Private Equity Investment
– Why China ? By Jiawen Miao
There are good reasons for global investors to focus on the opportunities in China, a market that is moving from international trading to manufacturing and service industry. While the world economy is growing at an average rate of 2 – 3 % a year, the China’s GDP has been growing and will continue to grow at a yearly rate of 6 – 8 %. After entering WTO at the end of 2001, the finance and stock market will gradually open to the foreign capital. China’s agriculture and manufacturing industry have already been opened to foreign investors for some time now. After entering the WTO, other industries such as infrastructure and service will be open to foreign investors as well. Constraints for foreign direct investment (FDI) such as ownership percentage limits, re-export percentage requirement, and domestic composition requirement will gradually be reduced or even eliminated. At the same time, legal environment and policy transparency are expected to improve, which will greatly reduce system risk and trading cost for investors. All these trends will make China very attractive to global investors. FDI in China was $ 42.09 billion in 2000 and $ 46.85 billion in 2001. As forecasted by Goldman Sasch, foreign direct investment will reach US$100 billion by the year 2005, which will represent 6.3% of the world FDI capital inflow. Looking back to the history foreign investors experienced three stages in the processes of entering China: trading and technology transfer in the 1980s, setting up manufacturing and distribution networks in the 1990s, and at the present, manufacturing and service followed by global financial service system. Although manufacturing will still play an important roll in attracting FDI, it is changing from labor-intensive assembling businesses to more capital intensive and hi-tech ones. As a hot spot for foreign investment, service industries will move even faster than manufacturing. These service industries include banking, insurance, security, telecommunication, traveling, and transportation. Real estate and infrastructure development will also attract some investors. Although the China’s coastal provinces have been attracting most of the FDI, inland provinces will attract more and more investment as they may provide more favorable policies for FDI. Overall speaking, quality assurance, environment protection, energy saving, and production efficiency are the big issues concerned by the Chinese government. Foreign
investors should gain big support from the government if the projects are big enough and the technology being used is advanced. Some ten to twenty years ago, investors came to China for low cost labor and the market destination was Western countries, and investors are mainly Chinese from Hong Kong and Southeastern Asia. Because of the government regulation, many multinational companies had to take the form of joint venture and, often times, had to accept the position of minority shares. On the other hand, most investors were not familiar with the rules and businesses environment in China in the early years. They did need a Chinese partner to help them to set-up the factory or sell the product locally. As the regulation becoming more favorable and multinationals gaining more experience in China, they started to realize that joint venture might not be the best form to enter China, because it is very costly due to poor communication and lack of common goals. As the capital market is maturing in the Mainland China, FDI has more options than joint venture and setting up wholly owned subsidiary, venture capital investment and M&A should be an important way to consider. Although the opening of capital market is not a part of the WTO agreement, China is gradually opening this market and allowing foreign investment firms to take part in industrial investment funds, security investment funds, and venture capital funds. In November 2001, Chinese authority officially declared that foreign invested companies can go public in domestic Chinese stock market. Although the actual implementation of the policy will take a little longer, it is expected that it will be implemented at the end of 2002 or early 2003. This means that international investors can set up a fund or an investment company in China and acquire a considerable amount of stake of a well-established domestic company and later bring it to the domestic stock market. This is a very different way of investment comparing to setting up joint venture companies or wholly owned subsidiaries in China. Some early birds to China from American venture capital industry successfully cloned some US business models in China during the “Internet bubble” age. Now the situation is totally different and VCs should be more adaptive to the local business environment and have a deeper understanding of the Chinese industries. State owned enterprises (SOEs) were only allowed to form joint ventures with foreign enterprises before, now they can be partially or wholly acquired by foreign companies. This provides more choices for foreign investors who are interested in the reorganization and M&A games of SOEs. Comparing to setting-up new manufacturing/service facilities and recruit a new team, M&A gives a much quicker access to the market and the manufacturing capacity. On the other hand, some fast growing and internationally competitive Chinese companies are also looking for foreign investors so as to expend their business internationally or go public in foreign stock
market. In the last few years, China has formed some financial asset management firms who own many un-profitable enterprises. These asset management firms are now eager to sell the non-profitable companies in the hope that the new owner can turn these companies around. From some ten years ago, many foreign investors have been more focused on the Chinese market. Some multinational companies once dominated the Chinese market with little market competition. P&G once dominated the shampoo and detergent market. The entry of Coca Cola and Pepsi Cola resulted in the bankruptcy of many local soft drink producers. During the same period, local companies got the chance to learn management and marketing skills from their international competitors, and they have gradually caught up. Early birds brought their supplier with them that helped the establishment of a complete industrial supply chain. During the process of localization, international manufacturers also nursed many local suppliers. Setting up R&D activities is also a trend for Foreign Invested Enterprises (FIEs), while they used to transfer only technologies from abroad. The maturing of domestic companies provides more opportunities of market entry or market expansion by acquisition. Although the lucrative market in China attracts many foreign investors, they are very concerned about credibility of the Chinese partners and pirated brand-name products. It also makes investors uncomfortable that the government policies and processes are not transparent. Investors in some industries are very sensitive to the new regulations and changing of regulations. Legal environment, victimization, and piracy are big concerns when international foreign enters China. Venture fund's money could finance technology that ultimately gets stolen because of weak intellectual property protection. Competition from the local private companies also adds pressure on FIEs. Now that many investors have learned their lesson and many consultancy services are available, foreign investors can make better decision and wait for the best opportunity for the right partner or the right asset. It is true that China has been a difficult market for foreign investors, but there will be many opportunities in the coming years. Some newly opened industry and service sectors may attract more FDI in the coming years. These industry sectors include but not limited to retailing, international trading, transportation and logistics, education and training, healthcare, financial services, insurance, telecommunication, asset evaluation and auditing, and public utilities. The industries with well established manufacturing base and those are cost effective in China should be also the hot spot for cross boarder M&A. Those industries used to have high tariff or non-tariff barriers will attract more and more FDI after the lifting of the barriers. The technology level of these Chinese industries is usually low. Automobile,
pharmaceutical, and chemical industries are examples of this kind. The entry of these industries through M&A will gain domestic market shares and at the same time, access to low cost manufacturing facilities. In viewing of the trend of FDI through M&A, VCs can move one or two steps ahead by investing in these industries and use M&A as a major exit channel. Foreign private equity funds can access the Chinese market in a different way comparing to the ways they used to fund fast growth enterprises. The new way is to use M&A, MBI, and LBO to get controlling share in the target companies first, turn the companies around or expend them, then sell the stake to industrial giants or bring the companies public. Venture capital firms can also team up with industrial investors to access the Chinese market. A good example is the venture capital arm of Citibank and Nomura Securities teaming-up with Taiwanese industrial investors and formed a large discount retail store chain Trust-Mart in China. Since we are suggesting foreign VCs to team-up with industrial investors to get access to Chinese market, we are not restricting our discussion in the area that VCs traditionally focused on. Another reason that we are going to discuss a broader range of industries is because there are a lot of opportunities in the traditional industries for LBO and MBO, which many investment funds like to involve. The ownership reform brings a lot of opportunities for foreign investment funds to participate in MBO/MBI. The encouragement of acquisition of SOEs by the Chinese government is an incentive for foreign industrial player to buy out Chinese SOEs using LBO. The lift of entry barrier brings high return opportunities in some traditional areas that only yield low investment return in developed countries. During the process of privatization of SOEs (state owned enterprises) and in the process where matured private companies looking for international investment partners, industries that have well established companies with well-known brand or wide spread distribution network are attractive to foreign private equity investors when balancing the risk and return. These industries include petrol-chemical, pharmaceutical, and computer software. Industries where there are big gaps in business model and management skill comparing to western counterparts should be the focused area for Western investor. Most of these kind opportunities are in the service industries. (Mr. Jiawen Miao is Senior VP with K&J Consulting Ltd. His Email address is: miaoj@yahoo.com)