Looking off the Beaten Track

Rising competition – and prices – in China’s crowded coastal cities has led some smaller private equity firms to look further afield for investment opportunities.

For any private equity investor looking at committing to the physical and demographic enormity that is China, there are some obvious places to start.

The comparative accessibility of China’s eastern and coastal regions, which include the cities of Beijing, Shanghai, Guangzhou and Shenzhen, has ensured that the bulk of private equity capital
entering China has not sought to go any further.

Beyond the fact this region’s cities make an obvious place to start, there is also asound investment logic behind the decision to focus deal-sourcing here – especially for the larger funds eyeing China’s developing market.

“By and large, Eastern China is home to more investments that are larger, and more mature companies, so it’s logical that a disproportionate focus develops on these regions,” says Derek Sulger, a founding partner at Shanghai-based Lunar Capital.

But the concentration of capital has had some unwanted side effects: good deals have become increasingly hard to find, and valuations in some cases have sky-rocketed.

Leaving the herd behind

The competition – and rising prices – in China ‘s principal municipalities has led those private equity firms that are small and nimble enough to look further afield and into China ‘s hinterland.

In some cases, they are doing the same thing as the potential investee companies themselves, as Zheng Song, managing director at Russian investment banking firm My Decker Capital (MDC), explains.

“Even some of top-tier fast food chains feel that the rent in Beijing/Shanghai is too high and it is too difficult and competitive to make money. They also plan on expanding to second and third tier cities in the next few years,” she said.

MDC’s private equity unit last August made a $40 million investment from its debut fund into New Cooperation Supermarket Chain (NCSN) for a 40 percent stake. Although incorporated in Beijing, the supermarket’s 600 outlets serve China’s expansive rural market.

But alluring though the numbers may be, investing off China’s beaten path presents a host of new challenges. For one, simply sourcing and subsequently managing these deals is an obstacle in itself.

Though based in Shanghai, Lunar Capital has made China’s ‘inward and inland growth’ a core part of its investment focus – though Sulger notes that the implementation of this strategy necessitated the hiring of a larger team.

“We believe if you’re going to be successful in these regions, you can’t just rely on a team that’s sitting in Shanghai, you have to have extra resources, whether it’s in our Chengdu office or people who are based locally with our portfolio companies full time,” he says.

Sulger says Lunar typically takes a top-down approach to finding deals and that one key question to ask is, what businesses will benefit the most as these underdeveloped regions grow?

“Look at these regions and identify their core strengths, because most of these regions in China are where you tend to have a lot of primary industry located,” he stated. “So from that very top
down perspective, we have tried to find opportunities that fit the development pattern of these emerging regions.”

Adam Roseman, chief executive officer and founder of Arc China, whose firm recently invested in a chain of clothing retail outlets in Shishi City, a Tier 4 city in Quanzhou municipality, agreed that it was important to be on site to able to manage these businesses and to source potential deals. Arc invests in second and third tier areas such as Fujian, Liaoning and Szechuan.

“The key really is spending time in those regions and not sitting in Beijing, Shanghai, and Hong Kong, and waiting for deals to cross your desk,” says Roseman.

Arc’s strategy includes placing individuals in target areas responsible for building the firm’s brand name and sourcing deal flow. The firm also works with a network of third party finders, whose main task is to identify promising opportunities for the firm.

Simply gaining physical access to some areas of China, however, can sometimes prove difficult.

“Our forestry business, Yunnan Forestry, is headquartered in Simao, which is about a four-hour drive from Kun Ming,” says Sulger. “It’s a 45-minute flight, but there’s only one flight a day [and] it’s not the easiest place to get to.”

Another approach – and that taken by MDC with New Cooperation Supermarket Chain – is to seek out investee companies incorporated in China’s main cities, but with the bulk of their business focused on less developed parts of the country.

Competing against the pre-IPO

Another potential challenge facing private equity pioneers talking to entrepreneurs in China’s unexplored regions is lack of knowledge about the asset class. This disadvantage is often compounded by the focus of many entrepreneurs on achieving a public market listing for their company, which carries with it a certain amount of prestige.

“They are never initially fully receptive; it’s a long period of relationship development,” says Arc China’s Roseman. “It requires a very lengthy educational process with the entrepreneur – which is critical to go through so that they actually understand the impact of taking a private equity investor. We spend a lot of time working to demonstrate that we have taken the time to understand their business, [and to] demonstrate to them the areas of value that we’re going to be able to add.”

He warned that not laying out the cards up front prior to going in these deals “could present a potentially dangerous situation down the road for the investor”.

Small firms, big opportunity

One common thread tying Lunar, Arc and MDC together is that their strategies do not typically involve making deals greater than $50 million in size.

“We are competing more by effort than by money,” Sulger states, adding that as such Lunar does not cross paths with many of the global players on deals, but instead operates within its own niche market.

And all three firms are confident that China’s provincial cities are playing catch-up to the country’s tier one cities in terms of development and economic growth.

“[The provinces are] where the vast population is. Because this population’s current wealth level is still very low, it has to grow higher. Combining the factor that the government is emphasising
growth in these areas, these cities are quite like Beijing and Shanghai 20 years ago, ” says MDC’s Song.

“Companies that establish themselves in an area where the competition is not very strong yet will have a first mover advantage,” she adds.

Summing up the investment potential offered by China’s far-flung cities and provinces, Arc China’s Roseman simply states: “It’s bigger than anyone understands if they are not dealing in these
Summing up the investment potential offered by China’s far-flung cities and provinces, Arc China’s Roseman simply states: “It’s bigger than anyone understands if they are not dealing in these regions. ”

Exploring India’s ‘non-metros’

The shift of focus away from primary cities to those in less-explored regions is by no means a phenomenon unique to China: several private equity firms in India have also begun to explore
investment opportunities beyond Mumbai and Delhi and into the country’s provinces.

Data from the CIA Fact Book shows that although roughly 71 percent of India’s 1.17 billion population remains impoverished, like China, there is a rapidly growing middle class flush with disposable income.

This is something that has not gone unnoticed by firms like Pravi Capital, currently in the market with its maiden vehicle, a $200 million fund focused on India’s lower mid-market.

“[With] the way the economy has developed from 1990, there has been a large percolation of wealth in the non-metros,” says Jayanta Banerjee, managing partner at Pravi, which has made these “non-metros” a key focus.

Banerjee says a growing entrepreneurial spirit within these regions is now presenting firms like Pravi with an entirely new market to tap into.

Balaji Srinivas, a managing partner at UK-headquartered firm Aureos Capital, agrees. He adds that the first-mover advantage offered by this nascent market makes it particularly attractive.

“Not many private equity funds are focused on this as a priority,” he states, adding that the expansion of their investment remit into India’s tier two and three cities was a key focus currently at Aureos.

Aureos India invested about $10 million each in two India transactions of this nature in 2010. The first was in return for a minority stake in Chennai-based renewable energy company Auro Mira Energy, which supplies the provinces, and another was made into Central-India based BSR Super Speciality Hospitals, a chain of hospitals and diagnostic labs catering to India’s rural areas.

As in China, however, investing off the beaten track brings with it some fundamental challenges. Srinivas says one of the key obstacles lay in sourcing businesses that were large enough to generate good-sized profits.

Certainly, investment in less developed areas is – again like China – suited to smaller funds looking to deploy comparatively small amounts of capital into minority transactions.

Banerjee notes that from a private equity standpoint, “it is not easy to do deals in these places because they are typically not that well-connected”; due diligence in India’s less developed cities
requires, he says, “a lot of hard work, a lot of local connect”.

Banerjee also warns that private equity firms might encounter resistance from local governments, depending on what sectors they plan to invest in.

For example, one question to ask when investing in India’s mineral resource sector is, he says, who should be responsible for setting standards – the private investors or the local bureaucrats? Even if India ‘s central government is promoting investment into more rural areas, Banerjee says that private investors can sometimes be viewed by municipal authorities as overstepping their boundaries. That being the case, “then the local government becomes very important”.

Another deterrent for private equity investors is the lack of basic amenities in some of India’s less-explored areas. Where even the most remote cities in China usually have some modern infrastructure in place, this is not always the case in India.

“Even India’s top cities are not fully developed – smaller cities don’t even have metro rail,” Banerjee says. “If it’s a $10 million deal coming from a place where there’s no connectivity, how realistic is it going to be for a large global firm to park their resources there?”