For stranded Chinese IPOs, private equity to the rescue

HONG KONG Tue Sep 20, 2011 8:13am EDT

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HONG KONG (Reuters) - An $80 million investment in a Chinese baby diaper producer normally wouldn't generate much buzz.

But last week's deal for AAB China was interesting for a few reasons, among them the involvement of Richard Ong's new $2.3 billion private equity fund.

The deal shows that private equity firms, like Ong's RRJ Capital, are stepping into China where hedge funds once roamed, pursuing deals that look more like short term financing than long term growth bets.

According to buyout industry and banker sources, Bain Capital, Blackstone Group LP (BX.N), Kohlberg Kravis Roberts (KKR.N) and Permira PERM.UL are among the private equity firms that are showing interest in what's commonly known as pre-IPO financing, or providing capital to fast growing companies on the listing track that need a chunk of money before they can float.

TPG too, appears to be keen, as one source involved with the AAB deal said the firm was also interested in the Chinese company. The $80 million stake, which RRJ took with another investor, was confirmed by the source, though he would not specify the percentage. TPG declined to comment on the deal.

Private entrepreneurs in China in capital intensive industries often go to local lenders for cash. These lenders can function like loan sharks, said Derek Sulger, partner at Lunar Capital Management, a Shanghai-based private equity fund.

Sulger says the rate on that money has gone from 2.5 percent to 5 to 6 percent a month.

"That clearly opens up an enormous opportunity -- if those businesses are strong and deserve that capital -- to go and be that capital provider," said Sulger.

The interest of buyout firms pre-IPO style investing underscores a few key factors that helps explain the current state of financial markets in Greater China.

One factor is that the IPO window in the region is all but shut, open for only a few select names, with no clear view on when the floodgates will lift again.

Second, it shows that lending across China is extremely tight, with banks keeping a close grip on their purse strings, forcing companies to look for other ways to generate cash.

The idea is for private equity firms to target either Chinese companies gearing up for an IPO or to target companies that were in the IPO pipeline and pulled the offering when the markets sold off this summer.

Since August, 16 Greater China IPOs worth $23 billion were put on ice.

Online clothing retailer Vancl, coalminer Inner Mongolia Yitai Coal Co, precision engineer CN Innovations Holdings and real estate investment trust Gateway Capital -- to name a few -- were on that list.

These are the types of companies that private equity firms could offer capital to in the meantime.

Private equity firms normally plunk money down on slower moving companies that are at least a few years away from either listing or being ready for a sale. The current climate in Greater China and elsewhere is changing that.

FUNDING NEEDS

This story -- fast growing Chinese companies, poised to IPO, seeking capital -- has been told before, only last time it involved hedge funds.

Around the time of the 2008 financial crisis, hedge funds were heavily involved in pre-IPO financing in Greater China. At the time, it seemed like an easy bet. Hand over $50 million or a $100 million to a company seeking cash but motoring toward an IPO. Watch it grow, take it public, and then cash out that loan for a much bigger premium and a tidy profit.

When the credit crisis hit and the IPO market slammed shut, the hedgies and their Chinese partners found themselves at odds. Hedge funds, facing redemptions, needed to cash out of these illiquid investments, and yet the Chinese companies needed the money. It did not end well, with both the funds and the companies suffering.

Having learned their lesson, hedge funds and executives are no longer discussing pre-IPO financing as they did in the past, but private equity managers are.

Private equity argues that their structure allows them to stay in longer, with 10 year lock ups for their investors, as opposed to a hedge fund who could face a redemption every month.

The pairing makes sense, as China banks are showing a reluctance to lend to the sector.

By some estimates, Asia based private equity firms have $50 billion to $70 billion of money they've yet to spend, otherwise known as dry powder.

"Big state-owned enterprises can wait it out. Their IPOs were seen as opportunistic anyway. We're targeting smaller firms that can't get bank finance, where the only solution to their funding needs was to go to IPO," said a private equity investor, who did not want to be named.

(Additional reporting by Elzio Barreto; Editing by Michael Flaherty)

(This story was corrected to fix Lunar Capital partner's name to Sulger from Luger in paragraphs 7-8)

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