Importance of differentiation

PE, VC firms must surpass the deal-making stage and become real active investors

The private equity industry has grown considerably in recent years with the total amount invested by these companies increasing from a few hundred millions dollars 10 years ago to $15 billion (11 billion euros) in 2011. It is estimated that more than two-thirds of funds raised in Asia last year were focused on China.

In China, the PE industry has evolved in three stages. The first stage was the era of precursors that began sometime during the end of the 1990s and lasted till 2006.

The precursors were mostly fund managers, often originating from the Silicon Valley and largely composed of Chinese returnees. The abundance of quality entrepreneurs, often the first to seize a market, and a scarcity of capital, gave these PE funds much room to maneuver.

The second phase was a period of euphoria, spanning from 2006 to 2009, with most investments following a quasi-unique model of "pre-IPOs" - or investments primarily aimed to take a company public. The generated internal rate of return (IRR) was fabulous and reached its pinnacle in 2007 with an average IRR of 57 percent.

It is interesting to note that since most of these deals were growth capital, it largely preserved the Chinese market from the turmoil created by the global financial crisis that subsequently cut into leveraged finance.

The third stage was the turn of the market and current consolidation. The Chinese stock market started plummeting in 2008, exits became more difficult, and IPOs started becoming scarce from 2010. However, the one bright spot during the period was the launch of the Chinese Nasdaq or ChiNext in Shenzhen in 2009 as it provided a new exit option for many PE funds. But cash-to-cash, the real cash returning to investors' coffers remained hazy. A precise analysis is necessary to go beyond the smokescreen of portfolio valuations.

In the future, differentiation will be the key word, to access the better deals, to create most value, to achieve the best exits.

Another major trend is the emergence of yuan funds, which for the first time represent more than half (60 percent) of the total funds raised in 2011, indicating increased localization of this market, both on the fund manager (general partner) and investor (limited partner) side.

Today, private equity is an essential financing element for the Chinese private sector, still little favored by banks. The best credentials for it are that almost all entrepreneurial success stories - Baidu, Ctrip, Lining, Belle, Home Inn, just to mention a few - have been funded by private equity funds.

The Chinese private equity market is on a continuous growth pattern, with 0.3 percent of GDP invested in this asset class compared to 3.4 percent in the US and 1 percent in Europe. The overall perception of the sector is extremely positive, with strong support by the government, entrepreneurs and even the general public.

However, a few clouds darken the picture. First of all, competition is fierce: strong liquidity in the market and an estimated "capital overhang"' of $15 billion makes it a sellers' market for performing firms.

Differentiating strategies is crucial, but this remains a weak point in the market: very few GPs are able to surpass the stage of deal-making to become real active investors. Things are moving in the right direction, but it will take time.

Exits are less easy and profitable than in the past due to the weakness of the Chinese stock market for the last three years, as well as their greater selectivity. While a typical stock was shooting up 100 percent the first day of trading five years ago, bankers and investors are today satisfied with a more traditional 15 percent.

Team instability is a great source of concern for LPs: many funds are now in their second, third or fourth generation, but teams have rotated a lot, making performance analysis difficult.

Regulation is still in its infancy with multiple regulators that are sometimes in contradiction or overlap.

The author is the managing partner of A CAPITAL, a Euro-Asia PE fund with offices in Beijing, Shanghai and Brussels.