Month: September 2008

Why Wall Street rules rule in China Private Equity Deals

Quite possibly, these have been the two toughest weeks in the history of Wall Street. Two of the largest, most well-established investment banks (Merrill and Lehman Brothers) have been shattered by losses in mortgage and derivatives markets. Two others, Goldman Sachs and Morgan Stanley, are now converting to traditional bank holding companies. Other banks are teetering, and the stock market itself has experienced some of its largest one-day losses ever. 

Amid all the change and turmoil, it’s worth remembering just what makes Wall Street so central to the world’s financial industry. The US capital markets are both the largest, and the most liquid in the world. This is no less true today than it was a month or a year ago. As important is the fact that Wall Street has developed, over the last 70 years, a set of rules, procedures and best practices for raising capital.   These have become the de facto global standard. Put another way: Wall Street rules rule. 

I’m reminded of this fact quite frequently these days. We’re in the process now, at China First Capital, of closing an investment round for one of our Chinese SME clients, from one of Asia’s most successful PE firms. The closing legal documents are weighty, running to over 300 pages in total. The governing law is Hong Kong’s. But, the actual text of many of the documents comes direct from US private equity and IPO closings, including numerous references to the “Securities Act of 1933”, the basic foundational law for share offerings done in the US since then. 

So, here we have a Chinese company obtaining equity capital from a Hong Kong-based investor, while the securities law cited is from the USA. It seems a puzzle at first, even allowing for the possibility our client may one day choose to list its shares in the USA. So, why the reliance on US law and practice? 

Quite simply, because it comes closest to striking an ideal balance between the often competing interests of management and outside shareholders. In economics terminology, this is known as the “principal-agent problem”. (For anyone who wants to read more, Wikipedia has a decent summary:  This describes the frequent, and often inevitable tensions that can arise between outside investors and the inside management that makes the day-to-day decisions. The management has access to far more information about a company than the providers of capital.   It’s important to keep these divergent interests aligned. That’s what a lot of US securities law assures. It does so by mandating, for example, how often board and shareholders’ meetings must be called, with what kind of notice period, and what rights an investor has to inspect the books and records of the company they’ve put money into. 

For private equity deals, the US has also evolved a series of specific protections for investors. These rules make sure, for example, that an investor has the right to sell its shares in a public offering, and to be kept fully informed during the IPO process. These are essential for the proper functioning of the global private equity industry. As you’d expect, the investor rights figure prominently in the closing documents for our client. I recognize the terms and conditions, since I’ve seen them, more or less verbatim, in PE and VC deals I’ve worked on in the US. 

So, while Wall Street may be undergoing the most far-reaching changes in several generations, it’s leadership position is unchallenged in resolving these principal-agent problems, and making the flow of capital more ample and more secure than it would be under any other legal structure. 

Moving From Transaction-Based to Relationship-Based in China’s PE Business

The PE industry in China is growing up. Fast. There are two key factors are at work. The first is the onrush of cash. The second is the onrush of talent.


Billions of new money is flowing into the Chinese PE industry. This is in marked contrast with the situation elsewhere. There’s not a lot of appetite for committing capital for any purpose except to invest in China. Other, traditional large PE markets (US and European buyout funds) are in cyclical decline, owing largely to the problems in global credit markets. Then, too, there’s the announced intention of the China’s $75 billion social security  fund to begin investing more freely in private equity firms in China.   


The weight of all this new money entering the China PE market is having an interesting effect on valuations. While valuations have certainly come down over the last year, they arguably would have fallen faster and farther if not for all the new money looking for opportunities. It’s what financial markets like to call “the weight of money” argument – the more cash there is around, the higher prices will rise. 

That’s one side effect of the new money entering the market. The other is that the level of professionalism, across the board, is rising in the PE industry. There’s a good reason for this. As the pool of capital grows, so too does the demand for higher levels of fiduciary responsibility and accountability. This is evident not just in tightening DD procedures, of course, but also in the involvement in the PE investment process in China of some the world’s leading professional service firms. 

This past week, I met with a Hong Kong-based partner at one of America’s largest and best law firms. This firm has been very active in China’s IPO market the last five years, and served as lead counsel for many of the larger public offerings by Chinese companies in US exchanges. This is a great business, with very fat fees. But, it’s also a highly cyclical one. The IPO market has cooled this year. So,  this firm has now made the shrewd decision to work on some smaller PE deals, rather than just the +$100mn IPOs they’ve relied on in the past.  The upfront transaction fees are, of course, lower. But, by getting involved earlier in a company’s financing process, at the time of PE financing, this law firm believes that it will be building a very solid base for the future. 

The calculation is very sound. By working on a PE financing today, the law firm will be ideally-positioned to serve as IPO counsel several years down the line. In other words, the firm is moving from being “transaction-based” to “relationship-based” , from targeting only high-dollar one-off IPO transactions, to building a longer-term relationship with a select number of very promising pre-IPO Chinese companies. Over time, this should yield far more revenue for the law firms that follow this path. There’s money to be made advising on PE investment rounds, on Board matters, on M&A work, and litigation. 

In principle, it’s an obvious shift to make, and more closely reflects best practices in the legal profession. In fact,  a good law firm, like a good merchant bank, should choose its clients wisely, and then commit to serving and advising them over the long-term. 

For us, at China First Capital, this is very much at the heart of our operating ethos. For larger law firms, it can sometimes be a tougher shift to make. For one thing, their existing fee structures make it harder to work with smaller clients.  The law firms will often need to cut fees as a way of building these longer-term relationships. That’s not always easy to do in a large law firm, where all partners are expected to generate maximum revenues. 

But, this change in mindset is happening. I know from experience, since this big US firm has offered to work with several of our clients, on their PE financings, and to cap their fees at an appropriate level. This is a great thing for our clients, since it gives them access to the best legal counsel possible, at a time when it will make a significant positive difference. The PE firms stand to benefit as well, since it should raise standards overall. 

This shift from transactional focus to relationship-building is more proof that China’s PE market is coming of age, and building the infrastructure on which to prosper for many decades to come. 

Infinite Opportunities ÷ Finite Capital

To a hammer, every problem is a nail. Equally, to many fine entrepreneurs, seeing abundant opportunities for profit, the only problem is capital. Not markets. Or competition. Or industry cycles. 

In other words, good entrepreneurs usually plan big, to build big new businesses that will generate huge returns. That’s great. The only limiting factor they perceive is access to adequate capital to build big enough and fast enough to earn the largest potential return. The problem here, as we say in America, is that such an approach can be “assbackward”. Companies usually need to adjust their plans to the capital they can raise — not decouple the two entirely. 

We had a series of meetings this week with Chinese companies interested in working together with China First Capital to secure private equity funding. These meetings are usually long, detailed, and for the most part, highly enjoyable. We’re lucky to have so many outstanding companies approach China First Capital. They come from a very wide range of industries. For example, this past week, we met with one business in the high-tech synthetic fiber industry, and another that owns a large-scale sugar refinery. 

I’ve learned, over many years, first as a Forbes Magazine reporter and then as a venture capitalist, how to form a quick (and one hopes, accurate) assessment of a business’s potential. With both of these companies, the assessment is very positive. In both cases, though, the laoban clearly hadn’t thought very deeply about how much capital they both should and could raise. There was, at least at the start, this disconnect between the size of their plans, and their ability to finance them with equity capital. 

So, we needed quite a bit of time to explain things. Opportunities in business are infinite, but capital is finite resource. Investors want to achieve the highest risk-adjusted return possible. But, equally, they will determine how much capital to invest not purely, or even primarily, based on the potential return. They will also give strong consideration to issues of corporate control, valuation, ROI, even asset coverage. 

So, while investors will applaud a company with a solid plan to build a new division with annual profits of over $25mn within three years, they won’t be rushing to invest the $50mn that’s required to get there, if the current business is worth $70mn. That would require the investor, in most circumstances, to take a controlling stake in the overall business. The $50mn investment represents over 70% of the current company value. Few investors want to own that much of a portfolio company, even if they foresee great returns. 

There are all kinds of proven and effective ways to raise larger sums, two of the most common are using a mix of debt and equity, or staging the investment in tranches. The starting place for any business seeking equity finance is to ask “how much money can we best raise now?” rather than “how much money do we want to achieve most quickly our business goals?” The answer to the first determines not only which businesses opportunities a company can pursue, but at what scale. 

Capital – its cost and availability — is often among the last considerations for an entrepreneur. Part of our role as merchant bankers is to bring the entrepreneur’s plans down to earth, to keep those plans and the ability to finance them in harmony. The appropriate-sized tool for the appropriate-sized task. This idea is beautifully expressed by this ancient carved image of Chinese rice threshing machinery.