Month: September 2012

A Bond Market for Private Companies in China

Capital allocation in China was built on a wobbly pedestal. One of its three legs was missing. Equity investment and bank lending were available. But, there was no legal way for private companies to issue bonds.  That has now changed. In May this year, the Chinese government approved the establishment of a market for private company bonds in China. This is an important breakthrough, the most significant since the launch three years ago by the Shenzhen Stock Exchange of the Chinext board (创业板) for high-growth private companies. The new bond market has the potential to dramatically increase the scale of funding for private business in China.

Companies can issue bonds through a group of approved underwriters in China, who place the bonds with Chinese institutions. The bonds then trade on secondary markets established by both the Shenzhen or Shanghai stock exchanges. Bonds should lower the cost of capital for Chinese companies, and provide attractive returns for fixed-income investors. Another positive effect: the bonds disintermediate Chinese banks, which for too long have overcharged and under-served private company borrowers.

Up to now, though, China’s private company bond market is off to a bumpy start. Regulators are over-cautious, investors are inexperienced, companies are confused, the secondary markets are lacking in liquidity. We have no direct involvement in the private company bond market. We don’t issue or trade these instruments. But, we are eager to see private company bonds succeed in China. It will increase the capital available for good companies, and allow companies to achieve a more well-balanced capital structure. Capital remains in very short supply. Many PE firms in China have recently cut back rather dramatically in their funding to private companies, because of a decline in China’s stock market and a marked slowdown in the number of IPOs approved in China.

We recently prepared for the Chinese entrepreneurs we work with a short briefing memo on private company bonds. It’s in Chinese. The title is  “中国中小企业私募债”. You can download a copy by clicking here.

We explain some of the practical steps, as well as the potential benefits, for companies interested to float bonds. At the moment, only companies based in a handful of China’s more economically-advanced provinces (including Shanghai, Guangdong, Zhejiang, Jiangsu) may issue the bonds. Most underwriters expect the geographical limitations to ease, over the next year, allowing companies in all parts of the country to participate. There is no clear threshold on how big a company must be to issue bonds. But, there is a clear preference for larger businesses, with profits of at least Rmb20mn (USD$3mn). In several cases, underwriters have pooled together several smaller companies into a single bond issue. Real estate developers, currently hurting because of the cut-off in bank lending to this industry, are not eligible to issue bonds.

In theory, a company can issue bonds without offering collateral or third-party loan guarantees, both of which are required by banks to secure a typical short-term corporate loan. In practice, however, the market is signaling strongly it prefers these kinds of risk protections. Interest rates on some of the private company bonds already issued have been below the levels typically charged by banks for secured lending. But, the rate is starting to move up, to over 10%. My guess is that interest rates for good borrowers should move back below 10%. That level offers bondholders a very solid real rate of return, and prices in the risk. In the US and Europe, decent companies can borrow at LIBOR+4-6%, or around 5%-7% a year.

Overall, as the new bond market expands and matures, we expect these bonds to offer the lowest cost of capital for growth companies in China. Bond maturities can be as long as three years;  interest and principal payments can be structured to accommodate future cash flows. This is generally far more suitable than the rigid short-term lending facilities available from Chinese banks.

Underwriters are promising companies they can complete the process of issuing a bond, including regulatory approvals, in three months or less. That’s remarkably quick for any capital markets transaction in China, and reflects the fact China’s finicky securities regulator, the CSRC, has no role in approving private company bonds. The Shanghai and Shenzhen stock markets regulate and approve bond issuance.

PE firms are starting to notice that access to bond market gives private companies more leverage and a little more pricing power when negotiating equity financing. The Chinese companies that can successfully issue bonds are generally the ones that PE firms also target.  Over time, though, PE firms should welcome the emergence of a functioning private company bond market in China.  The new bond market gives companies, including those with PE investment, an opportunity ahead of a domestic IPO to operate in the capital market, build a reputation for transparency and good performance. This should mean a higher IPO valuation if and when the company does decide to go public.



Reflections on a Sunday of Protests in China

“To reap the whirlwind”. It’s an ancient English saying, taken originally from the Bible. It means that actions in the past can end up having very large, unexpected consequences.

This phrase is very much on my mind today, as I listen to two unfamiliar sounds from outside my window in Shenzhen: one is of helicopters circling close overhead. The other is thousands of voices shouting angry slogans in unison. In Shenzhen today, as in cities across China, there are large demonstrations being staged to protest Japanese claims to some offshore islands nearest to Taiwan known, in Chinese, as Diaoyudao, and in Japanese as Senkaku.

I happen to live near both one of Shenzhen’s largest shopping malls, as well as its main street, known as Shennan Avenue. Demonstrators are parading down this street, and then stopping in front of the mall to wave Chinese flags and scream “Smash Japanese imperialism”, and, somewhat more incongruously, the soccer chant, “Let’s Go China” (”中国加油“) .

The shopping mall is shut today, for a second straight day, with a phalanx of Chinese police in riot gear standing between it and the demonstrators. The main tenant inside the mall is Jusco, the Japanese supermarket and department store. The mall also houses local outlets of high-end global brands like Louis Vuitton, Cartier and Ralph Lauren. A lost weekend like this is the last thing these big luxury brands need, of course, as their sales in China are already weakening because of slowing economic growth.

I’m no expert in maritime law. Equally, I’m not familiar with all the facts, claims and counterclaims about these islands. It seems rather self-evident, when looking at the map, that the islands should belong indisputably to China. But, at the moment, they are mainly a source of significant national irritation in China. Demonstrations here are rare, and always involve some degree of government approval. Tempers are high today, but not uniformly so. Mixed in with angry young men of all ages are lots of families with kids, waving small Chinese flags, taking photos as well as taking obvious pride in their Chinese identity. That’s all to the good.

And yet, I’m still more than a little uneasy. I probably have a higher-than-average sensitivity to the character and tone of Chinese street protests. I was in Beijing during the Tiananmen Incident in June 1989. All these years later, the two filaments embedded in memory are the sound of a massive angry crowd chanting in Chinese, and how quickly, explosively, unpredictably an orderly, even good-natured, protest can turn into a violent and uncontrollable mob.

The term “collective wisdom” is one I often struggle with. In my experience, the size of a crowd is often inversely correlated with the reasonableness of its behavior.  This is as true in the US or Europe as it is in China. Less than a year after witnessing the events in Tiananmen, my neighborhood in London was engulfed in what was called the Poll-Tax Riots, as tens of thousands of people took to the streets to protest an unpopular new tax. It turned into an anarchic frenzy of looting and hooliganism, as rioters set fire to restaurants and cars, and beat unarmed British police. Excitement and incitement are close cousins.

Anti-Japanese feelings run deep in China. There is no easier way to rouse a rabble here. On any given night, at least one of the country’s main television broadcasters will show during prime time a historical drama about the Japanese invasion of China, often featuring quite graphic levels of violence.  For an American, it would be something like one of the three networks broadcasting every night, every week of every year a series about the cruel Japanese mistreatment of Allied POWs during the Bataan Death March. Anti-Japanese entertainment sells in China. This year’s big budget Chinese movie, the Zhang Yimou directed The Flower of War (金陵十三钗), was set against the backdrop of the 1937 Rape of Nanjing, and included the most horrifyingly violent and realistic images of barbarism and cruelty I’ve ever seen in a film.

Chinese lack no justification for their anti-Japanese sentiments. And yet, as this nation continues its remarkable rise, the dark grievances of the past must fade in the light of China’s current achievement and progress.  I find powerful logic in the words of a Chinese patriot who died 99 years ago, Tang Guo’an (唐国安), the first president of Tsinghua University. During the height of the deplorable Western occupation of China, Tang wrote  “were the positions reversed, China might accord even worse treatment to foreign nations. It behooves us, then, not to entertain unworthy thoughts of hatred and resentment, which will be of no avail.”


Private Equity Valuation: Terminal Multiple Is All That Matters

A lot gets written, and even more gets discussed, about how to value private companies for the purposes of PE or VC investment. There is an awful lot of “Mongolian talk” going around, a translation of the Chinese term, 胡说 , meaning senseless drivel. PEs often use irrelevant or misleading comps to justify a lowball valuation. Companies are no less guilty, setting their valuation expectations unrealistically high, based on hear-say about other deals being done or a misreading of current stock market p/e multiples.

So, how do you work out a fair valuation? The only way I know is if both sides agree on the same set of facts to advance from. That is already challenge enough. How big a challenge?

Below, I share part of an email memo I sent to a large Chinese industrial equipment manufacturer. Their controlling shareholder hopes to sell down some of its shares, while also raising some new capital for the business. They are a sophisticated group, with strong management. They approached several investment banks, including ours, to represent them in the capital raising. We made the final cut, and they then insisted that the advisor they choose must achieve a valuation for them of at least 10X this year’s net income.

In more than just the two words “that’s unreasonable”,  I set out why they need to be more accommodating with reality.

“Your goal, which I thoroughly share, is to bring in a first-rate PE and get the best price for a valuable asset. I would work with all my diligence to achieve that.  But, let’s look frankly and factually at current market conditions. At the moment, domestically-listed Chinese companies in [your]  industry are trading at a trailing p/e of 28X and forward (this year’s) p/e of 22x. Both have fallen by approx. one-third in the last year. (The 22X is the basis we should use, to compare like-with-like. You have set your valuation target of +10X based on this year’s net income.) 

Your valuation target of +10X is a discount to quoted comps of 50% or narrower. That is a smaller discount, and so higher entry valuation for PE firms, than deals being done now. 

As you know, all PE deals, since they involve illiquid companies often years away from IPO exit, are always done at discount to quoted comps. The discount is not fixed, but the only time PE deals were closed routinely at prices over 10X (rarely if ever above 15X) was two years ago or more when comparable stock market p/e valuations (generally on the CHINEXT)  were 70X-100X previous year’s net.   A rich price indeed, and for a while, it had a levitating effect on PE valuations.

Current market conditions are that there are no investments from first-line PEs with terminal multiples at +10X. I emphasize the word “terminal multiple” because quite often — too often in our experience — a PE will offer a higher multiple at term sheet stage, to win the competitive right to pursue exclusive due diligence. These deals are almost always “repriced” at closing to a level below 10X, when PE firm has most of the leverage. PE will claim they turned up “new facts” in DD, as they always do, that justify the repricing.  They promise you +10x in a term sheet knowing they will only close the deal at a lower price, when all other interested investors have vanished from the scene. Unfair? Duplicitous? Get used to it. It’s the way the game is played.

The other common occurrence in China PE is that there is a headline multiple of +10X but it is linked to an aggressive next year + this year (sometime even three year) profit guarantee. The level is set by PE firm in full expectation that company will not meet the profit targets, so triggering the ratchet, often quite punitive. This process will bring the terminal multiple down significantly. We’ve seen and heard of deals where this terminal multiple is half the headline number at signing of term sheet or Share Purchase Agreement. In other words, the SPA has a headline multiple of 12X, but terminal multiple, after ratchet is triggered,  works out to 6X-7X.

From my experience, the ratchet is triggered in over half PE deals done in China. In the case of some leading China PEs, [names omitted to shield the guilty], the ratchet is triggered in over 80% of the deals they do. The ratchet trigger is very unfortunate for the company, and reflects the fact they are badly advised, by advisory firms paid a fee based on “headline valuation at closing” not terminal valuation.  

The other condition attached to deals with headline p/e of +10X is a high IRR (usually +20% p.a. simple interest) for buybacks triggered by “no qualifying IPO”. The buyback is a feature of almost all PE deals done in China. As you would be financially liable for such a payment, if I work as your investment banker, I’d want to negotiate this mechanism very carefully with PE, to assure your best interests are fully protected. It’ll mean a fight with the PE firms, but it will be gentlemanly. You want an IRR of no more than 10%. Why? One way to think of it is that for every 100 basis points the buyout IRR is fixed above LIBOR, you can argue the terminal multiple falls by 0.3X to 0.5X, because of the contingent liability.  

Yours is a highly cyclical industry. We are now in the downward loop, heading for the bottom of cycle. This negatively impacts valuation. Your cap table, particularly the fact the company is controlled by a CEO who has no capital directly invested in the business, also negatively impacts valuation. For last three years (2009, 2010, 2011) your net income has been flat, and net margins have fallen by almost half. This too negatively impacts valuation.  That’s three strikes already. You’re not “out”, as in baseball. But, it’s a three-ton weight pushing down your terminal multiple. 

I can promise you that if we work together, you will get the best outcome available in current marketplace, and be working with a firm that shares your commitment to integrity, professionalism and accountability.  

But, if you do decide to move forward with the other advisor, I’d urge you to ask them to address the specific points raised here, and structure their compensation on an “all or nothing” basis: they only earn a fee if the terminal multiple is above 10X, as they are now promising.  

A seller’s focus on valuation is understandable. But, too often in our experience, it can play into the hands of both the PE investor and your investment banker. Both will encourage your expectations knowing that the final bill on valuation will only be presented to you in two to three year’s time.  More often than not, only they will be feeling victorious at that point.


This company decided to retain the other investment bank.