In this episode of China Money Podcast, guest Derek Sulger, co-founder of Lunar Capital, discusses why he likes to take controlling stakes, how he manages to return capital to LPs at a satisfactory rate, and the reasons behind his passion for baby apparel.
Listen to the full interview in the audio podcast, subscribe to our podcast in iTunes, or read an excerpt.
Q：Can you first give a brief introduction of Lunar Capital?
A: Lunar Capital is a private equity firm headquartered in Shanghai, with 30 investment professionals primarily located in Shanghai and Chengdu. We also have an office in Hong Kong. Our focus is middle-market private enterprises that are in the consumer sector and where we can take a large or majority controlling stake. We then use our experience as entrepreneurs and professional managers to add value to the company.
Q: Last year in 2011, you completed two exits through trade sales (selling to a strategic buyer). Since the IPO market essentially closed for Chinese enterprises, private equity firms in China have been desperately searching for alternative exits such as trade sale or secondaries. Already, private equity-backed mergers and acquisitions have increased 53% compared to last year. Why did you initially not focus on IPO exits?
A: We like the idea of building good businesses, meaning companies that are profitable, growing and have real value to future shareholders. Whether that future shareholder is an individual who buys shares of our companies in the public market, or a strategic acquirer, it does not matter.
We have always been relatively indifferent between IPO exits and trade sale exits. I think it's a great thing for China that an M&A culture is evolving. That means we can be on both sides. Aside from the two strategic sale exits in 2011, we also acquired majority shares of two companies in 2012. And we are in the process of acquiring a few more that will either be closed this year or early next year.
Q: So, what are some advice and lessons that you can share about selling to Chinese strategic buyers?
A: I think people have to just use common sense. That means focus on margins, profits and sustainable growth. Often in China, people get into these really outstanding growth rates, but they never asked themselves: Are these growth rates sustainable?
I would personally much rather invest in a company with lower growth rate but that is sustainable over ten years, than a higher rate growth that may only be sustainable for one or two years. I'm an enormous believer of the compound effect of slow growth. In China, slow growth might be 15% or 20% a year. But that is a phenomenal opportunity when compounded over several years.
Q: Valuations can often be tricky in China because of expectation gaps between sellers and buyers. What's your experience in handling valuation negotiations?
A: In our case, valuation has not been complicated because most of our companies are profitable businesses in well-understood sectors. Last year, we sold a beverage business called Beihai Perfuming Garden. There are comparable companies that are publicly-listed, or are acquired by multinationals and domestic conglomerates. So the valuation was straightforward.
But you see irrational expectations when the company is not profitable and/or in newer industries. Those businesses are inherently more difficult to value. An entrepreneur might think it's worth millions of dollars, but there may not be a community of potential acquirers who can value that business or are willing to pay a premium.
Q: Your original plan was to complete three exits in 2011, but only two were completed?
A: Yes, there is still one exit that we are working on, which we are hoping to close this year. But we are running out of time.
Q: Is that a reflection of the difficult market environment, or anything specific relating to this company?
A: I would say it's more specific to the way China's M&A is evolving.
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