New exit strategy emerges in mainland PE industry

Private equity on the mainland has seen explosive growth in the past decade. In the last five years, 800 new funds of $58 billion have been launched, according to Zero2IPO. At the same time, the industry has spawned a new investment class: direct secondary.

This is a little known, yet growing area that plays into the need for investors to exit investments. All investors in private equity face the need to exit and return capital to their investors. It is a time versus total return decision. The direct secondary market provides an avenue to achieve those goals.

A direct secondary transaction occurs when an investor buys an existing stake in a company from another investor. This provides an alternative liquidity solution to traditional exits. The buyer effectively steps into the seller's shoes as a shareholder and can now work with management to grow the business and inject additional capital, if needed.

Statistics reveal an enormous opportunity for the industry to develop in Asia. We expect more participants to enter this market including specialized secondary investors and opportunistic investors, particularly for single asset opportunities.

This is not to be confused with the more widely talked about secondary investments, where stakes in funds are exchanged among fund investors. This is referred to as indirect investments because the stakes transacted are a layer removed from actual operating companies.

So, why is there such a backlog of un-exited private equity positions?

First, ongoing market volatility has meant that exiting through IPOs is no longer readily available. The route has historically accounted for 80-90 percent of exits on the mainland. The need among LPs and GPs for liquidity has increased the attractiveness of the direct secondary market in Asia. This is already an ongoing trend in Europe and the US as IPOs in these markets only account for around 10-15 percent of PE exits.

In actual fact, PE investors should not prefer IPOs, because they are not immediate cash exits. As such, a sale to another investor or strategic buyer provides the immediate cash exit that investors are increasingly seeking.

In the Chinese mainland, a US listing, a once-popular route for smaller mainland companies, has a limited chance of succeeding today. The actions of short sellers and researchers, such as Muddy Waters, have raised questions around mainland corporate accounting practices. As such, US investors' trust in mainland companies has eroded. This has led to huge uncertainty regarding the share price and liquidity prospects of those stocks. A US IPO has lost its allure and would most likely destroy, rather than create shareholder value at this point.

In addition, trade sales, where stakes in companies are sold to other companies in the same industry, are still rare and account for less than 5 percent of exits in Asia. One reason is that most PE investments in Asia are minority stakes in first generation companies. The founders are usually not prepared to give up majority control, which is usually what a buyer seeks.

Finally, an important factor of why there is a growing need for the direct secondary market is time-more so, the lack of time. Mainland's PE market is maturing. Fund managers, who may have started funds five to seven years ago, need to exit their positions to provide returns to their investors. In order to start a new fund, they need to show that they are capable of managing old investments.

On the mainland, there remains an over-reliance on the IPO market to exit PE investments, which is typical of Asia. With limited options for fund managers to seek liquidity, we are now seeing the rise of the direct secondary market. It is yet another exciting stage in the PE industry's ongoing evolution and one that is starting to play a strategic and valuable role in Asia.

The author is a partner at private equity advisory firm NewQuest Capital Partners. The views expressed here are entirely her own.