Easing Chinese Wariness of Private Equity Investment

With its vast population and soaring economy, China represents remarkable business possibilities for in-bound investment. Relaxed regulatory restraints and ongoing privatization have opened up this vibrant market, spurring an increasing number of international investors to branch into the region. Private equity investors are no exception. According to a report released by PricewaterhouseCoopers earlier this year, M&A activity in China grew 34% in 2005, with deal value reaching $46.4 billion, as compared with $34.6 billion posted in 2004. Industry analysts expect at least $6 billion in private equity investments to be made in the country this year. Implementing a successful investment strategy in the world’s biggest country requires sensitivity to cultural and business differences – which can be significant enough to foil the ventures of even the savviest PE pros. Impediments that investors face in selling a deal proposal to Chinese business owners include differing deal expectations, reluctance to transact business with people outside of their relationship network, disinclination to giving up control of their business, and concern about selling a stake in their company to foreigners too cheaply – issues that often are at odds with private equity aims. Wise investors must be willing to shed much of their traditional ways of doing business and learn the political and cultural ropes as part of the price for landing good deals. Patient, flexible investors who are alert to sticking points and can work around business and cultural differences should be able to get a foot in the door and cement successful transactions. China is not for the rigid or the hurried. Investors need to take time to understand the Chinese people, their way of thinking, and the rules of the game. Since experts believe that it could take a couple of years for the expectations of buyers and sellers to align, they suggest that investors be willing to compromise on deal structures or terms and, in some cases, prepared to entice business owners with more than just capital. Chinese business culture is deeply rooted in personal and family ties, and often maintaining harmonious relationships takes priority over other concerns. To access quality deals, investors need good connections with government authorities and with the local business community, and should retain local advisers who can bridge cultural gaps and coach investors on how to work the Chinese system. Many of the deal successes to date stem from investments in large stated-owned enterprises (SOEs), such as big Chinese banks, or ventures in which the investors hold only a minority stake and gain little, if any, governance control over the company – not the usual Western-style of PE investing. In recent years, the Chinese government has encouraged limited foreign investment in banks, for example, as a way of helping to strengthen the finance sector. Government regulators wanted non-Chinese banks to own stakes in the businesses, enhance managerial capabilities, and instill good governance controls, with the goal of taking the companies public. “When the government sponsors such activity, the likelihood of success is going to be much higher. But as you go down in deal size and head into the private sector, where most of the PE activity is going to come from, transactions are more challenging,” says Gordon Pan, a Partner at Baird Capital Partners who oversees the firm’s Asia investment efforts. Brian Smith, a Shanghai-based Managing Director at Conway, MacKenzie & Dunleavy, agrees. “At the next level of private equity, it’s an entirely different ballgame. I’m talking about guys who like to write equity checks between $20 million and $50 million who have historically focused on the middle market. In those deals, you’ll see reluctance,” he says. And not just leeriness of non-Chinese private equity investment but private equity investment in general, notes Chip Chaikin, a Partner at Blue Point Capital Partners who is based in Shanghai. “Therefore, I don’t think that a well-connected foreign firm with local Chinese investment professionals is at a meaningful disadvantage to a local fund in winning deals,” he adds. Basic cultural and business differences underlie the reticence to private equity investment. First, in China, chronic suspicion prevails, and people tend to be wary about interrelating with and trusting outsiders. Additionally, many wealthy families in the country who own family businesses tightly control their companies and hand them down from generation to generation within the family, says Pan. “Family bonds are stronger than anything. Even if someone sells you his or her business that doesn’t mean that he or she isn’t going to help a relative in a similar business and compete against you after selling. Understanding family connections and how to protect yourself from entrepreneurs competing with you after they sell are very big issues,” he adds. And since business dealings are relationship-based, they are established more on who you know and how you know them and less on a company’s financials or business plan, adds Chuck Moore, a Managing Director at Conway, MacKenzie & Dunleavy who is based in Detroit. Second, not all cultures are accustomed to the detail-oriented and document-intensive style of Western due diligence, notes Wilson Chu, a Partner in the Business Transactions practice at Haynes & Boone who focuses on technology deals and cross-border investments in the Asia-Pacific region. In many foreign countries, including China, due diligence is considered intrusive, insulting, or even a sign of bad faith and can become a deal breaker, he adds. In China cultural secrecy and a desire to keep information to oneself persist. Third, the Chinese dislike losing control, and many perceive private equity investment as a loss of control, since most funds aim to buy a majority stake in a company. The experts note that tax avoidance in China is common, due to the high level of profits tax that companies have to pay, and many companies keep two sets of books. Therefore, there is fear among Chinese companies that outside investors will impose financial and governance controls that management doesn’t want to have. PE investment also can involve layoffs – a “bad cultural situation” since the Chinese government strives to achieve 100% employment in the country, states Smith. Leland Lewis, a Managing Partner at mid-market PE firm Key Principal Partners, agrees, adding that state-owned enterprises controlled by local governments, particularly in the inner provinces, are politically oriented and focused on local issues. “Government officials are worried about retaining local jobs and the company’s prestige in its community,” he notes. To that Chaikin adds, “No one wants to be the person to sell a national asset to a foreign company then see that company make a lot of money. That would be a huge loss of face for the regulators involved.” American managers realize that a PE firm might replace them immediately upon making an investment, or somewhere down the road if they don’t deliver on performance. Conversely, Chinese managers think they are “in for life and they don’t think investors have the right to kick them out,” states James Koshland, a Partner and chair of the Emerging Growth and Venture Capital Practice Group at DLA Piper Rudnick Gray Cary. Chinese people are also long-term-oriented. Whereas in the Unites States, managers are accountable for their company’s performance by the quarter, Chinese management teams are accountable by the generation – 20, 25, even 30 years. And since the Chinese think in much longer blocks of time than Westerners do, even if a PE firm offers managers “a significant liquidity event,” they often have a hard time understanding why the firm intends to invest in their business for only four, five, or six years, says James Hill, a Managing Partner at Benesch, Friedlander, Coplan & Aronoff and a member of the law firm’s corporate/securities and private equity groups. Add to those deep-seated cultural traits the fact that equity ownership is a relatively unfamiliar notion in China. “The whole idea of wealth accretion through equity ownership in a company that’s appreciating in value is an unfathomed concept in China,” says Hill. “Most mid-market Chinese firms do not understand that the driving force behind PE is that the equity will appreciate, hopefully, and that they can participate in that. It’s not that they don’t care about equity. Once they get it, they’re intrigued by it. They just don’t naturally think about their businesses that way, and require some education on the topic.” Also, says Patrick Hurley, Managing Director of MidMarket Capital Advisors, the traditional U.S. concepts of investment holding periods, seller/issuer representations and warranties, non-competition provisions, and items like confirmation of good title are difficult to align with the realities of Chinese companies. “What we take for granted as customary deal documentation may not be at all familiar in some Chinese companies, so it can easily be misinterpreted or ignored,” he says. Atop a traditional reluctance to sell businesses, Chinese entrepreneurs generally have not seen a downturn in the modern economy. American business owners, in contrast, have experienced ups and downs and realize that it’s sometimes worth giving up a bit of control to gain needed capital or managerial know-how. That’s not the case in China, says Chaikin. “There’s an unbridled enthusiasm and belief that the world can’t go bad, so they don’t see the upside of giving up any control.” Moore points out that investors may confront differing degrees of reluctance depending on a company’s industry or location. In the technology sector, for example, business owners are more receptive to in-bound investment and management expertise because the business culture is different than that of a more traditional companies, such as a manufacturing firm, says Rocky Lee, a Beijing-based Partner and head of DLA Piper’s Venture Capital and Private Equity practice in China. “Managers of a technology company are generally younger, better educated, and more open to new ideas.” Companies in coastal cities also are more willing to work with foreign investors and more receptive to new ideas, Lee states. For that reason alone, more deals are completed in Shanghai and Beijing than anywhere else in the country, he adds. “There’s no question that cities like Beijing and Shanghai are more cosmopolitan. Lots of Chinese nationals gained educational and work experience overseas and are bringing their experiences back to China, which helps the country’s economic development,” says Pan. But overall, receptivity to private equity capital still significantly lags openness to investment in Western markets, he adds. “Look at private equity in Europe, Germany in particularly. It took a long time for that market to mature to the point where German entrepreneurs put their businesses up for sale or allowed third-party investment. If it took that long in Germany, I think you’ll see the same time frame for acceptance, if not longer, in China.” On a brighter note, Chaikin asserts that in some cases, privately held businesses that want to boost management skills, shore up governance controls, and eventually go public regard foreign private equity investment as “a Good Housekeeping seal of approval.” In fact, many Chinese companies aim to go public on Nasdaq, so if they think that U.S. investors can help in that regard, they may warm up to a deal, says Koshland. What’s an investor to do? Cultural and business differences need not preclude deals, the experts say. There are a number of steps foreign investors can take to ease Chinese business owners’ concerns. Having the right team – with cultural and language skills and local connections – on the ground is a must, they say. And local Chinese nationals should be part of that team, Pan states. “You might be okay having a Chinese expatriate run your office in China, but when you’re talking about getting down to the entrepreneur’s level and are communicating on a one-to-one basis and trying to build trust, you need to have a local representative,” he adds. Next, bring more than your checkbook to China, warns Lewis. Four or five years ago, capital would have been sufficient to entice a Chinese company, but now that’s not enough, he says. Given the flood of domestic and foreign capital available for investment, investors need to bring more to the table than that. “Many Chinese business owners plan to stay involved in their company, and what a lot of them are looking for are technology and access to new markets. Given their aversion to layoffs, managerial expertise has not been much of a lure,” he adds. It is also recommended that investors consult with a local adviser to familiarize themselves with the country’s due diligence practices, says Chu. That way, PE funds can tailor their review to glean as much information as possible, but in a way that respects Chinese customs. “Companies investing abroad may have to settle for less information than they want,” he warns. “Some cultures view U.S. due diligence as insulting, or even as a sign of bad faith. Ultimately, the investor must figure out how badly it wants to do the deal. Too much pressure from the buy side can be a deal breaker,” he states. Too much rigidity when negotiating deal terms can sink a transaction as well. Pan believes that private equity investors targeting China might have to develop a new investment methodology to get deals done there. “For U.S. firms to expect that they’re going to get the same kinds of deal terms, deal structures, legal rights, and governance controls that they’re used to in other markets is unreasonable,” he says. To that Lee adds that to help sell a deal, investors may have to settle for “supplementing” existing management, not changing the entire team. For some PE funds, Hill says, it might make more sense to forego direct investments and instead focus on opportunities for helping their portfolio companies sell in China, source from China, or set up manufacturing capabilities there. “There are many companies in the U.S. that are missing out on not only selling to their customers who are already in China but also on selling into the Chinese market directly. That’s where the real opportunities lie for most PE firms, but not many PE firms have that expertise,” he says. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com