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Private Equity Looks for the Exits
Summary:As the queue to list on China's stock market grows, private equity firms are looking to ditch their stakes in companies that they invested in on the basis that they would one day go public.


By Hu Zhongbin (胡中彬), Shi Jun (石俊) and Chi Youlei (迟有雷)
Issue 614, Apr 11, 2013
News, page 1
Translated by Chi Yi
Original article: [Chinese]

In April the number of enterprises queuing to list on either of China's two main stock markets finally shrank. Over 120 companies couldn't stand the new 2-month financial verification process and decided to pull the plug on their aspirations to go public.

The fate of these companies is closely tied to that of many domestic private equity (PE) firms that had invested in them on the understanding that they would one day list on the stock market.

Data suggests that at least 47 of the companies that dropped out of the IPO pipeline received investment from private equity firms or venture capital outfits.

For the investors, the failure of these companies to go public serves as a major blow.

Private Equity Firms Search for an Exit

Many PE funds have reached the stage at which they'd like to retrieve the capital they've invested, but the companies that they have a stake in haven't even had a chance to file for an IPO yet.

A report from China First Capital (中国首创) shows that at present, around 8,000 private equity funds are invested in firms that are yet to go public, with almost 6.5 trillion yuan tied up in these investments. The firms that invested all this capital are now in desperate search of a way out.

Min Lin (林敏), a partner of New Quest Capital (新程投资) told the EO that more and more of her counterparts in the PE industry have been getting in touch with her recently. She can still remember how she raised the prospect with those firms of buying their stakes in some of these firms on the secondary market a year ago. The most common reply was "Your model is interesting. But I am sorry, the projects we invested in are working well. We have nothing to sell."

They remember Min Lin too and this time they've started to get back in touch with her to ask if she's still interested in buying some of their projects. So far this year, Lin's company has already looked into purchasing 50 to 60 projects.

Starting from the bull market in 2007, PE firms have flourished in China over the past few years. From 2007, domestic PE firms invested in over 1,000 projects every year. In 2010 and 2011 the figure surpassed 2,000.

For a Chinese PE fund, five years is a comparatively long time. Most funds set up in 2007 have already reached the exit phase and most choose to remove their investment when the company is listed on the stock exchange. However, this is now becoming much harder to achieve.

Since October 2012, there have been very few companies that have gone public in China as IPOs have been put on hold while the securities regulator reviews the current approval mechanism.

There is still no clear timetable for when the market might open again and over 800 companies are reported to be caught in the queue. Another 8,000 private equity funds are said to be invested in thousands of other companies that wish to list at some stage. Even if new listings were allowed to take place tomorrow, it could still take more than 20 years for all those companies to make it onto the stock market. Many PE firms and projects are unwilling to wait that long.

A person working in the industry told the EO that many small funds had been forced to close, but as they were small and largely unknown, this didn't attract much attention. Even the big players are under pressure now. Min Lin told the EO that when big funds report to their limited partners, they will emphasize that the projects are developing and growing, but no one really knows when they'll be able to realize the long-term returns on their investments.

The Alternatives: M&A or Secondary Market

Since the IPO pipeline is now closed, PE funds are having to find other ways in which they can profitably remove their investment in companies. At present the three alternatives are to seek a merger or acquisition or to sell on the secondary market.

Mergers and acquisitions (M&A) involve the PE firm exiting the company in which it is invested by selling it or merging it with a different company. This option is seen as taking less time than waiting for an IPO and there are no limitations in terms of the financial performance or scale of the companies involved. For many struggling PE firms, the M&A option is their only way out.  However, this M&A activity is often easier said than done. Most of the PE funds are only minority stakeholders in the companies they've invested in. Whether the company is to merge with or be acquired by another firm is not a decision that they get to make.

The other option is to sell their stake in the company on the secondary market. In the second half of last year, Beijing Financial Assets Exchange set up a platform called China Private Equity Secondary Market Federation (中国PE二级市场发展联盟) with several other institutions. While initially there were only a handful of inquiries and actual transactions through the platform were rare, the secondary market is now already starting to pick up. Min Lin believes there will be a lot of opportunities in the secondary market this year.

Differences Between PE Firms in China and the U.S.

In the U.S. PE funds take a different approach to their Chinese counterparts. Exits through IPO are becoming less common in the United States. In 2012 only 6 percent of PE funds exited through an IPO.

While almost all PE firms in China will seek to recoup their initial investment through the IPO process, in the U.S. 48 percent of PE firms exit through M&A activity and another 46 percent through secondary market transactions.

Peter Fuhrman (傅成), an American who used to run a PE fund in California, came to China five years ago and founded China First Capital. After dealing with Chinese funds for years he realized how different the Chinese market is.

"IPO is the only game the Chinese investors know how to play, that is invest in a company and then try to get it to list as soon as possible. After the IPO pipeline was closed, they were afraid to invest any more. In any other country in the world, you cannot find such a connection between private equity investment and listing on the stock exchange."

He used a famous PE firm as an example. "When they make investment decisions they don't care about what industry a company is involved in or what products it makes or its size, the only thing they care about is whether the company can get listed. For this purpose, they've even set up their own mock China Securities Regulatory Commission (山寨证监会) to determine whether a company will be able to get through the real regulator's company investigation process. Only if a company can make it past their own mock CSRC will they invest."

Fuhrman also finds it interesting how "all the PE firms tell the companies that they've invested in how they have such a strong relationship with the CSRC, as if they can somehow control the CSRC's process of approving a listing. Now the companies are discovering that they [the PE firms] are all lying."

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