November 4, 2011 / 8:12 AM / 9 years ago

Credit squeeze driving China firms towards private equity funding

* Companies turning to PE financing after banks shut loans

* Creates investment opportunities for PE, venture funds as valuations fall

* New funding channel could come at a cost for companies

By Samuel Shen and Kazunori Takada

SHANGHAI, Nov 4 (Reuters) - Six months ago, private equity firm BeiKai Capital was greeted with a cold shoulder when it sought to invest in a Chinese security information firm that was at the time saddled with ample cash.

Now, in an about-face, the technology company based in China’s eastern city of Nanjing is courting BeiKai for funding, having been shut out of bank loans.

“The company is suffering from liquidity shortage so they came to us,” Beikai’s Managing Director Ronald Shuang said. “Many Chinese companies are now cash-strapped due to the credit squeeze and that’s good for us.”

Following a series of policy tightening measures by Beijing to control inflation, more and more non-state-owned companies are turning to private equity and venture capital firms for funding, helping create new investment opportunities.

Real borrowing costs of small- and medium-sized enterprises from commercial banks have soared to over 10 percent annually from about 6 percent a year ago as lenders become increasingly cautious also due to concerns over the economic outlook.

“In the past, we were chasing companies. Now many companies are short of money so they have started chasing us,” said Fang Weiping, a manager at Zhejiang Redearth Venture Capital Co.

Private equity firms are flexing their financing muscle in other areas too.

Industry and banking sources have said Bain Capital, Blackstone Group LP , Kohlberg Kravis Roberts and Permira are among 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.

Chinese real estate funds raised $2 billion during the third quarter, a jump of 60 percent from the previous three months, as they responded to rising financing needs from developers suffering from lending curbs and stagnant sales, according to consultancy Zero2IPO.

Heightened liquidity strains — highlighted by a series of scandals in Wenzhou in Zhejiang province involving company bosses fleeing the city to dodge debt obligations — have also prompted local governments to turn to private equity firms for aid.

Last month, the government of Zhejiang launched a 10 billion yuan ($1.6 billion) fund in partnership with an independent asset manager aimed at supporting small- and mid-sized enterprises (SMEs) in need of capital.

“You cannot rely on banks, who under the current government policies are aggressively calling back loans,” said Du Huaping, vice general manager of Zhejiang Apeloa Medical Technology Co.

FALLING VALUATIONS

As a result of rising demand for cash, private equity firms are now gaining bargaining power. Many companies used to sell their stakes at lofty valuations — nearly 20 times earnings — but now prices have come down to about half and is expected to fall further next year, according to Beikai’s Shuang.

“But most of those cash- starved companies knocking at your door those days are very small and not in good shape. Not the ones that we would normally want to invest in,” Shuang said.

To mitigate investment risks, private equity and venture capital firms would sign various binding agreements with target companies.

For example, if a company cannot generate the promised level of profit during a set timeframe, investors have the right to seize an additional stake in the firm for free as compensation.

Another agreement often used is if a company fails to go public within an agreed period, it must buy back the stake from its private equity investor, paying the principal plus annual interest rate of around 20 percent.

That means while a credit lifeline maybe available for some cash-starved companies, it could come at a significant cost.

“We demand a more than 30 percent return from our investment,” said Gan Jianping, managing director at Qiming Venture Partners. ($1 = 6.351 Chinese Yuan) (Editing by Muralikumar Anantharaman)

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