By Andrew Woodman
Long a feature of the developed markets private equity, succession-planning opportunities are beginning to pop up in emerging Asia. Regardless of geography, convincing a founder to sell his business is a challenge
Over the course of three decades, Chinese meat snacks producer Guizhou Yonghong – best known for the popular Niutou jerky brand – has grown from a small rural operation to be one of the leading players in its market. The three founders, who set up the company in 1984, are now in their 70s and considering retirement. However, they are unable to keep the business in the family.
It is an increasingly common dilemma for Chinese entrepreneurs of this generation. Many have become rich enough to send their children to be educated overseas, but on return these youngsters express no interest in succeeding their father or mother as CEO. Property development and financial services in Shanghai have more appeal than factory management in relatively remote provinces like Guizhou.
Yonghong's founders examined their options. An IPO was quickly crossed off the list and the prospect of allowing the business to be swallowed up by a local competitor was unappetizing. This left option three: partnering with Lunar Capital, a local consumer-focused private equity firm that said it could give the founders liquidity and protect their brand. The GP bought a majority stake in the business last year for $50 million.
“The pitch – far from being a financial pitch – was a solution for how they maintain their legacy and how the business can keep going,” says Derek Sulger, founder and CEO of Lunar. “Succession issues are the source of many deals in our pipeline. It is an enormous opportunity in China that strategic players are taking advantage of, but private equity, which mostly focuses on minority deals, is not.”
A scale opportunity
Succession planning is a well-established source of private equity deal flow in developed markets but in Asia's emerging economies it is only just coming to the fore. This is particularly the case in a country like China where the first wave of entrepreneurs who set up shop in the late 1980s and 1990s, when the country's economic reforms began to take hold, are now those graying founders looking to retire.
The opportunity could substantially alter Chinese private equity – “We are now going to do more buyout deals, in particular for private companies. Aged entrepreneurs are willing to sell their businesses because of succession issues,” John Zhao, CEO of Hony Capital, said last week – but it remains to be seen if it can be properly addressed. And while studying patterns in more mature markets is logical and potentially helpful, it also underlines how sensitive and bespoke these situations tend to be.
Demographics are one of the major causes of succession planning challenges in China. While the lack of an heir apparent is an issue that affects family businesses worldwide, the situation is especially acute in China where the one-child policy has ensured that the pool of next generation CEOs is even smaller.
Younger generation talent that might be available is not only disinterested because of more enticing opportunities elsewhere; running a business is hard. Chinese companies are no longer able to ride a wave of macroeconomic growth. The typical mid-market consumer business targeted by Lunar is likely suffering from margin squeeze as rising labor and input costs are no longer counterbalanced by sales growth. Professional management is required to eke out efficiencies.
“Most of these kids have been educated in Europe or North America and have decided they are not up for the hard work of running a consumer products business,” says Sulger. “You are no longer talking about an industry with 300% growth in a year. Instead it is full of competitors, both regional and national. You have to be good at what are doing to survive.”
But the issue goes beyond just a lack of credible successors. There has also been a shift in how entrepreneurs view exits. Three years ago, retiring might not have been a priority for many founders; rather, they were thinking about the riches to be obtained by selling a minority stake in their business at a valuation of 30-40x forward earnings via the IPO market.
That window is now closed. The 12-month embargo imposed on mainland share offerings created a huge backlog of companies waiting to list, and the regulators are scrutinizing IPO candidates much more closely than before. David Shen, managing director at Olympus Capital, notes that even if a founder managers to jump the queue and list within three years, his holding will still be locked up for another three years. During this period the founder must meet shareholders' performance expectations.
“GDP in China is slowing down to 7-8%, so growing at 30% a year is not a given,” says Shen. “So you have got to put in a lot more effort. As a result, a lot more entrepreneurs are receptive to proposals from sponsors like us.”
China, by virtue of its size, may represent the largest opportunity, but it is not the only one. Succession- planning issues permeate the region and, China's unique demographics situation apart – similar factors are driving founder-owners to seek an exit route.
A recent Asia-wide survey carried out by Deloitte in conjunction with the Singapore Management University's (SMU) Business Families Institute shows that family-owned companies are still overwhelmingly in favor passing control on to next generation. According to the study, 89% of businesses said family management succession was important while a further 81% said they believed the next generation would take over, versus 6% that said no.
However, there is also an acceptance that the desired succession may not come to pass. Nearly one third of respondents said they expected management of the family business to transfer to a non-family member, while 26% anticipated monetizing their businesses via an IPO or an acquisition. One of the major push factors, cited by 65% of first-generation family business, was lack of family talent to take over.
“What is happening is that the next generation is either too comfortable, or they are too happy doing something like investing in real estate,” says Karam Butalia, co-founder and CEO of Southeast Asia-focused GP KV Asia. “What the parents have been doing is really hard work in comparison, so inevitably there is no succession.”
In some cases, succession opportunities are not so much triggered by legacy issues as a founder's desire to free up the wealth accumulated over the years so it can be easily passed on the next generation. This is more prevalent in developed markets such as Japan where entrepreneurs fear their family wealth could be diminished by the country's onerous inheritance tax laws.
“If you die in Japan and you own a lot of stock, not only is it quite difficult to transfer it to your children, but you have to think about how they are going to get liquidity,” says David Gross-Loh, managing director with Bain Capital in Tokyo. “Even if they are going to continue working and do something else, they need to figure out a way to solve that.”
Richard Folsom, a co-founder and representative director with Japanese mid-market buyout firm Advantage Partners, adds that while succession opportunities are a well-established feature of the domestic market, they are also growing in number. He estimates that of the deals his firm has closed in its near 20-year history, around 40% have been succession solutions; however, in the past two years it has been closer to 80%.
It is not just a function of more founders looking to transition out of their businesses, but also that they are increasingly willing to work with private equity. They have a better understanding of the asset class and recognize the advantages of selling to a financial investor over a trade buyer. “Generally, strategics are regarded with skepticism by founder-owners,” says Folsom. “There is the fear of being absorbed by a competitor as they have an emotional attachment to the business and a pride in the brand and product they have created.”
The reality of being acquired by a larger competitor that offers similar products is redundancies designed to remove overlaps. In these situations there is a reasonable chance the that the brand will not survive. Giving the Australian perspective, Richard Burrows, a director with Wolseley Private Equity, notes that, in building their businesses, founders usually spend a lot of time battling larger industry players. As such, they don't like selling to them.
There are similar concerns among Chinese founders, but their lack of familiarity with PE can be an obstacle. Prospective investors must therefore create an attractive succession solution.
“Legacy is important and they don't want a financial buyer who will turn up and slash and burn,” says Olympus' Shen. “And at the same time they don't want to sell to a strategic, so they are stuck in a way. This is where – if you can bring a well-crafted proposition and message – they are willing to listen.”
Pitching an opportunity
Accessing these founders requires a pro-active approach. Lunar's Sulger describe a process by which his firm will identify a favored consumer sub-sector and then narrow down the pool of targets to those that can be pitched. From the start of negotiations, the GP emphasizes how it can bring in a strong management and transition the old-fashioned founder-led business into a modern and professionalized organization.
“We always discuss our ability to make decisions because a lot of times legacy founders are in a bit of a trap,” says Sulger. “They have family members and old employees involved. We find that even with 100% control, they may not have the will to direct 100% of the decision-making, and often welcome new outside involvement to help make tough but necessary decisions.”
Being proactive is also important because founders generally don't publicize their willingness to sell. Even if they hire an advisor, it is often a small, informal process. For this reason Eugene Lai, managing director and co-managing partner with Southeast Asia-focused GP Southern Capital highlights the value of local sourcing networks.
“We have to explain what kind of partner we will be. The ability to work well with the founder and his team is very important and that plays to the strengths of a local team.” he says “We often know people who know the founder or his team and that provides a reference point for them to get comfortable with us.”
Most GPs note that this process rarely delivers immediate results. The objective is to get a foot in the door and then maintain the relationship over time, with a view to securing a deal 2-3 years down the line. While mature markets are generally more accessible, networks are still vital. In any situation where deals come about via closed process, a GP that is not visible doesn't stand a chance.
“It is on us to be able to get our story out there to the various people who act as advisors to founders so they can see the success stories and understand how we can work through whatever issues and complexities there might be,” says Advantage's Folsom. “Hopefully we then move to the top of that short list of potential buyers.”
This was the case with Komeda Coffee, a road side café chain in which the Japanese GP acquired a 78% interest in 2008, paying JPY15 billion (then $146 million). The founder, who was approaching 70, had decided that, for the company to achieve the next level of growth, he needed to pass control to outside professional management, rather than a family member.
Advantage felt Komeda had the potential to expand its 300 locations to 800-1,000, but this would require additional infrastructure in terms of management and operational systems and controls. The founder retained a 10% stake in the business and stayed on as non-executive chairman for a year. He exited when Advantage sold its stake to MBK Partners in January 2013 for JPY40 billion.
However, not all deals go the same way. Bain's Gross-Loh says a lot of Japanese founders are keen to exit straight away. They recognize they are no longer in control and worry about how and when they will sell that last piece in the business – so many just decide to sell the whole thing. This was the intention when Advantage bought Hokou Service, an assisted living facilities company, but the founder shelved his retirement plans because he was interested in the strategic initiatives the GP had proposed.
“We closed the transaction, bought the company and he reinvested 20% and decided to stay on as CEO for at least the next couple of years,” says Folson. “We then augmented the management team with a CFO and a COO.”
In emerging markets, the consensus among GPs appears to be that the founder should retain a stake. Keeping the founder on board as a shareholder is a key part of Lunar's value proposition: if he retains a 20-40% stake, he is better incentivized to support the GP's efforts and ensure a smooth transition. However, Lunar insists the founder gives up all decision-making powers.
Olympus' Shen echoes the importance of the founder staying involved, but he is less insistent on control. “We view buyouts a little more cautiously because there is a reason why the entrepreneur is important to the business,” Shen says. “If all of a sudden you take him out there is a potential risk.”
Founders are not the only stakeholders to consider when negotiating a transition. Disputes over family involvement in a business are commonplace, although the nature of the problems vary by market. The issue is less pronounced in China, where most entrepreneurs are first-generation, but it does come up. Lunar looks to avoid situations where there is infighting between shareholders, content to wait patiently on the sidelines for tensions to pass.
“This is a critical reason why we proactively target businesses – we never want to be in a position where we feel that we must rush a deal and agree to some crazy things like continuing to employ relatives, or accommodating other requests that add to the potential for nuisances or confusion,” says Sulger. “It flies in the face of the whole reason they decide to do a deal with us in the first place.”
However, in jurisdictions where families are large and the businesses have longer histories, tensions can be harder to avoid. On several occasions, KV Asia's Butalia has walked away from deals where the founder agrees to sell and then it turns out his children are the ones really running the business. The GP wasn't satisfied with the children's ability and sought to replace them, but naturally the family resisted.
Often, the more mature the market, the deeper more intractable the issues become. “Once ownership of a family business has gone into the second or third generation, ownership might be dispersed among many family members and at that point it can become almost impossible to achieve a consensus about what to do,” says Advantage's Folsom. “So, almost all of the succession deals we have done have been in situations where the first generation founder-owner has complete decision making capability.”
Bain's Gross-Loh also describes encountering a range of family issues in Japan. In some instances a GP might even be forced to pick sides where a father is trying to kick out his children or vice versa. Bain makes its excuses and leave.
“The process of negotiating these deals is complicated and time-consuming because you are dealing with a lot of emotional issues that are not driven by economic goals,” he says. “So the deal processes goes through ups and downs and there is a lot of uncertainty but that is what is necessary to unlock the opportunity.”
Even once these issues are ironed out, problems can persist in the post-investment period. GPs across all markets describe scenarios in which a founder has held a lot influence over his company, running it in almost a dictatorial manner. As a result, the organization has suffered from a lack of professional senior management and excess or redundant middle managers. Reorganizing this inefficient structure is normally top of a GP's to-do list.
“Most companies have too many employees,” says Lunar's Sulger. “Rather than a core executive team of six or seven people, they have 30 middle managers and they realize when they are in thick of it that it can be exhausting dealing with the trials and tribulation of managing many people.”
There is also the issue of a founder – who might now be relegated to a position on the board – not being able to let go of his former power. Untangling an individual from an organization he might have fashioned in his own image is challenging, particularly if he effectively controls supply chain relationships through long-standing personal ties, or he retains a natural authority over staff.
Chad Ovel, a partner with Mekong Capital in Vietnam, has seen a number of cases in which the founder, after giving up the reins, walks around the office asking people what is going on because he is not yet confident in the new management team.
“One of the big success factors is getting the founder and the new CEO – who typically is external – to truly speak with one voice to the organization.” says Ovel. “Employees will try and drive a wedge between them. For so many years they worked under one person and have become accustomed to how he treated them, and suddenly there is a new sheriff in town.”
No matter how much effort goes into aligning interests and securing a consensus before going into a deal, there will be differences of opinion. Southern Capital's Lai stresses that there is no magic bullet and being able to manage patterns when disagreements arise is just one of the skill-sets GPs need if they are to successfully execute a succession strategy.
“We don't try to micro-manage or second-guess everything they do, there is a bit of give and take,” says Lai. “In the worst-case scenario we will have to change the CEO and that might happen in 20-25% of cases.”
However, once the new management is in place, the private equity investor can implement the growth strategy that might have won the deal in the first place. One of the key reasons a founder looks to partner with a PE firm is because it can provide the expertise and networks needed to take the company to the next level. If all parties can get behind this plan, interests become aligned: the business grows, the founder's legacy is protected, and everyone profits.
The emerging markets succession opportunity is still in its nascent stages and the number and nature of deals will be influenced by cultural and macroeconomic factors, as well as the individual entrepreneur's familiarity with the asset class. But many of the parallels with developed markets are likely to hold because the same broad theme applies: success hinges on building and maintaining relationships.
Lunar's Sulger recounts a recent meeting with the founder of baby wear company Yeehoo – another of the private equity firm's portfolio companies – in Palo Alto, California, where she now spends six months of the year. He remarks that the woman who now attends meetings in her tennis shoes is far removed from the apprehensive individual he first met several years ago, so worried about giving up control.
“She still has concerns about the business – why we hired that guy or fired that guy and that's natural. Overall she realizes her legacy is really being built upon,” says Sulger. “Whoever thought the babywear brand she started in Guangzhou in 1985 could grow to 2,000 stores and be acquired by a really well-known Italian luxury brand? I can't think of a time a founder has experienced seller's remorse – a week after closing they are normally our biggest cheerleader.”
Case study: Mekong Capital and AA Corporation
Setting up Vietnam-based interior design business AA Corporation in 1994, Nguyen Quoc Khanh hoped to demonstrate that by leveraging his skills and experience as a designer, he could also become a successful business owner. But Kanh underestimated the size of the task.
By 2006, with the business really starting to grow and annual revenues reaching $8 million, he found himself stretched. His abilities were not enough to see the business through to the next stage. Khanh sold the business to Mekong Capital, which put in place a professional management team.
“Khanh wasn't operationally minded. He was a designer and an architect by nature and he soon realized he was the bottleneck to the company's growth,” recalls Chad Ovel, partner with Mekong and a former CEO of AA Corporation. “So he generated the idea that he should step aside and take a chairman role, he found me, and recruited me into the CEO role.”
As a result of this decision, AA Corporation was able to increase its top line revenues nearly 10-fold over the course of Mekong's six-year holding period. However, the process of handing over control was a gradual process. Even if Khanh was ready to exit, his personality and leadership was deeply ingrained in corporate culture.
“It was all about converting the culture of the company,” says Ovel. “For the employees it was historically all about loyalty to the founder as an individual – that is what got them out of bed in the morning, what motivated their performance.”
Prior to Mekong coming in, all performance-based compensation was essentially linked to the Khanh's personal assessment of the employee. This was the private equity firm's first big challenge: restructuring performance evaluation and democratizing the bonus system so it was tied to quantifiable performance targets.
The next job was to change the way employees thought about the company. The cult of the founder had to be replaced by the cult of the company – which meant staff had to start believing in what they were doing, as opposed to what Khanh thought of what they were doing.
“It took two years to achieve this and during that period he took the CEO title and I took the deputy CEO title,” says Ovel. “Once we felt the employees were willing to shift their thinking – to respond to anyone in senior management not just the founder – then I was promoted to CEO.”
Case study: Bain Capital and Dominos Japan
Ernesto Higa, the former CEO of Higa industries and the master franchisee for Domino's Pizza in Japan, is fairly unique among domestic founders in that he helped instigate a succession plan where the beneficiary was a private equity firm. The way the deal came about speaks to the importance of having a strong network of contacts when seeking out such opportunities.
Higa had already part-exited the business to a Japanese strategic -Duskin Co, owner of the Mister Donut chain – and Daiwa SMBC Capital, a direct investment arm of Daiwa Securities Group. He wanted to sell his remaining 12% stake and step down as a CEO, but Duskin was not convinced it could take over the business. His only other option was to reach out to Bain Capital.
“We knew Ernie because he had a good relationship with Yuji Sugimoto, who was a managing director in our Tokyo office and they had met from time to time,” recalls David Gross-Loh, a managing director with Bain in Tokyo.
Higa's children were not involved in the business, so he saw it as a good time to make a transition and move on to something else. However, it wasn't simply a matter of handing over the company, but also the Dominos Japan brand. The situation was potentially complex because taking on Higa Industries meant taking on certain caveats that came with being a master franchisee.
“The company hadn't really opened new stores but the seller wanted to make sure there was a commitment to open new stores,” says Gross-Loh. “This was partly to keep the business growing but also because there was master franchise in place with Domino's Pizza in the US and a requirement to grow the store count.”
Fortunately, Bain had previously made investments in Dominos International in the US. Drawing on its track record in the industry, it was able to reassure Dominos in the US and secure an exit for Higa. Free of his responsibilities, Higa moved on to his next venture – as CEO of hamburger chain Wendy's Japan.