Month: October 2009

The Closing of the American Mind: Seeing China As It Was, Not As It Is

China First Capital blog post -- Qing Dynasty dragon plate

I recently returned from a two-week stay in the US. I was very busy seeing friends and business colleagues, which means I was also very busy answering questions about China. 

China occupies a very special place in the minds of many Americans, including many who’ve never been. The level of curiosity in America about China is enormous. This contrasts notably with the indifference with which many Americans view the world abroad. For example, during the 14 years I spent in London, I never found my American friends to be very interested in what life was like in England. Not so China. 

But, this intense curiosity is not matched by a deep knowledge among Americans about the current situation in China. In fact, even among the most well-read and worldly-wise of my friends, the level of ignorance about today’s China is high. That’s largely because the American media, for the most part, does an execrable job covering China. The result is that most Americans have an excessive focus on what’s perceived to be “human rights problems” in China, and a vast under-appreciation of the monumental, positive changes that China is now undergoing. 

My local shoe repair guy in Shenzhen has a more nuanced understanding of the US than most educated Americans have about China. Every time I get my shoes polished, I end up discussing the genesis of the American credit crisis and the challenges President Obama faces in trying to change America’s health care system. In the US, the main topics of discussion about China reflect an exaggerated negative view of what’s going on. Nine times out of ten, people want to comment on pollution and product quality, as if China was one large Satanic mill turning out killer toys. 

Of course, the speed and scope of all the positive changes in China are so awesome it’s difficult for anyone, including Chinese, to fully appreciate just how far the country has come in a short time. But, in my experience, the American misapprehensions about China have a stale, time-worn quality about them, as if America’s view of China stop evolving about five years ago. 

A friend of mine, for example, writes about Chinese-American relations for a leading US publication. He talked about the issues he’s most busy writing about and what is of greatest concern to the Americans now guiding policy toward China. North Korea and Iran figured prominently in the discussion, and he relayed the US strategy to win China’s backing for the American position.

There was lots of talk of high-level diplomatic meetings and various quids-pro-quo. While all this is no doubt important to the safety of the world,  I couldn’t help feeling that it also demonstrated a lot of wishful thinking on America’s part, that China would still be, as it often once was,  highly responsive to America’s strategic needs. 

The US has long commanded significant leverage over China. But, that leverage is lessening by the day. One reason, of course, is China’s own rising economic and military power. But, less noticed and perhaps even more important is that China is less and less reliant on access to the US market to sustain its own economy.

China’s economy is increasingly driven by its own domestic market, rather than exports. This is why China could absorb without much dislocation the sharp fall in exports to the US over the last year. Exports will continue to play a larger role in China’s economy than in America’s. But, its economy is changing, and growing far more balanced. 

China will more and more resemble the US — a large, continent-sized economy that grows by meeting the needs of its own citizens, and providing a stable environment for business to invest. This change has many more years to run. The simple formula: China can listen less to what the US wants because it needs less of what the US has to offer in return. 

This, too, is a change that seems to have escaped the notice of most Americans, including those in a policy-making position. China isn’t simply being difficult or stubborn by failing to tow a US line. It’s also less concerned about calibrating its own policies to expand the markets for its exports to the US. The last time the US was in recession, China’s economy was also badly bruised. Not so this time. OEM exporters have suffered, but not the businesses that focus on selling to Chinese consumers. They’ve played a key role in keeping China’s economy healthy, while the US has faltered. 

Americans need to see China for what it is, not what it was. It’s a better, richer, cleaner, freer place than they think. Americans may just learn to like what they see..


How & Where to IPO: Research Article by CFC Published in Chinese Magazine



The current issue of “Corporate Finance Magazine” has a Chinese-language research report written by the China First Capital management team. It’s the cover story. The title of the report is: “如何选择上市的时机和地点”. It examines some of the right  and wrong ways for a Chinese SME to IPO. 

The article begins on page 10. Download report here

We are very happy about the planned opening of trading later this month on the new Growth Enterprise Market (创业板 ) here in Shenzhen. We hope it will give many successful SME new opportunities to go public properly and efficiently.

Our goal is that the report in Corporate Finance will contribute towards a successful future for the Growth Enterprise Market and for all of China’s best-performing SME. 


The Time of Candied Crabapples and Persimmons: Beijing in Autumn

Persimmons, from China First Capital Blog Post

Back in Beijing after an absence of two years. I know enough to expect big changes every time I return to Beijing, a city that is undergoing the most “meta” of metamorphoses. The most noticeable one this time, in the midst of a short and busy stay, is the completion of at least four new subway lines, and a high-speed train to the airport.

While crowded, the subway is a far better way to get around than above-ground, where the traffic situation in Beijing continues to worsen. This in spite of the fact that 20% of the city’s cars are kept off the street each weekday. Weekends are a free-for-all. With car sales in China running now at over one million per month, traffic is only going to worsen, especially in Beijing. 

Beijing is the most car-crazy city in China. The simple trope is: in Shanghai, people would rather spend money to live in a nicer place and then ride the bus. In Beijing, the opposite is true. Having four wheels under you matter more than the four walls around you. 

October is, famously, the nicest month of the year in Beijing. Daytimes are still warm, the air fresh and the sky often a shimmering blue. The streets are filled with vendors selling the wonderful assortment of autumn foods that have been an inseparable part of October in Beijing for hundreds of years: candied crabapples, persimmons, chestnuts. 

I’m here to participate in a private equity conference organized by and held at Tsinghua University. I readily accepted the invitation to appear, both because it’s an honor to be invited to speak at Tsinghua, and also because I wanted very much to return to the northwestern part of Beijing where the university is based. I was last here (gulp) 28 years ago, when I first arrived in China. I haven’t been back since. 

The changes are so comprehensive that, but for a few old candy-striped smokestacks, nothing seems to remain from the early 1980s. The area around Tsinghua is now filled with shops and modernist glass towers. I remember the university district of Beijing (which houses both Tsinghua and Beijing University) as being very gray, remote and very somber,  with nothing either to comfort or disrupt the life of a student at China’s two most elite universities.  Now, it’s got a hip, Harvard Square kind of vibe.

Tsinghua has a special history, one that has always symbolized for me the unique nature of the relationship between US and China. The university was founded by the American government, using some of the indemnity paid by the Qing emperor following the Boxer Uprising in 1900. While the circumstances that led to the payment of the Boxer reparations are mainly ignoble, I’m nonetheless proud that my country used its relatively small share of the money to establish first a scholarship program for Chinese to study in the US, and then, later, to establish Tsinghua University. The Russians, Germans, British, French and Japanese, who collectively got 93% of the indemnity,  took their share of the money and did nothing of any kind to benefit China. 

Not always adequately or consistently, but America has mainly viewed its role in China as mentor and friend, the least barbarous of the foreign barbarians. 

The conference just ended. I’m going to huddle up against the nighttime cold, and go out to smell the roasted chestnuts, and dodge the fierce Mongolian winds that are juddering the trees.



How PE Firms Use Tax Arbitrage To Turbocharge Their Profits

Lacquer scholar's tools, from China First Capital blog post

Private companies the world over share one common trait: a preference for paying as little tax as possible. In Italy, for example, under-reporting of taxable income by privately-owned companies is an accepted national pastime. Italy even created a special national police force, the Guardia di Finanza,  just to go after this rampant tax-cheating. They haven’t had much luck, as far as anyone can tell. 

China is no different, of course. Private companies here will try to organize their affairs in such a way that taxable income is kept as low as is plausibly possible. Business taxes are large in number and relatively high considering China is still a developing country. Corporate income taxes, for example, can reach 33% depending where you are. This is on top of a national VAT of 13%-17%, and all kinds of other assessments on wages, assets, real property. 

The usual practice is to maintain three sets of books, one for tax authorities, one for banks that show a better picture to keep the loans flowing, and the third lets the owner see the real picture. Again, this is pretty much standard practice the world over.

Public companies, of course, have far less latitude to under-report taxable income, since they undergo a properly intensive audit every year. They also have a very different incentive than private companies. A public company’s share price is usually determined by its profitability. The higher the profit, the higher the share price. Many public companies have gotten into trouble by reporting too much profit, sometimes by fabricating sales, as a way to bolster their share price. 

This opposing approach in reporting taxable income creates a very nice arbitrage opportunity investing in private Chinese companies on the road to a public listing. This tax arbitrage often turbocharges the already high risk-adjusted returns for PE investors in China. 

Here’s how it works: PE investors generally use a Price-Earnings multiple to value a company on the way in. The multiple will usually be between six and nine times last year’s profits. That’s already a little low, given how large and fast-growing these companies often are. But, the 6-9X  valuation multiple becomes more akin to highway robbery when you look at it more closely. Everyone knows, of course, that the profit number used to make this valuation calculation is understated. It’s generally based on the only set of audited returns that are available, and those are the books prepared for China’s tax authorities. 

So, if the company’s tax records show a profit last year, for example, of $5mn, it’s a reasonable assumption the real figure is anywhere from 40% to more than 100% higher. But, the the purposes of calculating valuation, only the under-reported number is used. The effect is to lower the PE multiple from 6-9x. to perhaps 3-5x.  That makes these PE investments China in a screaming bargain, assuming everything goes well, of course, after the investment. 

But, from the PE firm’s standpoint, it gets even better than being able to buy in at very low valuations. They know that a big part of the plan, after investment, will be the get the company ready for an IPO. This is usually a two to three year process that involves reporting a larger and larger percentage of the actual profit as taxable profit, since this will also be the profit number used for IPO valuation. 

For every dollar of “found” profits inside a company, the PE investor stands to make at least five extra dollars in return, based on a typical-sized investment where the PE firms buys 25% of the shares. This gain occurs even if the company does nothing after investment to increase its profits. All that’s happening is an accounting change that puts money in PE firm’s pocket. 

It’s a reasonable assumption that a Chinese company going public will get a PE multiple of 20x. (Currently, in China, the PE multiples are often twice that level.) The PE firm buys the same dollar of profits for $4, and then sells it for $20 a few years later. 

Of course, the plan will be to do even better, by putting the PE capital to work in ways that will earn a good return over the same two to three year period. So, let’s assume that profits at least double, but perhaps even triple, from the taxable- reported income the PE investor used to make this original valuation.  The IPO valuation captures not just the profit from the accounting arbitrage, but the company’s own high-octane performance after the investment. 

Add it up, and it’s not unreasonable for the PE firm to make a +300% return in only two to three years. Of course, it’ll never be seen quite this way. Instead, the PE firm will get a lot of credit for improving a company’s financial reporting and controls, and so enhancing profits. The PE firms do play a role in this. But, a lot of the profit was there to begin with. All the PE firm did was ask the company’s owner to report more of it, pay more tax, and so bring his books into alignment with public company standards. 

Now, my friends in PE firms will probably view things differently, stressing the part about the work they do after investment to improve accounting controls, and that they will never know precisely how much buried profit there is a company until after they’ve invested. It’s a basic principle of finance that there’s an information asymmetry between the owner-manager and outside shareholders.

Sometimes, not only profits are hidden, but all kinds of other unpleasantness. Both are true, and yet on balance, PE firms are getting by far the better of the deal. Their due diligence, which is both extensive and expensive, should uncover anything serious before money is committed. Once the money is invested, however, the PE firm can start benefitting from profits that remained hidden from the taxman..

China First Capital’s New Website

Qing painting, China First Capital blog post

With CFC’s business motoring along nicely, I decided in late spring to redesign our very bare-bones website, to add more information, and make it a little more pleasing to the eye. After four months of sometimes tedious labor, the process is now complete. The English-version of the new CFC website went live earlier this week. The Chinese version will follow after the October holidays in China.

During my journalism career at Forbes, I had some experience working with designers, so I generally understand how words and images can best interact on a page.  Or, at least I thought so. Web design is a whole different ballgame. The web format allows for a lot more flexibility than designing print pages to in a particular newspaper or magazine’s existing template. You can incorporate animation, videos, pictures, sound.  But, there’s also a lot more chaos about the whole process. Maybe it’s the fact that a good web designer must be combine the character traits of a graphic designer and a computer programmer. Rendered in mathematical terms: flakiness 2

Everything turned out well. But, completing the site took far longer than I’d expected at the outset. I helped contribute to the delays by frequently changing my mind about which images should appear on the site. I decided one thing emphatically from the start:  I did not want to reproduce the hackneyed sort of imagery you see on every other financial industry website I’ve ever seen, from Goldman Sachs’ to a small regional bank’s. So, I wanted no photos of men shaking hands, or gathered around a conference room table, or walking purposefully down a busy urban street holding a briefcase. For one thing, I don’t even own a briefcase.

Instead, I wanted to do something far more personally meaningful on the site, and use only close-up images of Chinese art.  After some experimenting with images of Ming Dynasty porcelains and sculptures, I decided to use only Chinese paintings. I wanted them to reflect many of the broader thematic and stylistic movements in Chinese painting, from the Tang Dynasty to the Qing Dynasty.  And, of course, I wanted to feel a connection with each image, both aesthetically and also as  metaphorical statement of core principles and values that animate our work at CFC.

That’s a pretty tall order. I probably looked at over 1,000 paintings, and did my own, on-screen close-up crops of several hundred, before deciding on the 25 I liked most. In the end, there was room on the new site for only 13.  Early on, I’d thought of using close-ups from several thangkas I’m lucky enough to own. The images were gorgeous, but my team felt (and I ultimately agreed), they were too unmistakably religious, even in extreme close-up,to fit well on the site.

The text was not as difficult. We’re lucky in that our business has a very clear, narrow focus that’s easily expressed.  Ours is also, importantly, not a business that relies on website traffic, or Google search results, to create awareness and revenue. I know this other world very well, through my role at Awareness Technologies, which is a web-marketer par excellence. Every day, Awareness Technologies’ websites and Google strategy will deliver new customers who buy our software. It’s highly-specialized work, this kind of online marketing, and my Awareness colleagues do it as well as, and often better than,  anyone else in the world. Awareness Technologies also builds great software, which matters even more, of course, to the success of the business. 

CFC, on the other hand, is mainly a “word of mouth” business. Chinese SME come to us not through an online search, but because we’ve been introduced to them by others they know and trust.  In fact, I wouldn’t be surprised to learn none of our clients have ever visited our website.  They’re generally too busy running their companies to spend much, if any time, online – let alone searching the web to find an investment bank.

I wouldn’t have it any other way. I don’t look to the CFC website to generate “walk-in” traffic. We do no search advertising, or web marketing. So, someone finding our website will usually do so through following a link on what’s called a “natural search result” at Google, Yahoo, Baidu or other search engines. 

My main hope for the new website is that all those who do visit it, first and foremost, will get enjoyment from looking at the paintings, and allow the close-ups to meander around in their minds for awhile.  If that gets them then to read about what we do, so much the better.