PRINT THIS PAGE Opportunities arise as private equity in China evolves10/10/2007. Source: Nixon Peabody.
China’s economic growth has been phenomenal and this growth has made the country a magnet for investors, says Nixon Peabody. The evolution of the laws governing private investment are creating more opportunities for funds that do their homework and have the patience and flexibility to understand and work with the unique characteristics of private equity investment in China. China’s economic growth has been phenomenal. The country now has approximately 340 million cell-phone users, 120–150 million registered Internet users (many more are unregistered), 20,000 blogs, and 2,900 television stations. In Beijing, 80 percent of the world’s cranes are in use at 9,000 construction sites.
The country’s economic expansion has made it a magnet for investors. According to the Association for Corporate Growth/Thomson Survey, 50 percent of dealmakers surveyed in 2006 planned to be involved in cross-border transactions in the first half of 2007. Of those, 35 percent expected to be involved in a deal in China.
Private equity funds — large pools of capital raised for the purpose of acquiring companies — have been active investors in China; however, they play a different role in China than they do in the United States.
Current role of private equity
In the U.S., private equity funds tend to focus on middle-market or large-investment opportunities. In China, private equity funds tend to operate as late-stage venture capital investors, where most make investments in companies that have proven business concepts and models, established positions in their markets, solid management teams, and plans to expand within China or internationally. Historically, private equity funds in the U.S. have avoided the technology sector. However, private equity funds in China are active in technology industries such as health care, agriculture, pharmaceuticals, and energy.
Control vs. minority ownership
In the U.S., private equity funds tend to purchase controlling or majority interests in the companies in which they invest; however, in China, opportunities to purchase a controlling interest are rare. Unlike their Korean or Japanese counterparts, Chinese entrepreneurs use the “family business” model. They distrust investors, especially foreign investors, and are extraordinarily reluctant to give up control. As a result, private equity firms, like late-stage venture capital firms in the U.S., have been purchasing minority positions in Chinese companies. The ownership of minority rather than controlling interests has created a different type of relationship between management and other shareholders.
Size of investments
With the enactment of certain regulations on September 8, 2006, exit opportunities for Chinese companies are limited. As a result, with some exceptions, company valuations are substantially lower in China than in the U.S. In addition, the cost to expand and grow in China is less than in the U.S., so investments tend to be smaller. An investment of $5 million in a Chinese company, for example, might allow it to add 200–300 engineers and operate for two to three years.
Private sector vs. state-owned enterprises
Since entrepreneurs are driving the economy, most private equity funds investing in China have focused on the private sector. State-owned enterprises (SOEs) have received little attention from private equity funds because investing in or acquiring an SOE is difficult, time-consuming, and expensive. Chinese government officials who negotiate the sale of SOEs have careers to protect, and they often know little about the businesses being sold. Chinese law requires that a valuation be performed and an auction process be held. Moreover, many SOEs own and operate schools, hospitals, and other non-core enterprises, and these enterprises must be divested.
The role of leverage
Currently, private equity funds in China are using little or no debt in connection with their investments. The lack of leverage in these transactions is due to numerous factors. Only a limited number of banks in China are permitted to make loans to Chinese companies, and Chinese law prohibits foreign banks from participating in domestic transactions. Although banking reform is in progress, Chinese banks do not yet have the expertise and sophistication to participate in private equity investments.
Emergence of homegrown private equity firms
Chinese law has recently permitted “limited partnership” entities, which has created more favorable conditions for the formation of domestic private equity funds. The prior legal regime was tax-inefficient and did not accommodate the legal requirements of investment funds. The removal of this obstacle, in combination with the growth of domestic wealth, has created new opportunities for private equity funds to be raised in the national RMB currency.
Conclusion
The velocity of economic activity in China and the evolution of the laws governing private investment are creating more opportunities for funds that do their homework and have the patience and flexibility to understand and work with the unique characteristics of private equity investment in China.
Nixon Peabody LLP is one of the largest multipractice law firms in the United States, with offices in fourteen cities and more than six hundred attorneys collaborating across fifteen major practice areas. The firm's size, diversity, and state-of-the-art information systems enable it to offer a comprehensive, integrated range of legal services to individuals and organizations of all sizes in local, state, national, and international matters.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.
|
