Cai Lei, JD Capital: PE is Becoming an Important Orientation for Asset Allocation of Financial and I
As an investment mode that is attractive to capital, the most outstanding function of private equity (PE) is to find strategic opportunities in economic development. As China’s economy enters the new normal, during the process of creating new development engine, fostering new growth point and promoting economic transition, the rigorously growing PE in China has been witnessing new policy incentives.
In September 2015, the China Insurance Regulatory Commission (CIRC) issued the Announcement on Matters Relating to Establishing Insurance Private Equity, which expanded the scope of insurance fund investment to include direct investment in private equity fund and venture capital fund in a certain ratio.
In April 2016, the China Banking Regulatory Commission (CBRC), the Ministry of Science and Technology and the People’s Bank of China jointly issued the Guiding Opinions on Supporting Banking Institutions in Innovating Pilot Investment-Loan Linkage for Technology-based Start-up Enterprises, in which 5 pilot areas and 10 pilot banks were specified. In September, the CBRC permitted qualified banks to set up subsidiary companies for equity investment in the field of technological innovation.
On September 20, 2016, the State Council issued Several Opinions on Promoting the Sustainable and Sound Development of Venture Capital, in which venture capital was defined as an important means to improve investment structure and increase effective investment. It is also the first document circulated by the State Council to support equity investment development.
At the stage of high-speed economic growth, with large quantities of high-return and high-rating underlying assets flocking in, financial institutions focused on the capital side for the matching of relevant assets. However, under the new normal, though capital liquidity remains excessive, quality assets are still in scarcity, hence the so-called “asset shortage”. The lack of professional institutions capable of identifying quality assets also composes one cause. As major financial and investment institutions in banking, insurance, trust and social security are faced with the problem of coordinating capital and asset development, their capacity in asset development has become vital in outperforming others. Recently, reasonable asset allocation by financial institutions has become a heated issue in the sector. At present, PE fund is becoming an important orientation for financial institutions to allocate their assets, and PE institutions with strong capability in product design, profound understanding in industry rules, innovative thinking and global vision are expected to emerge as key partners for different kinds of financial institutions.
The development of real economy needs the driving force of equity investment. With favorable industrial policies, the emergence of PE just comes at the right time. How to understand the PE sector? How to allocate PE assets? How to choose PE institutions? With regard to these questions, recently, Mr. Cai Lei, Chairman of JD Capital (600053), also the head of the “Most Favored PE Institution by Insurance Fund” in 2015 and the “No.1 PE Stock”, gave his answers during a special interview.
Q: In times of the “asset shortage”, it has become a universal problem for major financial institutions to find major categories of quality assets. What are the major asset allocation means traditionally used by financial institutions? What is the future orientation for its development?
Cai Lei: The most valued index of financial institutions in asset allocation are fluidity and rate of return. First, based on solvency requirements, they normally allocate many standard assets with sound fluidity, such as bonds and money market funds. These are assets with the lowest risk level, highest fluidity, and, correspondingly, a lower rate of return. Meanwhile, to increase the assets’ overall rate of return, the institutions also have to allocate high-return assets at a certain proportion. In this regard, financial institutions used to rely on major categories of non-standard assets, including all kinds of debt assets of real estate, industrial enterprises, obligation of local financial platforms, and leverage financing in the stock market, etc. However, due to the direct influence of the economic cycle and market cycle, investment opportunities and products in these fields have been shrinking remarkably. In the bond market, from the end of 2014 to October 31, 2016, the China Bond CP (AAA+) YTM (yield to maturity) and China Bond Corporate Bond (AAA) YTM decreased by 36.12% and 37.08% respectively, from 4.585% and 4.6825% to 2.929% and 2.946%. Up to the end of October, China’s stock market witnessed a plump of nearly 40% from the peak in June. When the rate of return of non-standard assets started to decline, institutions could do nothing but put on leverage to maintain the rate of return. However, when the leverage rate increased from one-fold to two-fold, the asset needed also doubled, which naturally aggravated the “asset shortage”.
In recent years, while the assets’ return rate has been decreasing, the size of asset managed by financial institutions expands rapidly. Just take banks as the case: by the end of 2014, the balance of financial products was roughly RMB 15.02 trillion; and by the end of 2016 Q1, the number soared to RMB 24.6 tillion, an increase of nearly RMB 10 trillion in 15 months. Under this situation, the asset management departments of financial institutions have been facing an increasingly huge pressure in digesting investment demands, thus adding to the severity of “asset shortage”.
On this account, to realize a higher rate of return, financial institutions have to consider new ways of fund allocation beyond traditional standard assets and non-standard assets. Among these, exceptional high-return assets, such as private equity funds, should become an important option for large financial institutions.
Q: Could you please briefly introduce the concept of PE investment, as well as its major characteristics?
Cai Lei: PE investment can be classified into two kinds, namely, narrowly defined PE investment and broadly defined PE investment. In a narrow sense, PE investment normally refers to non-listing and equity investment of industrial enterprises. As PE firms mainly source capital from privately-offered funds raised from specific investors, and have specified investment horizon and exit requirements, PE assets are distinctively financial.
In terms of history, PE originated from the US, and gained its fame and fortune through M&A equity investment. Later, growth capital equity investments also became a conventional profit-making way of PE firms.
Taking M&A as its approach, M&A equity investment makes profit by integrating corporate resources and improving operational efficiency. A well-known example is the effort of the Blackstone Group on the Merlin Entertainments Group. When Blackstone just acquired Merlin, Merlin was just a small aquarium in the UK. However, under Blackstone’s operations since 2005, Merlin successively acquired LEGOLAND Park, Gardaland and Tussauds Group and was enlarged by 10 times within merely three years. So far, it is the world’s second largest operating company of tourist spots.
Growth capital equity investment mainly makes profit by investing in equities of non-listed and high-growth enterprises, and by supplementing the investment with added-value services. This is quite common in China in the early 21st century. For instance, ever since the investment of over USD 600 million by Morgan Stanley from 2002 to 2003, Mengniu Dairy has been maintaining a high-speed growth later on. After the company’s listing in Hong Kong, the investor successfully withdrew and realized a return rate of over 500%.
Generally speaking, being closely related with the real economy, PE investment can not only share the benefits from the growth of real economy and the industry, but also receive excess return by improving corporate operation and performance through proactive operation. Therefore, PE assets are also clearly industrial.
Based on the two reasons above, PE assets generally feature high profitability, low liquidity and medium security. In China, the standard benchmark for a PE fund include a duration of 5 to 8 years, a compound annual return rate of no lower than 20%, and a 5-year rate of return of over 1.
Normally, when we discuss PE investment, we refer to it in a narrow sense. Nonetheless, the PE sector is also enriching its scope. Besides typical equity products, PE, in a broader sense, includes mezzanine investment with features of both equity and debt, which allows for a broader space for innovation and improvement with respect to profitability, liquidity, rate of dividend and level of security.
Q: Could you please introduce the sources and allocation of PE assets in the international market? Are there any indications for Chinese financial investment institutions?
Cai Lei: In Europe and the US, where the financial system is mature, the major sources of PE assets are such institutional investors as pension funds, insurance funds, donation funds and family funds of all kinds; and the ratio of PE asset allocation by these investors is significantly higher than that in China. For instance, in 2015, the total size of endowment insurance in the US reached USD 24.81 trillion. Generally, the country’s objective of PE assets allocation would reach or even exceed 10%, also a benchmark for different kinds of large institutions in their asset allocation. However, the ratio of PE asset allocation by Chinese financial and investment institutions averaged less than 3%.
The total size of China’s investable PE assets, including insurance funds, pension funds and family funds, is continuously increasing rapidly. By the end of 2015, the size of social security fund was close to RMB 1.51 trillion, and the usable balance of insurance fund even amounted to RMB 11 trillion. The trend continued in the first half of 2016, with the fund size registering a growth rate of 10.44% compared with the beginning of the year. In recent years, the growth rate has always been over 15%. It can observed that there is a huge space in PE asset allocation for China’s financial and investment institutions, both in terms of size and ratio. There exists an obvious trend for these institutions to participate in PE asset allocation.
Q: Now that financial institutions have rarely been involved in PE asset allocation, why are they increasingly geared towards PE asset allocation? Or, what are the advantages of PE assets?
Cai Lei: The appeal and advantages of PE assets derive from their high rate of return. According to the latest report by Bain & Company on the PE investment sector, from the global market, the return rate of the major component of PE assets – M&A funds come better in terms of long-term products than in the secondary market (Graph 1).
Besides, seeing from the return rate over three decades or even a longer period, the return rate of KKR, one of the ancestors of the PE sector, significantly exceeds those of other major categories of assets. Its sustainable high return rate comes from its professional investment capability and proactivity. It is KKR’s excellent capability of asset management that makes its fund products increasingly popular in the market. In the last 38 years, its aggregated investment deal reached USD 500 billion. In 2013, the raising of KKR Asian Fund II was successfully completed, the total size reaching a record high of USD 6 billion.
From Table 1, it can be observed that despite its large size of asset under management, the return created by KKR for its investors is still considerable, with the funds’ annual return rate averaged over 26% in the last 40 years, significantly higher than other major categories of assets in developed economies.
For Chinese financial institutions, allocating PE assets can significantly improve the overall rate of return. If an insurance company allocates PE assets at the ratio of 10%, with an expected IRR of 20% and a duration of 5 to 10 years, these assets can bring additional return of 2% each year over a longer period. This will greatly improve its overall rate of return (4%-5%), and drive the development of capital business with its strong capability of investment.
Admittedly, for financial institutions, key indicators at the capital side include not only rate of return, but also liquidity, solvency and, for institutions, current performance of staff in the asset management department. Therefore, the long term of PE assets is often regarded as a disadvantage and scares many institutions away. In fact, for insurance funds and pension funds that require by themselves stable asset allocation over a relatively long period, the medium and long duration of PE assets can be regarded as their advantages, as we may design relevant products based on their individual needs.
Besides, PE asset allocation is not only restricted to equity fund in a narrow sense; rather, it may also include mezzanine funds that belong to PE assets in a broad sense. With innovative design, mezzanine fund products can have a more flexible and relatively shorter duration, higher security and possibly annual cash returns. With relatively stable “debt-like” profit at the earlier stage of fund duration and “equity-like” profit after due, the rate of return, liquidity and solvency can all be balanced. Mezzanine investment accounts for a relatively high proportion in the assets management of top PE institutions worldwide: mezzanine and fiduciary investment accounts for 26% of assets managed by Blackstone, 19% of those by Carlyle, and 33% of those by KKR. For Apollo, this ratio even exceeds a half to reach 56%.
To sum up, PE assets not only have absolute advantages in terms of return rate, but can meet requirements of different kinds of financial institutions through innovative liquidity and cash flow arrangements with mezzanine funds. As a whole, PE products have their clear advantages.
Q: Now that PE assets are so attractive to financial institutions, why were they rarely involved in such kind of investment previously? What are the major challenges and the bottleneck?
Cai Lei: The major reason why China’s financial institutions have been rarely involved with PE assets is that their capital-side business is at the initial stage of transition, and time is needed for the adjustment and upgrading of regulatory requirements and competitive strategies. The major challenges for financial institutions to develop PE investment and increase the proportion of PE asset allocation lie in the system and team construction.
As mentioned above, with both industrial and financial features, PE investment is remarkably different from traditional financial institutions, which are simply financial. In the past, financial institutions in China relied on licenses for development, whose business ideas, risk control system and management mode are in conflict with the proactivity and industrial feature of PE investment. In this sense, traditional financial institutions face major challenges when stepping into this field. Of course, many large financial holding groups have made attempts in this aspect, such as CITIC PE by CITIC Group, China Everbright by Everbright Bank, as well as China Jianyin Investment by Jianyin Group. These have all made great achievements in the field of industrial investment.
In the future, there will be nothing other than two choices for financial institutions to participate in PE asset allocation: one is to set up their own team; the other is to cooperate with professional institutions. In a realistic sense, to cooperate with outstanding market institutions is more practical for most financial institutions.
Q: Currently, major ways of asset allocation have been suffering from the shrinkage of investment returns. As PE investment is rooted on real economy, is it a favorable opportunity to allocate PE assets at the stage of China’s economic adjustment?
Cai Lei: We believe that the trend of enlarging PE asset allocation will last for at least 10 to 20 years, and the current stage is the golden times for such endeavors.
Compared with the international level, the PE sector in China is still at the initial stage. While China’s top 10 PE institutions manage an asset of USD 1 to 5 billion, for their counterparts in mature markets overseas, the number is generally between USD 50 to 80 billion. Blackstone, the absolute “boss” of PE institutions, manages an asset of over USD 330 billion, i.e. RMB 2 trillion.
Vertically, since its start-up around the year of 2000, PE investment in China has experienced the two phases of growth capital investment and listing investment, and is now facing the era featuring integrative investment, or the 3.0 era for PE in China. The underlying factor is the tremendous opportunities of industrial integration brought about by the development of China’s real economy and structural adjustment. Compared with conventional M&A investment by international PE institutions, integrative investment in China has the factor of M&A, and also benefits from China’s relative high growth as an emerging economy, which is fully able to create relatively high returns for investors at the global scale, with huge development potential.
While asset allocation by Chinese financial institutions is clearly pro-cyclical, M&A business in PE assets is typically counter-cyclical. Besides, focusing on consumption, health and public utility, PE assets usually have weak periodicity. These are all highly valuable for the asset allocation of financial institutions.
Q: If cooperation with excellent PE institutions is an option for financial institutions to allocate PE assets, then how should they find suitable partners?
Cai Lei: We believe that in the current situation, capabilities of PE institutions in four key aspects should be examined: product design, industrial depth, innovative thinking and global vision.
Product design refers to the capability of PE institutions to satisfy the demand of asset allocation by financial institutions. Although the basic asset of PE assets is corporate equity, it should not be ignored that different financial institutions have diversified demands in rate of return, liquidity and security. Only institutions with strong capability of product design can meet the individual demands of financial institutions on asset allocation.
Industrial depth refers to the capability of PE institutions to be deeply engaged in the industry. Since the basic asset of PE assets is corporate equity, understanding of and engagement in the industry directly determine the quality of PE asset allocation. At the PE 3.0 era, PE institutions, rather than simply being growth capital investment or listing investment, should become totally proactive financial capital with profound understanding of industry rules and engagement with the decision making of enterprises, in order to receive excess return higher than normal financial capital. For instance, in May, 2016, by subscribing to over 40 million shares of Luolai Home through private placement, JD Capital helped it realize continuous optimization and upgrading of its business mode. The proceedings will be used to forge its O2O operating system and supply chain system to enhance its status as an industrial leader.
Innovative thinking enables the continuous innovation in the investment mode. In M&A investment, core business of PE, China is a hundred years late than the US. The US has experienced five major rounds of M&A boom, including horizontal M&A, vertical M&A, mixed M&A, leverage M&A and global strategic M&A. While M&A investment has just started in China, it cannot simply repeat the development process in the US. Instead, from its start, the five types of M&A should be mixed and combined with the new technologies and trends such as the internet. By helping Baolilai, precedent of CHSR, in its acquisition of Sheenline, and participating in several times of its asset restructuring, JD Capital successfully helped Baolilai to transform from a “shell company” into an “internet+” high-tech enterprise with rail transit as its main business. Innovative thinking was reflected throughout the whole investment process.
Global vision. With the development of Chinese economy and its outstanding enterprises, many Chinese enterprises have had the urgent need of overseas M&A. In addition, capital is borderless, and Chinese PE institutions themselves have to face competition from transnational PE institutions. In 2014, JD Capital helped Utour set up a fund and purchase Club Med, the world’s largest holiday inn chain group, which vertically extended its industry chain and made it more competitive. In 2016, JD Group also completed the acquisition of FT Life Insurance. The above cases demonstrate that excellent PE institutions not only have to be capable of helping leading enterprises in global M&A, but also need to allocate their capital, asset, team and business globally.
Q: What are the focuses of JD Capital in terms of institutional fund raising? What is its plan for cooperation with institutional clients? How does it plan to increase its capability of cooperating with institutions, as well as its service quality?
Cai Lei: At the stage of listing investment, investors of funds managed by JD Capital were mainly high-net value individuals or families. There were also a small number of large institutional investors. Entering the phase of integrative investment, as the investment in single project expands,, big institutions start to take up the larger share, and the share of high-net value individuals declines. The purpose of JD Capital for implementing its “institution cooperation plan” is to form stable partnership with financial and investment institutions, and provide products that can better satisfy their allocation demands.
The first thing of JD Capital’s cooperation plan is to upgrade its client service system. JD Capital sets up different teams in different areas, including insurance, foreign capital, banks and third-party financial advisors, and provides professional and targeted services.
Second, continuously upgrading products according to the asset allocation demands of financial institutions. Apart from enhancing previous PE funds, it is also expanding its business to PIPE funds, mezzanine funds and subsidiary categories, which satisfies different demands with different features in their duration, return and profit.
Third, customizing products that take both return rate and profitability into consideration, in order to help relevant institutions to boost their capital side business with capital side business.