Hong Kong’s US$11bn private equity problem

The money has been raised, but competing with larger Chinese domestic funds is challenging as Isabelle Ulanday reports. 

Private equity funds in Asia are overtaking those in the west in terms of growth, but challenges remain, especially in China where a string of accounting scandals has many foreigners wary of investing. Meanwhile, many Chinese banks and other locally funded groups are stepping into fund ventures where previously western firms would have dominated.

This is creating a difficult and increasingly volatile market for investors who are caught between not being ripped off and missing out on the action. Making things harder are the high valuations many investee companies are seeking, making returns for private equity firms slimmer even as their fund sizes increase. Once again, too much money seems to chase too few deals. According to research by Asian Venture Capital Journal, private equity fundraising passed $14 billion last year, up 116% from 2009, and accounted for nearly half of the total fundraising in Asia. Private equity investment in China came to $19.9 billion in 2010, up 41.3%.

“It is difficult to talk about Hong Kong’s private equity industry without talking about China – the two are so interrelated. Most China-focused funds and fund managers investing from offshore are based in Hong Kong, ” said Tim Burroughs, managing editor of Asian Venture Capital Journal.

Rising valuation concerns

“With so much capital available in China – particularly for local, Renminbi- denominated funds – there are concerns about rising valuations. These concerns are largely focused on the growth capital or pre-IPO segment of the market. On one hand, there is intense competition for deals; on the other hand, entrepreneurs see the strong performances of Chinese companies listing domestically or in the US and therefore ask for more money from potential investors. For other parts of the market, for example early stage or restructuring deals, are less populated,” he added.

According to Burroughs, there are certain parts of China that could offer better deals. “It’s also worth noting that other parts of China – away from major coastal cities – might deliver better value deals, but the less mature the private equity market, the harder it is to do business. Another important point is that many domestic Renminbi funds are small, poorly structured and managed, and only in the market for pre-IPO deals that are perceived to deliver high returns in a short space of time. The expectation is that, once the capital markets calm down and public market exit multiples on investments fall, many of these domestic funds will disappear. More established players with strong track records, settled investment teams and a longer-term perspective would remain.” 

Jon Parker, partner at KPMG China, said activity in the Chinese market has been picking up in the past few months. He noted that there had been a significant pick-up in the China market over a number of months, as it looked like PE houses and sellers seemed to be getting closer on expected valuations. “We have seen this taking place in financial services, consumer markets and infrastructure, including property, and we expect this to continue in the near future.” 

The $29bn question

More deals will need to come, and soon, with private equity firms in Hong Kong and China sitting on $29.4 billion of uninvested funds. So just how big is the private equity market in Greater China? According to report by research firm Preqin, as of March, 2011 China had 127 private equity firms headquartered in the country, whilst there were 80 fund managers headquartered in Hong Kong and just 24 in Taiwan.

In terms of funds raised over the last 10 years and dry powder available to fund managers, China is the most prominent country. In the past decade over USD 31.1 billion has been raised by fund managers based in China and they still have an estimated USD 18.5 billion in uninvested capital. By comparison Hong Kongbased private equity firms raised over USD 29.2 billion in the same time period and are sitting on an estimated USD 10.9 billion of dry powder. Private equity firms headquartered in Taiwan raised nearly USD 1.6 billion in the last 10 years and have an estimated USD 489 million in available capital.

Hong Kong-based Baring Private Equity Asia is the most active fund manager based in the Greater China region in terms of capital raised in the last 10 years, having raised nearly USD 4.7 billion in this period. The firm recently held a final close on USD 2.46 billion for its Baring Asia Private Equity Fund V, which exceeded its target of USD 2 billion. 

China-based Hony Capital is the second most active fund manager based in the Greater China region in terms of capital raised in the last 10 years, having raised over USD 3.9 billion in this period. 

Europe falling

While the size of Asian deals is rising as fund sizes increase, this stands in stark contrast to American and European firms which have found it difficult to grow, according to Amanda Janis, senior editor of Private Equity International, a trade publication. She noted that firms focused on emerging markets are commanding a larger slice of the private equity fundraising pie, with Asia-focused fund managers leading the charge.

“The firms making this year’s PE Asia 30 list have collectively raised just under $81 billion in the past five years, representing an increase of nearly a half a billion dollars for the second year running. That’s an impressive feat given fundraising conditions have remained challenging at best since the onset of the global financial crisis. By comparison, the capital raised by the 50 largest firms  globally, as tracked by Private Equity International PEI 300, has been decreasing each year since 2009 by about 5%,” she added. 

According to Janis, one visible trend is that General Partners from Hong Kong have been collecting most of the capital, outperforming fund managers from the Middle East and North Africa. 

“One of the most striking trends evident from examining this year’s ranking was the changing of private equity apital centres. While fund managers focused on the Middle East and North Africa (MENA) continue to be responsible for the bulk of capital raised by PE Asia 30 firms, commitments to MENA managers have been decreasing over the past three years while capital collected by Hong Kong-headquartered GPs has been on the rise and seems set to eclipse MENA.” The capital raised by both Hong Kong- and mainland Chinabased fund managers – together accounting for nearly $33 billion of the PE Asia 30 cumulative fundraising total this year – making it clear that investors are clamouring for access to investments expected to capitalise on Asia’s, and in particular China’s and Southeast Asia’s, projected macroeconomic and demographic trends, noted Janis. 

Dodgy accounts 

If raising funds for investment in Asia is the easy part, investing it wisely against a backdrop of questionable accounts and shady profit figures is causing some concern in the industry.

Simon Luk, a partner from Winston & Strawn LLP, focused much on foreign capital in Chinese private equities. He said,“Foreign capital, clearly, has a given requirement and perspective. When they make investments, they want transparency and western style management. They want to change the culture, so that’s really the challenge. When foreign capital comes in, there are certain requirements since it’s a different culture and the management is not the same, so that makes it difficult. 

“If there’s one main problem, clearly it would be due diligence and it relates to the accuracy of accounting, revenue and profits. This is one of the main issues right now. In the past, it was the organization. We don’t know if it’s properly organized and available for foreign capital injection and that requires a lot of analysis about the current M&A rules,” he added.

Luk notes that foreign investors prefer a foreign holding structure, but that has its own disadvantages. “With a foreign holding structure, there is transparency and everything else you can look for in a foreign company. But it may not be that easy.

At the moment, what attracts a lot of attention are probably the ones involving IT. You can either make a lot of money from it or none at all. So that industry may attract quite a bit of attention; however, it would be difficult for other traditional businesses like manufacturing, because export is declining and the world economy is not doing well,” he said.