When I left the firm I co-founded to start Nexus Point over three years ago, several people asked me why I would want to start a new private equity (PE) firm. Allow me to explain my motivations. The first is personal: I wanted to return to the aspects of deal-making that I most enjoy, characterized by seeking out mid-market companies with ample room to drive growth, and creating value through operational improvements and transformative initiatives. I found proprietary deal sourcing and forging strong working connections with company management teams hugely fulfilling. Founding Nexus Point allowed me to resume the style of PE investment that made my work so gratifying.
The second motivation is that Greater China was on the verge of an unmissable opportunity amid strong growth of control transactions, exactly the kind of deals I wanted to do. Up to that point, control had been viewed as a relatively narrow strategy in Greater China, accounting for just 8.5% of all PE deals completed in 2016, or US$7.4 billion, according to financial data company Preqin. China’s breath-taking macroeconomic growth had previously enabled business founders to succeed relatively easily, and PE firms were content to ride along as minority growth investors without having control. Growth of control deals was also impeded by China-focused PE firms’ inexperience in creating value for portfolio companies through operational improvements, not to mention a dearth of senior management talent and a lack of acquisition financing.
All this has changed in the past few years, and the change is accelerating. Control transactions – those that allow investors to control companies’ cashflow and operational direction through majority share ownership – are taking off in China. Here are three reasons why I believe this to be the case:
1. China’s moderating growth and founder succession issues mean that founders are more willing to cede control
In 2019, China’s economy expanded by 6.1%. While still the highest rate of growth among major global economies, it was a far cry from the 10%+ annual growth rates enjoyed in the 1990s and 2000s. As growth has moderated and China’s economy has matured, labor and other regulatory compliance costs have increased, squeezing profit margins. For example, according to data from China’s National Bureau of Statistics, the average wage of urban employees in the private sector went up by 11.4% per annum between 2009 and 2019. Social security costs are also on the rise as China’s tax bureau now monitors employee income to identify gaps in employers’ social security contributions. Meanwhile, a national action plan has widened the net for pollution control inspections, raising environmental compliance pressure for businesses operating in many industries.
Founders are realizing that in this environment, their companies require a robust strategy and, more importantly, experienced partners and a team capable of driving operational improvements, to secure growth. They are unlikely to have developed these skills in-house during the years of plenty, and are thus more inclined to consider partnering with – including selling control to – PE firms capable of adding operational value. In addition, this is happening as a generation of entrepreneurs who started companies in the ‘80s and ‘90s reach retirement age. Many face difficult succession issues and are therefore willing to sell their businesses to investors who can help institutionalize their firms by locking in the processes that have helped drive growth.
2. China’s pool of senior management talent is deepening
Another impediment to doing control transactions in the past was the lack of professional management talent. According to an annual survey conducted by ManpowerGroup, a leading workforce solutions provider, senior management personnel had consistently been among the most difficult to find in China, ranking second-hardest in 2009, and third in 2013. The situation has started to change in recent years. In 2018 and 2019, senior management roles were only sixth-hardest to fill in China, indicating improved availability of management talent. Exposure to multinational best practice, a sizeable increase in business school graduates, and the ongoing reform of China’s state-owned enterprises are all contributing factors. The result is that PE firms are no longer reluctant to replace management teams in their portfolio companies due to weak or non-existent capability.
3. Access to acquisition financing has improved
While most control transactions in China are still done with no or little acquisition financing, going forward, as macroeconomic growth continues to moderate, the need to secure acquisition financing as a lever to drive PE investment returns will become more important. In recent years, acquisition financing has become increasingly available from both local and locally-incorporated foreign banks. Adjustments to commercial banking guidelines in 2015 raised the proportion of funds Chinese banks could provide for acquisition financing to 60% from 50%, driving robust growth of credit available for mergers and acquisitions. For example, as of year-end 2019, the balance of onshore acquisition loans stood at RMB 1.2 trillion, up from RMB 414 billion in 2014, according to interbank survey data.
Not surprisingly, control transactions are becoming more commonplace in China. Total transaction value doubled from US$7.4 billion in 2016 to US$14.7 billion in 2019, accounting for almost one-fifth of the total PE deal flow. The COVID-19 pandemic has further highlighted the distinct advantages of control strategies, which add value by making lasting operational improvements, optimizing deal structure to better withstand shocks and risks, and exercising better control over the timing and method of exit. Whatever the future holds, I have little doubt that these advantages mean control strategies are set to flourish in China as the economy recovers.