This is a post related to a job application, and is intended to highlight my view on what opportunities there are for long term development in the Chinese economy, particularly for the establishment of a Leveraged Buy-Out (LBO) market. It is filed under economics musings and touches on items that are unrelated to the immediate market situation.
Basically, the reason for LBO’s to occur is that there is a mature company that could be vastly more efficient under new management, which creates a profit opportunity. This works well from a value-added perspective when there is a high revenue stream for the company with high associated costs, allowing an outsider to relatively easily lower the cost-to-revenue ratio. Also, the LBO is more attractive in these situations since the marginal improvements to management as well as lower associated risks and higher implied costs of acquiring a mature company results in a low-risk, low-reward, high-cost scenario that favors leverage.
Currently in China, these companies do not exist widely, or are effectively controlled by the Chinese government when they do. The focus of the last few decades has been the construction of behemoth companies that populate the steel sector and other materials, housing, banks and infrastructure, all of which are essentially treated as systemically important by the Chinese state. Beyond this, there are then a slew of smaller capitalization companies that then act as the bulk of the economic activity as projected to the domestic consumer. The creation of these smaller companies has been extremely popular for capital providers specializing in everything from seed- and venture capital, up to pre-IPO structuring. However, this is the point at which the development has stopped: the market as such is still in a high-risk, high-growth phase, and the costs of acquisitions are much lower than the western world counterparts. Thus, the venture capital field has blossomed, while the LBO market is still waiting to develop.
Is there any case for expecting the Chinese markets to develop to the point that the LBO market can grow substantially (1), and if so, when is this likely to happen (2)? For 1, there are hopes to be had, even if we ignore the somewhat fanciful idea of true privatization of several larger Chinese companies. The basic idea is that this has to start with the domestic consumer, and that this has to be on items that are deemed to be beyond necessities to allow greater diversification and a broader span of price elastic product industries for the newly urbanized, higher wage population. This would allow a domestic base for the companies to build their revenue and cash flow structures, which would then be ripe for (costly) overseas expansion which is better suited for a private equity company to manage.
1: Luckily, the data feeding through in these days from China is showing an increasingly intensive move towards the popular term “rebalancing” with increased import/export ratios and high but stabilizing levels of inflation. The Chinese person is on average having a very strong savings base, and with increasing opening of the economy more outlets for placing this in inflation-beating financial instruments looks promising for enabling spending as it places less stress on continued saving. Inflation is risky, definitely, but China is also in the high growth phase where there is a lot more cash available and both productivity and consumption is going up, therefore “automatically” lowering the relative price of the currency versus goods and services. Having it stable at recent levels (6.2%) or marginally lower coupled with some widening of the offered financial product catalogue would thus work favorably to create the domestic base from which companies can grow. In addition, the increased openness of the economy would make LBO’s procedurally easier and more attractive to undertake than they currently are in China, given lending restrictions and an attempt to hold back hot-money inflows.
In forecasting when it is likely that the LBO market has significantly grown (say, to half the relative share of Chinese overall PE activity that LBO’s currently make up in their western market counterparts) is obviously a very vague question that partially requires more data than I have available, and will be one lined with so many factors of uncertainty – like world growth and details of the Chinese policy path, neither of which I am comfortable in forecasting – that this section is simply here to illustrate my reasoning and allow for a few snippets of observations in the Chinese markets.
Let’s first consider the overall policy path. Here, China is currently making great strides in internationalizing its currency and policymakers have even dropped the date 2015 to some Eurozone officials regarding the timing of full convertibility. China has also continuously pressed the enormous need for domestic reform and rebalancing to meet these demands. We can also see the moves for opening up a yuan bond market and the PBOC efforts to create swap lines across borders, and Hong Kong’s efforts to manage the liquidity needs (reference to article by Charles Li on the subject).
Expecting some delay, most likely because there is unlikely to be an all-clear given potential structural problems in Europe and the US, one would say that this seems likely in the best of worlds near 2017-2018.
How does this then affect the Chinese entrepreneur which would be likely to create future LBO targets? One thing that one needs to keep in mind is that the allure of the Chinese seaboard commercial hubs like Shanghai and Guangzhou has not only been for the less well off to earn a little bit of money to provide for elders and children back home. A major appeal has been with the entrepreneurs that have already started companies and are offering relatively good salaries and working conditions. This has attracted talent throughout the country to learn firsthand from other entrepreneurs while simultaneously allowing for accumulation of a small starting capital pool or contact with future investors.
2: The general status of these entrepreneurship students and their whereabouts – as well as their capital accumulation relative to what is necessary in their home provinces/towns – is of course impossible to overview, but with greater access to a market and various economic and financial tools I expect this to be a booming field very soon. As a lot of the companies from the first wave of initial movers could get a lot of growth potential when the Chinese officials turn to monetary easing rather than tightening, I would expect to see differentiation of a new wave of private Chinese companies within the coming five years. They would of course need to mature a lot further to become attractive for LBO’s, but an aggressive estimate I would be ready to make would be that the LBO market could flourish as a buyout is seen as a tool to provide further differentiate and grow a company in a crowded and more developed market as soon as 2020, or slightly more than eight years from now.
In the meantime, the same processes and policy paths that are discussed above opens up markets for other nations, and allows “LBO by proxy”, out of which Taiwan would be the closest. The strong presence of a technology sector which could deliver computers, TV’s and mobile devices to growing China, along with recently increased tourism quotas, and a strong position in global heavy machinery are open opportunities at the moment. I am highly optimistic that this is just scratching the surface as the island has a longer experience with market economy and export, and is thus a much more mature economy which is unlikely to present investors with the same magnitude of the growth risks that they would face on the Chinese mainland. Furthermore, the Taiwanese are generally highly entrepreneurial, and have therefore long ago established a strong foothold in many industries that are intrinsic parts of the Chinese growth story, and effectively control companies that provide some of the more wide-spanning services, components and products that are either needed or processed on the Chinese seaboard.