Sweet as Hony

Tim Clissold, a Briton whose memoir Mr China describes how a US private equity firm lost over US$400 million (HK$3.12 billion) while investing in mostly state-owned companies, talks of a "whole business landscape littered with the wrecks of failed joint ventures.''But for John Zhao, a Silicon Valley returnee in his early 40s who is chief executive of Hony Capital, investing in state-owned enterprises is a "historic and secular opportunity.'' Hony got its seed capital, 300 million yuan (HK$288 million), from its parent, Legend Holdings, the flagship enterprise of the Chinese Academy of Sciences and a power in China's high-tech sector.A second round of fund-raising brought in 725 million yuan as investment bank Goldman Sachs, Temasek, a Singapore government investment vehicle, and Hong Kong's Sun Hung Kai Properties and its principal owners, the Kwok family, came on board.Zhao prefers to focus on mature industries, ones where many firms are competing for a highly fragmented market.He likes to buy one of the better firms, restructure it, list it on the stock market to raise capital, and use the funds to build an industry leader through mergers and acquisitions.

Zhao already has one success to his credit. Or half a success, at least. In June, China Glass, a Jiangsu province float glass factory Zhao invested in December 2003, was listed on the Hong Kong bourse after raising HK$196 million in an initial public offering.

Now, Zhao is hard at work trying to achieve the second part of his ambitions for China Glass, flying around, meeting managers of other mainland glass factories in hopes of identifying those that are ripe for takeover.

It's a time-honored capitalist strategy. The late-19th century American robber barons who built empires like US Steel and Standard Oil did it in much the same way, by patching together disjointed industries.

What's novel about Hony Capital is its targets - SOEs that many people in the private equity industry in China would just as soon forget about.

Since China began to liberalize its centrally planned economy, SOEs have stood by mostly powerless as private companies gnaw away at their market share. Their ability to respond is severely hamstrung by the need to provide for the life-long welfare of their too numerous employees, and to refer all important decisions back to Beijing.

``While many managers of SOEs understand they have to change with the times, it is impossible for them to do it themselves,'' Zhao says.

Managers of SOEs have no power to hire or fire their deputies, who, like all managerial level staff, are appointed by the personnel directorates of the local Communist Party organizations.

Even if they come up with good profit-making ideas, he adds, they may not get the money to apply them.

State-owned banks are usually their only channels of funding, and even they are wary of lending to the less profitable SOEs for fear of adding to their heavy burden of nonperforming loans. China Glass was suffering from just such problems when Zhao and his colleagues zeroed in on it.

``The management of the company was actually quite competent and they knew what to do. But without external help, they could do nothing,'' he says.

When Hony bought the controlling stake in China Glass from the government, management was finally able to break free of the state bureaucracy.

The fresh capital and managerial best practices that Hony introduced allowed China Glass to upgrade its equipment and improve its corporate governance, while introducing worker incentive programs geared to performance.

The company was registered in Bermuda prior to its listing in Hong Kong. To increase motivation, management was given a 13 percent stake in the company and stock options, too.

With the proceeds of its IPO, China Glass plans to build a third production line and begin acquiring other float glass factories in the mainland.

The glass industry isn't Zhao's only interest.

Hony has also invested in an automobile component factory in Jinan and acquired a conglomerate that had been taken over by Bank of China, one of the big four state-owned banks. (It also bought into two privately owned firms, one producing kitchen cabinets and the other seeds for rice and corn.)

Meanwhile, Zhao's team of investment managers has more than 10 other companies under the microscope as possible investment or acquisition targets.

So far, Hony has spent all its initial seed money and 25 percent of what it raised in its second round of financing.

Zhao is confident that once 70 percent of the second installment of funds has been committed, he will have no trouble persuading investors to ante up more cash. Hony Capital is up to its neck in an area of China investment that many of its peers shun.

Hanson Cheah, currently managing partner of AsiaTech Ventures, a veteran of 15 years in the private equity field, would rather forget his early days in China, and the SOEs he invested in 10 years ago.

``SOEs are difficult for foreign investors to understand,'' says Cheah. ``For one thing, they are not profit-oriented.'' Many put their social responsibility to employees ahead of shareholder interests. ``Before investing in one SOE, we had to make sure the government would agree to take care of 600 or 700 redundant staff,'' he recalls.

Equally frustrating was the fact that the company he worked with at the time was usually a minority shareholder in a complicated joint venture.

Essentially, it was expected to hand over its money and wait while management carried on business as usual. The early payback or exit strategies - initial public offerings, for example - that were supposed to reassure investors concerned about being able to get their money out never materialized.

Cheah declines to talk about what happened subsequently to these SOEs. ``I left that investment firm, and I've been investing in technology startups ever since.''

Another private equity player that has found it hard to make headway in the mainland is Peak Pacific, whose major investor is US-based Alliant Energy International.

Alliant is trying to unload its stake, discouraged by the rising coal and oil costs of the past two years that Beijing won't allow power plants to pass on to customers.

All of Peak Pacific's generating companies are in the red. ``The government won't let us increase electricity rates,'' says Kent Carter, senior vice president of mergers and acquisitions at Peak Pacific. ``I never thought that would be possible, freezing the rate for so long.'' Since 1999, Peak Pacific has invested US$180 million in nine power plants. Before finding those nine, it investigated 250.

In two cases, it pulled the plug on its investment prematurely. ``For one of the companies, our customer, who was also our Chinese partner, refused to pay,'' says Carter.

In another case, the Chinese partner/customer demanded a renegotiation of the electricity rate just a month after the joint-venture agreement was signed. ``That was not a good sign. We wanted to be out.''

Luckily for Peak Pacific, it was able to recoup its initial investment in both cases with the help of the local government. ``But we wasted a lot of time and manpower - one year of negotiation for each case,'' says Carter.

Even as sole or majority owners - Peak Pacific wholly owns two of its power plants and is majority partner in the rest - foreigners must live with compromise when investing in SOEs, according to Carter.

``Being the majority owner gives you the legal right, but in practice, you cannot make all the decisions. Not all the time.''

Cutting headcount would be out of the question in many places. If a company is drastically overstaffed, Carter prefers not to invest in it.

What control there is is generally in the area of finance. ``We always appoint the financial controller to ensure good reporting and high-level control. We prefer appointing the general manager, too. But usually, the existing one is the most suitable.''

The general manager is a key figure from the outset, usually representing the seller in takeover talks. ``If the current general manager didn't want us to come in, it would be very difficult,'' says Carter.

The situation is nothing at all like the West, where purchasers can replace the existing management if they choose.

Over the years, the central government has gotten more willing to relax its control of SOEs, giving investors a freer hand to restructure what they bought. What Hony did with China Glass is an example of that.

Hony is no ordinary private equity firm, however. Its parent Legend Holdings not only has impeccable government connections through the Chinese Academy of Sciences; it also controls Lenovo, the mainland computer maker that made its mark on the world stage by taking over the PC division of IBM this year.

In 2002, the National People's Congress issued a directive encouraging SOEs to seek private funding.

In 2003, Legend president Liu Chuanzi recruited Zhao to run a unit specializing in SOE investments, later spun off as Hony Capital.

How does Zhao get access to SOEs, and how can he distinguish the good from the bad? How does he convince banks to finance his buyouts? How is he able to control the companies he invests in? Certainly, Zhao is a powerhouse in his own right.

Born in 1963, he earned an MBA at a top American school, Northwestern University, and held senior management posts in a number of American high-tech companies, including US Robotics. His wife and five children still live in San Francisco.

Helping him at Hony is a staff of about 20 experienced investment managers, a third of whom are overseas returnees like himself.

Still, Zhao admits that he would probably not have been able to achieve what he has in such a short time had he not enjoyed the backing of Legend. ``Legend Holdings opens a lot of doors,'' he says.

He had no problem, for example, getting mainland banks to help him finance the China Glass deal. All those holding the company's debt at the time agreed to stay on. In another of his deals, the banks agreed to refinance the firm's debt at a lower rate of interest.

Most of Zhao's competitors can only dream about such advantages. Leveraged financing for private equity deals is almost unheard of in China, says Cheah of AsiaTech Ventures.

However, China won't have fully demonstrated its commitment to SOE reform until the day that a private equity firm without favorite-son status is allowed to do the same thing that Hony did with China Glass.

Where there is one, others will be sure to follow, says Zhao, and the result will be a much faster process of reform and a better deal for everyone. ``All three parties - investors, employees and society - will be the winners.''