Chinese private equity has been overwhelmingly characterized by pre-IPO deals and growth capital investments whereby PE returns were driven by the deployment of investment capital, not human capital or sweat equity. Most firms lacked the culture, will and expertise to take on operationally challenging investments. Meanwhile the scale of buyout opportunities has grown, driven by (1) generational and succession issues, (2) rising levels of mergers and acquisition activity; (3) founders acknowledging the need for external operational expertise, (4) inability for SMEs to access capital markets, and, ironically, (5) the need for growth capital firms to exit their investment in a weak listing environment.
Corporate acquirers have historically benefited from private equity’s absence and acquired companies with limited competition and an insider’s edge if they were able to help run the business. We believe that private equity must now be more aggressive in competing for these opportunities. Lunar’s success to date in participating in successful buyouts has been driven by our ability to convince legacy shareholders to give us control, which we can then leverage to mitigate risk and maximize value for our investors. We are well positioned to use this control for the benefit of all shareholders because we have a systematic and process driven approach to operations, and we actively seek to incentivize founding shareholders to aid in our process as we transition our businesses from a founder-culture to a mature, professionally managed culture.
In working with founders of our businesses, we have seen that we earn their trust and gain their respect by allowing them to retain large incentives and benefit from professional management as shareholders. We also work hard to position ourselves as a good custodian of their legacy. In this manner, we retain access to founders’ knowledge of business operations, brand positioning and a broader group of stakeholders to help fuel our success. The incentives we provide are typically a combination of (a) a large minority stake in the business; (b) incentives for achieving operating performance; (c) board nominations; and (d) escrows and clawbacks. Yeehoo’s shareholders appreciated this approach and, enthusiastic about our vision for the business, sold us control rather than taking minority growth capital financing. Joysun’s owner believed that we could help him run a branded beverage business better than he could himself, given that his core expertise was in food packaging, not FMCG.
To be clear, it is challenging to ask legacy shareholders to “buy-in” and relinquish control, but we believe the potential valuation uplift as a result of the transition we undertake is very compelling. We emphasize the multiplier effect of bringing in seasoned professional management and a process-driven approach to business planning and strategy. We saw this work with Yonghong, where we convinced sellers of the value of transitioning away from family-led management, shutting down non-core activities, and leaving legacy shareholders with a large stake in our future success.
We are often asked why, if this formula works, private equity remains relatively absent from majority and buyout transactions in China. The simplest answer is something we wrote about long ago. For a period that ran from about 2001-2006, investors had it, in many ways, too easy. A while back we referred to this time as “PE 1.0”. Minority deals were plentiful, relationships could be leveraged, and rising valuations covered up risks. This worked well for the majority of private equity professionals, who were financiers rather than operators, and many promoted the view that majority deals were riskier, despite all evidence to the contrary globally and increasingly in China. We have long argued that this will change. The attractiveness of buyouts is now too compelling to ignore.
We therefore expect more attention to be paid to our specialty. We welcome it as we are confident in our team, are ahead of the curve in our approach, and appreciate the validation. We also think it will create a new universe of buyers for our companies, as we remain focused on the middle market, which for most cashed-up funds remains below the radar. It's a widely recognized sweet spot, and we are fortunate to be right in the middle of it. We look forward to convincing many more great businesses to join our family, benefit from our culture, and buy into our vision for building better businesses in China.
