New exit strat­egy emerges in main­land PE in­dus­try

The Pak Banker - - Front Page - Bon­nie Lo

PRI­VATE eq­uity on the main­land has seen ex­plo­sive growth in the past decade. In the last five years, 800 new funds of $58 bil­lion have been launched, ac­cord­ing to Zero2IPO. At the same time, the in­dus­try has spawned a new in­vest­ment class: di­rect sec­ondary.

This is a lit­tle known, yet grow­ing area that plays into the need for in­vestors to exit in­vest­ments. All in­vestors in pri­vate eq­uity face the need to exit and re­turn cap­i­tal to their in­vestors. It is a time ver­sus to­tal re­turn de­ci­sion. The di­rect sec­ondary mar­ket pro­vides an av­enue to achieve those goals.

A di­rect sec­ondary trans­ac­tion oc­curs when an in­vestor buys an ex­ist­ing stake in a com­pany from an­other in­vestor. This pro­vides an al­ter­na­tive liq­uid­ity so­lu­tion to tra­di­tional ex­its. The buyer ef­fec­tively steps into the seller's shoes as a share­holder and can now work with man­age­ment to grow the busi­ness and in­ject ad­di­tional cap­i­tal, if needed.

Sta­tis­tics re­veal an enor­mous op­por­tu­nity for the in­dus­try to de­velop in Asia. We ex­pect more par­tic­i­pants to en­ter this mar­ket in­clud­ing spe­cial­ized sec­ondary in­vestors and op­por­tunis­tic in­vestors, par­tic­u­larly for sin­gle as­set op­por­tu­ni­ties.

This is not to be con­fused with the more widely talked about sec­ondary in­vest­ments, where stakes in funds are ex­changed among fund in­vestors. This is re­ferred to as in­di­rect in­vest­ments be­cause the stakes trans­acted are a layer re­moved from ac­tual oper­at­ing com­pa­nies.

So, why is there such a back­log of un-ex­ited pri­vate eq­uity posi- tions?

First, on­go­ing mar­ket volatil­ity has meant that ex­it­ing through IPOs is no longer read­ily avail­able. The route has his­tor­i­cally ac­counted for 80-90 per­cent of ex­its on the main­land. The need among LPs and GPs for liq­uid­ity has in­creased the at­trac­tive­ness of the di­rect sec­ondary mar­ket in Asia. This is al­ready an on­go­ing trend in Europe and the US as IPOs in these mar­kets only ac­count for around 10-15 per­cent of PE ex­its.

In ac­tual fact, PE in­vestors should not pre­fer IPOs, be­cause they are not im­me­di­ate cash ex­its. As such, a sale to an­other in­vestor or strate­gic buyer pro­vides the im­me­di­ate cash exit that in­vestors are in­creas­ingly seek­ing.

In the Chi­nese main­land, a US list­ing, a once-pop­u­lar route for smaller main­land com­pa­nies, has a lim­ited chance of suc­ceed­ing to­day. The ac­tions of short sell­ers and re­searchers, such as Muddy Wa­ters, have raised ques­tions around main­land cor­po­rate ac­count­ing prac­tices. As such, US in­vestors' trust in main­land com­pa­nies has eroded. This has led to huge un­cer­tainty re­gard­ing the share price and liq­uid­ity prospects of those stocks. A US IPO has lost its al­lure and would most likely de­stroy, rather than cre­ate share­holder value at this point.

In ad­di­tion, trade sales, where stakes in com­pa­nies are sold to other com­pa­nies in the same in­dus­try, are still rare and ac­count for less than 5 per­cent of ex­its in Asia. One rea­son is that most PE in­vest­ments in Asia are mi­nor­ity stakes in first gen­er­a­tion com­pa­nies. The founders are usu­ally not pre­pared to give up ma­jor­ity con­trol, which is usu­ally what a buyer seeks.

Fi­nally, an im­por­tant fac­tor of why there is a grow­ing need for the di­rect sec­ondary mar­ket is timem­ore so, the lack of time. Main­land's PE mar­ket is ma­tur­ing. Fund man­agers, who may have started funds five to seven years ago, need to exit their po­si­tions to pro­vide re­turns to their in­vestors. In or­der to start a new fund, they need to show that they are ca­pa­ble of manag­ing old in­vest­ments.

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