GPs play arbitrage amid soaring China valuations

Amid major discrepancies in valuations both geographically and between private and public markets, Greater China private equity managers are eyeing arbitrage opportunities.

Speakers at the HKVCA’s 15th China Private Equity Summit in Hong Kong discussed how slowing mainland growth has pushed investors more into higher-growth sectors and driven up the price of such assets – and how they are coping with this challenge.

“In the past few months, we’ve announced about $300 million private investment in public equity [PIPE] deals, to arbitrage between private and public markets,” said Frank Yu, founder, CEO and CIO of healthcare-focused PE firm Ally Bridge Group. PIPE refers to the private purchase of stock in a company at a discount to the share price.

Current valuations in private market are higher than those public markets, noted Yu. “There is too much money chasing too few good deals in the private market, resulting in high valuations, whereas valuation in public market may drop quickly after a stock is sold,” he told AsianInvestor on the sidelines of the conference. 

Hong Kong-based Ally Bridge, with around $1 billion in AUM, makes arbitrage plays through both private equity and hedge strategies.

It also plays the price arbitrage across different geographies. For example, in the healthcare space, private-market valuations are cheaper in the US than in China. So there are cases of mainland companies buying US firms from Ally Bridge at higher prices than US buyers would normally offer, Yu said.

Cathy Zhang, managing director of Beijing-based CICC Private Equity, saw a similar trend in cross-border transactions. There is surplus liquidity in China, so big US deals – such as that for taxi-hailing app Uber – have come to the mainland to raise funds. Chinese investors are also increasingly proactively going to the US to buy technology companies, Zhang said, speaking on the same panel.

However, high mainland valuations have proved a challenge for PE managers in China, she conceded. When CICC Private Equity made its first investment in 2010, she said, it was very disciplined, targeting companies with 10x to 13x price-to-earnings ratios, which enabled them to deliver very good investment returns to investors.

There is now a big question mark over whether Chinese companies can further grow their revenues and earnings to generate good returns for investors, argued Jacob Chiu, Shanghai-based managing director of $12 billion PE manager HQ Capital, on the same panel.

Chiu bore witness to the first wave of high-octane PE development between 2000 and 2008, when China’s GDP was growing at 8%-14%. Investors could buy sector-leading companies at 5-7x P/E ratios and thereby double their revenue and earnings in three years. After being listed, they were delivering 4x returns.

Then the 2008 financial crisis struck and everything went quiet for around 18 months, said Chiu. There followed the IPO boom in China in 2010 and 2011, which heralded the “second wave” of private equity. Private deals were valued at 15-20x, while companies could list at 40-60x P/E ratios or even higher, resulting in 4-5x returns.

“At that time, China GDP still grew at 8%-10%,” said Chiu. “So, though companies couldn’t double their revenues or earnings in three years, [they could do so] in four years.”

From 2014, China’s economic growth dropped below 8%, slowing to 6.7% in the first quarter of this year, casting doubt on companies’ ability to post strong revenue and earnings growth, Chiu said.

That has driven general partners to focus on higher-growth sectors, the panelists agreed, such as travel, sports, movies, intellectual property (IP), healthcare and food.

The healthcare sector in particular, both in China and globally, has attracted billions of dollars of investment in the past few years, said Ally Bridge’s Yu, but China cannot rely on importing innovations in healthcare.

“We’ve seen tremendous home-grown innovations in TMT [technology, media and telecommunications],” added Yu. “Now we see more and more genuine innovations in healthcare, from machinery and medicine to medical IT.”

Meanwhile, despite the slowdown in mainland economic growth, domestic food consumption still grew about 10% in the first quarter and was the largest component of consumer goods demand with about 25%, said Alex Zhang, founding partner of Beijing-based Hosen Capital on the same panel.

The IP sector boomed in China last year thanks to popular novels, originally distributed via the internet, being turned into blockbuster movies and TV dramas based on popular novels, CICC’s Zhang said.

According to Chinese PE research firm Zero2IPO, there were 39 published IP-related acquisitions totalling Rmb20.96 billion ($3.18 billion) in 2015, about 2% of total M&A value in China last year.

Moreover, 30 movies were released in 2015 based on such IP projects, generating Rmb8 billion in box-office revenues, accounting for about 18% of China’s total box-office income last year.

Zero2IPO did not have data on these areas for 2014.