A leading private equity investor explains why the time is ripe for control investments in China.
By Wouter Baan and Ivo Naumann
Underpinned by decades of stellar economic growth, China’s private equity (PE) market has rapidly expanded to become the third-largest in the world, with more than $620 billion in assets under management (AUM) in 2019.
Even before the COVID-19 crisis struck in January, China’s moderating economic growth and an uncertain regulatory environment had sharpened the competitive landscape, tightening margins and reducing returns.
It is a scenario that KC Kung believes is ripe for control investments. Kung is a top dealmaker in China’s PE industry, having led Carlyle Group’s Greater China business before co-founding MBK Partners, one of Asia’s largest private equity funds, which today has over $20 billion in capital under management.
In early 2017, Kung stepped aside to launch Nexus Point, a firm focusing on control investments in Greater China.
Speaking with Ivo Naumann, a Shanghai-based partner who heads McKinsey’s private equity practice in Greater China, and Wouter Baan, an associate partner in Hong Kong, Kung explains how economic conditions are spurring entrepreneurs to cede control, what PE managers need to do to generate alpha in China, and why attracting and retaining top talent is key to consistently creating value.
McKinsey: China’s PE market has expanded rapidly, but remains relatively small as a percentage of GDP. How do you think the market will develop?
KC Kung: China’s PE market is growing rapidly and will continue to do so. Deal types are multiplying, encompassing everything from founder succession to businesses divesting, as well as multinationals entering and exiting the market, and public companies being taken private. That’s at the late-stage end. Then you have venture capital, which is also very active.
On the investor side, we expect international and local investors to continue to seek access to the world’s second-largest economy. As a result, and as businesses continue to mature, you will see the size of China’s PE market relative to GDP catch up with more developed markets.
McKinsey: How will China’s slowing GDP growth impact PE and fundraising?
KC Kung: Moderating growth will not slow the growth of PE in China but may impact deal type. Specifically, there’ll be more control deals. In the past, when the market was growing rapidly, you could create a lot of value just by being in the market. Now, with economic activity moderating, you may be looking at 15-20 percent growth rather than 30-40 percent. The market is becoming more competitive, even as compliance, labor, and environmental costs are rising. Margins are shrinking, and as a result your bottom line is not growing as fast. Businesspeople are realizing that to create value, they need to implement operational improvements. Moreover, as industries mature, they start to consolidate, and become more competitive. Entrepreneurs are consequently more willing to cede control or find a partner to help them realize operational value, which is why we are focused on control investments.
We’ll see the same trend with respect to fundraising; limited partners gradually moving capital from growth to buyouts—not just betting on overall market growth. Studies have shown that PE returns are higher than public markets, but there’s also more dispersion among managers. That will make general partner selection more important going forward.
McKinsey: What opportunities do you see in China’s PE market in the next 3-5 years? Are there specific sectors where you see opportunities?
KC Kung: The China-US trade dispute and COVID-19 have accelerated some long-term trends. For example, domestic consumption is in play because you have no idea what may happen with international trade, and China’s government wants to boost consumption for sustainable growth. In this uncertain market, control of portfolio companies becomes more important for value creation. We take advantage by focusing on select industries such as healthcare, consumption, business and consumer services, and education. Our coverage has not changed significantly from the previous five years, but has adapted to take advantage of accelerating trends.
McKinsey: What impact will COVID-19 have on the PE industry? In the 2007-08 crisis we saw deal activity pick up rapidly about six to eight months after the trough. Will we see a similar phenomenon play out this time?
KC Kung: Going into the COVID-19 crisis, a lot of people felt that it was going to be a repeat of the global financial crisis in ’08 and ’09, when a shortage of liquidity led to a drop in valuations that proved enticing for PE investments.
This crisis is playing out differently. PE players are busy. Many are flush with liquidity and looking for deals because we think everything should be cheaper because of COVID-19. But many asset owners—shareholders and founders—have realized that the COVID crisis is subsiding. They’re keen to exit but they don’t think their businesses are worth any less than they were before the crisis, particularly because there’s so much liquidity in the capital markets. There is a valuation gap between buyers and sellers, and it’s not clear whether all the PE activity will translate into real transactions.
McKinsey: How should PE funds evolve in terms of value proposition, and their approach to investment, talent, and management?
KC Kung: PE growth in future depends on building a sustainable competitive advantage. In a PE context, that means adding value to your portfolio companies. There are different approaches to doing this. Some firms develop sectoral expertise. Others build broad operational expertise to make sure they can add operational value to portfolio companies. Some focus on geography. All of these approaches are valid but the key is understanding your heritage and DNA, and what makes sense for you. Talent is another important factor; whether you’re able to attract, retain and excite exceptional talent, and build a culture where people can really excel. We focus on building culture because once you have the right people, you’ll come up with strategies and investments that generate good returns.
McKinsey: Creating alpha is likely going to be the key to success in future, but how do you achieve this in the China context? Is there sufficient experience and expertise in managing control deals? What are the biggest challenges to generating alpha in China?
KC Kung: Generating alpha in PE in China has to be an end-to-end package. China is a relatively less developed and more fragmented PE market, so deal sourcing can create alpha. If you have the right relationships, and you know where to look, you can source deals on a proprietary basis. Next, deal execution or deal structuring, aligning your interest with your partners, is also important, as is creating value by defining how governance will work and what the management team will look like going forward. Then comes formulating a business plan that makes sense, generates exceptional returns and takes account of operational improvements, potential acquisitions, and strategic changes. Finally, of course, is the portfolio side, and actively creating value and executing the business plan rather than just monitoring your portfolio companies.
That’s the package you need to create alpha within the China context. The key is to find the right people, the right management team members, which is also the biggest challenge in China. When I started in the industry in the late nineties, it was very difficult to do control investments because we couldn’t find the right management team members. They didn’t exist. Today, there is a lot more talent. In about a third of the PE deals I have done, we replaced the CEO and many of the management team members. That’s much more feasible today than it was in the past. Team member selection is both the biggest challenge and the biggest opportunity in China.
McKinsey: One often-debated element of creating alpha in China is operating groups. What’s your view on the composition of operating groups, and the timing of interventions at portfolio companies?
KC Kung: Value creation is the most important thing when it comes to PE, and having operating groups is one way to create value. We follow two major principles. The first is that you should always integrate the operating group into overall deal execution. That means that instead of having an operating group that comes in after an investment is made, you integrate them early on, so they become part of the team. For example, it’s good to have the operating group involved in governance negotiations—negotiating shareholder agreements—so they have the support to do the things they want to do.
The second one is making sure that you motivate the operating group properly, so they don’t feel like second-class citizens. In many PE funds, the deal people get all the glory, and the operating group ends up sorting out portfolio problems. That model doesn’t work. Having an integrated team where the operating group shares in the upside is important.
From a smaller firm perspective, you cannot afford to have too many people in the operating group. If you hire just a few people, choose functional experts instead of industry experts because they can cut across many industries. For example, hire a supply chain expert or someone who knows online advertising; we think that’s a good way to think about operating people to start with.
Finally, you want to make sure that the operating team knows what you need in your portfolio company, and can reach out to other experts to help. In that sense, it’s no different from having, for example, legal counsel who can access the help that’s required to solve all the legal problems.
McKinsey: We’ve observed an increasing concentration of fundraising geared towards a smaller set of funds in China. How do you see this playing out, and how can funds stand out beyond their track record?
KC Kung: LPs these days try to consolidate their GP relationships, which makes sense because they become more important in the funds and accrue, for example, co-investment rights. GPs are also more likely to observe the things LPs care about, such as environmental, social and corporate governance requirements. It also makes it easier for them to manage given the bandwidth issue.
From a GP perspective, track record is extremely important, not just investment returns, but also the dispersion across deals and the types of deals the GP does. Distribution, returning money to our investors, is critical. Providing equitable compensation and motivating a team so that it remains stable is also important, along with how you communicate the challenges of your fund to your LPs so they feel that you’re a trusted partner. These are necessary conditions. In the end, if you want to be successful in fundraising, you also need one or two unique selling points that LPs can understand. For us, that is focusing on the mid-market control-buyout space, which is probably the least crowded space within PE, because most control funds in Asia tend to be much larger and are not focused on the mid-market. Most mid-market funds in China are growth or venture. That’s one differentiating factor. Another is our ability to source deals and create value. Every fund needs to come up with a unique hook, as well as fulfill the basic conditions for successful fundraising.
McKinsey: Different funds pursue different growth strategies—some are growing into different asset classes while others become more specialized. Which approach do you think generates the most opportunities?
KC Kung: The largest firms today are alternative asset managers and were originally based in private equity, private debt, or distressed assets. Despite these distinct backgrounds, their composition of assets under management now look very similar. They have some private equity, some credit, maybe some other asset classes as well. They’re in different positions in multiple geographies around the world, but they’ve all converged into this alternative asset management model. On the other hand, you have firms that are more specialized, and pursue a sectoral approach, focusing on consumer, or technology, media, and telecom. Both approaches are valid and firms that can decide and execute a strategy can succeed. Again, it comes down to deciding how you align your heritage with your growth strategy, and what you aspire to be in future. Do you want to be in every asset class, in every geography? Or do you want to be a specialist? That’s a very individual choice for PE firms. Firms that pick one and stick to it can succeed.
McKinsey: How ready do you think PE funds are today for the challenges of the future?
KC Kung: PE is a new industry in China and as a result, many funds are still run by founders, so one of the biggest challenges is managing the succession plan. Listed companies have systems in place to transition to the next group of leaders. Private firms have to figure out how to do that transition before getting into the business and the strategy. You need to make sure internally that you can hang on to your talent. From that perspective, PE is very new. Most firms within our industry don’t have that experience or expertise.
McKinsey: Will that drive LPs to put their money in funds that have a succession plan in place, and shy away from others? How do you think it might drive the landscape of funds?
KC Kung: Institutionalization is going to become increasingly important in the GP selection. LPs want a firm they know is institutionalized, and therefore will not be disrupted by HR or senior management changes. That’s something PE firms have to think through. When we talk to LPs about the equitability of the economic arrangement, about how responsibility is being shared, they understand they’re not just betting on one or two people anymore. They have to bet on a system and institution that can perpetuate itself.