China’s private equity (“PE”) market has grown rapidly in the past two decades. As the economy grows, control investments have been gaining momentum. Today, there are many large-cap buyout funds active in China. In the mid-market space, however, the situation is very different. We at Nexus Point are one of the few PE firms dedicated to doing mid-market control transactions in Greater China. I would like to share how this has come to be, and why we believe that a mid-market control investment strategy is attractive, with the potential to generate outsized returns while taking on limited risk.
Reasonable entry valuation in mid-market control space due to relatively limited supply of capital
After years of economic liberalization and as growth moderates, there are an increasing number of control-oriented opportunities in China. At Nexus Point, we see a huge increase in high quality acquisition targets driven by several deal archetypes – founder succession/retirement, founder “partnership” and corporate divestitures/joint ventures.
On the other hand, in the mid-market segment, very few PE firms are focused on doing control investments. To understand why, we need to look at the historical development of the Chinese PE industry, which started in and has traditionally been dominated by minority growth and venture investments. There were no homegrown control funds. The only funds doing mid-market control deals in China in the early days had a western (mostly US) heritage. As these funds made good investments and generated solid performance, they went on to raise increasingly large funds, thereby exiting the mid-market space. At the same time, since there are no homegrown control funds in China, no one is coming in to fill the void in the mid-market control space.
This explains why, in China today, there are a large number of attractive mid-market control targets, yet the competition for such deals is very limited, leading to very reasonable entry valuations. We at Nexus Point have completed seven investments in the past few years, all sourced on a proprietary basis or negotiated on a bilateral basis. Most importantly, we secured these companies at reasonable entry valuations, averaging under 10x EBITDA.
Mid-market companies present significant EBITDA growth potential
Globally, mid-market control/buyout as an investment strategy has generated consistently high returns partly due to the significant potential for value creation through EBITDA growth. Unlike large-cap companies which present less room for rapid growth because they have generally reached a more mature growth phase, mid-market companies are often still in an earlier stage of growth with significant potential for rapid EBITDA expansion. The tried-and-true PE toolkit for value creation is also very well-suited to mid-market companies, including professionalizing the management team, implementing internal systems and process upgrades, and solving specific operating issues.
We at Nexus Point are very proud of our portfolio, which consists of market-leading companies with strong business fundamentals and good growth prospects. Through our rigorous asset selection and due diligence process, coupled with our value creation focus, our portfolio has achieved an average EBITDA CAGR of over 25% since our investment.
Enormous room for valuation arbitrage on exit
While the entry valuations for mid-market control transactions are reasonable (below 10x EBITDA for the Nexus Point portfolio), there is enormous room for valuation arbitrage on exit if these companies can successfully grow EBITDA to a scale of $40 million or $50 million. This is because the buyer universe expands very significantly (and the capital markets option also becomes available) once a company reaches that scale given the large and increasing number of large-cap PE firms hungry for high quality targets in China.
So, what is the quantum of the arbitrage opportunity? Based on the publicly available information, the average entry valuation for China large cap PE transactions has increased to over 20x, highlighted by several high-profile examples that transacted through hotly contested auctions in 2021. These lofty valuations reflect the intense competition in the large-cap space, where the supply of capital is more plentiful. From an entry valuation of below 10x to an exit valuation of over 20x, the room for valuation arbitrage is enormous.
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We at Nexus Point are committed to the mid-market control investment strategy because it has the potential to generate outsized returns in China due to reasonable entry valuation, significant EBITDA growth opportunities, and enormous room for valuation uplift on exit once we have successfully grown our portfolio companies. At the same time, we believe the corresponding risks we take are quite limited given our valuation discipline and unyielding focus on portfolio value creation. Finally, because of the limited number of PE firms pursuing this strategy in China, our portfolio construct differs meaningfully from others, providing our investors with diversification in their China exposure.
China is an enormous market with many different investment strategies. We at Nexus Point believe we have identified a winning one, with an asymmetric risk/return profile that rewards our investors.
