On the inside track

Buyouts in China are still elusive, but Hony Capital has amassed a portfolio of 25 control investments already. Chinese institutions and international blue-chip limited partners make up an illustrious funding base. Philip Borel asks founder John Zhao how he did it all.

“With every deal, it's crucial to develop an operating strategy and then execute. I learned that in Silicon Valley.”

Just five years after inception, Hony Capital is rapidly becoming a household name in international private equity. Alongside its Beijing rival CDH Investments, the firm has emerged as one of a small group of go-to firms with that rarest of private equity skills: the ability to source and deliver buyouts in China.

Despite the country's large reserve of state-owned enterprises and expansion-minded private businesses, private equity-backed buyouts have been few and far between. International buyout groups in particular, including those with teams on the ground, have learned the hard way that control investments in China can be heinously difficult to achieve.

The most prominent case of a foreign sponsor trying and failing to close a buyout in the country was The Carlyle Group's doomed attempt to acquire Xugong, a state-owned construction equipment company. Carlyle, which has an extensive presence in China, first agreed to purchase a majority stake in Xugong in 2005; three years later, with governmental approval still not forthcoming despite Carlyle conceding significant changes to the deal, the firm had no choice but to walk away in frustration.

Hony's experience as a buyout investor in China has been markedly different. Founded in 2003 with a mandate to help restructure and commercialise state-owned enterprises, as well as accelerating the growth of privately held mid-market businesses, the firm has already completed 25 platform deals. Among them are investments in Simcere, a drug developer and manufacturer that Hony helped secure a listing on the New York Stock Exchange in April 2007, and Solar fun Energy Holdings, a corporate carve-out whose shares now trade on NASDAQ.

Hony started life as a captive private equity platform for Legend Holdings, the influential government-controlled conglomerate that is also the largest shareholder in computer manufacturer Lenovo. The firm is run by John Zhao, chief executive officer who also serves as a vice president of Legend Holdings. According to a source familiar with Hony's history, Legend handpicked Zhao to build the private equity operation.

Earlier in his career, Nanjing-born Zhao had spent 15 years studying and working in the US, including stints at a number of venture capital-backed technology businesses in Silicon Valley. He moved back to China in 2002 to scout for opportunities in his home country. Soon after his return came the call from Legend.

Hony's 2003 debut fund was a US dollar-denominated $38 million pool sponsored single-handedly by Legend. The fund did well and successor offerings followed quickly, with the firm soon looking to bring in third parties. Fund II closed in September 2004 on $88 million and included commitments from Goldman Sachs, Sun Hung Kai and Temasek. Fund III raised $580 million in 2006.

2008 saw Hony garner $1.4 billion for yet another vehicle.A cast of international bluechip LPs invested, including CalSTRS, the endowments of Stanford and Notre Dame universities, Rothschild, Pantheon, Partners Group, Squadron Capital, Asia Alternatives, Temasek and Goldman. Legend is a large investor in all four funds and owns a piece of Hony's management company. The firm's operating managers own the balance.

Also in 2008 Hony broke new fundraising ground by establishing an RMB-denominated fund exclusively for Chinese public sector institutions. It raised RMB 5 billion ($732million) from a handful of handpicked state investors, including China's giant Social Security Fund (SSF).

In total, the firm's asset under management now stand at $2.8 billion, of which $1.8 billion is available for new investment. In a market still getting to know private equity as a source of corporate funding, it is a considerable war chest.

In an interview with PEI Asia, Zhao explains that the US dollar fund and the RMB vehicle do not invest in tandem. They will co-invest in deals whenever possible, but according to Zhao, there will also be opportunities in which regulations may prevent Hony from drawing on the dollar fund, as well as others where the use of RMB will not be appropriate.

Hony's relationship with Legend and its close ties to some of the country's leading financial institutions illustrate how deeply the firm is embedded in the fabric of the Chinese economy. “They are close to the government and the progressive forces inside the Department of Finance who are trying to develop China's private equity culture,” says an observer who knows the market well.

Zhao's approach to discussing his firm is one of transparency, and he openly talks about the firm's ownership structure. But implicit in his comments is also an insistence that Hony's success rests on something other than simply good relations with government and friends in high places.

Hony, whose name derives from the Chinese terms “hong” (ambitious) and “yi” (perservering), is “one of a number of large, wholly domestic and internationally competitive private equity groups”, he says. Commenting on the firm's ability to access investment opportunities, he insists: “The government doesn't decide who gets to invest. The entrepreneurs do.”

Among these entrepreneurs are “corporate managers, both at SOEs and in private companies, who after many years training in large corporations are now keen to go it alone”. He says that in contrast to 2003, when Hony first appeared on the scene, these managers are now showing strong interest in private equity as a source of capital.

This change of attitude among business executives is perhaps the most striking development Zhao and his colleagues have witnessed in the past five years – and helps explain the firm's speedy growth. He says spotting the opportunity at the time wasn't difficult: “It was fairly obvious to me that SOEs needed to be more market driven, which would require injecting some private sector skill sets.”

What Zhao advertised as Hony's particular blend of private equity investing was – and still is – “money plus”, or capital with resources. “We invest selectively and get very involved. With every deal, it's crucial to develop an operating strategy and then execute. I learned that in Silicon Valley.” Preferred industry sectors are pharmaceuticals, consumer-related, and construction materials and equipment; in others, such as new energy, the firm is currently building up expertise.

Back in 2003, in conversations with corporate managers and private business owners, Hony's message as a financial investor wasn't being heard. This was in part because there was no understanding of what private equity was; and also because anyone looking for capital would immediately turn their attention to China's booming stock exchanges as a ready-made source of apparently abundant funding.

Says Zhao: “During the boom, companies didn't want help. Also, there was a misconception that private equity means pre-IPO.”

The credit crunch has changed all this. China's equity markets have contracted markedly, the IPO window has shut, and there is much greater appreciation among growth-minded managers of what long-term private equity can bring to the table. “The concept is just beginning to be understood – but the Chinese are fast learners.”

Given private equity's sudden appeal, as well as Hony's well-filled coffers, it is no surprise that Zhao is bullish about the future. His assessment of the market is unequivocal: “China today is one of the most, if not the most, interesting private equity markets in the world – especially if you are a Chinese investor through and through.”

Zhao is also encouraged by what the government is doing to keep the economy on a growth trajectory despite the global tightening. “The economy relies on growth. Anything less than eight percent growth feels like a recession, and there are many measures being discussed right now to achieve the right result – public sector spending, fiscal stimuli, etc.”

Some time in 2008,Hony's investment pace began to slow – “even though we didn't anticipate there would be a global economic catastrophe”, as Zhao admits. A self-proclaimed “perennial optimist”, he says the main priority now is to figure out the macro-trend and understand whether the recession will be V-, U- or L-shaped. “We absolutely believe in our vision, but we also need the discipline to do nothing for extended periods if necessary.”

In the meantime, Hony will undoubtedly continue to educate Chinese decision makers about private equity. In November, the Emerging Markets Private Equity Association (EMPEA) and the Beijing Private Equity Association jointly held the First Annual Beijing Private Equity Forum, which attracted senior officials from several regulatory agencies. According to a source close to EMPEA, one driving force behind the event was John Zhao – ever determined to spread the word about the power of his chosen industry.