One of the biggest challenges for small- and medium-sized private enterprises in China is debt financing. A recent study conducted by Development Research Center under the State Council showed that while 66.7% of the SME see bank loans as the primary source of financing, more than 62% of the SMEs are unable to acquire them, effectively limiting their ability to improve product quality and invest in new technology. However, recent reforms allowing for private placement bond issuance may begin to alleviate financing pressures on SMEs and open up new opportunities to create value.
In mid-2012, the government formally legitimized the issuance of private placement bonds to address the disparity in supply and demand of financing for SMEs. Prior to these reforms, publically-issued bonds required a lengthy government approval process, and leverage was capped at a 40% company net asset value level. The SME Private Placement Regulation streamlined the approval process and increased leverage limits, offering a more realistic chance of debt issuance and additional leeway for leverage. Since the regulation was passed in late June of 2012, close to 150 SMEs have issued private placement bonds, and size of the market has grown from nothing to over RMB 10 billion in under a year.
Opportunities for Private Enterprises
Whereas bonds are quite a new concept to China’s financial market, appetite is growing. The overall corporate bond market grew from 1% of the total corporate financing to 8%, an increase from RMB 165 billion to RMB 6.89 trillion, between 2002 and 2012. Going forward, this growth will be further aided by new private placements to smaller enterprises, as well as larger corporates looking to escape from the stringent requirements demanded by Chinese banks. We believe this market development bodes well for private equity investments. Many of our best performing portfolio companies still struggle to obtain any leverage from banks. While we remain prudent with debt, it is clearly sub-optimal to run large, growing and profitable businesses on equity financing alone. By way of example, our Yeehoo Group babywear business saw revenues last year rise over 40%, and still is effectively debt-free.
We also believe that the private placement bonds fits well into our control-oriented strategy. Guiding how our companies manage their balance sheet is one further way we can unlock value through more efficient financing. Further, while many PE professionals can assist their portfolio companies to obtain debt, as minority investors few will have any say in how that money is spent or distributed. We have a unique opportunity in this regard to ensure the leverage obtained is used prudently for growth and to instill confidence to bondholders. Additionally, as the bond market becomes more mature, LBOs may also become a new possibility in China, an idea unimaginable a few years ago.
Challenges
Although a significant breakthrough for SMEs, bond market investors are moving cautiously to embrace private placements. Most who have obtained financing through this new channel are well establish names and respected leaders in their respective industry such as Borun Industrial in manufacturing, Hongrui Department Store in retail, and Tiandy Technology in multi-media production. Even though issuers tend to be sizable, their debt issuance has been small – the average size per issue has averaged only RMB 100 million. Yields for SME bonds are high as well, averaging near 9%, as compared to 5.33% for Chinese bonds as a whole. It is clear that issues of corporate governance and transparency remain a challenge, as does the lack of clarity in the Chinese bankruptcy process. This will continue to result in substantial risk premia being applied. Here again, we think that a control-oriented strategy has benefits. We believe that investors in private placement bonds can be educated to favor private equity backed firms, where issues surrounding transparency and motivation are clearer.
It is impossible to mention debt in China without mentioning concerns about the scale of local and shadow bank debt. On this point, we tend to agree with a comment made this week by Jim O’Neill from Goldman Sachs, who said, “While I can see the confined aspects of such concerns, I don’t share the broader macro concerns as China is an economy that has very large national savings and needs to save less and – while better channeled – borrow more.” Surely market liberalizations, such as reforms enabling greater choice in debt instruments, may begin to address the concern of debt being better funneled, and certainly will encourage companies to borrow more.
We believe that the development of this market is likely to accelerate a convergence between listed company leverage ratios in China and their global peers, and help advance a culture of domestic mergers and acquisitions. For our portfolio, this means the greater chance to benefit from recapitalizations, and open up the opportunity for more buyouts in the future.
