An Opportunity for China’s Domestic PE Industry

As the pendulum begins to swing in the other direction, domestic players may grab the best deals while foreign investors remain on the fence.

Talk to Chinese businessmen or take a walk through local malls, and it appears the Chinese don’t realize that the world is in the midst of a major recession. Last fall’s puckering contraction in exports generated wide-eyed fear in the Chinese markets, but only briefly. By early first quarter of this year, people in China were already heralding the bottom and looking forward to a quick recovery. Now Chinese entrepreneurs are once again highly optimistic about their future prospects, and consumers are swarming to hair salons and auto dealerships. All of this stands in sharp contrasts with the gloom that lingers in New York and London. And no where is the contrast greater than among investors, where local investors appear to be back in full swing, while the rest of the international investment community is still on the sidelines.

To be fair, the mood within the Western financial community has also improved somewhat since our own stock markets began to climb earlier this year and the credit markets relaxed just a bit. Nevertheless, pundits in the West continue to debate whether it is really the start of the bulls, or just a bear market rally. Meanwhile, the international investment community is looking around, but for the most part is sitting on the fence.

The few international investors that are active in China are mostly bottom fishing: they are looking for depressed valuations and offering harsh stipulations that are only found in a buyer’s market. And as long as the number of buyers remains few, foreign investors can still offer rock-bottom terms and snag great deals. For the moment, the strategy may work while the majority of foreign investors are still evaluating when and how to jump back in.

But there is no such deliberation among Chinese investors. Most are fully confident in their country’s economic future, and eager to stake their claims. And with the A-Share’s up 44% on the year, a lot more of them have money to invest again. This combination of eagerness, optimism and ability will likely give domestic investors a big leg up while foreign investors are still deliberating about jumping back in.

Over the course of the next 9 to 12 months, the confluence of an upswing in general sentiment and an increase in the number of domestic investors with cash is moving the market towards the seller. That’s not to say that we’ve reached a seller’s market yet—by any measure, it remains an extremely tough environment for private Chinese companies to raise capital—but entrepreneurs are increasingly more willing to wait for the markets to turn rather than accept a lowball offer.

Enter the domestic players. Chinese investment funds are showing an increasing willingness to invest and offering terms that, while not what entrepreneurs were receiving in the heydays of 2006 and 2007, are better than what is available from the handful of international firms which are driving hard bargains. If China’s economy continues to expand as expected, it is probably safe to assume that valuations for PE deals reached the bottom at the end of last year, and will only go up in the future. This being the case, China’s domestic players may just snatch up the best deals while most international players sleep. Even worse for the international players that stay to bottom fish, they are increasingly likely only to attract the most desperate companies—those that cant wait or can’t attract domestic capital.