Buyout with Chinese characteristics could be the catchphrase for Legend Hony Capital's approach. The firm was set up 18 months ago, supported by China 's Legend Group, now owners of IBM's PC division (see AVCJ Dec 20). It exists, in the words of CEO John Zhao, “to capture the Chinese buyout opportunity,” a mission he does not take lightly (see AVCJ Dec 13). “When I say buyout, it means two things. It means we pretty much adhere to the classical buyout business model, but it also means that we are carrying a special responsibility: that is, to make the clsssical model work for China .”

Fund structure and strategic planning

Zhao' young firm is backed to the by Legend Group and some of the region's top investors: Temasek. Goldman Sachs, Sun Hong Kai. But Zhao admits that it will be some time before it can prove that it merits their support.

“It's too early to tell,” Zhao told AVCJ. “I really don't want to give the impression that we're a hugely successful fund. I don't think that anybody could suggest that when we're only 18 months old. But I do want to say that we gave it a lot of thought before we started the fund, and then before we started each deal we had very detailed plans, and so far all the investments we made are within the expectation range. In that sense, we're successful, and that's demonstrable. It's because of that that we had such a good time fundraising.”

Zhao and Legend Hony's founding team spent around a year on planning and preparation before beginning active investment. “The strategic formulation period took a year. It was very important for us,” Zhao says. “We visited some 23 cities: not for deals, just to see if … the kind of business we wanted to pursue was there.”

Legend Hony operates two buyout funds: Hony 1 and Hony 2. Hony 1 is a RMB 300 million ($36 million) fund, already fully invested into three investments. The second fund, closed in late September 2004, is a RMB 725 million ($88 million) fund.

“We invest in what called mature market and developed companies,” Zhao explains. “Average size is about $100 million, and we do take control positions, just like any buyout guys. These are all very nice cashflow-driven deals. These are not easy deals; they are deals that tale a lot of work to make them work, which is very much suited to our value creation mandate.”

Market environment and home advantage

Legend Hony has already distinguished itself in one way: it appears to be sourcing good deals and executing well in China's nascent buyout market while its international peers still struggle to find a footing (see AVCJ Dec 6).

“Anybody who participates as an investor is basically exploring a new opportunity” Zhao explains. “Buyout is a craft that has been perfected in Western markets. Now we are seeing its attempts to function in Chinese markets. My conviction is that it needs to be suited for the Chinese situation/”

For Legend Hony, this means targeting SOE restructuring as a major opportunity. It means targeting pharmaceuticals, auto parts, construction materials, and later healthcare, restructuring. It also means learning to restructure debt.”

“One of the very common things if you look at any of the state-owned companies, they're loaded with debt.” Zhao explains. “It's a debt by permission of government, which says, just park it on your balance sheet, don't pay interest. But then you can't write it off. There are debts that have been there for 20 years. Well, if you're a buyout guy that wants to restructure debt, what better opportunity can you find?”

Present and future prospects

The result, as Zhao says, is “so far, so good.” He sees no lack of opportunity. “I do enjoy the luxury of having abundant dealflow. If there is any problem we have, it's not lack of deals.”

However, he looks to the long term for real validation, in line with:”our development goal, which is mid-term to long-term. There are three elements. One is obviously that we want to produce a superb return for our limited partners. Secondly, along the way we want o create, train, and retain the best buyout investors. Thirdly, we want to build a culture that will allow us to sustain ourselves and continue, just like some of the successful private equity firms that exist today. They're 100 years old and still going strong.”