Lunar Capital characterized the Year of the Dragon (2012) as the Year of the IPO Hangover*, as the domestic economy shuttered, domestic IPOs were suspended, and high prices paid by growth capital firms contributed to a sizable correction in public market valuations. These past twelve months – the Year of the Snake – was cleaning out the liquor cabinet and getting out the running shoes.
Although the Shanghai Stock Exchange Index remains at historically low levels, with PE ratios hovering around 11x, attitudes within the private equity community are shifting. The traditional investment focus on growth capital to hot sectors with quick IPO exits, such as TMT, education and healthcare, is no longer the norm and we are seeing an emphasis on domestic consumer plays and value-added investing. Lunar Capital has pioneered this investment philosophy and remains highly confident that our operating model and processes of identifying and sourcing opportunities will continue to deliver results. Increased rational competition throughout the private equity community, more knowledgeable entrepreneurs, better run companies, improved safety standards, and sweat equity will generate higher risk adjusted returns for market participants.
Policy makers are providing further tailwinds. The new Xi Jinping and Li Keqiang administration has also put forth eagerly anticipated economic and regulatory reforms. After the Third Plenum held in November 2013, several notable reforms are positioned to benefit our investment thesis and portfolio companies in the long term.
Highlights include the following;
– Reforms on Farmland and Rural Land Rights
Rural land rights reform will increase the operational efficiency of large-scale modernized farms. This will not only bring productivity improvements to the agricultural industry, but the long-term benefits will flow downstream and improve product quality, product safety, and help reduce price volatility affecting the food and beverage sector.
– Fiscal Reforms for the Tax System
China is implementing VAT tax reforms across select industries. Tax reforms should help level the playing field between established companies and smaller fragmented competitors who compete via tax avoidance schemes.
– Relaxation of the One Child Policy
Although the effects of this reform are somewhat mitigated, due to the shifting demographics and the declining labor pool, the relaxation of the One Child Policy is expected to provide a larger long-term consumer base and promote sustainable economic growth driven by domestic consumption.
– Hukou Reform
The current household registration system (“Hukou”) is a major barrier to rural residents with hopes to migrate to urban centers, and further hinders the benefits of social welfare. If reforms are successfully implemented, urbanization rates will remain high, and portions of social security will flow to new rural consumers, freeing up additional disposable income for consumption. Beneficiaries: Consumer Businesses generally.
– Domestic Listing Reform
The Chinese Securities Regulatory Commission (CSRC) outlined plans to reform the domestic listing process from an approvals-based system to registration and disclosure. CSRC has also reopened the domestic IPO window with 11 companies taking advantage in the first half of January, raising more than 21.4 billion RMB. While the new IPO activity is welcome news for private equity, we caution against pre-IPO players getting too excited – more than 700 companies still remain in the queue. We are optimistic that improved regulations will yield higher quality listings, and further act as a key signal to China’s evolving capital markets.
We therefore remain cautiously optimistic that China will again “middle through” the year of the Horse. We will build on our attractive investment thesis, operating model second to none, and a portfolio well positioned to benefit from the overall economic and political tailwinds. The Chinese PE industry is maturing and identifying improved avenues toward realizations, and we look forward to 2014 being the year of the steady stallion, rather than a foolhardy foal.
