As we ring in the New Year, it’s déjà vu all over again in China, with market volatility giving rise to investor concerns. With this backdrop, we’d like to offer Lunar Capital’s reflections on the past and beliefs for the future.

The first generation of private equity in China, or Chinese PE 1.0, was driven by tremendously successful private entrepreneurs who, with limited capital and negligible bank support, built businesses that now account for 60% of China’s economy, and remain a primary driver of growth. PE and VC firms who provided early financing for these entrepreneurs generated strong returns, particularly from 2002 to 2007.

As PE 1.0 attracted more participants, the landscape changed. Investors focused on multiple arbitrage, and were judged on the quantity and speed of deals closed. Passive minority investments were lauded as respecting Chinese entrepreneurs’ independence. Sourcing became highly brokered, and promoted companies all claimed to have a leading brand, sound audited financials and to be 18 months from an A-Share listing. PE 1.0, which had captured tremendous arbitrages in its early days, began arbitraging itself out of the market. In short, PE 1.0 had become too commoditized, like a cha can ting (茶餐厅) with weak pricing power that repeatedly serves the same dishes with limited attention to service, detail, or subtlety.

The stimulus-driven rebound from 2008 to 2010 led many to believe that PE 1.0 could remain the norm. By December 2011, however, Chinese equities had given back their post-financial crisis gains on most valuation metrics. Earlier this week, the CSRC announced that it would reduce the number of IPOs approved for issue in 2012 and take steps to reduce frothy valuations.

Within this environment, we believe that a more active approach – Chinese PE 2.0 – will be of increasing importance. PE 2.0 places more emphasis on the traditional hallmarks of private equity; a more proactive approach, higher specialization and demonstrable, process-driven value-add. Additionally, PE 2.0 means more aggressively pursuing larger stakes, often majority, to better control the destiny of investments and mitigate risk.

For PE 2.0 to be effective, investors must develop strong trust with entrepreneurs and management, and also be highly involved in the daily affairs of their portfolio companies. This requires a localized operations team and clear processes to integrate into finance, business development and operations. Because structural barriers remain for financial engineering-driven buyouts, taking larger stakes must be motivated by a passion for running Chinese companies.

We believe opportunities for this approach are increasing. Aging first generation entrepreneurs, orphaned publicly listed companies, increasing M&A activity, greater stickiness of branded franchises, and large portfolios of discreet businesses under the control of a single entrepreneur, will all beget opportunity.

PE 2.0 strategies are not without risk. Operating partners, and their costs, need to be brought on board in the earliest stages of analysis. Practitioners need to think as iconoclasts, and endorse businesses that may be temporarily unloved. In some circumstances, investors may be the only interested capital provider, and fearful of the buyer’s curse, especially in majority transactions. However, we believe these challenges are more predictable, quantifiable and addressable than the blindside risks inherent to passive minority investments. Corporate governance failures, accounting irregularities and the public market’s whims have demonstrated this over the past year.

As we look towards 2012, we believe a community of insightful private equity firms is emerging with the resolve to differentiate by diving deep to drive value creation. If PE 1.0 was a cha canting, PE 2.0 will be far more gourmet and service-oriented in its approach.

We remain optimistic that inward demand, spreading consumption, and the urbanization of central and western China will drive growth. Recent economic data validates this view, as have the daily operating metrics of our portfolio companies. We also tend to be the most enthusiastic about deploying capital when pessimism and fear causes paralysis, giving us time to research, diligence, and plan how to best monetize sweat equity in challenging situations.