When private equity observers assessed the Year of the Dragon, which ended recently, they found it to be the “best of times and the worst of times” for private equity investment activity in China.  The year featured a number of headline grabbing buy-outs and exits and a number of notable fundraising highlights among private equity managers with strong China franchises.  However, it also saw a number of equally deflating developments that serve as powerful reminders of the challenging issues and growing pains associated with private equity activity in China.

Although private equity professionals in the region remain confident about the long-term opportunities in China, it is difficult for some of them to be particularly optimistic about the shorter term opportunities in the just commenced Year of the Snake.  Notably for the broader Asia Pacific region, however, the challenges facing the private equity market in China have increasingly caused many global and regional private equity professionals to evaluate the investment opportunities available in nearby South East Asia in a more favorable light.

PE Activity During the Year of the Dragon

Among other bullish developments, the Year of the Dragon witnessed the largest ever buyout in China in which a Carlyle-led consortium agreed to a US$3.7 billion buyout of Focus Media Holding Limited.  Carlyle also completed a spectacular US$5 billion exit from China Pacific Insurance Group – an investment with approximately a 7x return in less than seven years.  China-focused funds also raised US$15.4 billion in the aggregate during the Year of the Dragon, further positioning themselves with significant amounts of dry powder for deals.

Still, there has been enough negative news with respect to Chinese businesses in the last year to remind sponsors of the risks of investing in the PRC.  Caterpillar’s recent US$580 million write-down of its US$700 million investment in ERA Mining Machinery Ltd. (a Chinese maker of mine safety equipment) due to “deliberate, multi-year, coordinated accounting misconduct” is a particularly extreme example.  Private equity firms are understandably troubled by this scenario impacting a respected international player like Caterpillar as well as by other significant fraud incidents, including the iconic case of Sino-Forest’s overstated revenue (and missing trees).  The concern runs deeper than the damper that the specter of such accounting issues may place on exit sales to strategic buyers because it also may impact the availability of future capital commitments from LPs wary of the Chinese business environment.

The international regulatory environment is now also intensely focused on Chinese companies.  For example, the U.S. Securities and Exchange Commission has now deregistered more than 50 Chinese issuers for accounting irregularities and brought fraud charges against more than 40 individuals and companies.  China’s securities regulator, the CSRC, is also cracking down on issuers and potential issuers and has stressed the importance of truthfulness and accuracy of an issuer’s financial information.  In Hong Kong, the Securities and Futures Commission and the Hong Kong Stock Exchange are in the midst of adopting a number of reforms meant to improve the quality of companies that list in Hong Kong, including the well-publicized possibility of potential criminal liability for underwriters.  While these developments should eventually help stabilize the investment environment in China, they are currently inhibiting interest in Chinese acquisition opportunities.

As would be expected, these headline grabbing fraud cases have also significantly dampened interest among investors in U.S. stock markets for new offerings of Chinese businesses.  Perhaps even more troubling is that they appear to have helped solidify a complete freeze on IPO exits for Chinese portfolio companies.  Historically, the Chinese private equity market has relied almost exclusively on IPOs for exits, either domestically or via an offering in Hong Kong or the United States.  Today, it is estimated that some 7,500 PRC investments are held by private equity funds with limited alternative exit opportunities, even as the IPO market in mainland China essentially ground to a halt during the fourth quarter of 2012 when the CSRC stopped approving new listings.  As of January 2013, there were over 850 companies in the queue for listing approval in mainland Chinese markets, a number that probably represents at least a five-year backlog of listing applications.

Since the vast majority of PRC private equity investments are minority investments, many PE firms have limited effective means of forcing an alternative exit to an IPO.  Even where minority investors benefit from sale or put rights, the regulatory overlay makes it very difficult to force a transaction that is not fully supported by the majority shareholders.  In addition, there are significant additional obstacles to M&A exits in the PRC because few domestic buyers have the cash or shares to use as currency and foreign buyers are subject to extensive regulatory scrutiny.

Go South East, Young Emerging Market Funds

In light of the challenges discussed above, a number of PE firms have shifted at least some of their focus away from China and towards South East Asia.  This has resulted in a number of global PE firms opening offices in Singapore and elsewhere in South East Asia.  At the same time, a number of global PE firms have ramped up the hiring of local deal teams and announced intentions to allocate increased amounts of capital to South East Asia.

If China’s staggering demographics have made her a belle of the private equity ball in recent years, South East Asia is certainly no wall flower.  The ten ASEAN nations  have an aggregate population of more than 600 million (more than either North America or the European Union).  Collectively, these countries have rapidly growing economies with an aggregate GDP in excess of US$3 trillion on a purchase power parity basis (more than either Brazil or Russia).  In addition, the countries within the bloc—some with large domestic markets, others export-focused, some with significant natural resources, others with developed technology industries—represent a mix of economies with an increasing potential for integration as a result of the ASEAN Economic Community’s goal of a tariff-free, integrated South East Asian market by 2015.  Finally, given the extensive trade some of these countries have with China, these markets offer indirect investment exposure to China from offshore.

South East Asia also enjoyed robust M&A activity last year as compared to a relatively flat to down year for China.  M&A deals with an aggregate value of approximately US$90 billion were announced in 2012 in South East Asia, representing nearly a 90% increase from 2011 levels.  Moreover, each quarter of 2012 saw South East Asia recording increasing amounts of deal activity, with the fourth quarter alone representing more than US$35 billion of deal activity.

In addition to a growing M&A market, South East Asia has demonstrated a number of viable exit routes.  For example, in 2012, more public money was raised through the Malaysia stock exchange (approximately US$7.6 billion) than on the Shanghai (approximately US$5.3 billion) or London (approximately US$4.6 billion) stock exchanges.  In addition, there are a number of successful private equity managers in the region who are able to regularly consummate control transactions as a result of South East Asian legal and regulatory regimes that permit certain types of control transactions as well as the presence of entrepreneurs and family-controlled conglomerates that are receptive to control sales of a target business to fund their other business activities.  The ability of these managers to execute control transactions affords them significantly more power to pursue a trade sale or other alternative exit for a portfolio investment.

Fundraising activity during the Year of the Dragon provides additional evidence of the sharpened focus of the private equity community towards investment opportunities in the broader Asia Pacific region, including South East Asia, and not just China.  During the year, LPs allocated US$14.5 billion to pan-Asia funds, or a 74% increase in such allocations compared to 2011, whereas, as noted above, LPs allocated US$15.4 billion to China-focused funds during this period, a 47% decrease compared to 2011.  Amounts raised for pan-Asian funds during the Year of the Dragon, including KKR’s record-breaking US$6 billion Asia fund, have contributed to an aggregate fund pool for the Asian private equity market that now exceeds US$400 billion.

The Value of Diversification

Of course, private equity opportunities in South East Asia and China are not mutually exclusive and China’s position in the region should not be understated.  Indeed, many private equity professionals with successful track records in the PRC are quick to state that reports about the scope of accounting and other frauds in the PRC are overblown and that a well-qualified local team that picks its partners and advisors wisely can still avoid most pitfalls.  In addition, many LPs still seek exposure to the larger Chinese private equity market and continue to invest with private equity managers with a strong position in the PRC market.  Still, Chinese companies will likely need the benefit of time and, in some cases, reformed business practices, to reverse the image and related problems arising from the adverse market developments that emerged during the Year of the Dragon.

At least one Fengshui expert in Hong Kong has already promised in the South China Morning Post that things are going to get better soon and that the IPO markets will reopen in the Year of the Snake because “Snakes are skin shedders, [which] signifies radical change.”  A decision by the CSRC to significantly increase the pace at which it has been permitting companies to list in the PRC would be one such radical and welcome change.  The expansion of alternative exit opportunities would be another beneficial change, which seems posed to happen as a more sophisticated market for secondary buy-outs develops.

Still, the drama in the Chinese market during the Year of the Dragon serves as a timely reminder of the enduring wisdom of investment (and exit) diversification and the benefits of flexible investment mandates.  While there will always be room for investment specialization (e.g., country funds), particularly as individual private equity markets grow and mature in the Asia Pacific region, for the moment at least, it appears that many PE firms with flexible mandates in the Asia Pacific region may be in a position to buck the headwinds currently facing China and ride the tailwinds powering South East Asia.