Private equity is making itself at home in China

The easing of regulations and the announcement of big-name deals, as well as the growing interest of foreign companies, suggest the sky is the limit for these investors.

The private equity sector in China is showing "a new effervescence", says Bruno Roy, the Beijing managing partner of the consultancy McKinsey. Regulations are becoming more favourable, big-name deals are being announced regularly and foreign interests are becoming more active in putting up funds.

Growth of the sector in China has outpaced that in almost every other part of Asia. But, as with so many things in China, what has happened so far is just the beginning. In the US, private equity investments constitute 0.8 per cent of GDP, while in the UK they make up 1.9 per cent. In China, the figure is a mere 0.2 per cent. The average private-equity deal in China is worth US$40 million (Dh146.9m), while in the UK the average is almost seven times as big, at $271m. That means there is plenty of scope for deals to become larger, and that is exactly what seems to be happening. In 2004, just 7 per cent of deals were worth more than $100m, while in the first quarter of this year 12 per cent were.

Many people believe private equity in China is about taking the state-owned enterprises (SOE) public. In fact, Mr Roy says, if the large deals in the banking sector are removed, the majority involve private companies. Often it is entrepreneurs - who tend to be more nimble and easy to deal with than the lumbering SOEs - selling their companies to private equity funds. When it comes to exits, most of the deals are initial public offerings of stock, Mr Roy says. Competition for these is becoming tougher because they are hugely profitable and the number of companies available is dwindling. As a result, management teams are becoming "more picky" when selecting private equity funds.

"They say 'you have to add more value. You need to help us get to the US market'," Mr Roy says, adding this in turn means the management of private equity firms in China is changing. Instead of being primarily bankers, they are increasingly made up of highly skilled managers capable of adding value to a company. Despite the regulatory changes, which include a reduction in lock-up periods, hurdles remain.

While in more mature markets most deals come from auctions, in China most are "predatory" - the private equity company directly approaches the seller. This necessitates building up good networks of relationships, including with local officials. Foreign operators such as Carlyle, which have a large share of the Chinese market, have to be "more local than the local [firms], or at least as local". Also, in China typically only minority stakes in companies are acquired and that poses challenges in terms of influencing those firms.

"If you invest 20 per cent in a company, you have to be sure that company is committed to change," Mr Roy says. But finding managers with the ability to restructure and grow companies can be harder in China. And in some sectors he says is it simply "very hard to buy anything". Despite these difficulties, an economy growing as fast as China's will remain attractive. The macroeconomics in China are "so compelling" that Mr Roy predicts that by 2015 the total private equity market, including both SOEs and private companies, will be worth more than 200 billion yuan (Dh108.45bn), or 0.5 per cent of GDP.

Some believe it could be even higher. Andy Mok, the president of Red Pagoda Resources, which undertakes executive searches for venture-backed companies, thinks the more favourable regulatory environment, continued rapid economic growth and enthusiasm among foreigners for investing in China will spur faster growth. "As the market becomes more sophisticated, you will see a diversification of asset class investment that should be positive for growth," he says. "And as you see more and more wealthy people in China, they are going to have more and more money to invest.

"If you look at all these pieces, they all point to very strong growth in private equity."