Transactions involving control are rare in China, and for the most part, unpopular.
According to research by McKinsey & Company, buyouts accounted for just 17% of private equity investment from 2005 to 2010. Their rarity has stemmed, in part, from legitimate factors, including a historically complex government approval process, the reluctance of first-generation entrepreneurs to cede control, and the limited availability of debt financing in China. We believe other, less valid reasons have led the private equity community at large to view control-oriented transactions as risk-prone. Below is a brief explanation –
• Control is time consuming. Transactions involving control are, by nature, complex, requiring alignment among various parties, extensive post-transaction planning, and, at times, regulatory approval. Closing periods can, and often do, extend for 1-2 years past initial due diligence. We have observed that most private equity investors would rather deploy money within 2-3 months than spend 1-2 years working on a deal that may or may not close. Protracted closing periods, albeit frustrating, do not deter us, and we have found that, unsurprisingly, our understanding of any investment opportunity grows with time.
• Control transactions require a heightened degree of operational involvement. For private equity firms unwilling, or unable, to assume excess operational “risk,” this added responsibility can be alarming. By contrast, we believe opportunities requiring our involvement are the most rewarding and provide us with the greatest opportunity to leverage our entrepreneurial strength to drive value creation.
• Companies willing to sell are not worth buying. Chinese entrepreneurs are typically reluctant to cede control, as is the case with first-generation entrepreneurs anywhere in the world. As a result, there are limited opportunities to acquire private businesses, and in particular, healthy private businesses. In China, the prevalent mindset among private equity investors is that any investment worth acquiring is growing at double digit growth rates and has several private equity firms bidding for it. While this may be true in a large number of cases, there is evidence of an increasing number of minority deals where entrepreneurs are willing to share control, and of majority transactions where we believe investors will be compensated for the risks taken and efforts made.
We believe the continued unpopularity of control-oriented minority and majority investments should position us well. As Howard Marks, Chairman of Oaktree, wrote; “Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge. The safest and most potentially profitable thing is to buy something when no one likes it.”
CHINESE INVESTMENT ENVIRONMENT UPDATE
Concerns over inflation and tightening monetary policy tempered public market performance in Q1 2011. While the Shanghai A-Share index rose 4.27%, more speculative markets have experienced volatility. Chi-Next, for example, dropped nearly 11%. NASDAQ listed Chinese companies have seen incredible valuations assigned upon initial public offering, but poor after-market performance and continued concerns regarding fraud.
Valid concerns regarding the risk of asset price and consumer inflation have been overblown to some extent, and are overshadowing China’s long term fundamentals. We believe (a) inflation remains a risk but is increasingly under control; (b) real estate may be a bubble, but one that is being digested and is not systemic; (c) technology stocks are likely a major bubble; and (d) equity valuations overall remain at near historic lows and are, in our opinion, a much broader indicator of overall asset prices in China than either real estate or techn stocks.
Details are as follows:
(a) Consumer price inflation remains a risk. While inflation remains above target and is probably understated in official statistics, reserve and interest rates are beginning to take hold and growth is slowing. Last week, Goldman Sachs’s Jim O’Neil estimated that GDP growth would move towards the 8% level by year end from 10%+ currently.
(b) The real estate bubble is evident, particularly in major urban areas. However, real estate prices are becoming more affordable given China’s rapid growth (Figure I), and the industry overall remains a relatively small percentage of overall GDP versus other major economies (Figure II). Therefore, our view is that whatever one’s concerns are about real estate, they should be treated to some extent in isolation, rather than as a systemic risk. Additionally, it is important to note that policy makers have taken stringent measures to dampen housing prices given that the relative level of unaffordability is widely evident.
(c) Technology stocks are a bubble. Many within our firm believe the venture capital-driven technology bubble is as severe as that which took place in the 1990s in Silicon Valley, although proof beyond anecdotes is difficult to come by. Regardless, venture-funded technology businesses do not represent a large percentage of Chinese GDP, and any correction in listed technology stocks will not have a significant effect on the overall economy.
(d) The broadest measures of equity value in China are attractive. Figure III shows historical PE ratios for the A-Share (most representative of China) and Hang Seng (not as representative but interesting nonetheless) indexes. The A-Shares, in particular, remain at near historical lows, despite periods of ample liquidity, low interest rates, strong growth and asset price inflation in the narrower real estate and technology stock sectors. This would suggest that equities represent value, which would explain the stability we have seen in the valuations of private companies. Additionally or alternatively, this could mirror a long-held observation we have had on China, which is that when the herd is hunting east and south, no one is roaming north or west. In other words, as domestic savings has continued to flood into real estate, and public/private equity investors continue to be captivated by Nasdaq, valuations of companies that represent broad swaths of the economy are left unnoticed and undervalued.