We believe there is a silver lining to the cloud hanging over the initial public offering malaise. Positive side effects include far more rational expectations of shareholders and entrepreneurs, and a corresponding increase in mergers and acquisitions. We believe this is a further signal that control and value creation will be rewarded.
The Chinese government enacted the Stock Trading Reform for Listed Companies in 2007, which liberalized the trading of previously restricted corporate equity in the public markets. One side effect was a surge in the number of IPOs on the domestic A-Share market. The creation of the Chinese SME Board, or ChiNext, in 2009 opened another channel for new listings. By 2011, the number and valuation of IPOs reached historical highs. The high premium paid by investors for new issues, combined with loose oversight over the IPO process, enabled easy multiple arbitrage, and generated a reasonable level of short-term success for investors. Since late 2011, however, the domestic IPO machine has broken down. The performance of those companies that did list has generally been anemic. Of the 913 companies that went public between 2007 and 2011, 752 companies, or 82%, are trading below issue price. Underperformers include some highly anticipated issuers, such as China Merchant Securites, down 48%, and Beijing Century Real Technology, down 49%.
The Rise of M&A
According to data provided by Zero2IPO, there were 204 M&A transactions completed in China in the first quarter. This represents strong year-on-year growth of 88.4%, and quarter-on-quarter growth of 177%.
The effect has provided private equity firms with some needed liquidity in an anaemic market for distributions. Dow Jones estimates that there were 7 exits by PE/VC firms in the first quarter of this year through acquisition, an increase of 250% over last quarter. Meanwhile, there were no exits reported through a domestic initial public offering. This is a new record for the Chinese PE industry, both in terms of the number of M&A exits, and for being the first period in which M&A exits exceeded the number of IPOs. It is also a trend that we believe will continue. While China has relatively few listed companies and we are confident this number will grow, there is a long backlog to list. The CSRC reports an official queue of over 900 companies waiting to list, and we estimate that there are a further 4,000 waiting to apply. Historical rates imply that this would take 3 years for the market to digest.
What M&A Activity is Telling Us
While the private equity begins to incorporate more about “trade sales” into their pitch books in the hopes that a new exit channel is opening up, we believe this raises a more interesting opportunity for acquiring large stakes in good companies. The private equity community at large has remained very cautious, if not outright hostile, to taking control. Refrains of “it can’t be done”, “minority is better, and majority is risky” and “we wouldn't want to buy anything someone is selling” remain the norm. We pose the following question: if the private equity community is so reluctant to buy controlling stakes, why and how are corporates becoming so acquisitive?
We believe that corporates are well positioned to make acquisitions because they have platforms, management talent, sector expertise and limited competition for deals from private equity. Further, we believe corporates are seeing many acquisitions at valuations that provide substantial margins of safety on reasonable terms, with the control necessary to solve challenges. Our view is that the acquirers for the past quarter have been finding good value and getting control on reasonable terms, and that private equity firms with a commitment to operational value add and a willingness to devote the time and effort to the process will become viable acquirers in their own right, taking advantage of the value currently enjoyed by corporates.
Further Catalysts: Death, Taxes and Succession
Generational transfers are also beginning to play a pivotal role. Typical private equity investments are in private enterprises founded by entrepreneurs born between the 1950s to the 1970s. As these founders age, securing their legacy and ensuring a smooth transition of management has become increasingly important. With every passing cigarette, baijiu banquet and stressful negotiation with a local government, some entrepreneurs are starting to see their own mortality. Like death and taxes, succession is inevitable. Others are feeling the pressures of moving from managing a “growth at any cost” business to one where expenses, margins and ratios are increasingly scrutinized. All good entrepreneurs are also concerned about the social responsibility they have toward their non-shareholder constituents, such as the local communities and workers who have entrusted them with their security and welfare. They feel tremendous responsibility for ensuring that their businesses continue to contribute positively, even after they have moved on.
“Who takes over?” has therefore become a timely question. China’s independent-minded younger generation, in many cases “little princes” or “little princesses”, have grown accustomed to the luxuries that their parents have provided to them over the years, and in many cases lack the will or desire to take over the family business. At the same time, China is experiencing the rise of the professional manager. It seems like every week well-regarded founder-CEOs, like Jack Ma of Alibaba, Niu Genshen of Mengniu Dairy, or Ren Zhengfei of Huawei, relinquish control and hand over the reins to capable management. As Jack Ma recently said upon his resignation as CEO of Alibaba, “Starting tomorrow, enjoying life will be my work.”
We believe that in the face of succession, entrepreneurs will increasingly turn to partners who can deliver operational value add and professional management to ensure proper succession as their business proceeds beyond the founder-centric model of the past. This will result in acquisitions and control transactions that work for a broad base of constituents.
The IPO dream is no longer the only answer.