Citic Capital and The Challenge of Buyout Business in China

One way or another, every good money-making idea ends up in China. But, they don't all succeed. Possible case in point: current efforts by China's Citic Capital Partners to create a homegrown competitor to the global private equity leaders Blackstone, TPG, KKR, Carlyle.

These global firms started and prospered in the US at very opportune time, when many tired, poorly-managed older industrial companies were in need of shaking up. The PE firms seized this opportunity. Though their styles and investment appetite differed somewhat, all had a similar M.O: buy a controlling stake in an existing business (or division of a larger corporation) using a slim wedge of their own equity capital and a large helpings of debt, either in the form of bank loans or bonds. They then installed new management, slimmed down bloated workforces, tightened operations, improved cash flow and margins to pay down the bank debt, and then exited by selling the newly-fit company to someone else, or staging an IPO.

Today's global PE giants were all once known as Leveraged Buyout shops. The firms ditched that name in favor of the more innocent-sounding term of Private Equity about ten years ago. But, it's the leverage that gave the global firms the keys to the kingdom, and often produced stunningly high return on equity. The math is simple. If you only put up 25% or so in cash, and then double the value of a business by improving profitability, you can earn upwards of six to eight times your original equity investment. Returns like this, and often higher, allowed the big global firms to raise well over $100 billion in the last five years, and made their founders billionaires.

When the financial crisis struck in the summer of 2008, banks stopped supplying the debt finance. No leverage, no buyouts. The last major deal, Cerberus's $7bn purchase of 80% of Chrysler from Daimler-Benz collapsed in 2007, with losses of over $5 billion. The big firms are still licking their wounds. The dearth of bank finance means the deals they are trying to do now require them to put up all or most of the cash themselves, without recourse to leverage. That, of course, will put strong downward pressure on what were once very high rates of return.

With what looks to be bad timing, a successful and well-established Chinese PE firm has now apparently decided to try to become a leader in doing buyouts in China. At first glance, leveraged buyouts look well-suited to China. There are lots of tired old industrial companies, mainly state-owned enterprises (SOEs), that seemingly could benefit from some radical restructuring. Slice the fat away and a trimmer, profitable business could emerge.

There are, however, a number of serious problems with this business model in China. Start with the fact that it's generally difficult, if not impossible, to buy a controlling stake in one of these giant SOEs. If you don't have control, you don't have a sure way to implement any changes to improve things. Next, leverage is also unavailable to finance such deals. Third, for the most part, all the better SOEs have already gone public, leaving a rump of outcasts that no amount of restructuring could save. Fourth, arranging an exit is at best uncertain and time-consuming, and at worst, impossible, depending on the decision of China's security regulators.

Finally, any Chinese firm entering the buyout market now will need to compete successfully against TPG, Carlyle, Goldman Sachs (GS), KKR and Blackstone, all of whom have long experience in the field as well as established operations in China. They are struggling to find good buyout deals in China. Too much talent and money is already chasing too few opportunities to do big buyouts in China.

There have been a few success stories doing buyouts in China. The most notable was TPG's purchase five years ago for Rmb 1 billion ($145 million) of 16.76% of Shenzhen Development Bank. TPG was able to exercise significant management control. They brought in an American CEO, improved the bank's operations, and are now in the process of selling it to Pingan for over Rmb 11 billion ($1.7 billion). If the deal is approved by Chinese regulators, TPG stands to make a profit of about $1 billion, or an eleven-fold return.

The lure of those fat returns – and probably the reputational boost that comes with pulling such deals off – have seemingly convinced Citic Capital to focus on buyouts in China. Citic Capital launched this new strategy over a year ago, and closed its second dedicated China buyout fund, raising over $900mn, in February of this year. Overall, Citic Capital has over $3bn under management.

I've met some of the Citic Capital team, and they are all first-rate: smart and clearly able. Still, the shift in investment focus seems puzzling, at least to this outsider.

Citic Capital Partners is the PE arm of one of China's best banks, and a leader in providing loans to private SME. CITIC Bank could certainly continue to provide a steady source of high-quality deal flow to its PE business. Indeed, Citic Capital was successful and well-established doing the best kind of PE deals in China: investing $10 million – $20 million per deal to acquire a minority stake of around 20% in a fast-growing private Chinese company, then aiding that company in the process of planning for an executing a successful IPO.

Why would Citic Capital change a winning formula? My sense is that it's part of an effort by Citic Bank to differentiate its PE business, and establish early leadership in an area that they believe may well day prove lucrative. This may turn out to be prescient. China's laws change often, and somewhat unpredictably – just because buyout investments are difficult today, does not mean they will always be.

But, the problem remains that good buyout deals in China are scarce, and competitors are numerous. Buyouts are out of favor everywhere in the world, including with those who put up the money, the endowments, pension funds, family offices and other institutional investors who serve as Limited Partners.

At this moment in financial history, and likely for quite a long while to come, the best risk-adjusted returns are available for minority PE investments in successful fast-growing Chinese SME. That's where Citic Capital and other firms have made their reputation and made investors very good money.