China PE prostrates itself to secure pre-IPO deals

Late-stage equity finance is being targeted by the new raft of Chinese domestic private equity companies.

These funds tend to appeal to high-net-worth investors who want a piece of the action, although they may have different return objectives, from a steady 10% per year to big-time 25-30%.

“These new funds have pressure to invest and get a return and at times they have to dilute terms in order to secure deals,” says Lewis Wan of Pride Group, a Hong Kong-based private equity firm that invests in China.

The segment in which the new funds are investing is being avidly pursued. There is a lot of interest in target companies that are on the cusp of going public. Entry prices for pre-IPO deals are 14 to 18 times price-to-earnings (P/E) ratios. Two years ago, Chinese pre-IPO deals were priced at 8 to 10 times P/E.

Chinese pre-IPO deals are often negotiated in tandem with a buy-back option. That means a clause in the docs that says if an IPO is not undertaken in a fixed period of time, then the party who has received the money has to repay the initial investment, plus a coupon that gives a 10-25% internal rate of return.

Both equity financing and secondary offerings are being held up due to the performance of China's A-share market. In China, IPOs often do not take place as planned, and getting a promised lump sum repayment when they don’t can be tricky. The person who made the undertaking was never planning on this ‘put option’ being triggered, and often his cash is tied up in that self-same equity position that has not been liquidated due to the delayed IPO.

That is when the negotiations start. The repayment might be offered in stages, or without the additional coupon.

Sometimes the negotiated payout will be denominated in publicly quoted shares of a parent company, which is satisfactory as long as you can sell that block without the price cratering. Why, though, does a pre-IPO company need private equity finance if it has a publicly quoted parent? An important reason is that even these types of companies are finding it harder to get conventional finance due to tighter bank lending quotas.

The buy-back arrangement may also be subject to a personal guarantee of an entrepreneur. Obviously if guarantees are supported by third-party security, then they are valuable, but with the pressure to write deals, these guarantees are usually not collateralised. Therefore they are little more than a letter of comfort or letter of awareness.

For practical purposes, they are not worth actioning. However, such support documents do radiate a feel-good factor, making the investor’s risk committee feel happy, but only up to the point that the cash is actually needed.