March 22nd, 2011
24. Why KKR Will Get Killed in China (Probably)
In late 2010, Henry Kravis was on a panel at a New York investment conference and described his China ambitions. Paraphrasing, he said, “The Chinese need everything. The local PE competitors are still small and we have hired really smart local staff – including the winner of China’s math competition”.
I was speaking on a later panel that day but had come in early to hear his comments. Partly out of curiosity. But mostly because I had just finished a section of my book arguing that large Western private equity firms, like KKR, would likely not succeed in China. I needed to make sure I hadn’t missed anything.
Fortunately, his response on how KKR would succeed in China put me at ease. My assessment remains the same: foreign PE firms competing in China primarily on their capital and reputation are going to get killed. You can also likely count in months how long it will be before their newly hired super-smart staff join (or start) local competing firms.
My assessment is based on the following three points:
1) Private equity firms going east in search of growth have a limited tool-kit
When moving into developing economies, the standard “leveraged buyout through distressed turnarounds” playbook gets reduced to mostly growth equity. You just don’t have that many tools for structuring transactions. You also get reduced to taking only minority stakes. Unsurprisingly, many PE firms focus on pre-IPO situations.
In practice, this type of developing economy private equity looks a lot like traditional value investing – with an overwhelming emphasis on discounting projected growth back to current intrinsic value. And also like value investing, you face the 5 primary “going global” challenges – deal access, current uncertainty, long-term uncertainty, weakened claim to the enterprise, and foreigner disadvantages. If you are curious, please see my previous article on this.
Private equity in developing economies quickly boils down to trying to use reputation and capital to get growth equity deals.
2) Institutional real estate firms have already tried this “reputation + capital” approach in China – and failed
We heard this exact same story five years ago when institutional real estate firms entered the Chinese mainland.
For example, Morgan Stanley Properties opened its Shanghai office in 2006 with similarly grand ambitions. The firm announced it would invest across all property types—publicly traded and privately held real estate companies, direct real estate assets, and direct developments. And by all accounts, the firm had some very successful initial years. It acquired multiple properties in Shanghai, including prominent commercial developments and redevelopments near Huaihai Road. And it comfortably pulled ahead of competitors Citi Property and the Carlyle Group’s real estate operation.
Takeaway: “Reputation + capital” can work well in China in the short-term.
But significant developments quickly buffeted, if not derailed, Morgan Stanley’s ambitions. The first was that China discovered it no longer needed foreign capital for real estate; in fact, too much capital was going into the sector. Second, Morgan Stanley encountered a surge in local competition. Local private equity firms, large real estate companies, private investors, various state-owned enterprises, and just about every type of Chinese company started getting into real estate.
Morgan Stanley quickly found itself less and less competitive at the deal level, particularly in sectors such as residential housing. Even in commercial development and redevelopment, where the firm’s reputation and expertise gave it a bigger edge, it still faced serious challengers. After all, how do you compete for deals as a foreigner if the competition is mainly about reputation, capital, and political access?
Within only four years, Morgan Stanley Properties Shanghai found itself in the situation you never want to be in in China—a foreign company with no clear advantage in an intensely competitive industry.
With state capitalist rules tilted against them, no real strong advantage to help it win deals, and intensifying local competition, it is only a matter of time before a serious blow arrives. This appears to have happened with the emergence of renminbi-denominated (RMB) funds. Companies using RMB funds have significant advantages, such as faster transaction approvals and the ability to raise funds from local investors and banks. But although local Chinese companies can use RMB funds, the rules for foreign companies are still fairly unclear. Not only has Morgan Stanley lost its main advantages (reputation + capital) while facing intensifying competition, but also its international funding is now almost a disadvantage.
This situation is not unique to Morgan Stanley Properties. Real estate investing in developing economies is mostly a competition for deals fought with reputation, capital, expertise, and political access. Most foreign real estate companies in hypercompetitive China now lack any significant advantage in this.
3) We are already seeing the same pattern repeat itself in Chinese private equity
Currently, many foreign private equity firms are ramping up their operations in the Chinese mainland. KKR, Bain, and many others are migrating from Hong Kong into Beijing and Shanghai. But they will likely face the same key questions as the real estate investors. Reputation and capital currently are strong advantages at the deal level in private equity, but will they last? They are certainly much larger than any of the local private equity companies, and the major Chinese companies have not yet entered this space. But is there any reason to think they won’t?
In Shanghai last month, I spoke with a friend in healthcare private equity who was already shifting to venture capital. The competition for pre-IPO and later stage deals had intensified so quickly that the returns had plummeted in just a few years. In response, many companies were moving early stage and effectively becoming VC shops.
The press has also recently started to notice this trend. In yesterday’s Wall Street Journal, Tom Orlik addressed this same subject in “Competition for China’s Private-Equity Dream”. His assessment was similar. Western firms will likely not be the ones capturing the China PE dream.
The key lesson for investors is that reputable capital plus political access in the hypercompetitive Chinese market appears to be a necessary but insufficient strategy—particularly for foreigners. It is an entry strategy but longer term success requires a greater value-add.