China’s CSRC recently undertook what the private equity industry has dubbed the harshest IPO approval process in history. After an eight month freeze, the CSRC suspended the IPO application of 269 companies, almost 1/3 of the 900 companies in queue. This heavy-handed approach dealt a blow to the IPO dreams of many PE firms and entrepreneurs alike. LPs that were promised handsome and unrealistic returns are now left holding the bag, and while some are optimistic, we remain skeptical about the near term IPO pipeline and believe more suspensions are yet to come.

One increasingly obvious conclusion is that the multiple arbitrage model of private equity investment is dead for the foreseeable future, and returns will both suffer and likely eat into earlier gains racked up by growth capital arbitrage-oriented firms. Of the 269 companies suspended from this wave of IPOs, 141 companies are PE/VC backed and an estimate RMB 8.4 billion of capital is now stranded. Even for those companies that achieved listing, the returns have fallen to more rational levels. IPOs for 1H2013 generated only an average of 2.59x return on invested capital, a 50.9% drop from last year’s 5.27x. We believe many more suspensions are yet to come.

We believe that the issue for China’s current IPO market is structural. Companies were thrown out of the queue for questionable growth, weak governance and, in some exceptional cases, falsified reporting. Of the 269 companies that failed to pass the IPO examination, 50% were targeting listing on ChiNext, China’s SME board, due to more relaxed requirements. However, due to the economic environment last year, many companies fell short of their projected growth, exposing the fallacy of many “innovative” business models claiming hockey stick growth.

The manufacturing industry is the biggest casualty accounting for more than 1/3 of total suspended IPOs. Given that China’s labor cost has almost increased 4 folds from 2000 to 2012, we believe that there is good fundamental reason why their growth models are now called into question.

In reaction to the lack of foreseeable exits for minority investments predicated on arbitrage, several market players dubbed this the year of operations. However, from our experience, for many this simply means beefing up listing documents to get back in the queue given the lack of control necessary to solve governance and management challenges. This is evidenced by the surge in new listing applications despite the waitlist. In July alone an additional 80 companies were added, with the queue reaching 746 potential listings.

Our investment strategy has long encompassed a contrarian view on multiple arbitrage, and we remain convinced that a process driven approach to operational value add is the best offense in solving the challenge of making money for limited partners in this environment.

In the case of our snack foods business, Yonghong, we have devoted time to building a management team and structure with a high degree of governance, a major pitfall for listing candidates. We have also streamlined corporate procedures, such as procurement and expense reporting, to better protect the interest of the shareholders, and integrated our team members to provide the necessary checks and balances over financial controls and reporting.

We see this similar approach paying dividends in other businesses within our portfolio. Peek-a-Boo, for example, recently achieved its first quarterly profit as a stand-alone entity, after we implemented a process to separate management, implement new governance procedures and apply revised KPIs mapped to our long term vision for the business.

To be sure, the IPO market will not be dead forever. On the contrary, China needs and must have more and better publicly listed companies to better finance growth and offer superior investments to Chinese savers. Our contribution toward building these superior investments and the next generation of attractive listing candidates will largely be driven by our process driven approach to effecting operational improvements.