the regression (1), which means being an RMB fund increases an investee firm s future IPO probability by 8%. This evidence suggests that the advantage of organizing an RMB fund is that it helps to increase the future prospect of listing an investee firm in the public domestic market in China. In a contrast, RMB funds do not have much advantage in exiting via acquisitions. Overall, the evidence is consistent with the liquidity conditions in the Chinese capital markets: the establishment of the two new exchanges seems to provide easy liquidity access to the equity market and RMB funds have an advantage in tapping such liquidity. In addition, the results show that large PE investment is negatively associated with an IPO, while investee firm size (post-money valuation) or PE firm size (capital under-management) is positively associated with an IPO. The evidence suggests that large PE funds that invest in large pre-ipo firms with relatively small investment amounts are better able to exit via an IPO. Table 2: Firm Level Analysis of Performance for Government PEs and other PEs (1) (2) (3) (4) IPO IPO Acquisition Acquisition Dependent dummy Dummy dummy dummy RMB fund dummy 1.39 1.82 0.06-0.27 (16.15) (11.97) (0.72) (1.41) Log(PE investment amount) -0.28 0.28 (2.42) (3.61) Log(Start-up post money 0.19-0.001 valuation) (3.78) (2.99) PE ownership -0.11 0.01 (0.97) (1.13) PE investment round 0.11 0.11 (1.75) (1.30) Log(PE capital undermanagement) (2.59) (0.57) 0.04-0.01-0.01-0.04 PE fund age (1.01) (3.10) Industry dummy Yes Yes Yes Yes Year dummy Yes Yes Yes Yes Pseudo R 2 0.26 0.20 0.12 0.16 Observations 3782 1461 3782 1461 Conclusion Overall, China s PE industry has grown tremendously in the last twenty years, not only in scale but also in scope. The market will not witness such momentum in the future but the industry will keep playing an important fundamental role in the economy by funding growth firms and encouraging entrepreneurship. The development of the PE industry in China is however subject to many challenges related to unique legalities and market micro-structures. For example, the division of fund partnership due to the currency control 8
imposes a great challenge to many investors who wish to set up a partnership in China. RMB funds and US dollar funds are the two dominant forms of partnerships in China. The rapid rise of RMB funds seems to intensify the competition between RMB and US dollar funds. As RMB funds have a certain advantage in tapping domestic institutional investors and listing in the domestic equity market, many US fund managers will find it increasingly important to find alternative ways of tapping liquidity via international listings. The industry is also heavily influenced by regulation and new policies designated to promulgate the PE industry. It is such political uncertainty or risk that many US funds have to deal with and manage. With its unique intuitional and political socioeconomic environment, international PE organizations have to fully understand the value creation propositions in China, which means that they need to possess deep local knowledge and attract local management talent. References Bertrand, M. and Schoar, A., 2006. The role of family in family firms. Journal of Economic Perspectives 20, 73 96. La Porta, R., Lopez-de-Silanes, F., and Shleifer, A., 1999. Corporate ownership around the world. Journal of Finance 54, 471 518. Villalonga, B. and Amit, R., 2006. How do family ownership, management, and control affect firm value? Journal of Financial Economics 80, 385 417. 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: apei@smu.edu.sg). We look forward to receiving your suggestions and comments. 9