China secondaries dealflow disappoints

Secondaries specialists have been busy in Asia lately. While firms such as LGT Capital Partners and Paul Capital have been doing secondaries deals from Hong Kong since 2007, in the last 18 months other firms such as Greenpark Capital, AlpInvest Partners and Lexington Partners have all been enhancing their Asia presence.

So far, secondary market activity in Asia has been more of a gradual flow than a wave of deals. But the changing macroeconomic conditions are increasing pressure on GPs – and that could result in more opportunities, particularly in China.

Asia’s largest and most attractive market is losing some of its shine, thanks to a sustained slowdown in annual GDP growth and a frozen IPO market that has left GPs holding assets that they need to exit.

“If you could do [secondaries] at this moment – wow,” says Peter Fuhrman, chairman and chief executive of China First Capital. “In this market, some LPs could sell out for 10 cents on the dollar.”

“For LP secondary buyers, it is nirvana: a distressed exit market, portfolios with solid growing businesses inside of them, and a group of somewhat distressed LPs. A lot of these LPs, even bigger ones who have their money in China, have lost faith.”

Jason Sambanju, managing director and co-head of Asia at Paul Capital, adds that foreign LPs are growing more prudent when looking at their Asia private equity investments. “A lot of these LPs have already done a lot of the pruning that they want in their US and European assets, and they find suddenly that they have one or two big positions in Asia. People are becoming more sober in terms of their view of the China growth story.”

But the huge potential of China secondary opportunities has not yet been unlocked. In fact, completed sales of LP stakes have been scarce. As one industry source comments: “There are a few, but it is out of all proportion to the number of people and amount of money [put in]. I don’t think there is any other example where productivity against spending has been so low.”

PRICE/PERFORMANCE ISSUES

One of the biggest barriers to completing secondary transactions in China is pricing, industry sources widely assert. “For [stakes] in high-quality GPs, what I’m seeing is pricing that is on par or at a small premium to par,” Brooke Zhou, executive director at LGT Capital Partners, explains.

Prices can get as high as at 3 to 5 percent above the net asset value of the fund – which is expensive in the secondaries world, according to Zhou.

Fuhrman agrees that prices are too high. “The only substance to doing these deals is to buy things at a net asset discount. But what we know is that among the very few [secondary deals] that have taken place involving China GPs, some were actually bought at a premium to net asset value.”

For example, in June, online portal China.com sold its interest in New Horizon Capital’s fourth fund to AlpInvest Partners for $516,000 – roughly on par with its original commitment, according to a Hong Kong stock exchange filing. Following the deal, AlpInvest took over the balance of China.com’s total $4 million commitment to the vehicle, the filing says.

However, LGT’s Zhou says that even cheap deals aren’t getting done. “For low quality GPs, even at a higher discount, the deal is sometimes difficult. Even at a 20-to-30 percent discount, people sometimes hesitate for different reasons, such as concerns over quality of the portfolio, quality of the manager and whether the manager can raise the next fund. If they can’t raise a follow-on fund, then their motivation towards the current fund, which we are purchasing, becomes questionable.”

BOOTS ON THE GROUND

Concerns over fund manager quality are common in China – and as LPs pull back from investing, many GPs can’t raise new vehicles, industry sources say.

Fuhrman believes that sifting through GPs is difficult for Western secondaries firms that have opened offices in Hong Kong or China over the last five years, as they don’t have significant resources or local teams in China to assess the quality of portfolios.

“In the end, what you are buying can seem like a pig in a poke. If you don’t have Chinese language fluency, if you don’t have a comfort level of doing business in China, if you can’t talk to the Chinese lao ban [boss] who is running that company – how can you assess the value of the companies inside a GP portfolio? As far as I know, few if any of these guys speak Chinese. And fewer still have significant experience investing in and working alongside Chinese private sector businessmen.”

As a result, because many deals on offer are smaller and resource-intensive to diligence, funds with an existing (and substantial) presence on the ground are likely to benefit.

“A lot of deal flow we come across in Asia – including from China – involves smaller transactions, and we’re happy to put the resources to work on the smaller deals if we find them attractive,” says Adam Howarth, managing director at Partners Group. “We leverage our existing platform so even if they’re smaller transactions, we’re able to pursue them because we have the resources on the ground.”