Will Bad Money Drive Out Good in Chinese Private Equity?
The financial rule first postulated by Sir Thomas Gresham 500 years ago famously holds that â€œbad money drives out goodâ€. In other words, if two different currencies are circulating together, the â€œbadâ€ one will be used more frequently. By â€œbadâ€, what Gresham meant was a currency of equal face value but lower real value than its competitor. A simple way to understand it: if you had two $100 bills in your wallet, and suspected one is counterfeit and the other genuine, youâ€™d likely try to spend the counterfeit $100 bill first, hoping you can pass it off at its nominal value.Â
While itâ€™s a bit of a stretch from Sir Thomasâ€™s original precept, itâ€™s possible to see a modified version of Greshamâ€™s Law beginning to emerge in the private equity industry in China. How so? Money from some of â€œbadâ€ PE investors may drive out money from â€œgoodâ€ PE investors. If this happens, it could result in companies growing less strongly, less solidly and, ultimately, having less successful IPOs.Â
Good money belongs to the PE investors who have the experience, temperament, patience, connections, managerial knowledge and financial techniques to help a company after it receives investment. Bad money, on the other hand, comes from private equity and other investment firms that either cannot or will not do much to help the companies it invests in. Instead, it pushes for the earliest possible IPO.Â
Good money can be transformational for a company, putting it on a better pathway financially, operationally and strategically. We see it all the time in our work: a good PE investor will usually lift a companyâ€™s performance, and help implement long-term improvements. They do it by having operational experience of their own, running companies, and also knowing who to bring in to tighten up things like financial controls and inventory management.Â
You only need to look at some of Chinaâ€™s most successful private businesses, before and after they received pre-IPO PE finance, to see how effective this â€œgood moneyâ€ can be. Baidu, Suntech, Focus Media, Belle and a host of the other most successful fully-private companies on the stock market had pre-IPO PE investment. After the PE firms invested, up to the time of IPO, these companies showed significant improvements in operating and financial performance.Â
The problem the â€œgood moneyâ€ PEs face in China is that they are being squeezed out by other investors who will invest at higher valuations, more quickly and with less time and money spent on due diligence. All money spends the same, of course. So, from the perspective of many company bosses, these firms offering â€œbad moneyâ€ have a lot going for them. They pay more, intrude less, demand little. Sure, they donâ€™t have the experience or inclination to get involved improving a companyâ€™s operations. But, many bosses see that also as a plus. They are usually, rightly or wrongly,Â pretty sure of themselves and the direction they are moving. The â€œgood moneyâ€ PE firms can be seen as nosy and meddlesome. The â€œbad moneyâ€ guys as trusting and fully-supportive.Â
Every week, new private equity companies are being formed to invest in China â€“ with billions of renminbi in capital from government departments, banks, state-owned companies, rich individuals. “Stampede” isnâ€™t too strong a word. The reason is simple: investing in private Chinese companies, ahead of their eventual IPOs, can be a very good way to make money. It also looks (deceptively) easy: you find a decent company, buy their shares at ten times this yearâ€™s earnings, hold for a few years while profits increase, and then sell your shares in an IPO on the Shanghai or Shenzhen stock markets for thirty times earnings.Â
The management of these firms often have very different backgrounds (and pay structures) than the partners at the global PE firms. Many are former stockbrokers or accountants, have never run companies, nor do they know what to do to turn around an investment that goes wrong. They do know how to ride a favorable wave â€“ and that wave is Chinaâ€™s booming domestic economy, and high profit growth at lots of private Chinese companies.Â
Having both served on boards and run companies with outside directors and investors, I am a big believer in their importance. Having a smart, experienced, active, hands-on minority investor is often a real boon. In the best cases, the minority investors can more than make up for any value they extract (by driving a hard bargain when buying the shares) by introducing more rigorous financial controls, strategic planning and corporate governance. The best proof of this: private companies with pre-IPO investment from a â€œgood moneyâ€ PE firm tend to get higher valuations, and better underwriters, at the time of their initial public offering.Â
But, the precise dollar value of â€œgood moneyâ€ investment is hard to measure. Itâ€™s easy enough for a â€œbad moneyâ€ PE firm to claim itâ€™s very knowledgeable about the best way to structure the company ahead of an IPO.Â So, then it comes back to: who is willing to pay the highest price, act the quickest, do the most perfunctory due diligence and attach the fewest punitive terms (no ratchets or anti-dilution measures) in their investment contracts. In PE in China, bad money drives out the good, because it drives faster and looser.