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Financial Advisory

ChinaPrivate Equity Confidence SurveySeptember 2010

Deloitte Financial Advisory Services is pleased to present the 2010 Private Equity (PE) Confidence Survey, our annual project exploring viewpoints of important private equity investors about the China market.

In the recent 12 months, China has seen continued expansion and diversification of financial players in the marketplace, with a significant part of the domestic capital flows largely unregulated. The pace of renminbi (RMB) fund growth in the first half of 2010 was approximately three times that of 2009, surprising many observers. Trust companies that behave like RMB PE funds have assumed an important role in the marketplace, introducing new financial products that securitise loans from the largest state banks but have only recently come under the scrutiny of regulators.

Secondly, the window is opening wider for foreign financial investors, both through the opening of some previously restricted sectors and the further liberalisation of sectors already open. Several formal pronouncements have fueled this discussion, including the April 2010 circular (the Several Opinions of the State Council Concerning Further Improving the Work of Utilising Foreign Investment) from the State Council on improving the use of foreign investment, and the "New 36 Measures" document from the State Council in May 2010 which focused on guiding the healthy development of all private investment. But as new sectors open, the actual opportunities they present remain somewhat unclear, pending the formal publication of detailed catalogues and the testing out of regulator behavior.

From both market and regulatory perspectives, the changes underway may mark an inflection point in China's engagement with the global financial system. The recent developments unfolded against the background of intense debate over the post-crisis and post-stimulus role of the State and role of markets in China. Consistent with its entire history of reform, China has again created an unprecedented investment landscape, by opening the door to more private equity activities, establishing a new stock exchange, and approving a dramatic series of new IPOs, while maintaining tight control on capital accounts, keeping the renminbi tethered to a managed float, and embarking on strengthening rather than reducing the role of the State-owned sector.

The SurveyThe survey respondents this year show a continued, if gradual growth in confidence overall in the Chinese investment environment, but they also continue to emphasise the challenges in the environment, especially challenges from regulation and competition.

Respondents expect LP interest to grow or remain strong and accordingly for investment activities to continue to grow. They expect deal size to grow modestly. On the other hand, their expectations are not aligned with the government's continuous push toward investment in second-tier cities, nor do they expect Chinese targets to improve much in terms of their investment readiness.

Sector interests expressed by respondents are roughly half aligned with government priorities for foreign direct investment (FDI) and private investment, with over 40 percent expecting consumer/retail and mining/power energy to be the sectors of greatest interest. Government guidelines are focused on FDI that will promote key campaigns, like green growth.

The global economic crisis is one of several forces changing China's position in the world of global finance. An economic shift to the east is obvious in the marketplace and is among the several change factors reflected in the survey:

RMB fund activities • RMB fund activities increased faster than expected, and respondents shared the opinion that RMB fund activities would be the

main drivers of investment in the future. A very substantial change occurred in response to questions about what kind of investors would be most active in the future: in 2009, 36 percent said foreign PE fund managers while that number dropped to 9 percent in 2010, reflecting the surge in domestic investment channels. In other words, local investors move with agility in ways which are sometimes difficult for global money managers to match.

Valuations and exits • Valuation multiples are likely to stay the same this year with price expectations moderating to a more realistic level. Linked to this

is the expectation, expressed by an overwhelming 94 percent of respondents, that IPOs would be the main mode of exit.

The 2010 Deloitte China Private Equity Confidence Survey

China private equity confidence survey 1

Key challenges • Oversupply of capital/ competition (29 percent) has emerged to become the top key challenges for PE. Despite positive regulatory

changes, respondents continue to see a key challenge in government regulation and intervention (22 percent). However, 78 percent of respondents believe that the government is working hard to help the development of private equity.

Looking aheadThe diversification of investors in China's booming financial services sector, including an increasing number and variety of private equity and trust investors, could be seen as liberalising in some instances but not in others. Not all players competing as financial investors operate under the same commercial imperatives and toward the same market goals, bringing to financial services in China what has been true for decades for competition in industrial sectors. The expansion of the FDI catalogue, similarly, will have an upside and downside, as the State refines its interests and significantly improves its technical skills in reaching its development goals.

The new investment landscape with more RMB funds and a wider variety of investors will create new roles for all players, GPs and LPs. Large public investors in China, including state-owned enterprises, are a new kind of LP - more engaged in fund activities than other market players. We are seeing new players and new relationship structures. For those who get it right, there are great benefits waiting.

We continue to be bullish about the prospects for the future of PE in China. But given this new mix of players, resources, strategies, and investment goals, getting it right will take expertise and innovation, and it will be the mission-critical hurdle for China's new investment openness.

As these changes materialise, global private equity investors will need three keys in this highly competitive deal environment:

an established and nimble infrastructure to source prime deals, •

the human resources to assess, negotiate, and close these deals expeditiously, and •

sufficient understanding of China to construct genuinely meaningful value propositions for partners and regulators. Funds with •these keys in hand will be well-positioned for super-returns from their China initiatives.

The market will inevitably encounter further ups and downs as it matures, but that does not undermine our optimism. Over time, we think there is huge potential.

We hope you find the survey of interest.

PE Team Leaders:

Danny Tong Eric Leung Chris Cooper

People's Republic of ChinaSeptember 2010

2


Contents

4 Introduction to the study 5 Headline indicators 6 What the results show 6 China 7 The private equity cycle 8 Section 1: Investment 9 Investment activity 11 Deal type 14 Deal size 16 Industry sector 17 Geographic 19 Section 2: Investors 20 Investor type 22 Deal competition 24 Competitive differentiators 26 Section 3: Origination, portfolio and exit 27 Entry multiples 29 Origination routes 30 Investment readiness 32 Portfolio management 34 Exit activity 36 Exit horizons 37 Exit routes 38 Returns 40 Section 4: Fundraising 41 Spotlight - Fundraising environment 43 Section 5: General outlook 44 GP time allocation 45 Challenges 47 Government role 48 Human capital 49 Corporate governance 51 Legislation 52 Long-term confidence 53 China’s strengths 54 Economic climate 55 Appendices 56 Methodology notes 57 Contacts


Introduction to the study

Taking the current temperature of the Chinese private equity market and examining likely trends for the year ahead.

What was the focus?

A measure of current confidence in the Chinese •private equity market as felt by general partners operating at a local level in a range of private equity areas (growth capital, buyouts, real estate, etc).

The study examines how sentiment amongst •private equity executives in China is changing as the industry develops in the country, and how practitioners see the opportunities and threats ahead.

This is the third China study produced by •Deloitte and Arbor Square and forms part of a global series of PECS looking at likely future trends in emerging private equity markets.

How was the research undertaken?

The views of respondents were obtained via •peer-to-peer discussions designed to draw out key themes and to understand expected directions in the Chinese private equity industry. The questions asked about the likely trends in the various stages of the ‘private equity cycle’.

How were interviewees selected?

A ‘long list’ of the most senior executives •operating within the Chinese private equity market was compiled by Arbor Square Associates and Deloitte. This resulted in a total of 33 interviews with key practitioners.

Further information

More detailed methodological notes can be •found as an appendix to this document, or contact Arbor Square Associates directly for further information.

4

Headline indicators


2008 2009 2010

New investment activity 5 5 5Entry multiples 5 6 =Exit activity 6 5 5Returns 6 = =Competition level 6 6 6Long term confidence 5 5 55 Opinions were generally positive

= Opinions were mixed

6 Opinions were generally negative

Highlights a negative shift in sentiment against the previous results

Highlights a positive shift in sentiment against the previous results

This page highlights the general direction in which the key private equity market trends - "the headline indicators" - are moving. The arrow signals below indicate whether overall sentiment is positive or negative, and comparisons between the 2008 and 2009 survey results signify whether this sentiment is improving or declining.

FundraisingInvestment

Portfolio

Exit

What the results show: China

‘SWFs are very active players in the financial sector; they have much capital to deploy.’

‘Domestic-oriented industries will do well - there is a lot more attraction here than in export. Retail, agriculture and alternative energy will probably lead the way, and there will also be growth in logistics.’

‘There are a number of factors. There is more liquidity; companies are maturing to the stage where they are ready for investment; and there has been a lot of fundraising recently - all the stars are becoming aligned.’

‘The environment is not getting any better just yet. Over the past two years' good funds have raised money and the weak funds have not been able to. The investment environment is a little better now, but there are more regulations which restrict LPs. It will not be a good time for fundraising over the next couple of years.’

‘We expect to see more venture capital deals in terms of the number of transactions; but in terms of value it will be growth capital deals. China has not yet come to an age where you can take majority control of companies.’

‘There is a good inflow of opportunities for the right deals, and there is not a shortage of exit options.’

‘Shanghai and Beijing remain key hubs. Where valuations are high, there is too much money chasing too few deals. In Beijing and Shanghai, they understand private equity better and are, therefore, less prone to make mistakes. However, investment opportunities are now spreading into the second- and third-tier cities where competition is less keen. Overall, there is a higher level of interest in the outside provinces, but you really do need resources there to get deals done.’

‘There is more money in US$-denominated funds, but the RMB funds are more aggressive. If you had asked me this last year, I would not have said that the RMB funds were as active as they are now.’

6

FundraisingInvestment

Portfolio

Exit

What the results show: The private equity cycle

Respondents expecting Global LPs' appetite to increaseReflects the growth of home grown funds, with China being viewed as a ‘hot spot’ by many.

Respondents expecting IPOs to be the main exit routeReflects the re-opening of the public markets.

Respondents expecting exit activity to increaseReflects an increased appetite for exits, following a stagnant period of few exit options available.

Respondents expecting GPs to focus their time on new investmentReflects GPs' interests in sourcing new deals, whilst managing existing portfolios out of the downturn.

Respondents expecting quality of companies’ ‘investment readiness’ to increaseReflects more market savvy entrepreneurs, who possess a greater understanding of private equity.

Respondents expecting domestic fund managers to account for most dealsReflects a significant recent rise in RMB funds, in addition to government's support for local funds.

Respondents expecting ‘second tier’ cities to be keyReflects an increase in opportunities extending beyond the coastal areas.

Respondents expecting investment activity to increaseReflects broader macroeconomic trends driving market recovery, a resurgence in IPO activity and growth in RMB fund activity.

76% 79%

41%94%

76%

88% 48%

70%


8

Section 1:Investment

8

Investment activity

Over the next 12 months, do you expect investment activity in the Chinese private equity market to increase, decrease or stay the same?

Continuing increase in private equity •investment activity is expected.

Over three-quarters of respondents expect •level of investment to increase; none expect a decrease.

The increase in investment activity is •boosted by a broad range of drivers, including favourable market trends, growing awareness of private equity and larger fund pool.

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Increase Stay the same Decrease

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Increase

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37

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04

Stay the same Decrease

2008 2009 2010

Investment activity timeline

Investment activity - underlying data

Responses %Increase 26 79Stay the same 7 21Decrease 0 0

Key drivers

Reasons for ‘increase’

Growth of the economy/macro trends •

Recovery of the public markets •

Growth of domestic RMB funds •

Better understanding of PE by Chinese •entrepreneurs

Companies turning to PE as a source of •funding

Increase from a relatively low base •

Pressure to invest post-downturn •

Market dislocations creating opportunities •


Why ‘an increase’?

‘Chinese entrepreneurs’ understanding of private •equity has increased. There are more home-grown private equity funds, although the market is not very organised or structured. There are a number of factors that will drive an increase in activity: 1) Private equity firms are putting more emphasis on doing deals now; 2) There is more money coming into China from overseas private equity firms; 3) RMB funds are being deployed and there are more investors starting RMB funds; 4) Companies are becoming more open to private equity as a solution to their problems.’

‘My expertise is in cross border transactions. •In the next 12 months' activity will go up as there will be a lot of dislocations creating opportunities to invest. The housing market and the banking sector will do well.’

‘China is still very active. There will be reasonable •deal flow over the next year. The macro trends are driving activity, and, overall, increased domestic consumption levels drive activity up. Macro policy is focused on renewable energy, alternative energy and, overall, energy conservation.’

‘In the first half of 2010, it has remained •steady, but we will gradually see a pick up towards 2011. This is driven by an improved economic outlook and recovering stock market. The IPO market is expected to be quite active throughout this year. There will be opportunities to take advantage of public-private arbitrage. We expect to complete two or three transactions over the next year - we did not carry out any transactions in 2008/2009.’

‘In the first half of 2010, activity has only risen •by 20 percent over 2009, which is much lower than expected, although the longer-term forecast is good. If the economy continues to recover, the level will gradually pick up.’

‘The transaction volumes are high, driven by •good macroeconomic fundamentals. The market is starting to recover from the 2008 downturn and compared to last year, which was at such at low level, it has to go up. The majority of investments are mid- to late-stage deals, and the capital markets are starting to recover and IPOs are becoming an increasingly viable exit route.’

‘There will be a strengthening in deal activity •levels due to continued growth in the Chinese economy. There was a slowdown but in the last six months we have seen economic growth and valuations increasing.’

10

Note: respondents could each provide an unlimited number of deal types they think will be most popular.

Deal type

What do you expect to be the most active type of transaction in the Chinese private equity market over the next 12 months?

China continues to be seen as a growth •equity market, reflecting the growth stage of many Chinese firms.

As a result, the private equity market will •remain characterised by minority equity positions.

Wariness of the public markets is reflected •in an expected falling trend for both PIPE and pre-IPO deals.

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90 91

79

3

32

21

7

18

4 36

4

17

3

32

300

Developmentcapital

Pre-IPO Venturecapital

Buyouts PIPE Secondarybuyouts

2008 2009 2010

Deal type timeline

Investment activity - underlying data

Responses %Development capital 30 91

Pre-IPO 7 21

Venture capital 6 18

Buyout 2 6

PIPE 1 3

Secondary buyouts 0 0

Response highlights

‘Minority positions will remain the central focus in •the Chinese market.’

‘To date, it has mostly been development capital, •but we are seeing more buyouts coming through, although the market is starting from a low peg.’

‘There will be more development capital in value •terms, but it should be quite equal in terms of volume of transactions with venture capital. Traditional VC in this region is more like growth stage investing.’

‘It has always been a growth market, not a •buyout market. The bad times are well managed here, and people do not get over-excited in the good times, therefore we are less prone to economic cycles.’


Do you think the number of buyout deals completed in China will increase in the next 12 months?

Respondent opinion remains divided on •likely future trends for buyouts in China.

Business owners are reluctant to sell and •regulatory constraints inhibit growth prospects, but….

….overall economic growth may drive •volumes from the current low levels.

An increase in buyout deals?

Responses %Yes 14 42No 19 58Not sure 0 0

Key drivers

Reasons for ‘yes’

Natural growth as economy grows •

Inevitable increase from low base •

More leverage available •

Government's support for buyouts •

Reasons for ‘no’

No historical presence here •

Business owners reluctant to sell up •

Regulations prohibit growth •

Response highlights

‘Buyout activity can only go one way because it •is starting from a very low point, but there will be no real activity to speak of.’

‘Buyouts have always been difficult in China. They •do not have a historical presence in China and the Chinese prefer to run businesses than sell them. This market will grow, but only slowly.’

‘It is not a good place for buyouts. Regulations are •prohibitive and owners don't want to lose control of their businesses.’

‘Most professionals in China are not ready for •buyouts. Recent deals in China in this part of the market are by global firms involving larger transactions.’

‘We shall see slightly more buyout activities than •we have seen so far. This will be a natural increase as the economy picks up.’

‘The trend towards more buyout deals completed •in China will increase. The government encourages such activities, but it needs time to become established.’

12

Do you think the number of venture deals completed in China will increase in the next 12 months?

Little change in expectations for venture, •with almost two-thirds expecting an increase.

Development of technology and •communications sectors and an innovation culture are seen as key drivers.

Significant proportion still believe there •is little appetite for venture capital (VC) in China.

An increase in venture capital deals?

Responses %Yes 21 64No 12 36Not sure 0 0

Key drivers

Reasons for ‘yes’

Growth in technology and communication •sectors

Growth in deal volumes •

Growth in culture of innovation •

Reasons for ‘no’

No appetite for VC in China •

Response highlights

‘The technology and communications sectors are •developing in China and, as a result, VC will be increasingly attractive over the next few years.’

‘Yes, there will be more VCs. It is driven by •innovation, and, as the Chinese economy grows, so too will innovation.’

‘Yes, VC and expansion capital will be the key •transaction types in China.’

‘VC has always been there. It is a small, but •robust market.’

‘This depends on the stage of VC deals. The •number of very early stage VC deals will decrease, while the number of mid-stage and later stage VC deals completed should stay the same.’

‘As a share of the overall private equity market, VC •will not necessarily represent a bigger proportion.’

‘Yes, we expect to see more VC deals, in terms of •the number of transactions, but in terms of values, it will be growth capital deals. China has not yet come to an age where you can take majority control of companies.’


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2008 2009 2010

Deal size timeline

Deal size

Over the next 12 months, do you expect investment activity in the Chinese private equity market to increase, decrease or stay the same?

There is a slight rise in expectations •regarding an increase in average deal sizes in China.

Just over half of respondents expect deal •sizes to rise, although many anticipate only a modest increase.

Abundance of capital, club deals and •privatisation are viewed as key drivers of deal size increase.

Overall deal size - underlying data

Responses %Increase 17 52

Stay the same 15 45Decrease 1 3

Key drivers


Natural growth as market matures •

Oversupply of capital •

GPs clubbing together on deals •

Growth in mega-deals •

Government funding/privatisation of SOEs •

14


‘Average sizes will increase due to general inflation •levels and valuations going up. Also, first-time funds used to be around the US$100 million-mark, whereas now they are more like US$1 billion!’

‘This will increase for US$-deal sizes, but RMB-deal •sizes will stay the same. In the case of the former, there are fewer good projects to invest in, but many of them should be bigger, and investors are now focused on these larger deals. For RMB funds, I expect sizes to remain the same as the greater amount of capital is offset by increasing numbers of companies seeking investment.’

‘We will see a continuation of the gradual •increase in deal size that we have witnessed over the past two years.’

‘It is very difficult to say. I don't expect a •significant upswing, but as China's economy develops further, there will be a natural increase in deal sizes.’

‘The general trend is going up, but not •significantly. It used to be around the US$30-$40 million mark and now it is more around the US$50-$100 million mark. Expansion and pre-IPO deals will have a greater presence in the future and this will push up investment sizes.’


Industry sector

In which industry sectors do you expect to see most deal activity over the next 12 months?

Expectations regarding industry sector •remain similar to last year.

The consumer/retail, power/energy/mining, •and pharma/biotech/healthcare sectors continue to be the most popular industry sectors for private equity.

Financial services has emerged as a sector •of interest post the downturn.

Consumer/retail Power/energy/mining

Pharma/biotech/healthcare

Technology, Media & Telecommunications

Financial services

Engineering & manufacturing

Media

Infrastructure *Other

Education

Real estate/construction

200820092010

27%

32%

21%15%

8%

8%

16%11%

16%12%

20%

15%

20%

7%

7%

5%

5%

12%

8%

8%

7%

3%2%

2%

10%

Note: respondents could each provide an unlimited number of sectors, BUT the results are displayed as a percentage of all responses received rather than number of respondents.

* ‘Other’ includes: infrastructure, agriculture, logistics, tourism, autos, food & beverage

Sectors underlying data

Responses %Consumer/retail 26 27

Power/energy/mining 16 16

Pharma/biotech/healthcare

15 15

Financial services 8 8

Technology, Media & Telecommuncations

8 8

Engineering & manufacturing

7 7

Real estate/construction

3 3

Education 2 2Media 2 2Infrastructure 0 0*Other 10 10

Response highlights

An active sector will be financial services, although •it is hard to get majority control. Construction will see growth over the next couple of years, which is very much a function of economic growth and the consumer confidence. Real estate is expected to see a pick up in activity as the housing market has blossomed over the last year. As affluence increases, healthcare and education will also see a surge in activity levels.’

‘Consumer - this sector is developing fast and •there are many activities going on here. Also, the healthcare sector is expected to see increased levels of activity with foreign investors being able to take control in hospitals, etc. Growth will also be apparent in some of the traditional sectors such as steel, where there is a lot of consolidations going on.’

16

Geographic

Which cities do you think will see the highest levels of private equity activity over the next 12 months?

Evidence shows a continuation of the trend •for private equity activity to spread out from the tier one cities.

Second-tier cities, again, receive more •mentions than first-tier centres, although the latter will remain a key focus.

Third-tier cities have shown a significant •growth in popularity since last year.

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First-tier Second-tier Third-tier Fourth-tier

35

41

22

2

Note: respondents could each provide an unlimited number of tiers, BUT the results are displayed as a percentage of all responses received rather than number of respondents.

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2008 2009 2010

Response highlights

‘In geographical terms, activity will actually be •quite spread out because private equity investors are moving inland. There are many opportunities for firms to invest in good companies across China. Previously, most investment opportunities were limited to the coastal regions, but now this isn't so much the case. There is a spreading out to the west and north.’

‘To some extent, this will vary by sector and •type of investor. Infrastructure will be strong in Southwest China, while there will be a focus on consumer and healthcare sectors in the centre of China. Foreign investment, which traditionally focused on the coastal regions, will increasingly look at central China.’

Geography - underlying data

Tier Responses %First-tier 18 35Second-tier 21 41

Thrid-tier 11 22

Fourth-tier 1 2Number of responses 51


Response highlights

‘Shanghai and Beijing remain key hubs, and •where valuations are high - there is too much money chasing, with too few deals. In Beijing and Shanghai, they understand private equity better and are, therefore, less prone to mistakes. However, in the second- and third-tier cities, there is less competition, but company owners are less compliant. Overall, there is a lower level of interest in the outside provinces - you really do need resources there to get deals done.’

‘The main focus will continue to be on coastal •and tier one cities - these will be the hub areas, although they have already been over-exposed, and fund managers are trying hard to penetrate into the western areas.’

‘The first-tier cities will continue to attract a •disproportionate percentage of deals, whereas the second- and third-tier have a robust group of SMEs.’

‘First-tier cities will continue to be the main •focus, but the best opportunities will be in the second- and third-tiers.’

‘The main cities in the second- and third-tiers •will do well, and there will still be a consistent amount of growth around the Shanghai and Beijing areas.’

‘We are a pioneer in looking at geographies •less covered by others. We are interested in the interior region in China, central and western China, although we will still have a healthy chunk from the coastal areas, despite the fact that competition here is huge, and there is a saturation point.’

18


Section 2:Investors


Investor type

Which do you expect to account for the greater proportion of deals in the Chinese private equity market over the next year?

There is a notable shift in favour of •domestic private equity fund managers away from their foreign counterparts.

Domestic managers are perceived to be •able to leverage on their local networks and influential relationships.

The rapid emergence of RMB funds is seen •as another key driver of this trend.

70%

21%

9%

Domestic PE fund managers

Both

Foreign PE fund managers

2009: 50%

2009: 14%

2009: 36%

Response highlights

‘Domestic PE Fund Managers - local managers •will overtake global managers in terms of activity. They are closer to the market and more diversified. In the next 12 months, activity will increase amongst this group.’

‘Domestic PE Fund Managers - this is a fluid •situation that is constantly changing. Offshore investors are working to increase their allocation to China. However, they face tough competition from aggressive RMB funds. RMB funds vary in size and function - some are government sponsored, adding to their power. RMB funds are experiencing robust growth versus offshore funds. China does not need foreign funds if they have an ample supply of domestic funds. Another factor is that Chinese insurance companies are now open to invest in private equity funds, illustrating how the market is starting to open up.’

‘Domestic PE Fund Managers - recently, there •has been a significant rise in RMB funds and they are starting to play a huge part in the marketplace. There are so much money chasing and too few deals here in China. There has been a huge recent upswing in PIPE deals, that follow more of a hedge fund strategy.’

‘Foreign PE Fund Managers - foreign managers •will be comparatively more active than domestic funds, although the latter group are catching up and have increasing amounts of capital under management. Their risk profiles are quite different to the international players - they have a more open structure and can take on bigger risks.’

‘Foreign PE Fund Managers - I think the foreign •managers will be most active. Although more RMB funds have entered the market, foreign funds will dominate for at least the next two years.’

‘Domestic PE Fund Managers - local funds are •pretty active, although they tend to flip deals quickly and have quite a different strategy from the international players.’

20

‘Domestic PE Fund Managers - RMB funds have •an ability to obtain approvals faster than foreign private equity fund managers, which experience much more rigid due diligence procedures. Local managers have a relationship with the government and local officials and, therefore, have the competitive advantage - it is far more difficult for foreign managers.’

In this period, do you expect the level of souvereign wealth fund (SWF) investment in China to increase, decrease or stay the same?

Overall view that SWF activity within the •Chinese private equity will not change significantly over the coming year.

However, just over a third do expect to •see increasing activity as the economic environment improves.

Many do not regard the core activity •of SWFs to be direct private equity investment.

SWF activity - underlying data


Stay the same 19 58

Decrease 0 0

Not sure 2 6

Response highlights

‘There are not many of them because of their •size. Their choices are pretty limited - they don't focus on small deals but get involved in larger infrastructure-related projects in China. We don't really come across them very often.’

‘To a certain extent, there will be some growth •by SWFs, but the players will be different to some extent. Southeast Asian and national funds will be more active in Europe than in China.’

‘SWFs are not a threat for foreign private equity •fund managers. They mostly play a role on the LP side rather than as direct GPs.’

‘SWFs are not active in the private equity •sector. Their mandate is primarily for a) listed companies, and b) debt markets. They are too big to compete with private equity players and usually have offshore holdings in the US or Western Europe.’

‘SWFs have a lot of capital to deploy. To a •certain extent they have a better angle on deal activity because of government support.’

‘SWFs have always been active yet. How visible •have they really been? They have always been there in the background, but their visibility is low.’

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SWF activity


Do you expect competition levels for private equity deals to increase, decrease or stay the same?

Competition for deals is expected to •intensify in the Chinese market; no respondents expect competition to fall.

The key driver is the rapid increase in •capital targeting China, both domestic and foreign.

Some concerning signs of due diligence are •being streamlined in an effort to win deals.

Deal competition

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82

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Deal competition - underlying data


Stay the same 6 18Decrease 0 0

Key drivers


Increasing number of home-grown funds •

Increasing number of new foreign entrants •

Overall attractiveness of Chinese market •

Increase in fundraising activity •

Nascent industry with room to grow •

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2008 2009 2010

Deal competition timeline

22


‘Chinese markets are developing and there •are more and more funds here. If you look at China compared to the rest of the world, China is a good place to park capital. There is much foreign capital flowing into China and its exact destination depends on sector. The neglected sectors sometimes offer interesting opportunities.’

‘More and more overseas funds are trying to •move into China. There are also more home-grown funds, although this is not just in China - you see this happening across other emerging markets as well, such as India.’

‘There is more money in the market - especially •from RMB funds. Also, funds are conducting less due diligence before making investments, largely because companies are less patient with those funds that want to undertake a thorough due diligence process.’

‘There are more RMB funds coming in and there •are more US$ funds looking to deploy their capital. The pitching round has started much earlier - we are now pitching for businesses by the second management meeting, and companies now have a choice of private equity firms and can test various sources of capital.’

‘Competition will become more intense. Some •firms are trying to do buyouts. But once they realise they can't be done, they will move into the growth capital space.’

‘This will intensify in time. China has a •relatively short history in terms of private equity - only around 10 years. Professionals have a background in investment banking and consulting, but few have real industry experience. Therefore, track records are less established than in Europe, and the US at the moment.’


Competitive differentiators

What do you believe are the most important competitive differentiators for private equity firms in the Chinese market when it comes to winning deals?

An investor’s reputation and ability to •add value remain the two most important differentiators for PE managers.

However, post downturn, the relative •significance of having a strong brand has fallen….

….while contacts networks, sector •specialisation and operational expertise are becoming more important.

Competitive differentiators - underlying data

Reasons Responses %Reputation/brand 15 20Ability to add value 14 19Network/contacts 12 16Chemistry/company relationship/trust

9 12

Sector specialism 8 11

Speed & flexibility/efficiency

4 5

Operational expertise 4 5

*Other 8 11Number of responses 74

* ‘Other’ includes: access to proprietary deal flow, local presence, accepting limited due diligence, corporate governance, understanding risk appetite in China, initiative/innovation, large amounts of capital, and price/terms.

Note: respondents could each provide an unlimited number of differentiators, BUT the results are displayed as a percentage of all responses received rather than number of respondents.

Reputation/brand

20%

19%

16%

12%

11%

5%

5%

11%

Ability to add value

*Other

Networks/contacts Chemistry/company relationship/trust

Speed & flexibility/efficiencySector specialism

Operational expertise

Reputation/brand Ability to add value

*Other

Networks/contacts Chemistry/company relationship/trust

Sector specialism Speed & flexibility/efficiency

Operational expertise Price/terms

200820092010

20%

27%

33%

12%

7%

10%

3%

7% 22%19%

16%

5%

16%

7%16%

5%

5%

9%

13%

12%

11%

5%

5%1%

9%

24

Response highlights

‘Key factors are brand, communicating well •with the company's management team and having the ability to convince the company's chairman that you are the right investor. Also of importance is the ability to actually demonstrate that you can add value by, for example, making introductions in new markets, helping to create new products and forming new distribution channels.’

‘Speed of execution is critical. Chinese •companies shop around and you need to move fast.’

‘If you are focused on a competitive segment or •region, then differentiation will help. In general, there is increasing amounts of liquidity in the market, and more and more people are chasing deals. There will be winners and losers in the market. Over time competition levels will drop off, as the market develops and the firms that are increasingly hands on will win hands down.’

‘Business owners like to know if we have •knowledge in their sectors and can offer value add capabilities through an established track record and specialist market knowledge. Other differentiators include being able to help companies expand overseas into Europe - we prefer to work with firms with a European face and that have local networks in place.’

‘Key factors are sector specialisation and a •network for sourcing deals - it is very important to see a deal early.’

‘Apart from meeting the valuation expectation •of the person you are dealing with, having a clear value add proposition is key. Whether it is operational or strategic, it is about what value you can add post deal - this is critically important. International private equity firms have a significant advantage over local private equity firms in this respect and local firms do not have an established track record.’

‘Experience is very important - you need to be •able to identify opportunities and engineer a deal. You also need to be able to be proactive about approaching business owners and have some ownership in the deal. Authority and credibility are important, as well as operational expertise.’


26

Section 3:Origination, portfolio and exit

26

Entry multiples

Over the next 12 months, do you expect entry multiples to increase, decrease or stay the same?

An element of stabilisation is expected •after large swings in expectations in recent years.

Entry multiples expected by many are to •remain at relatively high levels, but not rise any further….

….although levels of dry powder and public •market recovery will possibly drive further increment.

0

20

40

60

80

100

0

20

40

60

80

100

%


36

58

6

Entry multiples timeline

0

20

40

60

80

100

0

20

40

60

80

100

%

Increase Stay the same Decrease N/A

10

61

36

7

25

58

83

116

04

0

2008 2009 2010

Key drivers


Backlog of capital to deploy •

Increasing size of private equity funds •

Improved quality of companies driving up •multiples

Public market recovery •

Reasons for ‘stay the same’

Continuing high valuations •

Relative public market stability •

Entry multiples - underlying data


Stay the same 19 58

Decrease 2 6N/A 0 0

Number of responses 33



‘For some of the smaller deals, valuations will •increase. There is a backlog of capital to deploy that has built up over the last three or four years and this will continue to add pressure in terms of valuations.

‘Entry multiples are increasingly expensive, driven •by a recovery in the public markets.’

‘There will be an increase because private equity •funds are much bigger than before, but the number of really good companies to invest in is significantly fewer. Good companies will ask for bigger entry multiples.’

‘Multiples will increase dramatically. Since China •opened its latest stock exchange with 100 companies listed on it, valuations have increased dramatically - they were in the single digits and low-teens, and now they are in the mid-teens.’

Why ‘stay the same’?

‘Since the recession valuations have shot up - •they have got to a ridiculous level and have not settled down again. Entry multiples are still typically higher for RMB funds. To some extent, valuations are of secondary importance compared with quality. China is getting closer to the rest of the world in this respect, with sector expertise and an ability to spot quality businesses an important differentiator.’

‘I think pricing will remain flat compared with the •previous 12 months, although it is down from the peak. However, price expectations are slowly becoming more realistic in this market.’

‘This will very much stay the same as last year. •Valuations are tied to the stock market which is not expected to go up significantly.’

28

Origination routes

What do you expect to be the most important ways of sourcing deals for private equity firms in China during the next 12 months?

With deal activity expected to rise, the •trend is for all sources of deal origination to be considered again.

Evidence supports that private equity •managers do not feel they can rely on proprietary channels exclusively….

…particularly not in parts of China where •they do not have a local presence.

Proprietary Both Intermediated

200820092010

24%

32%

27%

7%

67%

42%

32%

36%

33%

Note: ‘Both’ refers to proprietary and intermediated deal flow.

Deal origination - underlying data

Responses %Proprietary 8 24

Both 14 42

Intermediated 11 33

Response highlights

No one can afford to rely on one method - you •need good coverage and you can't afford to lose out.’

‘Intermediaries are far and away the most popular •method of deal sourcing (at least 90 percent or higher are sourced this way). Proprietary methods are a grey area, and on the ground most deals are realistically sourced through intermediation.’

‘There are good deals in China available through •proprietary means. Sourcing assets directly is most effective, but China is a big market and there is still a reliance on intermediaries. China has many big cities across its provinces and if you want to be entirely proprietary-led, you would need local offices in each of these cities in order to have people on the ground. This is not easy.’

‘Personal networks, whether they are developed •through private or professional life, are crucial. If you rely entirely on intermediated deal flow, this will be very limiting - this tends to be of poorer quality and you do not see the best types of deals.’


0

20

40

60

80

100

0

20

40

60

80

100

%

Increase

63

48

64

27

42

21

10 914


2008 2009 2010

Investor readiness timeline

Investment readiness

Do you expect the level of 'investment readiness' of the companies you see in the Chinese market to increase, decrease or stay the same?

Quality of companies in China is still •expected to rise, although signs of pace for improvement is levelling off.

Downturn has sorted wheat from chaff and •entrepreneurs are more aware of investor needs.

However, some point to the broad spread •that still exists in terms of company professionalism.

Investor readiness - underlying data


Key drivers


Entrepreneurs are more market savvy •

Sorting of the 'wheat from the chaff' •

Increasing maturity of the market •

Greater understanding of private equity •

Opening of ChiNext prompting companies to •prepare better for IPO

0

20

40

60

80

100

0

20

40

60

80

100

%


48

42

9

30


‘There will be better companies out there, •certainly. The ones that have kept going through the downturn have shown their strength and will be looking for alternative sour ces of funding now.’

‘Quality has definitely increased, although •the negotiation process is more difficult now. Overall, executing deals has definitely got easier.’

‘Ten years ago, Chinese entrepreneurs did not •understand the private equity market. Now there is a much better understanding and more high-growth companies on the market positioning themselves for IPOs on local exchanges.’

‘Entrepreneurs are becoming more sophisticated •and are realising that private equity is a unique financing tool.’


‘I have some concerns over the quality of •opportunities, especially the 'investability' of pre-IPO firms. It is not that they are bad companies, but they have grown purely with an IPO in mind and it is not clear whether they are capable of standing on their feet as a listed company.’

‘The market is so diverse that it is hard to give •an answer. Some firms are so remote that they have never considered private equity funding, whereas others have the term sheet ready to sign.’


Portfolio management

Going forward, do you expect to become more operationally involved with your portfolio companies?

Just over half of respondents expect to •become more hands-on with their portfolio this year.

Even most of those who do not stress that •because operational involvement is already at a high level.

The need to assist with professionalising •firms in preparation for IPO is a key driver.

0

20

40

60

80

100

0

20

40

60

80

100

%

Yes Stay the same No Not sure

52

6

36

6

Overall operational involvement - underlying data

Responses %Yes 17 52

Stay the same 2 6No 12 36Not sure 2 6

Key drivers

Reasons for ‘Yes’

Being ‘hands-on’ seen as competitive •differentiator

Need to assist with company growth •

Need to help position companies for IPO •

Need to professionalise company boards •

Opportunity to add value via specialist sector •skills

Response highlights

‘Yes, we have been doing this for a long time and •we do not expect activity to increase in this area, but to stay consistent. China is a high-growth, dynamic market and we need to maintain close contact with portfolio companies.’

‘Yes, this is a critical area for us. It is pretty •important to know what is going on with your portfolio companies, such as checking the balance sheet and financial statements. You need to be aware of any potential issues. There is also a growing awareness of the need to play a hands-on role.’

‘We have a model where we try to be very •hands-on, and this is probably quite unusual. In the next 12 months, we shall be more hands-on, and helping to position some of our portfolio companies for exit. It is very much about creating a clear path to IPO.’

32

39%

45%

Yes

No

(N/A: 15%)

Do you have any plans to enhance the level of operational expertise within your team to assist with portfolio management?

An even split exists between those private •equities which plan to augment their operational resources and those which do not.

For those that do, a fairly broad range of •operational appointments appear likely.

For several of those which do not, •this reflects the existence of adequate resources in this area.

Response highlights

‘Yes. We have already recruited one person and •are looking for one more.’

‘Yes, we plan to hire multiple former senior •executives in various industries to join our team of in-house operating partners.’

‘We will increase our expertise in the areas of •legal processing, accounting and finance, and will use consultants who specialise in portfolio management.’

‘We will be adding strategic value by advising •on acquisitions and sales channels outside China. We already have the expertise in-house to provide this advice.’

‘Whether we consider recruiting more people •depends very much on the fundraising process this year.’

‘The expertise comes from the partners. We •have a CEO from UBS Japan on the team. I have an industrial background. We all bring different qualities to the table and grow our benchmark accordingly.’


0

20

40

60

80

100

0

20

40

60

80

100

%

Increase

13

7675

10

21

11

77

3

14


2008 2009 2010

Exit activity timeline

Exit activity

Over the next 12 months, do you expect exit activity in the Chinese private equity market to increase, decrease or stay the same?

A healthy mixture of supply and demand is •expected to continue to drive an increase in exit activity.

Launch of ChiNext is seen as a key driver. •

Many portfolio companies have reached •maturity and investors are eager to achieve realisations.

0

20

40

60

80

100

0

20

40

60

80

100

%


76

21

3

Exit activity- underlying data

Responses %Increase 25 76Stay the same 7 21

Decrease 1 3

Key drivers


Market receptivity to IPOs •

Funds have been waiting to exit deals •

Increase in M&A activity •

Likely increase from a low base •

Opening of ChiNext •

Maturity of portfolio companies •

34


‘The exit market will be receptive to IPOs over •the next 12 months, either exiting domestically through the growth board or in Asia.’

‘There is a good inflow of opportunities for the •right deal, and there is not a shortage of exit options.’

‘Exit activity is 10 percent down in terms of •volume and value from what it has been over the last 12 months, but it will pick up again going into 2011.’

‘Exits will be realised this year. 2010 will be a •crazy year for going public with a significant pick- up in IPO activity.’

‘In terms of domestic activity, exits in China •will be difficult. The merger & acquisition (M&A) market is so small in China that it can only increase, and IPOs, while tricky, will see a pick-up.

‘The key drivers of exits will be: 1) Domestic •investment demands are increasing sharply and also ChiNext has started - these factors will give private equity firms more exit opportunities; 2) There are many mature portfolio companies that need to exit; and 3) There are many more domestic funds available now and some companies may want to find new investors.’


‘It very much depends on the vintage of funds. •There were a lot of funds set up in the 2007-2009 period and, given the life cycle of funds, exits will be very difficult to achieve from these vintages at this stage.’


Exit horizons

Over the next 12 months do you expect exit time horizons to increase, decrease or stay the same?

The majority of respondents do not expect •holding periods to change significantly over the next year.

However, a range of views exist, with some •pointing to the need to allow companies to develop for longer….

….and others suggesting the move to back •more developed growth businesses will see horizons shortened.

Exit horizon - underlying data


0

20

40

60

80

100

0

20

40

60

80

100

%


27

64

9

Response highlights

‘It's very difficult to say, as it depends on the •maturity of the companies invested in. In general, time horizons should stay the same this year, but we expect to start seeing more exits in 2011.’

‘Holding periods will increase. If you want good •numbers, you have to wait. You need to work harder on IPO plans.’

‘It is hard to say, but generally I think holding •periods are getting shorter. There are more deals in their growth stages now, which has led to shorter horizons.’

‘More early-stage companies have been funded, •meaning it will take longer to work with them and achieve an exit.’

‘Exit time horizons will increase. It was less than •three years in most cases before, but now it will be three to five years. This is because there are fewer quick deals now - more time is needed to let companies develop. Also, it is worthwhile waiting until the market becomes more mature, then exits may achieve better returns.’

36

Exit routes

What do you expect to be the most common exit route for private equity deals over the next 12 months?

There is little change in expectations •regarding the industry’s preferred exit routes in China.

IPOs continue to be seen at the most •popular exit option.

Trade sales witnessing a bounce-back to •near 2008 level.

Note: respondents could each provide an unlimited number of exit routes that they think will be the most common.

Exit routes timeline

0

20

40

60

80

100

0

20

40

60

80

100

%

IPOs Trade sales Secondarybuyouts

Managementbuy-backs

77

9394

47

32

45

74

0 04

0

2008 2009 2010

Exit routes - underlying data

Responses %IPOs 31 94

Trade sales 15 45

Secondary buyouts 0 0

Management buy-backs

0 0

Response highlights

‘IPOs will be the most common. We would prefer •strategic sales, and would consider accepting a lower price for these, but the issue is that a lot of strategic buyers might like a company but have issues with its business model. If we can get past this, then trade sales are our first priority, followed by IPOs.’

‘I think IPOs will be the most commonly-used exit •route, provided the US capital markets hold up.’

‘It will mostly be a case of IPOs. Trade sales make •up a smaller proportion of the market in China.’


Returns

Over the next 12 months, do you expect the returns achieved from private equity exits to increase, decrease or stay the same?

Private equity returns are expected to •stabilise, if not decline going forward.

Increase perceived to be unlikely given •current high and unsustainable pricing of the public markets.

The effect of competition on entry prices, •coupled with increasing market efficiency, could hit future returns.

Returns timeline

0

20

40

60

80

100

0

20

40

60

80

100

%

Increase

10

39

6

1718

61

70

39

33

3 40

Stay the same Decrease N/A

2008 2009 2010

0

20

40

60

80

100

0

20

40

60

80

100

%


6

61

33

Returns - underlying data

Responses %Increase 2 6Stay the same 20 61

Decrease 11 33N/A 0 0

Key drivers

Reasons for ‘stay the same’

Lack of pressure on returns given lack of •leverage

Exit activity has resumed •

Market stabilisation •

Public market growth forecasts unrealistic •

Continuing macro uncertainties curtailing •growth

Reasons for ‘decrease’

Competition pushing up entry prices •

Increasing market efficiency •

38

Response highlights

‘Internal rate of returns (IRRs) will remain •at around 25 percent. We usually look at a company's potential and decipher returns based on that, with an aim of 25 - 30 percent. The growth potential of a company is about how much you can squeeze from the margin.’

‘There is a lot of disappointment around the •markets at the moment. The equity markets are overvalued and unsustainable, particularly in sectors such as biotech, internet and technology. Valuations are currently through the roof and there are unrealistic expectations when it comes to exit multiples going forward.’

‘Our expectation would be more conservative. •The return multiples are quite high already, coupled with natural increase in returns as the economy picks up. However, exits will be affected by the macro environment, and returns will not be as high as they have been, although they are still high compared to other emerging market regions.’

‘IRRs over the next year will be difficult because •valuations have been driven up by the stock markets and the quality of exit deal flow is deteriorating. It will be a tough year.’

Why ‘a decrease’?

‘Returns will decrease. The main reason for this is •simply that the prices required for private equity to win deals are much higher than before.’

‘Returns will come down as competition is •growing. Also, as the market becomes more efficient this will also cause returns to fall.’


40

Section 4:Fundraising

40

Spotlight - Fundraising environment

A reversal of last year’s trend, with now around half of respondents expecting fundraising to be less difficult than it has been of late.

However, mixed views are still evident, some citing increased interest from European, American and Asian institutions as a reason for a more favourable environment, whilst others believe there is simply less appetite for risk at this point in time, particularly if LPs do not see an increase in capital distributions.

0

20

40

60

80

100

0

20

40

60

80

100

%

Lessdifficult

Same levelof difficulty

Moredifficult

N/A

32

52

18

30

50

15

03

2009 2010

Fundraising environmentHow difficult is fundraising going to be?

Do you plan to raise a new fund over the next 12 months?

And in 2009...

Yes42%

No55%

(N/A: 3%)

Yes39%

No57%

(N/A: 4%)

Why ‘less difficult’?

Quality managers attracting backing •

Increased interest from overseas investors •

Pick up in activity post recession •

Response highlights

‘It is a good time to raise fund - there is increased •interest from European, American and Asian institutions.’

‘The environment is favourable and is very •interesting right now. Domestic funds, particularly, are seeing lots of growth, and there are reasonably good managers out there with a good reputation to attract backing.’

‘It will be less difficult compared to the depths of •the recession in 2009, but still would not be back to 2006/2007 levels’.

‘The environment is not getting any better just •yet. Over the past two years, good funds have raised money and the weak funds have not been able to do so. The investment environment is a little better now, but there are more regulations which restrict LPs. It will not be a good time for fundraising opportunities over the next couple of years.’


0

20

40

60

80

100

0

20

40

60

80

100

%


76

24

0

Would you consider it to be of strategic importance to set up an RMB Fund in the Chinese Mainland?

Yes96%

No4%

‘If you are fundraising this year, then you •probably have a 2006-07 vintage fund, which will have produced a negative IRR. So it is going to be more difficult for you.’

‘2010 is bad enough but I expect the worst is still •to come. If LPs do not see good realisations, they will not commit new capital.’

‘I think it will be more difficult. There is simply •less appetite for risk now.’

Three quarters of respondents believe LP appetite for China will increase, although there is recognition that in an increasingly competitive market place, LPs can be selective.

Evidently, there is a growing appetite for RMB funds, yet there are concerns regarding potential conflicts of interest with foreign currency funds.

Global LP appetite for China set to increase due to…

Increased interest in RMB funds •

Sheer number of opportunities in China •

The perception of China as a ‘hot spot’ •

Response highlights

‘I think international LPs will be very interested •in the Chinese market, but at the same time Southeast Asia is also very attractive.’

‘I have seen three or four cycles of China's •economy now and people are excited about the market. It is not for everyone, but there are plenty of opportunities out there.’

‘It will increase - everyone, feels they have to •play in China now.’

‘Institutional appetite will increase - China is •now the biggest market for all investors all over the world.’

‘Appetite will remain at a high level, not •necessarily because China is doing better than other regions, but because other regions are just not doing very well. LPs need to consider the balance of attractiveness versus competition.’

‘Right now, there are warning signs in China, •and investments have been overvalued. In the short term, appetite will not increase, but in the long term, I believe it will.’

‘RMB funds are a mega trend. Everyone is looking •at raising RMB funds now, although these are still smaller than average funds in terms of size, and there are still difficulties around getting a deal closed.’

‘Yes, we would consider it, although we do •not need a RMB fund - we can still make investments. There are too many rules and regulations surrounding RMB funds at the moment and we will be waiting until there is more clarity in this area.’

42


Section 5:General outlook


GP time allocation

Over the next 12 months, which elements of your business do you expect to spend most time on?

As was the case 12 months ago, deal-doing •is expected to be the key activity for GPs over the coming year.

More GPs than last year mentioned •portfolio management as a key focus for them….

….although for many the actual proportion •of time spent on this versus making new investments will fall.

0

20

40

60

80

100

0

20

40

60

80

100

%

Newinvestments

Portfoliomanagement

Raisingnew funds

Exits

89 88

32

64

14

27

18 18

2009 2010

GP time allocation

Note: respondents could give more than one activity.

GP time allocation - underlying data

Responses %New investments 29 88

Portfolio management

21 64

Raising new funds 9 27

Exits 6 18

Response highlights

‘Sourcing deals will be the bread and butter over •the coming months and a focus on planning will be key. After four months or so, we might consider exit options.’

‘Exits are always an issue as well as a top priority. •Deal sourcing takes up a lot of time and China is not an easy market to source deals in - you have to be in close contacts with the people you work with. Portfolio management also requires a considerable effort.’

‘It will be roughly 60 percent for sourcing new •opportunities and 40 percent for portfolio management - in 2009 this was 75 percent for portfolio management and 25 percent for sourcing new opportunities. In 2009, companies needed our support, whereas now we are keen to look for new opportunities.’

44

Challenges

What do you see as the biggest challenges and barriers to growth for the China private equity industry to overcome?

The challenges posed by increasing •competitions have intensified as the Chinese private equity market develops.

Regulation remain a key challenge for many •private equity companies, although its relative significance continues to fall.

Signs that the breadth of perceived •challenges faced by the industry is increasing.

Note: respondents could each provide an unlimited number of challenges, BUT the results are displayed as a percentage of all responses rather than number of respondents.

* ‘Other’ includes lack of due diligence, foreign exchange issues, governance/transparency, lack of reputation/track record, tax issues, lack of credible opportunities, deal origination, need to provide more value add to portfolio companies, fundraising difficulties/access to capital, infrastructure, competing with IPOs.

Top challenges - underlying data

Responses %Oversupply of capital/competition

12 29

Market regulation/transparency

9 22

Specific competition from RMB funds

7 17

Market volatility/difficult exit conditions

5 12

Immature legal framework for private equity

3 7

Human capital deficiencies

3 7

Lack of acceptance of private equity

0 0


In the words of the GPs…

‘Private equity has become overheated in the •region - there is too much money chasing too few deals. Returns are not as good as they were two or three years ago, and this provides a critical challenge for investment professionals. There will be a reshuffle in the industry - people need to think more about the long-term.’

‘Key challenges are linked to the legal •environment, which incorporates both regulatory and political factors. The Government changes laws at any given time, and this creates uncertainty in the market. Also, the nationalistic environment supports Chinese companies and state-owned enterprises - there is considerable favouritism there.’

‘The market is really hot right now - you have •to be able to think logically rather than jumping in at the deep end. There are a number of regulatory issues - it would be a lot easier if there was one specific policy. There have also been a number of poor performances by Chinese companies in the past that has led to scepticism.’

Oversupply of capital/competition

Market regulation/transparency

Specific competition from RMB funds

Market volatility/difficult exit conditions

Immature legal framework for private equity

Human capital deficiencies

Lack of acceptance of private equity

*Other

200820092010

29%

38%

12%

8%15%

15%

13%

22%

58%

17%

8%4%

15%

12%

23%

12%

7%

7%

34%


‘Competition levels and being able to •differentiate yourself are critical. In China, most funds struggle with this - they are all pools of capital. Track record is also important, but this is quite lumpy, with firms having had one good investment and several average ones. It is a challenge to maintain profitable investments and healthy returns.’

‘The same challenges are there - there's nothing •new - but it is all about how you position yourself in terms of investment discipline and know-how and overall judgement. Every week, new companies are judged, and new companies require resources and capital fund. Deals need to become professionalised - they should not look different to how they are done in the US, the only difference is the process. You need discipline and flexibility, with the right people to do the job. There are no new challenges, but new opportunities, and with these come increased competition levels.’

‘A challenge is the lack of truly experienced •managers with track record and discipline, coupled with lack of a long-term institutional investor base.’

‘An issue is the quality of private equity •teams - not many people are good at private equity here. Also, I worry about the gold-rush mentality.’

‘Regulatory issues - it is not exactly a free •economy here. Operators have to be market savvy as fraud issues are still prevalent. There needs to be greater due diligence and a strong research team - a local team to uncover these problems from a risk perspective.’

‘A key challenge is increasing competition from •local players. Although foreign investment is often more structured and focused on risk management, there is a growing amount of competition for deals. The second challenge relates to the difficulty for domestic firms to achieve high returns. As deal sizes get bigger, there is a need to lock in the price. The third issue relates to obtaining regulatory approval.’

‘Government regulation is a challenge. If you •look at the investment environment it is far less difficult now than it was, but regulation should be eased up. Another factor is currency risk. Offshore funds investing in US$ need to manage their exposure and risk. Also, the ability to exit - there are windows of opportunity but this still presents a challenge.’

‘In my view, a big challenge surrounds the •enforceability of the rules governing private equity - the legal system is still relatively immature in this country.’

46

Government role

To what extent do you feel the government is hindering or helping the development of private equity in China?

The overall view of respondents is that •the Chinese government is helping the development of private equity.

Its assistance is largely via supporting •growth and establishing a suitable environment.

However, while it is seen to help domestic •funds, its actions are less favourable to foreign managers.

Role of government - underlying data

Responses %Hindering 3 9

Helping 25 78

Neither 4 13

Response highlights

‘They play a very supportive role and promote •the domestic private equity industry in terms of RMB funds and local government funds that foster domestic growth. However the Chinese government does make it increasingly harder for offshore funds.’

‘Yes, they do play a supportive role but I have no •idea how it works. They have the right mentality but they need to put this into practice, and make growth an integral part of their strategy.’

‘The government is helping to create an •infrastructure for investment.’

‘Private equity is here to stay. The government will •work with it. The government very much supports RMB funds but will play a territorial role as well.’

‘They mainly play a supportive role, maybe too •supportive. Private equity is often seen as a 'fix-it resource' for many things by the government.’

‘The Chinese government play a supportive •role. There are a couple of trends here: 1) The government would like to foster home-grown funds (RMB), and recognise the role of private equity versus public funds; and 2) The attention that private equity has attracted has led to taxation of private equity gains. The government is getting smarter about offshore taxation and increasingly efficient about monitoring the private equity market.’

0

20

40

60

80

100

0

20

40

60

80

100

%

Hindering Helping Neither

9

78

13


Human capital

Do you believe that there are human capital constraints hindering the development of private equity in China?

Almost three-quarters of respondents believe that human capital constraints will impact •Chinese private equity.

These reflect limitations at both the company and investor levels, as well as in the advisory •community.

Some believe that talented and experienced are increasingly moving back to the region, •boosting the skill-base.

Yes72%

No28%

Response highlights

‘Yes, it is a constraint - you need people with deep •operational experience here. There is a big gap between the fresh MBA student and the industry insider/current private equity investor. Experienced private equity professionals are hard to find.’

‘There is a perennial shortage of good quality •CFOs in China. They are continually jumping ship to pre-IPO companies.’

‘Yes, this is constrained. As companies are evolving •to become more institutionalised there is a need for professional players. Good human capital is difficult to find - it is more expensive and pushes up spending.’

‘Yes, there are still constraints on two fronts: 1) •Finding suitably qualified investment professionals at a senior level with private equity experience (not just financial services experience) in China; and 2) On the portfolio company side, there is an issue finding qualified people with Big Four accountancy experience.’

‘There are no good quality CFOs. Having said that, •the local law firms and accountants are very strong and the commercial due diligence people are improving.

‘China is attracting people back into the region, •although few are qualified enough. There is a need for internationally-exposed entrepreneurs and professionals such as lawyers. There are people around but few brilliant ones.’

‘There is not a shortage of talent here. There •is a trend towards people moving back into the region. However, it is still difficult to find specialist local individuals.’

‘Chinese people are moving back into the •region, but these are not always the right people to employ. We need home-grown talent, as the market is becoming increasingly localised.’

48

Corporate governance

What do you see as the biggest challenges related to corporate governance in the Chinese private equity market?

Issues linked to accountability and •transparency, particularly in due diligence, are rising in significance.

Concerns regarding company ownership •distinctions continue to fall in terms of relative importance.

While challenges will always remain, •corporate governance standards are seen to be improving by some.

Note: respondents could each provide an unlimited number of challenges, BUT the results are displayed as a percentage of all responses rather than number of respondents.

* ‘Other’ includes: need for education, lack of minority rights, inflexible structure, involvement of hedge funds in PE, lack of vendor sophistication, company law, lack of incentives to encourage change.

Response highlights

‘China is unique and corporate governance will •always be a challenge, but there are steady improvements and this will continue to improve slowly year-on-year. There will be no overnight changes, but in the next two years there should be a significant improvement.’

‘Before, due diligence is the usual problem. It •really depends on the type of deal. Minority deals are about who you work with and finding the right partner. It is about being open minded, showing your values and getting involved on the management level.’

‘It could be better. Corporate governance very •much depends on who you are working with. Structures can be very inflexible, and due diligence is poor.’

‘This is always a challenge. The biggest issue •is that there is not always a clear distinction between the owner and the investor; you need to have the key people in place, such as a CFO and board professionals. Visibility and transparency are critical factors.’

‘A key challenge is the lack of proper accounting. •Even if a company is audited by the Big Four, you cannot guarantee the numbers are real.’

‘This is getting better. Firms have adapted to •corporate governance requirements and it is becoming an easier process to implement.’

‘Corporate governance is patchy - some •companies get it and some do not!’

‘There is a lack of international best practice. This •differs across the country and with each deal. But generally speaking, due diligence is still an issue.’

Corporate governance in itself Accountability

Transparency Lack of local knowledge

Quality of due diligence

Distinction between managers & owners

Trust and shared vision

*Other

Regulation

200820092010

28%

31%

4%

52%

13%13%

17%

13%

24%6%3%3%

16%

16%

13%

10%

10%

7%

3%

3%

14%

Corporate governance challenges - underlying data

Responses %Corporate governance in itself 8 28Accountability 7 24Transparency 3 10

Quality of due diligence 3 10

Lack of local knowledge 2 7Distinction between managers & owners

1 3

Trust and shared vision 1 3

Regulation 0 0



CSR policy

How important is CSR policy within the broader governance framework?

CSR policy - underlying data

Responses %Not important 15 47

Important 16 50

N/A 1 3

Response highlights

‘This is growing and has been triggered by •a number of companies going public. The entrepreneurial circle is increasingly aware of the significance of CSR, but it is still not developed to the stage it should be at.’

‘The environmental issue is a big topic here •in China. Environmentally-friendly companies would be favoured over those that pollute. The labour market is already improving, with a minimum wage now in place and the quality of life is improving. That said, there definitely needs to be more attention paid to this.’

‘This is a buzz word rather than visible action. •It is not at the top of the list for a majority of companies.’

‘This is not really that important. If LPs were •more interested in this, then you would see GPs showing an interest, but it is not on their crucial list.’

0

20

40

60

80

100

0

20

40

60

80

100

%

Not important Important N/A

4750

3

50

Legislation

If you could change any element of the legislation affecting the Chinese private equity market, what would it be?

The top issues linked to legislation remain •similar to previous years.

Restrictions and hurdles to foreign •investment rise in relative significance….

….as do concerns over the tax regime as it •impacts private equity.

Note: not all respondents answered, and respondents could each provide an unlimited number of issues, BUT the results are displayed as a percentage of all responses rather than number of respondents.

* ‘Other’ includes; listing and lock up rules, frequent changes in laws/enforcement of laws, restrictions in LP investment in PE, inconsistency in regulation across Chinese regions, streamline RMB fund laws, archaic laws.

In the words of the GPs…

‘The market needs to open up and become less •restrictive. There is too much protectionism and government fears mean that the economy is run like a very tight ship.’

‘The attitude towards foreign money - there •needs to be more encouragement towards foreign investors. We also need to establish more international best practice laws. The government takes a clear stance against private equity and there is much protectionism around the industry.’

‘It is accepted that you work within the limits of •the legal framework. The legal environment is a lot clearer now than it has been in the past, but there are still issues related to foreign ownership laws and taxation issues.’

‘Tax and regulations are the issue - taxes need to •be restructured. It would be great to go back to a pre-2005 tax environment.’

‘There is nothing, in particular, I would change in •the short-term, but, in general, there are plenty of regulatory issues, particularly with foreign money coming into China.’

‘The biggest challenge is the need to get •administrative commercial approval at the local level. This would be a lot easier if it could be done at the central government level.’

‘I would like to be able to bring my money •onshore more easily. Also, I would like to force some of the banks to sell their distressed assets.’

Foreign ownership restrictions/currency conversion

Tax regulationToo many rules and regulations/lack of clarity

Opening market/easier approval processes

More regulation to driver better corporate governance

*Other

200820092010

32%

21%

10%

12%

27%20%

32%

11%

20%

18%8%

11%

32%

17%

12%

20%

Legislation challenges - underlying data

Responses %Foreign ownership restrictions/currency conversion

13 32

Tax regulation 8 20Too many rules and regulations/lack of clarity

7 17

Opening market/easier approval processes

5 12

More regulation to driver better corporate governance

0 0

*Other 8 20



High

Low

Average: 7.9Median: 8

8.3 (2008)

7.8 (2009)

Long-term confidence

On a scale of 1-10, how confident are you in the long-term growth prospects of the Chinese private equity industry?

52

China’s strengths

What do you see as the key strengths of China relevant to the long-term growth of the private equity market?

The overall strength of China’s economy is •seen as a key factor in its attractiveness for private equity.

Rising consumerism and the spread of •urbanisation from coastal regions are also key factors….

….as government support for infrastructure •development and for private equity as an asset class.'

China’s strengths - underlying data

Responses %Strong domestic economy

13 46

Large consumer market 7 25Government structure and support for PE

5 18

Infrastructure growth 3 11Urbanisation 3 11Strong commodity sector 3 11Large population 2 7

Stable political system 2 7

Growth in opportunities in the interior regions

1 4

Relative attractiveness versus other emerging markets

1 4

Stable currency 1 4


Note: respondents could each provide an unlimited number of strengths, BUT the results are displayed as a percentage of all responses rather than number of respondents.

Response highlights

‘It isn't like the gold rush era again. China will •take time to recover. This year, we will see private equity investors renew their interest in China. There are still many people who doubt its potential, and it takes time to build power and credibility.’

‘China has huge reserves, a strong government, •and a relatively stable political environment’.

‘The long-term growth prospects are bright. •A lot of firms will drop off the radar and the quality companies will remain. China's three key growth factors are: 1) Urbanisation; 2) Growing consumption; and 3) The rise of China's central and western provinces away from Shanghai and Beijing - growth in the interior provinces.

‘There is more risk - and, accordingly, more •potential reward - in China than, say, Singapore, which has more mature companies but less growth opportunities.’

‘Key benefits for China are: 1) It is a one-party •state, which means the government is stable and has a long-term policy; 2) Government infrastructure spending generally supports the economy; and 3) There should be comfort regarding the currency, as there is less volatility than for other currencies.’

‘There are still a lot of opportunities around the •coastal region, but in the next three-to-five years there will be a slowdown because growth here has been too fast - the other emerging markets will catch up.’

‘China represents a better opportunity than SE •Asia in general. China is a pot of gold for Western investors, who are having issues in their home markets.’


Economic climate

Over the next 12 months, do you expect the overall economic climate to improve, decline or stay the same?

Cautious optimism is evident on the subject •of the overall economic environment in the coming year.

Two-thirds of respondents expect the •climate to improve….

….while only two envisage a decline. •

Response highlights

‘I think we'll see short-term decline, followed by •long-term improvement.’

‘The economic climate will remain unstable •due to the volatility of the European and US markets, which makes conditions difficult to predict. China's economy is gradually opening up, although it is still highly subject to changes and is not insulated from the rest of the world.’

‘There are no big changes expected - it will •stay pretty flat. By and large, both the US and European regions will continue to struggle, but they cannot be worse than they are now, and the market will start to see a pick-up into 2011.’

‘We have come out of the worst, although the •route of recovery is by no means smooth and there will be ups and downs.’

‘This is improving overall. Growth may not be •as spectacular as it has been before, but the economy will continue to expand.’

‘The economy is undergoing a restructuring and, •whereas I don't think it will suffer a catastrophic event, nor do I think there will be a huge uplift. It will remain neutral at best.’

0

20

40

60

80

100

0

20

40

60

80

100

%

Improve Stay the same Decline

66

28

6

Economic climate - underlying data

Responses %Improve 21 66Stay the same 9 28

Decline 2 6

54


Appendices


Methodology notes

P11: respondents could each provide an unlimited number of deal types they think will be most •popular

P16: respondents could each provide an unlimited number of sectors, BUT the results are displayed as •a percentage of all responses received rather than number of respondents

P17: respondents could each provide an unlimited number of tiers, BUT the results are displayed as a •percentage of all responses received rather than number of respondents

P24: respondents could each provide an unlimited number of differentiators, BUT the results are •displayed as a percentage of all responses received rather than number of respondents

P29: ‘Both’ refers to proprietary and intermediated deal flow •

P37: respondents could each provide an unlimited number of exit routes they think will be most •common

P44: respondents could give more than one activity •

P45: respondents could each provide an unlimited number of challenges, BUT the results are displayed •as a percentage of all responses received rather than number of respondents.

P • 49: respondents could each provide an unlimited number of challenges, BUT the results are displayed as a percentage of all responses received rather than number of respondents

P • 51: respondents could each provide an unlimited number of issues, BUT the results are displayed as a percentage of all responses received rather than number of respondents

P • 53: respondents could each provide an unlimited number of strengths, BUT the results are displayed as a percentage of all responses received rather than number of respondents

56

ContactsFor more information, please contact:

United KingdomChris WardTel: +971 4401 9612Mobile: +44 777 460 3031Email: [email protected]

ChinaChris CooperTel: +86 10 8520 7751Email: [email protected]

Cloey ChanTel: +852 2238 7263Email: [email protected]

Vivian MaTel: +86 10 8520 7035 Email: [email protected]

Arbor SquareGemma PughTel: +44 207 993 5514 Email: [email protected]

Kevin McNallyTel: +44 207 096 5017Email: [email protected]

Research undertaken for Deloitte by:

Arbor Square AssociatesSecond Floor64 Borough High StreetLondon, SE1 1XFwww.arborsquare.comTel: +44 0 20 7993 5514Fax: +44 0 70 0602 3734Email: [email protected]

For further information, visit our website at www.deloitte.com/cn


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