Three Phases of PE in China – Growth, Listing and M&A
2016-09-02
Speaker: CAI Lei, founding partner of JD Capital, incumbent President of JD Capital. The article is an excerpt of the speech CAI delivered at the Institutional Cooperation Forum 2016 held in August, 8.
Good morning everyone! Thank you for attending this Institutional Cooperation Forum. Today, I’d like to share with you some ideas about PE development and China PE 3.0.
PE in the US: From “Savage at the Door” to “Presidents’ Club”
We can tell from its name that PE is a concept introduced from abroad. It originates from the US. In the 1970s, three people quitted their jobs in investment banks and started a small PE firm KKR, the world’s earliest PE firm, for leveraged buyout.
The emergence and development of PE are closely related to the ground it exists, which is real economy and financial system of an economic entity. At the time when the US had experienced a long-term development after the World War II, there occurred some significant trends and opportunities. At first, there were some sales and acquisitions resulted from the succession of some family business (China is now confronted with opportunities like this). Then came many large diversified enterprises. Dispersed ownership had existed in some listed enterprises for years. A lot of funds and assets were controlled by the management and ran inefficiently, so the stock prices were not high.
In this historical context, PE firms came on to stage and participated in many large-scale M&A cases. The most typical one was that in the 1980s, when KKR acquired Nabisco, a large food enterprise, for USD 20 billion through leveraged buyout. This record of scale was not broken until several decades later.
The US possesses the most capital resources and the best financial innovation environment in the world, providing favorable conditions for firms like KKR to invest and finance in the financial system and real economy. Adopting innovative financial instruments like equity funds and junk bonds, these firms raised a large sum of money from large institutional investors, such as insurance enterprises and pension funds. They massively merged various kinds of enterprises, reorganized the management group and improved the efficiency of management, thus contributing to the rejuvenation of many traditional mature industries in the US.
The transformation and upgrading of traditional industries with PE’s financial capital and the introduction of financial capital into innovative economy by VC can be said to be one of the most important inventions of human beings in the last century. Actually, in the late 20th century, various milestones that marked human progress, such as Internet technology, artificial intelligence, aeronautical technology and so on, can be attributed to VC and PE’s deep engagement.
Due to the history of leveraged buyout, PE used to be labeled as “a savage at the door” in the US. However, with scale of PE firms continuously growing and resources increasingly accumulated, PE investment has not only engaged in leveraged buyout, but also equity purchase, stock controlling, industry and commerce, real estate, listed stock as well as unlisted stock, but invested in the best enterprise in the industry. Now, when talking about top PE firms in the US, people would say “presidents’ club” rather than its previous nickname “a savage at the door”. Take Carlyle as an example. George Bush used to be its consultant and his son used to be employed by one of its subsidiaries. Previous UK Prime Minister Major was its chief representative in Europe; and Ramos, retired president of the Philippines was its chief consultant in Asia. Romney, founder of Bain, once ran for President of the US.
The essence of PE, the abbreviation of “private equity”, is “equity”, i.e. unlisted stock. With a long investment cycle and high engagement in enterprise’s operation, PE has the financial capital that goes the deepest into real economy. Unlisted stock, for illiquid and insufficient information disclosure, is not proper for common investors. Therefore, the funds are mainly raised in a “private” way and have a high threshold for investors. The so-called “private” does not mean underground, but a high threshold.
These are generally the development of PE in the US, and also the past and present of the PE industry.
Three Phases of PE in China: Growth, Listing and M&A
Emerging in China in about 2000, though with a short period of time, PE has experienced two phases of development and is now coming into the third. Just as the development process in the US, PE’s development in China also has a stake in China’s economy and the characteristics of financial environment.
PE 1.0: Growth investment phase
The first phase PE experienced in China is the growth investment phase, from 2000 when PE was introduced to China to 2008 when the global financial crisis broke out.
China’s economy grew rapidly at that time, a golden time for investment. The way in which PE made money was so straightforward that it just recognized a good enterprise and invested it without much complicated work. Once becoming a stockholder of an enterprise, you could share its growth dividend directly and receive a high return passively. It was a time of “picking up money”, with everyone having the chance of making money.
The profit mode was really easy at that time, which was “gaining 4 or even more out of 1”. At that time, China’s economy was growing at an average of 10% each year. The annual growth rate of some industries could reach 20%, and some leading enterprises in the industry could have a 50% and even 100% growth. Investing in such an enterprise for 3 to 5 years, the profit could increase by several times. Typical PE investment examples are all by industrial bellwethers in China, like Mengniu Ltd, Co., Yurun Group, Shuanghui Group and Belle Holdings. Obviously, American-style leveraged buyout was neither proper nor necessary in China, and growth investment became the optimal choice at that time.
This phase was an introduction period of PE in China, with most institutions being related to foreign capital. In addition to Goldman Sachs, KKR, Blackstone and other typical foreign-funded institutions, domestic institutions, like CDH Investment and Hony Capital, also raised dollars to invest, equaling “quasi-foreign-funded”. Since the development condition and financial environment was immature, there was no domestic PE firm in real sense. JD capital was founded in 2007, catching up with the end of the first phase.
PE 2.0: Listing investment phase
China’s economy experienced great adjustment after the global financial crisis in 2008. The fundamental momentum in PE 1.0 – high-growth factors, was exposed to direct impact. However, the existing environment of Chinese PE firms was profoundly improved later when the market entered the second phase of Pre-IPO investment, also called listing investment phase.
This phase lasted from 2009 when the ChiNext was born to around 2013. Though listing investment still continues, major opportunities have gone. The opportunity that has changed the fate of PE firms in China was the tide of securitization, in which Chinese private enterprises went listed on a large scale.
China’s enterprises, especially private ones, after developing for one or two decades, were faced with bottlenecks. What enterprises required for their development was a large sum of capital, rather than traditional bank loans. Also, many start-ups’ stockholders required for realization of their funds. IPO became the optimal choice. Listing and financing of China’s private enterprises of various industries started from 2004 when the Shenzhen Small and Medium-size Enterprise Stock Market Board was open, and came to a peak in 2009 when the Shenzhen Growth Enterprises Market Board emerged.
Some clever PE firms came out at that time. They were extremely sensitive to the real economy and financial market, and established a new profit mode – JD Capital’s classic “2x2” model – on the basis of the previous model earning profit simply from enterprises’ growth.
The first “2” means gaining 2 out of 1 in the performance. The performance of invested unlisted growing enterprises will increase to 200% in 3-5 years with an annual growth rate of 15%-20%.
The second “2” means gaining 2 out of 1 in the valuation. The valuation of enterprises will at least double and even more after listing. In this mode, we can “gain 4 out of 1”, which is the model and secret of listing investment.
The double-factor profit model in PE 2.0 is apparently more complicated that the single-factor one in PE 1.0.
In this phase, to do well in China’s PE investment, judgment of growth investment value is simply a basic skill. What’s more important is the ability to strive for better enterprise resources throughout China as well as the ability of deeply integrating with China’s security market. Obviously, domestic institutions can better adapt to new environment than high-end foreign-funded institutions.
It was in this phase that JD Capital grew and expanded. In 2009, there were 28 enterprises first listed on the ChiNext, two of which were investees of JD Capital. Within several years after that, JD Capital has contacted with tens of thousands of enterprises, investigated two or three thousand and finally invested in one or two hundred, earning itself 10% shares in the Pre-IPO investment market and a top position in China’s PE industry. Investors also made a considerable return from these stocks with a 10-time growth.
However, no model lasts for a long time in China, and making huge profit in a short time is even more short-lived. Abundant funds brought by the profit effect of listing investment and stimulus policies like the “four trillion”, soon created a picture of “everyone participating in PE”. It seemed that everyone in China could do well in PE. With the joint effort of JD Capital and other PE firms, most of good private enterprises in China that were able to be listed have been invested. Then PE 2.0 as well as the picture of “everyone participating in PE” came to an end.
This is China’s PE 2.0 phase, the so-called time of “scrambling for money”, and its key word is “listing”.
PE 3.0: M&A investment phase
The contemporary characteristics of the real economy and financial system once again played a crucial role in the process of China’s PE development.
Since 2014, looking at China’s economy from a long-term perspective, the growth model that has lasted for more than 30 years is faced with transformation requirements; while from a short-term perspective, the aftermath of the large-scale stimulation policies adopted in financial crisis is emerging. This is the “new normal” a new stage of China’s economy featuring over-capacity and low growth rate.
Though there are still a small number of industries and enterprises developing rapidly, like Internet enterprises, China’s economy, with traditional manufacturing industry and service industry as its main body, is confronted with deep structural adjustment. The basis of large-scale growing investment is gone. Although an enterprise will get enormous return after its listing, there is few unlisted investment object left and the lock-up cycle remains pretty long. Large-scale listing investment is unlikely sustain. China’s PE must transform again. Against this backdrop, PE investment enters the third phase – M&A investment phase.
The profit model of the M&A investment phase is the continuous upgrade of double-factor model of listing investment. It is a triple-factor model, called “Three 1.5s Model” or “1.5×1.5×1.5” within JD Capital.
Factors of growth investment and listing investment are also required, but their driving force is obviously weakened – “making 2 out of 1” becomes “making 1.5 out of 1”. If an enterprise wants to do well in PE investment and gets a high return, it has to find the third growing factor – merger and acquisition. Through M&A, we can reorganize resources of different industries and enterprises, give play to the synergistic effect, and achieve new growth of the enterprises.
The first 1.5 means that we can still invest in growing industries, but not pursue high growth. The acceptable annual growth rate ranges from 5% to 10%, meaning that profits will increase by 50% in several years.
The second 1.5 means that we need to make full use of the premium between the primary and secondary markets of China’s capital market, and help targeted enterprises realize 1.5-time premium through direct or indirect listing.
The third 1.5 means that we can improve the enterprise’s efficiency, give play to the synergistic effect and bring extra growth to increase the profit to 1.5 times. Multiply the three 1.5 together, we can get an increase of 3 or 4 times.
Though the triple-factor model is complicated, JD Capital has completed some cases conforming to its features. In 2010, we invested an enterprise named U-Tour, an outbound travel service provider. Though its scale was not large and its main business only covered Beijing, it got an investment valuation of about RMB 300 million. After being listed, U-Tour continued to conduct integration, purchasing Zhuyuan International Travel Agency based in Beijing and Uzai, an online platform based in Shanghai. Together with JD Capital and some other institutions, it participated in the acquisition of Club Méditerranée. This year, the travel agency purchased Huayuan International Travel Agency, which was about to go public overseas. Through this series of acquisitions, U-Tour turns into a leading enterprise in Chinese outbound tourism market, with its valuation rising to RMB 20 billion, nearly a 100-time growth in five years. JD Capital also earned more than 10 times of its initial investment. This is a standard case of M&A investment.
There are more factors in this phase and the model is more complicated. Compared with the time of “picking up money” in PE 1.0 Phase and the time of “scrambling for money” in PE 2.0 Phase, PE 3.0 Phase could be described as the time of “making money”.
In the times of “picking up money” and “scrambling for money”, with models being simple, it was easy to gain profits, but it was also easy to lose money. In the time of “making money”, though the external environment is tougher and the professional requirements are stricter, there is a much bigger arena and is expected to last longer. It is a time specially designed for competent PE firms that are ready to achieve something. It requires PE to evolve from simple financial capital to industrial capital. There are higher standards and a bigger market in this era, only less players.
This is actually the golden age for China’s PE development. In PE 3.0 Phase, China may create several global PE giants to compete with Blackstone Group and KKR.
Four key abilities of PE firms in 3.0 era
In PE 3.0 Phase, who will be the main players? JD Capital began to transform and upgrade since 2014, and we are still exploring. Many large institutions, central SOEs and big industrial groups are also exploring in this field. It is hard to see who will succeed in the end. In the 3.0 era featuring more complicated profit models, if a PE firm wants to stand out in the competition, the following abilities are required:
Capital raising ability – the ability of finding a large amount of money quickly
Compared with shareholding investment, the scale of M&A investment increases by an order of magnitude or several order of magnitudes. In the past, the scales of JD Capital’s shareholding investment were mainly on the 10-million level. However, since last year, the amount of each investment of JD Capital has been on the 100-million or billion level. The investment scale will continue to expand in the future. Once the model is mature and the capital support is ready, a great number of enterprises in China will conduct investment of RMB billion or 10-billion, even larger scales.
Meanwhile, M&A investment requires strong timeliness. The firm able to provide RMB 1 billion within a week gets the deal. There are lots of opportunities for PE firms to cooperate with all kinds of financial institutions.
Recently, Baoneng Group purchased Vanke for dozens of billions worth of insurance products and bank’s wealth management products. Its essence is an American leveraged buyout. No matter what the result will be, I think it brings shame on China’s PE firms. They have talked about conducting leveraged buyout for more than 10 years, but it was an insurance enterprise that really did it. The key reason for PE firms failing to do it is that their capital raising ability is not strong enough.
Participation ability – participating in enterprise operation deeply
In the phases of 1.0 and 2.0, both growing investment and listing investment were actually passive ones. The state of operation and profitability mainly depended on external environment and the enterprises’ original actual controller and operation team. When PE firm invested in an enterprise, it was like signing a contract of terms of gambling. The value-added service was of little use.
However, the essence of PE is equity investment, the active financial capital. Getting deeply involved in business operation is necessary. Of course, this in-depth involvement does not mean that PE firms need to operate enterprise entities actually. It means that as controlling shareholders or principal shareholders, PE firms should know the law of industry development well, set appropriate goals for enterprises, build excellent entrepreneur teams, and help enterprises in their equity distribution and incentive mechanism.
The M&A era is crucial for PE firms. If finding a large amount of money is the first key requirement, being a qualified major shareholder is the second one.
Innovate thinking – PE firms need to innovate investment modes
China is now in the M&A era. Actually, from a global perspective, it is not news at all. We lag behind that the US for 100 years in this regard. There were five M&A tides occurring in the US, namely, horizontal M&A, vertical M&A, conglomerate M&A, leveraged buyout and global strategic M&A. However, though the M&A just starts in China, we are conducting the five modes simultaneously.
Therefore, we need to learn from the US to surpass it. This requires PE firms to have innovative thoughts, coming up with new ideas continuously. For instance, for industries like Internet technology, Internet model, and sharing economy that exerting great influence on the real economy and financial system, innovation is a must. Here’s another example. There are many differences between capital market environment in China and that in the US. There are disadvantageous factors like limited financial innovative tools, and there are also advantageous ones like high valuation and high liquidity. All of these can be sources of PE firms’ M&A investment innovation.
Global vision – PE firms should participate in global competitions actively
Globalization was not so obvious when M&A tides occurred in the US. Now, we must take globalization into consideration. If an enterprise’s battlefield is only in China, it can never become a world PE giant.
On the one hand, when investing in entity enterprises, PE firms must take global competition into consideration, and conduct integration globally. On the other hand, PE firms themselves are also confronted with global competition. There is no national boundary for capital. Capital, investment, partner and working team of PE firms all need to be globalized.
The four abilities above form the core competitiveness of PE firms in the 3.0 M&A era.
Plans and preparations of JD Capital in 3.0 era
Based on the above-mentioned ideas, JD Capital has its own business plan and practices in PE 3.0 era, mainly being preparations on the capital side and asset side.
1. On capital side
In the past, JD Capital mainly raised fund from high-net-worth individuals, and a few from institutions. Now, the situation is totally different, with a dominating part of capital being sourced from institutions. Meanwhile, as a listed enterprise, JD Capital has the opportunity to expand self-owned capital scale gradually. What’s more, self-owned capitals will be put into the funds under our management simultaneously, making them on the same front with client capitals.
As to specific measures, we come up with two “Institution Plans”, namely Institution Plan A and Institution Plan B. The former is that JD Capital cooperates directly with various institutions such as insurance enterprises, industries, state-owned assets, agencies and foreign-funded institutions, and provides them with all kinds of custom-made financial products with PE funds as the main product.
The latter is also called Partner Plan, by which JD Capital helps high-net-worth individuals in some key sectors and industries set up funds, and collect the separate capital resources together to establish a quasi-institution similar to joint investment partnership for long-term stable cooperation.
2. On asset side
The investment model of JD capital develops from the simple shareholding model into a comprehensive investment model which takes equity investment as the core part and includes PIPE, debt financing, and mezzanine investment as the supporting parts, in order to satisfy all demands of invested enterprises and fund providers.
As to specific measures, we set up two “Bellwether Plans”: Bellwether Plan A and Bellwether Plan B.
Bellwether Plan A means that JD Capital will invest in and cooperate with nearly one hundred leading enterprises from various sectors in China in the next few years. Most of them are listed enterprises, but some unlisted enterprises are also included. After investment, JD Capital will help them in integration, merger and acquisition, financing and development, supporting them to expand market value from several billion or nearly a billion per enterprise into tens of billion, and even hundreds of billion.
Bellwether Plan B is also called Industrial Integration Plan. At present, there are many sub-sectors in China with no leading enterprises. This gives JD opportunities to participate in creating regional even national leading enterprises. For example, there are many homogeneous underlying assets in every province, city and county, such as hospitals, schools, public utilities, shopping centers, and specialized markets. The profits as well as the returns on invested capital of each separate institution are not high, but they are rather stable. Once they are integrated, there will be obvious synergistic effect. Therefore, JD Capital plans to take the lead in conducting industrial integration in this aspect.
In this new M&A era full of opportunities and challenges, JD Capital looks forward to conducting deep cooperation with more institutional partners for joint development. Thank you!