Domestic private equity firms in China, hitherto unable to compete with better-funded foreign rivals on larger deals, are nevertheless hoping to match their rates of returns by adopting a lower-cost investment strategy - buying out and turning around struggling state-owned assets.

``The government's continued privatization of SOEs gives investors a lot of opportunities,'' said John Zhao, chief executive of Legend Hony Capital, a private equity firm specializing in corporate buyouts. ``The key is to be able to add value to the businesses.''

One of five companies in Hony's portfolio is China Glass Holdings, a former state-owned glassmaker, which raised HK$196 million in an initial public offering in Hong Kong last week, less than two years after it was bought out by a consortium of investors led by Hony.

Hony improved corporate governance and expanded production capacity through the addition of a third assembly at the Jiangsu-based glassmaker before taking it public, Zhao said. Apart from China Glass, Hony's portfolio includes four other companies in the pharmaceutical and vehicle parts sectors.

Hony has completed two rounds of fund raising since starting operations in 2003, attracting more than 1.2 billion yuan (HK$1.1 billion) in investments from Goldman Sachs, Singapore-based Temesek, Sun Hung Kai and its parent Legend Holdings, which also controls personal computer manufacturer Lenovo Group.

``Domestic private equity firms believe they could do a better job [on deals involving SOEs] because they have a better understanding than the international investors,'' said Vincent Chan, managing director of JAFCO Asia.

Private equity investments in China jumped by 17.5 percent last year to US$1.27 billion (HK$9.9 billion), according to Thomson Financial, making the mainland a relative backwater in the world market.

Transactions worldwide, involving private equity outfits totalled US$76.3 billion in 2004.

Early stage investments in mainland technology companies by global private equity giants such as Newbridge Capital and Carlyle Group, rather than buyout deals preferred by Hony, currently account for the bulk of the deals done on the mainland.

China 's underdeveloped debt markets means domestic players simply lack the financial muscle on the larger and more lucrative deals. ``Leveraged financing for venture capital or private equity is almost non-existent in China , particularly after the macro economic measures to cool the economy,'' said Hanson Cheah, AsiaTech Ventures managing partner.

Beijing has imposed stern measure this year to temper runaway growth.

The lower costs of buyout deals involving SOEs nonetheless present a different set of challenges. ``There is a tremendous amount of management work that is needed to restructure the companies. There are many sacred cows within the SOEs that one cannot touch, which further complicates the restructuring,'' Cheah said.

Hony's Zhao said Legend Capital, a private equity firm controlled by Legend Holdings, specializes in technology investments while Hony focuses on investing in more mature industries.

Legend Capital has attracted about US$105 million in funding.

``Hony focuses on buyouts, whereas Legend Capital is a venture capital company focusing on emerging technologies,'' Zhao said.

``In buyout deals, we target companies with strong cashflows, but venture capital investments are more concerned with a company's growth,'' he said.

However it seems likely firms such as Hony must continue to rely on non-debt financing in their efforts to turn around the operations of their portfolio companies.

``For domestic banks, it is still hard for them to fully understand financing based on pure cash flow without asset collateral, and a parent's guarantee,'' JAFCO's Chan said.

Apart from Hony and Legend Capital, Legend Holdings also has a 25 percent stake in Beijing Gao Hua, a securities firm run by mainland banker Fang Fenglei.

Beijing Gao Hua in turn has a two-thirds stake in Goldman Gao Hua Securities, a mainland investment bank joint venture with Goldman Sachs.

Legend Holdings president Liu Chuanzi, the former chairman of Lenovo Group, said Legend's growing interests in financial services are part of the group's diversification strategy. ``The IT industry can be high risk, and we want to balance our exposure in the sector with the new businesses in the interests of our shareholders,'' he said.

Legend Holdings is 65 percent held by state-run Chinese Academy of Science.