John Zhao founded Hony Capital as part of Legend Holdings, one of China 's most famous companies which grew out of an early foundation building DOS compatible computers in China . In 2002, Legend wanted to expand its work in investment management, following on its earlier founding of Legend Capital. Zhao and Liu Chuan Zhi , the founder of Legend Holding s decided to form a domestic private equity or buyout fund for China .

Zhao grew up in Nanjing , China , where he also attended Nanjing University , before going to work for a state owned enterprise in China for three years, after which he went to the United States to earn an MBA at Northwestern's Kellogg school. He remained in the United States for fifteen years, in various management and operations roles for technology companies. Zhao began at Shure Brothers, which makes audio products. In 1995 he joined US Robotics, then a famous maker of computer modems, as a Vice President and General Manager for two and one-half years. When that firm was acquired by 3Com, Zhao went to work in Silicon Valley where he began working at a couple of VC-backed tech companies, including Vadem (a maker of single-chip computers ), Infolio, a mobile software company and others. In 2002, knowing the opportunities that lay in his home country, Zhao returned to China .

We've been writing about John Zhao and his firm for several years now; he attracted our interest in 2003 the first time by telling us that he was investing in state-owned enterprises at a time when every investor in the United States was telling T&I that they wouldn't touch such opportunities. We caught up Zhao in Hong Kong in one of his non-stop, meeting jammed days.

T&I : Given your investment pace on the third fund, you're on the kind of 18 month investment cycle that we're seeing in China 's most active funds such as CVC, Baring Private Equity Asia or SAIF Partners.

JZ : We do have a five year commitment period in our LP agreement but we were well prepared to invest money from Fund III. I don't like to make big statements about what we're trying to do and which we can't realize, so the pace is faster than we had conservatively planned, but that is a good thing. But we'll most likely be fund raising again by the end of 2008 to 2009.

T&I : Your investment thesis is still based on privatizations of state owned enterprises?

JZ : When I began I thought that the commercialization of state owned enterprises (SOE) was a worthy opportunity. Worthy because there is a need and the country was advocating the diversification of the shareholdings in its state owned companies so that they would be more market driven. So I knew that there would be macro support for commercializing companies. It's worthy because most managers, while great in manag ing operations, have not been exposed to global strategies or in sophisticated financing in which Hony Capital has a lot of experience. So we can hand hold these managers and help them develop. Our concept was worthy because the economy is growing so fast, so that if you do your job right, you make a reasonable return for your work. And finally, this work fits in with my own background as an operating manager of companies. I've always thought that my experience can help our managers become better managers.

T&I : To date you have how many portfolio companies?

JZ : To date we have made twelve investments all in mainland China . And we'll continue to focus on companies in mainland China .

T&I : What market sectors are you investing in?

JZ : We invest in three major sectors: pharmaceutical, construction related, consumer and consumer channel related companies. But we're also looking at media, alternative energy and other areas.

T&I : Exits or realizations to date?

JZ : Fund I is fully invested but we're only partially exited with 150% of all capital invested already returned. We still have some public holdings that we don't want to sell because they're still appreciating. A lot of the value added service that we provided to the companies is just starting to show. From Fund II we have six companies, four of them are public already, and one will go public next year.

T&I : What companies are those?

JZ : Simcere, listed on the NYSE. Solarfun, listed on Nasdaq. Zoom lion , a Shanghai listed firm that makes construction machinery . China Fiberglass, which is another A share ( Shanghai ) listed firm.

T&I : And for Fund III you've made how many investments.

JZ : We've announced three. And the pipeline moving forward is very good.

T&I : How many of the firms to date have been state owned?

JZ : About half of them, the rest are privately held companies that were growth capital investments.

T&I : Looking forward to your next fund, will it continue to be a Caymans domiciled fund or a domestic renminbi fund?

JZ : We are looking at the possibility of starting a Ren min bi (RMB) fund, because we're such a China focused investment manager and we need to have a domestic product. But we'll continue to raise US dollar funds.

T&I : Many people are still coming to grips with the need to establish RMB funds.

JZ : We are as well. The government has put together a legal and regulatory framework that provides a basis for domestic managers to manage domestic LP's money. But we're at a very early stage to be talking about foreign LPs doing the same, as the laws are still coming out and they're subject to interpretation that makes the outcome very unclear, and everyone is faced with uncertainties. Having said that the macro-trend to RMB funds is very clear and we'll get there, so as long as that is the case, we want to be one of the first funds to be there raising a domestic fund which will have foreign LP participation. It means we have to deal with more of the uncertainties that there are in China , but I am comfortable that we'll get there.

T&I : We hear from some funds, such as Qiming, founded by former Intel VC staff, who have had a very difficult time over the last six months in getting two investments approved. What has your experience been?

JZ : It really depends. Some are approved very quickly. Some complicated deals take longer. Six months doesn't sound too bad to me for two deals. This is China , people are trying to do the right thing, and sometimes it just takes a bit longer to get everything done.

T&I : Given an end of '08 time frame for your new fund, many of these issues will have been resolved.

JZ : I certainly hope so.

T&I : Let's talk about deal valuations in China . It's hard to believe, living and working in Asia, that there are foreign funds coming here and spending amounts on $15 and $25 million dollars on A and B rounds that match investments rounds in the United States .

JZ : In the SOE and restructuring space, we have started to see more competition, but so far, price has not been a determining factor, not because of us, but because the selling shareholders in the government typically have a different set of considerations than privately held companies who are seeking investment.

T&I : So you escape some of the upwards pressure that other firms see in this market?

JZ : Yes. When you're talking about restructuring state owned companies, the government has a lot of issues to worry about. Social stability. Unemployment. So they're looking for credible investors that can take on their companies responsibly, at fair prices, and they're looking for investors who have the experience, not just the desire to invest in these companies, so that price is a consideration, but not the only consideration in these companies and it shouldn't be.

T&I : One of the concerns about the sale of state owned assets and companies in China at the moment, is the fear that these companies are being sold for too little money.

JZ : Yes. Everywhere. And the government should be worrying about pricing these assets correctly. The tendency to believe, however, that each and every deal is undervalued is wrong. I would be worried about over-valuing state owned assets, because a lot of the time, state-owned assets value is nowhere near the non-state owned asset value. I think that SOE investing is frequently situational, that each deal depends upon each company, and that is normally a consultative and negotiated process between the seller and the buyer, as it should be.

T&I : One of the great fears of foreign investors in investing in a SOE is that entrenched management is also poorly qualified management.

JZ : That is generally true. A lot of the SOE managers have been in a different system. They don't have a lot of common language with foreign investors. I think that suggests two things; one, management at these companies needs to improve and two, the investors, foreign investors, who are accustomed to foreign investment practices, also need to improve, to learn more about Chinese companies and practices. It's not correct to say in every case that just because a company is a state owned enterprise that the quality of management is low, I don't think that is the case. As a matter of fact, we've found that some of the managers, managing SOE are some of the best managers. And that makes improving the shareholding structure worthwhile, because after all they are the ones that we have to rely upon to run a business once we have become shareholders.

T&I : You haven't had to replace management teams to date?

JZ: We have not. As a matter of fact we're very careful. If there is a remote probability of that being the case then we pass on that investment.

T&I : Who are your competitors for deals?

JZ : I don't know. Seriously. I don't run into many competitors in state owned deals. That's the truth. Now private equity growth deals, that is a different story where we run into all of the normal names.

T&I : What is the price range for deals that you make today in the growth capital arena?

JZ: We're investing in the $20 million to $100 million deals.

T&I : So you see who?

JZ : I don't mention names, but it's the normal who's who.

T&I : Going forward, where do your exits come from?

JZ : Because the majority of the companies that we invest in are very much Chinese companies, serving Chinese customers, growing with the Chinese economy, our preference obviously is to list them on the domestic market. Before, we didn't do that because before share reform the domestic market was not a true market. When I say true market, I mean that it lacked governance and true transparency, not just fund raising. Now with the reform, the A share market is a true market, so that our preference now is to exit on the A share market.

T&I : Unless you're doing a really big deal in which case you'd go to the HKSE?

JZ : Even for a really big deal, we prefer the domestic market. But size is not the primary reason why we advise our companies where to list. Need is. For instance, we have companies that are absolute leaders in China already. If they need to go to international markets, to export more products, or to acquire foreign subsidiaries, then we think they should be a foreign listed company. [A foreign listing] that provides them with foreign currency, more credibility and better governance.

T&I : Your investment geography? Where do you invest?

JZ : W e only invest in China , so far . Within China we look everywhere, but we typically find ourselves investing where we find the investment climate is the best .

T&I : But today most of your portfolio companies are located?

JZ : In the Yangtze River Delta area and in some of the middle provinces.

T&I : So you're already a step removed from the coastal areas?

JZ : Correct. We don't have any investments in Shanghai or in Tianjin .

T&I : What is your impression of foreign investors, names like KKR, about which we hear so much and about their arrival in China ?

JZ : Frankly we don't bump into these firms but we know these guys. We have good relationships [with them] and we try to find ways to work with them, because they have a lot of good experience and resources that we may not have. On the other hand, we are investing in China so we do have advantages in dealing with Chinese situations, so it makes sense to team up . W e're looking for opportunities to team up with everybody to do deals.

T&I : Have you done co-investments to date?
JZ : Yes we have. But, we tend to want to lead our deals; we're a lead and a control investor. We always take a board seat.

T&I : And in terms of how closely you work with your portfolio companies?

JZ : It depends upon the investment on the company on the project, but we're there a lot.

T&I : Wrap up with your outlook for deals in China over the next six to eight months.

JZ : The private equity market in China is a great market, but it's in its early stage. Great because its potential makes it one of the fastest growing markets in the world over the next five to ten years. I say it's early stage because you have a lot of challenges; the regulatory environment, the legal framework and the entrepreneurs are not as well educated as they are in developed economies. There is too much money rushing into too many inexperienced managers. Everything that you see in developing economies everywhere. Growing pains. That is the phenomena for the next five to ten years. The market is growing, a lot of commotion and a lot of good returns that will attract a lot of new investments to come.

T&I : Your advice for LPs who want to invest in GPs here?

JZ : Go back to fundamentals. Do your due diligence. Find the best manger you can with good track records and then let go.

T&I : But I keep hearing that there are no track records for managers with available commitment allocations?

JZ : There have been about five years of investments in venture capital and buyouts now.

T&I : Yes but LPs have a hard time getting allocation into Sequoia in the US , let alone in China .

JZ : Well then they have to be a bit more creative, maybe take on a bit more risk and expecting more return.

T&I : In other words, investing in emerging managers?

JZ : Yes, in private equity or buyouts, which are very local businesses. There is nothing wrong with betting on local managers in those areas.

Thank You

T&I