Inside Perspectives: An Interview with Yichen Zhang of CITIC Capital

Yichen Zhang is the Chairman and Chief Executive Officer of CITIC Capital, an alternative investment management and advisory company with over US$4.5 billion of assets under management across private equity, venture capital and real estate. Yichen Zhang reflects on the history of private equity in China and shares his perspectives on what he sees as some of the biggest challenges and opportunities facing the industry.

The private equity industry in China has undergone a profound evolution over the last decade. Having increasingly commanded the attention of both international and domestic investors, fundraising reached a peak in 2011 when China-dedicated vehicles raised US$19 billion and accounted for 44% of total capital raised for emerging markets. Since a moratorium on new listings on the country’s public stock exchanges was put in place in 2012, however, fundraising activity in the country has declined. What are some of the biggest lessons learned during this period?

The private equity market in China was initially dominated by offshore funds as international LPs looked for a way to access the country’s growth. This lasted from the early 2000s until roughly 2009, when capital raised by local currency (RMB) funds overtook funds denominated in dollars, marking the beginning of a boom in RMB funds that lasted until 2012. During this period, growth capital was the most popular strategy in China due to two main factors: first, with the economy growing at a tremendous rate, most entrepreneurs only needed capital to expand their companies, and so they were hesitant to give up a significant amount of equity. Second, many private equity investors didn’t need to do much beyond providing capital to achieve high returns, as they were able to take advantage of considerable private-to-public arbitrage, with private multiples floating around five to six times P/E compared to public multiples of 20 times P/E.

Private equity is still a relatively new phenomenon in China, and the history is too young for me to say definitively whether the industry has fundamentally changed—but there is a nascent shift occurring in the private equity market as the economy evolves. In the last two years, growth has slowed and the IPO market in China has been suspended, putting a significant damper on growth capital investments and causing many people to question the sustainability of the industry’s reliance on public markets for liquidity.

Many economists argue that recent reforms introduced to reduce the level of debt in the Chinese economy and rebalance away from a reliance on government investment to power growth will invariably lead to a prolonged slowdown in the Chinese economy. How can CITIC Capital, and the private equity industry in general, remain competitive in this environment?

CITIC Capital has always focused on value creation and we do control deals whenever possible. Our focus on controlling stakes comes from our team’s background in the U.S. buyout market and our ability to work with the government in China. Private companies, by and large, were not for sale when CITIC Capital was established in 2002, as almost all the private businesses at that time were run by first-generation entrepreneurs who were loath to sell equity in a high-growth environment. Given the prominence of CITIC’s name in China, however, we were able to make control investments in the privatization of state-owned enterprises (SOEs). Moreover, competition in this area was limited, as many international firms encountered difficulties when trying to buy stakes in SOEs, a process that is often highly political.

In addition to limited competition, what have you found to be some of the main benefits of a buyout strategy in China? What are the primary challenges?

In developed markets, in general, and in the United States, in particular, investors tend to evaluate two aspects of a company separately: the asset itself, and the people managing the asset. This is based on the fundamental assumption that if you take control of the company you have the ability to remove the management if you deem it necessary to do so. In China, like many emerging markets, this is not always the case, and managing a company after an acquisition can be difficult. There is often a strong connection between management and the asset, and if an investor tries to separate the two, the result could be a great deal of value destruction. We work very hard with management to ensure that interests are aligned.

Focusing on control deals has also enabled us to cultivate more diverse exit channels, which helped us as the public markets cooled. Last year, we successfully sold two companies, an auto-parts company and a leading candy company, to domestic buyers in China. These exits were made easier for us by our controlling position in each company, which gave us control of the sale process.

Previously, you worked in debt capital markets for Merrill Lynch, and CITIC Capital is active in both debt and mezzanine financing. Could you speak to developments in the local credit markets in China and CITIC Capital’s strategy in this space?

Private debt markets are hard for new entrants to break into, as a lot of the debt investments we structure require significant expertise and knowledge of the local regulatory environment. Many different players have tried and failed to enter this business as the rule of law in China doesn’t always function as well as in developed markets, and enforcing your rights as a creditor is generally difficult. Given that most of the borrowers are private companies that otherwise can’t access any debt funding, they won’t try to defraud us unless they are truly out of money.

A lack of debt financing is often cited as an inhibiting factor in the development of a buyout industry in emerging markets. What has your experience been in tapping local credit markets for leveraged finance and do you see a rise in support for private equity deals among local lenders in China as buyout strategies become more popular?

Financing for our buyout deals has largely come from foreign investors. The debt for our recent take-private investments in Focus Media and AsiaInfo-Linkage mainly came from international banks, though some of them ended up syndicating a lot of the financing to Chinese and Taiwanese banks. The leveraged finance business remains underdeveloped in China. Up until now, Chinese banks have been comfortable sitting on greater than 3% net interest margins from their secured lending business, and have had little appetite to take on more difficult deals that require a higher degree of expertise. We are seeing an increased push for cash-flow-based lending, which is the basis for a lot of leveraged finance loans, and we had several Chinese banks wanting to take the lead on some of our deals.

Though the Chinese economy is over-levered on the whole, debt levels are not sufficiently high to signal a point of crisis or imminent collapse. People are right to be concerned, given the speed at which debt levels are increasing while growth in the economy slows, but the Chinese government recognizes this and is taking steps to resolve it. It is important to remember that most of the lenders and borrowers in China are state entities, and the central government has a high degree of control over them. When you have the left pocket lending to the right pocket, you can control the pace at which you recall these loans, and thus can avoid triggering a potential domino effect. Though GDP growth is slowing, it is still around 7% and tax collection is increasing at an even higher pace, leaving the government with many resources to repay its debts. We will likely see a gradual deflation of the credit bubble, rather than a pop.

One important reform that could go a long way toward resolving the debt issue would be to revise the national budget law to allow local governments to run a budget deficit, and to facilitate the development of a municipal bond market. A lot of local government debt is in the form of short-term, one- to two-year loans from banks. This capital, however, has been spent on longer term infrastructure projects, creating a maturity mismatch. If the central government were to allow local governments to issue 10-year bonds, this would extend the maturity of local debt and would lower the debt repayment burden per year, enabling governments to pay down debts through tax revenues.

Many people tend to focus too much on local government debt and ignore the more worrying corporate debt, especially debt held by SOEs. Many SOEs made sizable capital expenditures in the cement, steel, and other heavy industries, which now—given overcapacity in these sectors—likely lie redundant. This is a bigger concern, and is one that will take years to work out.

The venture capital industry has recently seen a surge in activity and last year CITIC Capital closed its first venture fund, CITIC Capital Venture Partners. Where do you see the opportunity in the venture capital space in China?

Much of the increase in venture capital activity has been in the internet space. This segment of the market is growing very rapidly and some companies established only around 15 years ago, such as Tencent and Alibaba, already boast market caps to rival the likes of Facebook and There is also huge consolidation taking place in many traditional industries as companies embrace new internet-based business models. CITIC Capital’s venture fund will focus on internet-related companies, clean energy and cleantech companies. Cleantech will grow tremendously over the next few years as the Chinese government mobilizes considerable resources to promote technologies to deal with some of the critical environmental challenges the country faces.

CITIC Capital recently made headlines by purchasing stakes in two U.S.- and Canada-based companies. What is CITIC Capital’s strategy in North America and how does this relate to its business in China?

We have been investing in the United States for over ten years and have made approximately 14 investments in the region. We tend to focus on deals where we can add value as a partner by helping our portfolio companies unlock their potential in China. One of our recent investments, Engineered Controls International (ECI), makes highly sophisticated valves used in the transportation and storage of liquefied petroleum gas. China has a huge pollution problem with 70% of the country’s primary energy coming from coal. The government is trying to increase the use of gas and therefore the growth potential for ECI in China is tremendous.

Finally, which book are you recommending to your friends this year?

The Power of Habit by Charles Duhigg. The anti-corruption campaign currently raging in China is a colossal exercise in changing habits, which will be interesting to observe over the next few years.