Patience has always been a much-needed asset when transacting business in China. US-based private-equity firm Carlyle Group has proved it has this sort of staying power. In October, Carlyle announced the acquisition of 85% of Xugong Group Construction Machinery Co Ltd from the city government of Xuzhou, Jiangsu province, for $375 million in cash. XGCM manufactures heavy plant and machinery for the construction industry.
The sale of XGCM was conducted through the local asset exchange and entailed a two-stage bidding process among six international bidders. That process, coupled with intensive negotiations over future restructuring and staffing levels, meant that the deal took two years to agree.
Buying a small domestic manufacturer of construction equipment is hardly the stuff to make the blood race, but what makes the deal important is that for the first time the Chinese authorities have allowed a foreign financial investor to acquire outright control of a state-owned business. Previous investments by international private-equity firms have entailed the purchase of minority interests. Carlyle will have full management and voting control over the business and says that it intends to improve technology, management expertise and corporate governance with the goal of creating a leading international construction equipment company based in China.
The only thing missing from an otherwise copybook buyout transaction is, of course, the leverage that normally accompanies such deals in western markets. Carlyle had to stump up the consideration from internal resources and, although it certainly is not short of cash, it would dearly have loved to gear up the asset and so increase its return on equity. That is currently not permitted in China.
What will be interesting to see is whether Carlyle reorganizes the capital structure of XGCM once the deal completes after the necessary provincial and central government approvals are obtained and, if so, how. Private-equity firms often gear up balance sheets of restructured businesses that they have acquired so that they can remit dividends back to equity holders, effectively reimbursing some or even all of the initial capital outlay. If Carlyle is able to hive off Chinese assets into an offshore vehicle, ostensibly something that is now within its control, such a financial restructuring might be feasible.
Other global private-equity firms operating in Asia will be watching the Carlyle deal closely. As China continues to restructure its state-owned sector, fewer assets are regarded as strategic and more are being put on the block. That, coupled with the fact that outright control of non-strategic state-owned assets no longer appears to be the sacred cow it once was, is very good news for the private-equity firms that have recently raised billions of dollars for investment in the region, much of it earmarked for China.
Even if Chinas buyout market starts to bear fruit, getting the kind of returns that limited partners in private equity funds are used to elsewhere will still be a challenge. Solving the leverage conundrum is one problem: over paying is another. Carlyle looks to have secured a good price for its deal. Although sufficient financial information was not disclosed, sources suggested that Carlyle paid roughly twice book value for XGCM.
The billions of dollars of capital that private equity firms have raised from investors for Asia investment will ensure that competition for assets sufficiently large to permit portfolios to remain manageable will be particularly fierce. And raising debt is not the one-way bet it was now that the interest rate cycle has turned. Returns may prove more elusive than in the recent benign investment cycle. Expect to see more deals out of China, but watch for high prices and, ultimately, lower returns.