Private Equity Investors Still Keen on China

The number of deals is small because many entrepreneurs don't want to sell while state-owned enterprises don't want to give foreigners equity

It is fitting that in China's still youthful private equity market (PE) the breakthrough transaction involved a manufacturer of children's products. The year was 2006 and Goodbaby Group—China's largest producer of baby strollers—was subject to a leveraged buyout (LBO) by the private equity arm of Hong Kong-based investor Pacific Alliance Group.

The foreign LBO—a sophisticated financing technique in which the acquisition is backed by loans secured against the assets of the target company—had finally landed in China. The country had crawled into the private equity arena; now it was starting to walk.

Or at least this was the plan. Two years on, there has been no real successor to the Goodbaby deal. Although China continues its gradual acceptance of new financial initiatives, private equity remains dominated by conventional deals that are relatively small by global standards.

"I am somewhat surprised it's the only transaction of its kind," said Chris Gradel, managing partner and co-founder of Pacific Alliance.

"I think the main barrier is the lack of companies you can buy a controlling stake in. Most private companies are founded by entrepreneurs who have majority control and don't want to sell up. With state-owned enterprises (SOEs), the government generally doesn't want to give foreigners the equity."

In fact, Pacific Alliance's bragging rights could be contested by LBO purists. Foreign exchange controls prevent the use of assets in China to guarantee a loan made outside of China, while domestic banks are generally unwilling to lend money for such deals. This meant Pacific Alliance had to find its leverage offshore.

When the company came into the picture, Goodbaby had already been privatized by its management and restructured as an offshore investment vehicle and an onshore wholly foreign-owned enterprise (WFOE). Pacific Alliance bought the offshore vehicle for US$122.5 million, with Taiwan's Fubon Bank providing US$55 million of this in debt.

The leverage was small compared to the proportions seen elsewhere because the bank had no direct claim on Goodbaby's China-based assets, just on the offshore vehicle that owned them.

"Fubon was comfortable with the various covenants saying what we could and could not do—they were happy we weren't just going to disappear into the night," said Gradel. "But there was a gap between the onshore and offshore parts."

In this respect, the Goodbaby deal—which took three months to complete because of the government approvals that were required on top of this financial handiwork—is a reminder that China's private equity is still very much a work in progress.

But deals are still being done. New international players are turning up in their droves, spurred by China's strong private sector growth.

"Private equity is increasingly perceived and accepted as an important alternative to raising funds—it allows firms to diversify their investor base, especially in turbulent capital markets," said X.D. Yang, who runs The Carlyle Group's Asia buyout fund. "The PE funds are getting larger and their number is increasing by the day."

Local funds, local currency

Beijing is also putting in place legal structures that enable foreign funds to operate as yuan-denominated onshore entities as opposed to making investments in US dollars through an offshore holding company (see "A legal bind: Waiting to go local").

Although the system has yet to be fully tried and tested, there is already considerable interest. Terry Teng, director of International Financing Services in Tianjin, which acts as a bridge between private equity firms and the Chinese government, said that 90% of the 40 or so funds registered with the China Private Equity Association are yuan-denominated and operated through joint ventures. One prominent early mover was Fang Fenglei, the man behind Goldman Sachs's brokerage joint venture in China. Fang is said to have enlisted backing from Goldman Sachs and Temasek, the Singapore state investment arm, to form the US$2 billion Hopu Fund.