Cherry-picking in China's development and growth finance market

What is the size of the debt market for growth companies?

Michael Wang: That’s hard to say because it is a fluid number; the total growth capital is mostly financed by equity today. There are lots of private equity investors and there are also private debt investors, banks and shadow banking. I would imagine private debt has a relatively smaller percentage of the pie.

Barry Lau: It would be around $10 billion max for institutional money like us. It is difficult to ascertain the scope of private debt; if you are including other informal types of lending, I would say it is probably around $100 billion-$200 billion. Banks’ participation in this area of lending (SME private credit) remains small because they don’t usually lend to companies without hard assets and they will not try to understand the SME’s business models and cashflows to structure the necessary lending.

Sabita Prakash: It depends on how you define growth companies. There’s no standard definition – they can vary from one sector or geography to another. Growth can also be organic (expansionary) or inorganic (acquisitive). There are too many numerous ways to classify ‘growth’ to be able to standardise measurement of the same.

How has the competitive landscape for growth finance changed over the year?

BL: It is a nascent industry. Traditionally, foreign investors have always thought of China as an equity play because they want the multiples but, over time, they have become a lot more realistic about the return and are willing to take a debt-like return instead of multiples.
MW: After 2008, a lot of lenders left the scene, which created a vacuum on the supply side. Today, I don’t think we are quite back to the pre-2008 levels because the availability of demand has gone up a lot even though the supply has been recovering. That’s why the yield by private debt investors is actually pretty good and on average higher than what was available before the crisis.

Francis Ho: Domestic corporate financing can be split into two categories: direct financing and indirect financing. The latter holds the larger percentage. But in recent years, with the development of multi-level capital markets, the proportion of direct financing in China has been increasing quickly. With the emergence of private equity firms and alternative asset management companies, PE investments and VC investments are more preferred by growth companies.

SP: Growth financing in mid-sized companies in China was traditionally dominated by trust companies, investment banks and asset management companies. The key difference over the last few years is that trust financing has reduced considerably. Therefore, these companies are going to be dependent on venture capital (for new sectors) and alternative (private capital) funds like ourselves.

Do growth companies prefer equity or debt – and why?

BL: Smart entrepreneurs who believe in the growth of the business will never want to be diluted unnecessarily. Debt financing provides a degree of certainty to both the lender and the borrower. The borrower can still have the option to sell equity after hitting various milestones by using debt as growth financing. The two are not mutually exclusive, but there’s only so much dilution an entrepreneur should entertain.

MW: It depends on how well the company does. If it’s a company that’s still in early stage growth, does not have cashflow and can’t fulfill the requirements of getting debt to take on, they will have to sell equity. It is not until at a later stage where they have the cashflow and the collaterals that they are qualified for private debt.

SP: Some early stage ventures may opt for equity financing because they can’t find that many willing lenders. But I can say that in general most SMEs in China, or even Asia, don’t prefer to dilute their own equity because they believe in the potential for business growth.

FH: In general, enterprises at early stage would prefer equity financing, because they usually have high risk and high uncertainties at such a stage. Therefore, it is more suitable for equity investors which pursue high growth and high capital gain. As the enterprises come to a mature stage, particularly close to an IPO, they would prefer debt financing.

Simon Andrews: I think it depends on what the company needs. Equity is generally longer term and equity investors are usually expected to add value to the companies they invest in. However, equity investors also expect a higher level of say in the way the company is run and a higher level of return on their investment. Debt is lower-cost and debt providers rarely get involved in the running of the businesses they lend to, but can be restrictive as lenders will typically impose covenants that can restrict the company’s operations.

What do you think is the biggest challenge facing private debt investors lending to growth companies?

BL: To understand the validity, necessity and growth of the business; the motivation and determination of the management, modelling the cashflows, running sensitivity analysis and worst-case scenarios and, lastly, our value-add, governance and strategic input if any. It is no different from private equity, but we are paranoid about downside risks – how much we can lose rather than how much we can make is the most important aspect of our underwriting.

MW: Firstly, it is still about cherry-picking the best deal. There are a lot of deals in the market but there are also a lot of traps. Secondly, the enforcement right remains crucial because it is in the emerging part of Asia and there is a manifest lack of legal protection and certainty. Thirdly, it is about the team’s expansion in order to take on more deals in the country.

SP: Identifying the situation is challenging because if these companies have the perfect credit quality they are able to get conventional financing at cheaper rates. We just need to find the right opportunities to finance companies that have a viable business profile but suffer from a funding gap due to various reasons.

FH: There are two main challenges for us. One is the downward interest rate. Enterprises become more sensitive to their financing cost. In order to meet the income requirement of debt financing we have to optimise deal structures to add value. The other is the light-assets operating approach conducted by many top-quality firms. For unsecured debt, how to design good deal terms to meet the risk control requirements is very challenging.

How can investors help Chinese companies with their growth plans?

BL: We always sit on the board and help them like a buyout firm. We differentiate ourselves by adopting ESG guidelines. We focus on companies that really do good in terms of the environment, society and governance.

MW: We go in as a debt holder, we don’t rely on changing the company to make our money like a buyout firm. We rely on safety by picking companies that are quite sizeable and with healthy cashflow. We can add value but it’s not a must, they are already doing very well.

SP: We are essentially an advisor in an informal sense where we advise them to restructure their balance sheets. Given our multi-regional presence and track record, we can give them advice that has a more international context – indeed, we often see ourselves as an intermediate step in preparing some of these companies to approach the public markets for financing.

FH: We normally use company-wide resources and experience to help the portfolio companies in different aspects. For example, after investing in an international school company, we offered the company strategic advice for M&A and searched for suitable targets for it. For another example, after the investment in a consumer company, we provided funds and advice to the company to carry out overseas M&A.


Barry Lau, founder and managing partner, Adamas Asset Management

Michael Wang, managing partner and president, Abax Global Capital

Sabita Prakash, head of business development, ADM Capital

Francis Ho, managing director and head of mezzanine and credit, CDH Investments

Simon Andrews, country manager for China, Korea and Mongolia, International Financial Corporation