Month: February 2012

CFC’s New Research Report on Capital Allocation and Private Equity Trends in China


Capital allocation, not the amount of capital,  is the largest financial challenge confronting the private equity industry in China. Capital continues to flood into the PE sector in China. 2011 was a record year, with over $30billion in new capital raised by PE firms, including both funds investing in dollars and those investing in Renminbi. China’s private equity industry seems destined now to outstrip in size that of every other country, with exception of the US. Ten years ago, the industry hardly existed in China.

Yes, it is a time of plenty. Yet, plenty of problems remain. Many of the best private companies remain starved of capital, as China’s domestic banks continue to choke back on their lending. As a result, PE firms will play an increasingly vital role in providing growth capital to these companies. 

These are some of the key themes addressed in CFC’s latest research report, titled “2012-2013: 中国私募股权融资与市场趋势”. It can be downloaded from the CFC website or by clicking here.

The report is available in Chinese only.

Like many of CFC’s research reports, this latest one is intended primarily for reference by China’s entrepreneurs and company bosses. Private equity, particularly funds able to invest Renminbi into domestic companies,  is still a comparatively new phenomenon in China. Entrepreneurs remain, for the most part, unfamiliar with all but the basics of growth capital investment. The report assesses both costs and benefits of raising PE.

This calculus has some unique components in China. Private equity is often not just the only source for growth capital, it is also, in many cases, a pre-condition to gaining approval from the CSRC for a domestic IPO. It’s a somewhat odd concept for someone with a background only in US or European private equity. But, from an entrepreneur’s perspective, raising private equity in China is a kind of toll booth on the road to IPO. The entrepreneurs sells the PE firm a chunk of his company (usually 15%-20%) for a price significantly below comparable quoted companies’ valuation. The PE firm then manages the IPO approval process.

Most Chinese companies that apply for domestic IPO are turned down by the CSRC. Bringing in a PE firm can often greatly improve the odds of success. If a company is approved for domestic IPO, its valuation will likely be at least three to four times higher (on price/earnings basis) than the level at which the PE firm invested. Thus, both PE firm and entrepreneur stand to benefit.

The CSRC relies on PE firms’ pre-investment due diligence when assessing the quality and reliability of a company’s accounting and growth strategy. If a PE firm (particularly one of the leading firms, with significant experience and successful IPO exits in China) is willing to commit its own money, it provides that extra level of confidence the CSRC is looking for before it allows a Chinese company to take money from Chinese retail investors.

From a Chinese entrepreneur’s perspective, the stark reality is “No PE, No IPO”.

CFC’s Jessie Wu did most of the heavy lifting in preparing this latest report, which also digests some material previously published in columns I write for “21 Century Business Herald” (“21世纪经济报道) and “Forbes China”  (“福布斯中文”). The cover photo is a Ming Dynasty Xuande vase.

Too Few Exits: The PE Camel Can’t Pass Through the Eye of China’s IPO Needle

The amount of capital going into private equity in China continues to surge, with over $30 billion in new capital raised in 2011. The number of private equity deals in China is also growing quickly. More money in, however, does not necessarily mean more money will come out through IPOs or other exits. In fact, on the exit side of the ledger, there is no real growth, instead probably a slight decline, as the number of domestic IPOs in China stays constant, and offshore IPOs (most notably in Hong Kong and USA) is trending down. M&A activity, the other main source of exit for PE investors,  remains puny in China. 

This poses the most important challenge to the long-term prospects for the private equity industry in China. The more capital that floods in, the larger the backlog grows of deals waiting for exit. No one has yet focused on this issue. But, it is going to become a key fact of life, and ultimately a big impediment, to the continued expansion of capital raised for investing in China. 

Here’s a way to understand the problem: there is probably now over $50 billion in capital invested in Chinese private companies, with another $50 billion at least in capital raised but not yet committed. That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15mn. 

At the moment, only about 250 Chinese private companies go public each year domestically. The reason is that the Chinese securities regulator, the CSRC, keeps tight control on the supply of new issues. Their goal is to keep the supply at a level that will not impact overall stock market valuations. Getting CSRC approval for an IPO is becoming more and more like the camel passing through the eye of a needle. Thousands of companies are waiting for approval, and thousands more will likely join the queue each year by submitting IPO applications to the CSRC.

Is it possible the CSRC could increase the number of IPOs of private companies? In theory, yes. But, there is no sign of that happening, especially with the stock markets now trading significantly below their all-time highs. The CSRC’s primary role is to assure the stability of China’s capital markets, not to provide a transparent and efficient mechanism for qualified firms to raise money from the stock market. 

Coinciding now with the growing backlog of companies waiting for domestic IPOs, offshore stock markets are becoming less and less hospitable for Chinese companies. In Hong Kong, it’s generally only bigger Chinese companies, with offshore shareholder structure and annual net profits of at least USD$20 million, that are most welcome.

In the US, most Chinese companies now have no possibility to go public. There is little to no investor interest. As the Wall Street Journal aptly puts it, “Investors have lost billions of dollars over the last year on Chinese reverse mergers, after some of the companies were accused of accounting fraud and exaggerating the quality and size of their assets. Shares of other Chinese companies that went public in the United States through the conventional initial public stock offering process have also been punished out of fear that the problem could be more widespread.”

Other minor stock markets still actively beckon Chinese companies to list there, including Korea, Singapore, Australia. Their problem is very low IPO price-earnings valuations, often in single digits, as low as one-tenth the level in China. As a result, IPOs in these markets are the choice for Chinese companies that truly have no other option. That creates a negative selection bias.  Bad Chinese companies go where good companies dare not tread. 

For the time being, LPs still seem willing to pour money into funds investing in China, ignoring or downplaying the issue of how and when investments made with their money will become liquid. PE firms certainly are aware of this issue. They structure their investment deals in China with a put clause that lets them exit, in most cases, by selling their shares back to the company after a certain number of years, at a guaranteed annual IRR, usually 15%-25%. That’s fine, but if, as seems likely, more and more Chinese investments exit through this route, because the statistical likelihood of an IPO continues to decline, it will drag down PE firms’ overall investment performance.

Until recently, the best-performing PE firms active in China could achieve annual IRRs of over 50%. Such returns have made it easy for the top firms like CDH, SAIF, New Horizon, and Hony to raise money. But, it may prove impossible for these firms to do as well with new money as they did with the old. 

These good firms generally have the highest success rates in getting their deals approved for domestic IPO. That will likely continue. But, with so many more deals being done, both by these good firms as well as the hundreds of other newly-established Renminbi firms, the percentage of IPO exits for even the best PE firms seems certain to decline. 

When I discuss this with PE partners, the usual answer is they expect exits through M&A to increase significantly. After all, this is now the main exit route for PE and VC deals done in the US and Europe. I do agree that the percentage of Chinese PE deals achieving exit through M&A will increase from the current level. It could barely be any lower than it is now.

But, there are significant obstacles to taking the M&A exit route in China, from a shortage of domestic buyers with cash or shares to use as currency, to regulatory issues, and above all the fact many of the best private companies in China are founded, run and majority-owned by a single highly-talented entrepreneur. If he or she sells out in M&A deal,  the new owners will have a very hard time doing as well as the old owners did. So, even where there are willing sellers, the number of interested buyers in an M&A deal will always be few. 

Measured by new capital raised and investment results achieved, China’s private equity industry has grown a position of global leadership in less than a decade. There is still no shortage of great companies eager for capital, and willing to sell shares at prices highly appealing to PE investors. But, unless something is done to increase significantly the number of PE exits every year,  the PE industry in China must eventually contract. That will have very broad consequences not just for Chinese entrepreneurs eager for expansion capital and liquidity for their shares, but also for hundreds of millions of Chinese, Americans and Europeans whose pension funds have money now invested in Chinese PE. Their retirements will be a little less comfortable if, as seems likely,  a diminishing number of the investments made in Chinese companies have a big IPO payday.




A Sense of Place – The Key Role of Laojia in Forging Chinese Identity

Ask Chinese where the country’s leader Hu Jintao comes from and you will be told “Anhui Province”. Simple. Except it isn’t. In Jiangsu province recently, I was told by several locals that Hu was raised and schooled in Taizhou, a small city in the northeastern corner of their province. Disinformation meant to confound a foreigner? Apparently not.

In this case, as well as in China more generally, both can be true simultaneously true, that a person is said to come from one place, although he was actually born and raised in another. The reason for this seeming conundrum is the central importance Chinese themselves place on the concept of 老家,(“laojia”), literally one’s “old home”. It is, after asking someone’s name, the most common as well as most pertinent question you hear people ask one another when first introduced, “where in your laojia?” .

Chinese ask because nothing else is meant to be as telling, as shorthand, in determining the character, interests, personal habits, even taste in food of a person you’ve just met. Your laojia is Henan? It’s a place of con artists and simple poor peasants. Hubei? The smartest Chinese come from here.  Guangdong? Not keen on education but good at making money. Shandong? Strongly influenced by the values of the province’s native son, Confucius. And so on.

Laojia matters because Chinese are convinced it does. Living here, I’ve adopted the habit of asking a person’s laojia and have come to see it as providing some clues to a person’s character – if nothing else, it can often indicate a person’s tolerance for spicy food, preference for noodles or rice, yen for hard liquor.

In Hu Jintao’s case, he is considered a native of Anhui because his grandparents (and probably innumerable generations before them) came from this region of China. It is meant to inform his judgment, personality and provide the main reason Anhui Province is said to have experienced very high gdp growth during Hu’s tenure. He oversaw policies and spending decisions that gave a big boost to this once-poor area of China.  In US politics, this is known as “bringing home the bacon”.

And yet, from what I was told, Hu has little personal connection to Anhui. He was born and spent all his formative years in Jiangsu.  His grandparents emigrated there.  Then and now Jiangsu was among the most developed, economically successful areas of China, with a strong tradition of higher education and high professional achievement.

Hu’s spoken Chinese bears no trace of an Anhui accent, or any regional accent for that matter. His working years before becoming China’s party secretary were spent in various corners of the country, including Tibet and Guizhou, but never in Anhui. But, from what I was told, his parents raised him on Anhui food, and with a strong sense of identity as “安徽人”, or a person whose laojia is Anhui. My guess is that is you asked him to name his laojia, he would say “Anhui”.

China’s likely next leader, Xi Jinping, is a born and bred Beijinger.  He is about to embark on an important visit to the US, a kind of trial run ahead of his elevation to the top spot as Party Secretary later this year. He is son of a first generation leader of the Communist Party, and grew up, it is widely assumed, with all the perks available to a child of one of the country’s top officials.  And yet, his laojia is considered to be Shaanxi, the ancestral home of his father, and a place he was sent to at 16 years old, during the Cultural Revolution.

Shaanxi is the cultural and historical heartland of Han China. Xi, it is widely assumed, will bring to the job of China’s leader not so much the values of a Beijing son of high privilege and power, known in Chinese as a 太子党, or “Communist Party Prince” but the practicality and diligence of Shaanxi folk.

 When Chinese find out I’m American, they often follow up by asking “where do your ancestors come from?” In effect, I’m being asked to name my laojia. I offer the answer (in my case, Middle Europe) and also a quick discourse on why this idea of laojia hasn’t such resonant meaning outside China.  Americans tend to be far more interested in where a person was raised and schooled, rather than the locus of the ancestral burial ground.  Anyway, I often explain to Chinese that as a Jew, my ancestors were pretty much on the run for 1,900 years before disembarking from a ship on New York’s Ellis Island over a century ago. We have no ancestral burial ground. No home turf. I am, for all practical purposes, a person without a laojia.

That would never be possible – or acceptable – for a native Chinese. Laojia provides a middle layer of identity for all Chinese, between family and country. Yet, unlike those other two, laojia is often as much mystical as it is practical.

For many Chinese, not just the current and likely future leader of China, one’s laojia may be a place you’ve seldom, if ever, visited. And yet it’s also the root source of one’s values and preferences, shaping one’s choice of friends, profession, entertainment, food. In China, one can be of a place but not from it.