John Zhao began his career in the movie business. Back in the 1980s, the founder and CEO of Hony Capital was a junior manager at Jiangsu Radio Factory, a state-owned enterprise (SOE) in Nanjing. The company was very much a creature of its era - a series of production lines gathered under one roof by local government planners, churning out a variety of goods. One division assembled first-generation PCs using imported parts; another was responsible for data transmission systems; and a third made audio systems for movie theaters.

That is where Zhao started out."The company got twisted into a few smaller pieces and was eventually moved out of the city," he says. "Those pieces still exist but they aren't very good. It's a shame I was too late to restructure them. By the time I returned from the US in 2002 they were already in that shape."

Zhao spent nearly 12 years in the US, first as a postgraduate student and then in several managerial roles. If that period equipped him with the skills to run a private equity firm and interact with international investors, working at Jiangsu Radio Factory taught him all about what would become his target market.

"I had no fear of SOEs," he recalls. "I thought most of them had very good assets, they just needed to make their system more market-driven."Impressed by the economic and political progress China had made in his absence, Zhao concluded it was an opportune time to start an investment firm. The question was how to go about it. 

Several foreign private equity firms had already made their first forays into China, with Goldman Sachs and Morgan Stanley Private Equity Asia backing Ping An Insurance as early as 1994. There was also one stand-out domestic player, the PE arm of China International Capital Corporation (CICC). It spun out in 2002 when the regulators banned securities houses from owning direct investment divisions and became known as CDH Investments Management. CDH quickly carved out a niche for itself in the growth capital space, making profitable investments in the likes of China Mengniu Dairy, China Shanshui Cement and China Paradise Electronics. The first two were IPO exits in Hong Kong, laying a path that would be well trodden by private equity investors as the decade wore on.

Creating a partnership though a frequent investor in private companies, Zhao endorsed a different approach and ended up with a very different platform. Its origins lie with Chuanzhi Liu, founder and president of Legend Holdings, the parent company of Lenovo, China's largest PC maker.

 In 2001, Lenovo and Digital China, an IT services provider, were rolled out as subsidiaries and Liu identified investment management as an area worth targeting. He set up VC firm Legend Capital the same year but wanted to take a step further.

"China had just held the 16th Party Congress at which it was declared that SOE privatization would be encouraged, especially among those operating in competitive fields," says Zhao. "Mr. Liu sensed this would be a good opportunity for Legend; I wanted to start an investment firm but wasn't sure whether to do it myself or partner with somebody. We decided it would be best for both to work together.

"Hony was founded in 2003 and Legend contributed all the capital for its $36 million debut fund, although the vehicle had a standard GP-LP structure. The firm's first transaction was unlike anything that has since followed. China's banks had been ordered to clean up their balance sheets ahead of the mid-2000s mega IPOs and so a wide range of assets - distressed and slightly less distressed - were put up for sale. Hony bought an asset management company from Bank of China complete with a portfolio of 28 equity investments."It was a one-of-a-kind deal," says Zhao. "It was done to demonstrate that Hony could quickly get into business with SOEs and make some money, and we did."

Several months later, the private equity firm secured its first proper restructuring deal with the acquisition of a majority share in mid-size flat glass manufacturer Jiangsu Glass Group for $9.7 million. The transaction was negotiated with the provincial State-owned Assets Supervision and Administration Commission (SASAC), which wanted rid of a loss-making enterprise on reasonable terms. Hony made improvements, including incentivizing management by giving executives stock, and took it public in Hong Kong two years later as China Glass. The company then embarked on an acquisition drive, consolidating its position as one of China's largest listed glass makers.

"People still talk about it because it was a classic buyout and restructuring, followed by a successful listing and aggressive rollout through organic and inorganic growth. And then the returns were very good," says Zhao. "We thought it was something we could latch onto and that these kinds of opportunities would continue to pop up. Ten years on, the majority of our assumptions have been proved true."

Heading overseas of the 70 or so deals Hony has completed to date, about half have been SOE restructuring of various kinds. They range from pure restructuring deals like Shijiazhuang Pharmaceutical, now a Hong Kong-listed firm that trades under the name China Pharma, to variations on the theme such as construction equipment manufacturer Zoomlion Heavy Industry, where the company was already an established leader in its industry but required assistance to achieve certain strategic goals. 

While the association with Legend certainly helps when negotiating with SASAC and other regulatory authorities - Zhao says structuring Hony as a Legend-sponsored platform is "one of the best decisions I have ever made" - there is a broader theme of alignment of interest and value creation.

"Once we buyout a company from the state we can focus on running the company rather than pleasing the state, which has different priorities and interests," Zhao adds. "By realigning management's interest and the company's interest we make them more interested in improving operations, introducing new technology and boosting competitiveness."

Hony's investment approach evolved as the firm grew in size. The second fund closed in 2004 at $115 million, more than three times the size of its predecessor, with international investors such as Goldman Sachs and Temasek Holdings coming on board. Two years on, Fund III represented another large step up to $580 million, but it was really the fourth vehicle, Hony Capital Fund 2008, that saw the firm establish itself as a player of significant size.At $1.4 billion, the fund was far larger than anything Hony had done before and saw the introduction of large institutional investors such as the California State Teachers' Retirement System (CalSTRS) and Canada Pension Plan Investment Board (CPPIB). But the private equity firm concurrently raised China's first-ever renminbi vehicle, which received commitments of RMB5 billion ($799 million).

With more firepower at its disposal, Hony began to support its portfolio companies in cross-border deals. Zoomlion was among the first, as the private equity firm participated in the $580 million acquisition of Compagnia Italiana Forme Acciaio SpA, an Italian construction equipment manufacturer, in 2008."Many of the companies we invested in earlier were considering international expansion," Zhao says. "It was a good opportunity for us to become a sponsor because we are close to the management teams and we also have a global LP network so there are many ways in which we could reach out. The deals also tend to be larger - exactly what we need as a larger fund - so everything fell in place naturally."

In another twist on the cross-border theme, Hony also invests in international companies that want to build up a presence in China but have neither the experience nor resources to address the market properly. Two years ago the private equity firm acquired a 29% stake in Singapore-based medical device manufacturer Biosensors International for $134 million and has since helped the company develop its distribution platform in China.

So far Hony has completed 5-6 cross-border transactions with more in the pipeline, particularly across luxury brands, high-end manufacturing and retail. Scaling up over the course of 2011, the private equity firm boosted its assets under management by a further $4 billion as a fifth US dollar-denominated fund closed at $2.36 billion, while the second renminbi fund attracted RMB10 billion, twice as much as its predecessor.

Hony now has about 180 people - including 65 investment professionals - in Beijing, Shanghai and Hong Kong and 30 more staff at its in-house consulting operation, which was set five years ago and is loosely modeled on KKR's Capstone division. The firm tends to hire people and train them up in expectation of each new fundraise.

"Our bottleneck has always been how quickly we could grow a quality team and I built the firm precisely with that as the limiting consideration," says Zhao. "Each time we raise a fund we make sure we have enough manpower to support however much capital we want to attract. And every time we hard cap the fund to make sure it doesn't get too big."

The rapid growth of the last 10 years has produced a well-known firm in what is an increasingly mainstream asset class in China. The explosion in renminbi funds - something no one in the industry predicted but Hony instinctively felt it should lead, as a strategic hedge if nothing else - is the principal actor in this. Zhao admits there have been some undesirable side effects as inexperienced managers who fall well short of global standards are carried along by the wave of private equity euphoria. But, equally, the slowdown seen in the past 12 months is expected to root out the underperformers.

"China is becoming a capital surplus country and it is better for these funds to be professionally managed rather than controlled by the old institutions," Zhao says. "Private equity has proved it can be a useful force and now we stand before a huge opportunity: China is entering a massive phase of restructuring and it also needs to improve management quality to become a strong global player."While private equity and Hony in particular are expected to play an active role in this process, the firm's sheer size and name recognition is a benefit but also a burden because it implies closer scrutiny.

On one side, Hony must fulfill the exacting compliance standards of large North American institutional investors; on the other, it is operating in a market that still has much in common with the Wild West."From day one, I was focused on building an institution that would last forever," Zhao says. "Strategy is important, focus is important. Reputation is everything. As we grow and have more impact, stepping on people's toes - unconsciously sometimes - we need to be more mindful about our public profile."