“… it was the age of wisdom, it was the age of foolishness… it was the spring of hope, it was the winter of despair… – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.”
-Charles Dickens, A Tale of Two Cities
The year of the Dragon was also the year of the IPO hangover. While Lunar has been fortunate to generate three exits, they were primarily through trade sales – the IPO path is troubled. Next year looks similarly challenging. This creates the looming risk of setback in investment returns for firms that invested in businesses predicated on capturing multiple arbitrage through listing. In looking at the root causes of this indigestion, there is also plenty of room for optimism, and a path to opportunity as we move forward into the Year of the Snake.
Hangover Act I
In 2010, the State Council issued the “New 36 Opinions” (“新非公36条”) formally allowing private investment into areas that previously were technically off limits, such as infrastructure development, financial services, education, healthcare, and telecommunications. The policy aimed to end to the de facto monopolies enjoyed by state-owned firms. 2010 also saw the creation of ChiNext board in Shenzhen, where early opportunities for easier listings generated spectacular exits and a corresponding mania for pre-IPO investments. In its first year, the average PE multiple for stocks on the board was a staggering 63x, as compared with 17x for the CSI 300 Index and 12x for Hong Kong Hang Seng Index. Additionally, the economy was digesting the four trillion RMB post-financial crisis stimuli. RMB fundraising targeting correspondingly surged.
Act II: 塑化剂白酒
By 2011, declining macroeconomic conditions, dwindling stimulus funds and declining market sentiment forced a correction. A large queue of companies waiting to go public formed, valuations dropped, and prospects for quick IPOs evaporated. Expensive and highly speculative ChiNext-targetted investments were orphaned. Investment proceeds had been spent to fund capacity expansion, with little remaining to effect share buybacks. Recapitalizations through debt were difficult due to most being private enterprises with limited cash flows or operating histories. Industry reports estimate that USD 22b of capital has funded 2,200 deals of this sort in China. The work necessary to work out the problem is daunting, and market resources are limited. One leading domestic private equity manager was asked to characterize his peers caught in this situation, and described the typical RMB fund as follows: three backers each with a third of the GP and no economic incentives for the managers. When asked how many RMB Funds fell into this definition he said “80%. Sorry I meant 99%. 99 out of 100.”
Given that the CSRC approved 247 domestic IPOs in total in 2012, the backlog will not clear. Moreover, funds are ill prepared for a culture of exits through alternative channels. In developed markets, IPOs account for under 20% of all private equity exits. In China, 70% of exits in 2010 were through public listings. In 2011, there were only 17 trade sales for a total value of USD 6.3b, while through November of 2012, only 12 trade sales for a total value of USD 1.8b were executed.
We believe that the supply of companies “in need of a deal” should inevitably beget a stronger M&A culture. However, investors most in need often have the least leverage to convince management to seek M&A alternatives given that they are minority holders with limited involvement. Further, the lack of operational expertise necessary to conduct thorough due diligence and execute complex transactions has inhibited many firms from seizing such opportunities, as well as creating a misalignment of expectations even when deals reach the bargaining table.
Therein lies opportunity. Specialization works in this environment. The willingness to obtain control provides leverage, and the IPO queue provides a pipeline full of opportunities. While weak corporate governance and questionable sustainability plague many, there will be opportunities to buy, restructure or fund formerly pre-IPO businesses of a higher caliber, particularly those with synergy to portfolio companies where we have control and management expertise. Moreover, the market dynamic will yield better-educated, more rational entrepreneurs and management teams. As always, certain key fundamentals, while often overlooked in the past, must remain paramount – attractive businesses, strong brands, and sustainable earnings. We would add that there is a wealth of opportunities in finding businesses that can generate dividends, even while growing, and in recapitalization of Chinese companies that have historically operated with little debt. While many of these things may seem obvious to investors in developed markets, as we have seen, China is far from developed in this regard.
Seizing Good Fortune
We conclude with our observations going into the New Year:
– Sentiment may not improve dramatically, but deal flow will.
– Stable consumer demand will continue to generate attractive returns.
– Broad quality consumption will displace luxury in the fight for consumer wallets.
– China must learn to model cash flows, not only comparables.
– Measure returns by dividend flow, recapitalizations and trade sales – not only IPOs.
– Operating, Restructuring and Problem Solving will be favored (versus sourcing).
– Consult the Chinese zodiac: acumen, divination and the ability to be selective are all hallmarks of the Year of the Snake.
Stay tuned for more specifics.