CEL-CEIBS PE Scholarship - Alex F. Favila - 2009-03-24
P.E.P. Talk P.R.C.
Talking about Private Equity Potential in
the People’s Republic of China
The 2009 CEL – CEIBS Private Equity Scholarship
Alex F. Favila
China Europe International Business School (CEIBS)
699 Hongfeng Road, Pudong, Shanghai 201206, PRC
Student No. 081026
MBA Candidate, April 2010
+ 86 158 2117 6871
We are in extraordinary times. The world is confronting its worst crisis in more
than half a century, with the global economy expected to shrink for the first time since
the end of World War II1. People in the US alone lost trillions of dollars of wealth in
20082, in line with falling home prices that triggered the subprime mortgage crisis, which
in turn caused a tailspin among the world’s leading stock market indices which have
fallen by the high double-digits over the past 18 months3. Indeed, we are living in
China is not exempt from the turmoil we are witnessing unravel today. Since
market reforms in 1978, GDP growth in the People’s Republic of China (PRC) has
averaged 9.9%4. In 2007 alone, GDP grew by 11.9%, the fastest in the prior 12 years5.
In fact, IMF data recorded an even higher 2007 figure – 13%. But in 2008, according to
the IMF, growth contracted sharply, down to 9%, projecting growth to deteriorate further
for full-year 2009 to 6.7%, then a slight recovery to 8% in 20106, thereby lowering their
projections made in October 2008.
Mainland Chinese companies are indeed feeling the pinch. After its accession to
the WTO in 2001, the PRC’s competitive labor costs led to a manufacturing and export
boom, earning the Mainland monikers such as “workshop of the world,” and “the world’s
factory7.” That road the WTO built for China that led to initial prosperity however set
the nation up for the difficulties it is facing today. Being very reliant on exports, China is
struggling with the weakest pace of economic growth in seven years8 due to significant
slowdowns in the major export markets of North America and Continental Europe, which
combined account for around 31% of total exports9. In fact, in the first half of 2008 alone,
67,000 factories were closed10, and an estimated total of 100,000 factories were closed
for the full year11. To further exacerbate the problem, there are increasing incidences that
owners of financially distressed factories choose to desert and abandon their debt-laden,
contracting businesses. This has devastating follow-on effects on their short-term
creditors and suppliers, which in turn face the risk of bankruptcy12. As of today, nearly
“World Bank: Economy worst since Depression.” CNN Money: March 9, 2009: 7:04 AM ET.
Bajaj, Vikas. “Household Wealth Falls by Trillions.” The New York Times:
Piboontanasawat, Nipa. “China's Economy Grows at Fastest Pace in 12 Years (Update6).” Bloomberg
News: July 19, 2007 05:39 EDT.
World Economic Outlook Update. Global Economic Slump Challenges Policies. January 28, 2009
Wong, Edward. “Factories Shut, China Workers Are Suffering.” The New York Times: November 13,
Shen, Irene. “China’s Stimulus Spending to Help Growth Reach Target (Correct).” Bloomberg News:
March 22, 2009 21:14 EDT.
Ministry of Commerce Statistics. January-October 2008.
Lee, Don. “Some owners deserting factories in China.” LA Times: November 03, 2008.
20 million migrant workers have lost their jobs, and exports, which have equated to at
least one-third of GDP13, fell 25.7% year-on-year in February 200914.
While the abovementioned paints a bleak picture, we should not lose sight of
China’s potential and growing importance in terms of contribution to global economic
growth. As early as 2007, a study showed that the PRC had surpassed the US as the
largest contributor to world economic growth. In a World Economic Forum (WEF)
report, PricewaterhouseCoopers (PwC) predicted that China contributed nearly a quarter
of global growth in 2008, ahead of a contribution of around 16% from the US15. In that
same report, the next largest contributions were less than 8%, originating from Russia,
India, and Brazil.
It is reasonable to suggest that China’s growth story is far from over. WTO
accession shifted China’s focus to external markets and transforming itself into a market
economy. On the other hand, the WTO’s existing members saw immense potential in the
opening up of the world’s most populous nation16. The key takeaway here is that the
PRC still enjoys a safety net amidst significant contractions in key export markets – its
own domestic economy. It is therefore high-time for China to turn to itself and unlock
the potential economic growth the world had seen in it since the run-up to approving its
WTO application in November 2001. However, in order to achieve this, it will take a lot
of time, and it will take broad financial expertise to advise companies and to provide
capital in order to facilitate the transition. In this regard, private equity plays a pivotal
Private equity (PE) has seen a remarkable evolution over the decades. While
there may be wide-ranging debate as to its origins, there is no doubt in their astounding,
meteoric rise in financial market clout, and not to mention, in deal size.
In 1965, Jerome Kohlberg, Jr. pioneered leveraged buyouts (LBOs) with what
were first termed “bootstrap investments” with the $9.5 million purchase of Mount
Vernon, New York-based Stern Metals17. That transaction gave the Stern family an
attractive exit for their dental products company. Kohlberg first formed a shell company,
backed by an investor group, and acquired Stern Metals mostly using borrowed money.
The Sterns retained a stake and continued to manage the business. Kohlberg
subsequently sold some of his stock, purchased at $1.25 and sold at $8, to retire debt.
Kohlberg then took Stern Metals on an acquisition spree, buying a California-based
dental supply company, an Ohio X-ray firm, and a European producer of dental chairs.
China Customs Statistics. 2008. http://www.chinacustomsstat.com.
“China's exports make record drop, but car sales up.” The Associated Press, as reported on the
International Herald Tribune. March 11, 2009. http://www.iht.com/articles/ap/2009/03/11/business/AS-
Global Growth @ Risk 2008. World Economic Forum: In cooperation with PricwaterhouseCoopers.
Burrough, Bryan; Helyar, John. Barbarians at the Gate. First Collins: 2005 Edition.
Two years later, the investors sold their $500,000 investment in the company to the
public for $4 million, a 300% gain18.
KKR, the buyout firm that Kohlberg founded with Bear Stearns colleagues Henry
Kravis and George Roberts in 197619, transacted the largest buyout in history with the
$25 billion ($31 billion, including debt) buyout of RJR Nabisco in 1989. While those
numbers are dwarfed by the $20 billion ($36 billion, including debt) buyout of Equity
Office Properties by Blackstone in 200620, and the $45 billion buyout of TXU Energy by
KKR, TPG, and Goldman Sachs in 200721, RJR remains the largest buyout in history
when adjusted for inflation22. By 2007, private equity deals were a leading driver of
In the 1980s, private equity firms earned a bad reputation due to hostile
transactions that used extremely high leverage. By the 1990s, PE firms had been able to
redeem themselves by exhibiting friendly, lower-geared transactions that focused on
creating long-term value23. Key illustrations of this are the turnaround of Continental
Airlines by TPG. Continental Airlines was on the brink of bankruptcy in 1993, but TPG
saw an investment opportunity24. TPG infused $66 million into the troubled airliner,
installed new management, and improved efficiency by increasing aircraft utilization and
focusing on lucrative routes. By 2002, TPG’s original $66 million investment had grown
to $700 million. Another key illustration was when KKR, which funded the 1989 $31
billion RJR Nabisco buyout with nearly 32:1 leverage, used 4:1 leverage in 2007 with the
$45 billion buyout of TXU25.
The LBO boom of the 1980s that saw massive buyouts such as that of RJR
Nabisco ended with the shutdown of the market for high yield debt, or junk bonds,
signaled by the collapse of Drexel Burnham Lambert. Such high-risk debt was the key
supplement to commercial bank funding in order to finance LBOs. However, even as
leverage for private equity transactions has fallen today, we are witnessing a more
immense contagion – a virtual freezing of global credit markets sparked by the collapse
of the US housing market, estimated to have first occurred in March 200726. This
contagion poses a direct problem for private equity in the present time – access to
leveraged funding. David Rubenstein, founding partner of one of the world’s leading
private equity firms, The Carlyle Group, contends that we will be seeing smaller, lower-
Cimilluca, Dana; Louis, Brian. “Blackstone to Buy Equity Office for $20 Billion (Update6).”
Bloomberg News: November 20, 2006 16:20 EST.
Lonkevich, Dan; Klump, Edward. “KKR, Texas Pacific Will Acquire TXU for $45 Billion (Update9).”
Booth Thomas, Cathy. “Is there a Doctor on Board?” Time: August 18, 2002.
Interview with David Rubenstein, Wharton Private Equity Club (WPEC). “Carlyle Group's David
Rubenstein: 'The Greatest Period for Private Equity Is Probably Ahead of Us'. Knowledge@Wharton: May
6, 2008. http://knowledge.wharton.upenn.edu/article.cfm?articleid=1957
Private Equity and China
Private equity is the key tool in weathering Chinese companies through the global
crisis today, by facilitating a transition in orientation of the PRC economy: from one
being disproportionately reliant on exports, to one that is more proportionately reliant on
Press coverage of private equity can distort the dynamic and efficacy of this
financial tool. The media exaggerates private equity transactions and buyouts in terms of
which transactions are the largest in history and by putting the spotlight on the latest
transaction that supplanted the previous record holder. While such attention has
undoubtedly brought clout to PE firms – not to mention, attracting new investors who
want to reap attractive returns – we should never lose sight of the tactical advantages of
undertaking private equity transactions in the first place. The key issue today is access to
funding, and private equity has the ability to provide it, albeit to a lesser extent due to
Private equity should use the full arsenal of financial tools at its disposal to assist
Chinese companies in navigating through the current crisis its economy and the whole
world are facing today. Private equity can provide seed, venture capital to breakthrough
Chinese startups, possibly in the technology sectors. Private equity can also provide
growth capital for Chinese companies looking to expand or restructure, especially with
distressed conditions in financial markets today and with depressed valuations that could
make acquisitions attractive. When the opportunity presents itself, private equity can also
undertake LBO transactions for Chinese companies which have the potential for
increased efficiency. Each approach here will be tackled in greater detail in the following
There is enormous potential to be reaped from venture capital in China. China
produces 600,000 engineers a year, yet the quality of education is still regarded as
subpar.28 While that supposition may seem discouraging, a private equity investor
should claim the contrary. The disequilibrium between quantity and quality of education
presents outstanding investment opportunities in education, such as computers and
Internet-based tools. With the present crisis, Chinese entrepreneurs who want to
participate in this space would find it difficult to obtain financing for potential startups,
but PE firms can help. Technology entrepreneurs can also leverage on multitudes of
competent engineers for new businesses, and similarly, PE firms are in a position to assist
in making capital available. A key technology sector is telecommunications, in light of
the government granting 3G licenses to China Mobile, China Unicom, and China
Telecom. The Ministry of Industry and Information Technology estimates that this
milestone development will generate investments of RMB 1.8 to 2 trillion in 3G network
construction from related sectors alone29. That leaves further, massive potential in
investing in 3G-related businesses. In each stage of this development, private equity
Liu, Melinda; Mazumdar, Sudip. “The Mythical Million.” NEWSWEEK: August 20-27, 2007.
Wang Xing. “IT: China issues 3G licenses.” China Daily: 2009-01-08 07:48.
firms can make capital available to create value, to develop the industry, and to help
move the domestic Chinese economy forward.
Current and established Chinese companies are not immune to the crisis crippling
the world economy today. As mentioned above, thousands of Chinese factories have
closed. While this is undoubtedly a result of deteriorating financial conditions, private
equity capital still has the potential to make strategic investments. Chinese producers
which are still above-water and have the potential to create value and ensure their status
as a going concern with the help of restructuring can put private equity capital to good
use. Private equity can also make distressed investments to facilitate turnarounds or
rehabilitations of companies in difficulty. Moreover, industries that are ripe for
consolidation due to overcapacity can undertake LBOs and acquisitions. Here, private
equity will play an important role.
Finally, we should also take into consideration domestic Chinese companies
which are not necessarily experiencing significant adverse effects from today’s crisis.
Competent management of Chinese companies with viable plans to create more value
outside the scrutiny of public equity can benefit from management buyouts via private
equity, as finding acquisition finance via commercial and investments banks could prove
difficult. Furthermore, private equity can facilitate the transition of businesses from
owners looking for an attractive exit to new owners willing to take on the responsibility
and challenge of continuing the businesses.
Overall, there is immense private equity potential in China because the Chinese
economy still enjoys tremendous upside. The enormous, unsustainable balance between
American spending and Chinese saving 30 needs to undergo an equally massive
correction31, and the global crisis unfolding today is the appropriate turning point to shift
China’s focus on its own domestic economy. Access to funding is an important strategic
advantage to have today. Chinese companies have limited access to it, but private equity
has the capacity to supply it. China still has loads of development potential in terms of
healthcare and financial services32, and the capital private equity makes available will be
a key determinant in unlocking these opportunities.
Prof. Xu Bin. “The Global Economy and China.” Discovery Week, CEIBS: March 2, 2009.
Pesek, William. “China’s 2009 Rebound Is Pure Fantasy: William Pesek (Update1).” Bloomberg News:
March 5, 2009 19:07 EST.
Prof. Xu Xiaonian. “A Delayed Recession.” Discovery Week, CEIBS: March 6, 2009.