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

2 Comments / February 21, 2012

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

4 Comments / February 7, 2012

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.


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Happy & Healthy Dragon Year

Leave a Comment / January 27, 2012

Wishing everyone a happy, healthy and prosperous Chinese New Year. This is a Dragon Year, which many consider the most auspicious in the duodecennial Chinese lunar cycle.

The vigorous dragon above is a “Kesi” embroidery from the Ming Dynasty, Wanli Emperor period.

 

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China’s Porous Glass Ceiling – How Women Entrepreneurs Compete and Succeed in China

5 Comments / January 16, 2012

“Women”, in Mao Zedong’s memorable phrase, “hold up half the sky”. While not strictly the case in the business world, Chinese women do play a far more prominent role, both in starting and running big companies in China, than their sisters do elsewhere, particularly in the US and Europe.

According to a study last year by accounting firm Grant Thornton,  women hold 34% of the senior management positions in China, compared to an average of 20% elsewhere in the world. The percentages are also moving in opposite directions, with a greater proportion of top jobs in China going to women recently. Women held 31% of management jobs in China in 2009. Meantime, women are becoming less common in senior management in Europe and US, down from 24% over the same period.

And, no, it’s not just a case of women dominating “soft functions” like HR and accounting, as they often tend to do in the West. In China, 19% of women in management roles are serving as CEOs, compared to 8% elsewhere. A significant quotient of partners at private equity firms in China are women. The most talented and capable person in investment banking in China I know, Wang Yansong,  is female — even better, she works with me.

If there is a “glass ceiling” in China, it must be quite porous.

In my three-plus years in China, I’ve met far more successful big-time women entrepreneurs and bosses than I did in 25 years working in US and Europe. I’ve also been lucky enough to work with several, including one of China’s most well-known entrepreneurs, Mrs. He Yongzhi, the founder of the country’s largest spicy hotpot restaurant chain, 小天鹅, or “Little Cygnet”, with over 400 high-end restaurants across China.

Mrs. He started the business 30 years ago in a tiny alcove, with just five tables –no capital, no powerful backers and a competitor on every street corner. And yet, she has thrived. She invented the now-ubiquitous “yin-yang” twin-flavored stock pot commonly used not just in her own restaurant but in hotpot restaurants around the country.

Along with the restaurant chain, she also runs a food processing company, producing bottled hot sauces with her face on every label, and a large commercial real estate business, including five hotels in Chongqing, Sichuan and Tibet. Her daughter Weijia is a chip off the entrepreneurial block,  having started a high-end tea business called Nenlü.

Mrs. He’s  restaurant company has Sequoia Capital as an investor, and is planning an IPO next year that will likely make her into another of China’s self-made billionairesses. Already, half of the world’s self-made billionaires are from China. Over 10% of the richest businesspeople in China are women. That may not sound like much, but is light-years ahead of most every place in the world. In a typical working year, I will meet at least 10 women bosses who are well on the way to building an enormous fortune as founder and majority-owner of companies that may likely one day have an IPO in China.

Indeed, it’s one of the great joys of my working life, that I meet so many great “lady laoban”, as we call them, using the Chinese word for “boss”. I especially like meeting with women running metal-bashing businesses.  One of the more successful and elegant women bosses I know started and runs one of China’s largest private auto parts companies, making aluminum ventilation and heating systems for cars and large trucks.

At the factory, she wears a smock with the cotton elbow-protectors once in vogue among 19th century English bookkeepers. Her husband works for her, as head of the security team. Her likely successor? Her one daughter, a recent new mom, who runs the company in tandem with her mother. Both mother and daughter are warm, lovely, attractive, fully at ease talking to truck mechanics and engineers, or walking the factory floor.

It may be a coincidence, but many of the women bosses I know do not have sons. Only daughters. Did they work harder in their professional lives to overcome the stigma (then large, now thankfully smaller) of having only girl children? It could be. But, such Western-style psychological theorizing seems misplaced. China has more great women entrepreneurs because 30 years ago, as China was ending its costly experiment with Maoist socialism, there were new huge areas of money-making opportunity open to all.  Gender mattered less than ambition, diligence, persuasiveness, business acumen and leadership skills. China after 1978 was a commercial “tabula rasa”. There were few established business rules and basically no role models (positive or negative) for anyone to follow.

China traditionally is a male-focused society, with deep-set roots in Confucian thinking that put husbands and sons well above the rank of wives and daughters. In many ways, this mindset still persists in China. And yet, paradoxically,  a society that puts men on a higher social plane can also provide women entrepreneurs with something of a level playing field in business.

In the last year, along with the two lady bosses already mentioned, I’ve met women who started and now run successful companies that make high-end LED screens, lease cars, provide an online B2B transaction platform, make and export embroidered blankets to Williams Sonoma. Never once have I heard a complaint about gender-discrimination or even a hint that the company has been victimized by negative perceptions about female bosses.

In the end, starting a company anywhere requires a tolerance of — if not full bear hug embrace of — risk. Women, so I’ve read, are programmed from birth to shun risk. It’s meant to be the reason there are comparatively few women combat soldiers and motorcycle riders, as well as successful entrepreneurs.

Gender theorists obviously never looked closely at China. Equally, Chinese women weren’t taught why they were destined by biology to underperform men in the workplace, to start fewer businesses, to climb high on fewer corporate ladders. Spared knowledge of these “facts”, they’re in full pursuit of their dreams and ambitions.


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Is Huawei a Paper Tiger?

1 Comment / January 3, 2012

No large Chinese company is more scrutinized, criticized, ostracized and demonized than Huawei, the Shenzhen-based manufacturer of telecommunications equipment. With revenues of $28 billion in 2010, and 110,000 employees, Huawei is the second-largest telecom equipment company in the world, along with being the largest and most prominent private technology company in China. It is also said to enjoy significant behind-the-curtain support from senior figures in the Chinese government and military.

Not much is known about the secretive company. But for all its size and prominence in the telecommunications industry, Huawei’s corporate finances and balance sheet may be a good deal weaker than commonly assumed. The problem comes from Huawei’s unbalanced balance sheet, and an over-reliance on loans from Chinese state-owned banks, rather than payments from customers, to finance its business. In 2011, instead of too much help from the Chinese government, Huawei seems to have suffered from a lack of it.

The bigger Huawei has grown, the more criticism it has attracted. Competitors outside China have loudly claimed the company was a front for the Chinese military, and that it owes its size in large part to an efficient process of stealing others’ technology and then selling its cut-price knock-off equipment within China and to telecom monopolies in the world’s poorer, most despotic countries.

Huawei has had a particularly hard time of it in the US, where it was sued in 2003 by Cisco for patent infringement. More recently, its plans to buy several US tech companies were blocked by the US government or obstruction by US politicians. Some of the same politicians also blocked Huawei’s sale of some larger telecom equipment in the US by asserting, without producing any real evidence,  Huawei equipment was used by the Chinese military for eavesdropping.

In part to counter all the criticism and alter its reputation as a technological lightweight, Huawei has been spending heavily in recent years to build large R&D centers around the world, hiring lots of PhDs, both Chinese and Western. The company is filing patents by the truckload, a total of over 50,000 at last count. In 2010, the company is said to have invested over $2 billion in R&D. According to the company, profits in 2010 were Rmb24 billion (US$3.7 billion) up from RMB18.27 billion in 2009.

But, the question still remains: is Huawei a solid high-tech company that is misunderstood and unfairly attacked by jealous competitors or attention-seeking politicians? Or, is it more of a bloated, backward and barely profitable machine-maker kept in business through hidden subsidies and support from various arms of the Chinese government?

I have no way to accurately judge, nor any particular interest in the company. I meet with Huawei people occasionally. Huawei is, after all, the largest and most prominent company in Shenzhen, where I now live. As a private company, Huawei releases limited financial information.

My sense is that Huawei’s main problem, at least at the moment, isn’t technical competence, but poor cash flow. This has been brought on by fast-declining profit margins, slow market growth, erratic payments from customers in less-advanced countries where Huawei derives a significant percentage of its sales. To top it off, once compliant Chinese banks have turned stingy in extending loans. Add it up, and Huawei may currently be in much less robust financial condition than previously. A paper tiger? Probabaly not. But, it does look like a very large company with a similarly large imbalance in its financial structure.

To sell its products, Huawei must usually be the cheapest supplier. But, its costs are rising fast and some of its largest markets of late, like equipment for 3G and other high-bandwidth mobile phone systems, are no longer growing quickly. Other product areas are basically stagnant, especially for traditional fixed-line telecom switches.

Though the company has made no public announcement about its financial condition, my conversations with Huawei people suggest the company had a relatively poor year in 2011, and has run into some serious cash-flow challenges. One example: Huawei’s private equity arm, which until recently was trumpeted by Huawei as a key source of future profits and access to new leading-edge technologies, has all but shriveled up and died. Funding has been basically cut off. The cash is needed apparently to keep other parts of the business above water.

In the past, Huawei could sustain its cash flow by tapping China’s state-owned banks for loans. This year, the flow of loans seems to have been curtailed. One reason:  the Chinese government has clamped down hard on all bank lending to stem rising inflation. That’s impacted most heavy borrowers in China, including, it seems, Huawei.

Chinese banks have cut back lending to Huawei, so Huawei apparently has cut back elsewhere in its business. If so, it suggests Huawei’s own cash reserves are scarce, particularly for a company its size. This is caused not only by low margins, but also because Huawei, as a private company, cannot raise money from the capital markets. Its only cushion is taking loans from Chinese banks. These loans, in turn, are dialed up or dialed down not based purely on Huawei’s creditworthiness, but also the overall credit stance of the Chinese government.

The simplest solution, a Huawei IPO, seems as a remote a possibility today as it ever was. The company does not seem ready to endure that level of public disclosure — of its murky financials, ownership, profit margins, management structure, reliance on orders and loans from Chinese government-backed entities.

Over the years, most of Huawei’s erstwhile competitors – including Northern Telecom, Alcatel, Fujitsu, Siemens, AT&T – have either gone out of business, or been dramatically slimmed down. Only Sweden’s Ericsson has sales larger than Huawei.

In the absence of reasonable profit margins and reliable cash flow from customer purchases, Huawei has used a ready flow of Chinese bank loans to finance its operations and investment. But, those low margins also make it a challenge to repay the ever larger bank debts. Ultimately, positive cash flow needs to come from customers, not bank loans.

Whatever the situation with Huawei’s books at the moment, I’m rather sure we will not be reading financial headlines anytime soon about a cash crisis at Huawei. It is a large business,  and well-connected politically. It is also reportedly a large supplier of equipment to the Chinese military.

The large banks in China are state-owned and are routinely used to advance economic, political and social goals.  These banks may have cut back on funding to Huawei this year, but if the company needs money to stave off more serious – and public — financial problems, it’s all but certain the flow of bank cash will be increased. If need be, Huawei could be put on heavy state loan intravenous support.

As Huawei has grown larger, the reliance on bank lending becomes ever more of a risk. It is, above all, a very stilted, unbalanced way for the company to manage its capital needs. A diet of too much debt and too little equity often leads to corporate malnourishment.

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In China, Newspapers Can Still Thrive

1 Comment / December 19, 2011

Newspapers, as everyone knows by now, are a crummy business, being slowly but surely pounded to death by two major forces they can’t control. First, news is now available for free, instantly, online. So, no need to wait for – and pay for — tomorrow’s newspaper to find out what’s happened today. At the same time, Google and Craigslist have created a far more efficient, and generally far cheaper,  form of advertising online than traditional print advertising.

On the whole, it’s a very gloomy picture. But, there is one new newspaper business model that not only goes from strength to strength, it will likely continue to make big money for many years to come. It’s the free newspapers distributed on subway and metro systems. The first one appeared in Sweden in 1995. Shenzhen, where I live, this year got its first entrant, called “地铁早8点”( “8 O’clock” in English). These free newspapers seem inoculated from every pathogen that is killing off the big urban newspapers around the world like the New York Times, LA Times, Le Monde, South China Morning Post. 

Start with the fact they are free. That certainly makes it easier to find readers. Next, there’s guaranteed, efficient and low-cost distribution. In the case of 8 O’clock， the paper is handed out by reps or left in big piles weekday mornings at many of Shenzhen’s 137 subway stations. Based on my daily subway commute, I’d say the newspaper is now being read by well over 60% of the people on my morning rush-hour train. The newspaper is bulging with ads. By any standards, this is a both a business success and a repudiation of the notion that print newspapers are sledding towards extinction.

The key to success for 8 O’Clock is knowing who its readers are and what they want to read about. 8 O’Clock, like most free subway newspapers, attracts mainly under-40 office workers. They have very clear editorial tastes, and these differ in some key ways from the many newspapers that are now headed for the boneyard. For one thing, 8 O’clock doesn’t try to break major stories or even stay current on political or economic stories fighting for headlines elsewhere. Instead, it offers its readers a mix of brief articles about celebrities, sports stars, oddball “human interest” tales and the occasional local scandal. Around half of each page is pictures, either advertising copy or outsized art work accompanying the short articles.

8 O’Clock is owned by the biggest traditional newspaper publishing company in Shenzhen, called Shenzhen Press Group. It has ten other newspapers in Shenzhen, all using the conventional paid-circulation model. This offers some obvious traps for Shenzhen Press Group, most obviously in selling a product at newsstands with some strong similarities to the one it’s giving away for free in subway stations.  But, against that, Shenzhen Press Group is reaching people with 8 O’clock that most likely never buy paid-for newspapers. What’s more, Shenzhen Press Group already has an in-house advertising team and deep knowledge of the local market to sell ads efficiently in 8 O’Clock. A full-page color ad sells for around USD$25,000-$35,000, depending on the day of the week and placement. Readership is somewhere around 300,000 a day.

Beijing, Shanghai, Shenyang and Guangzhou all have their own free subway newspapers. All seem to be thriving.  Other countries also have them, including US, UK, Germany.

China is the ideal place for free subway-distributed newspapers to thrive. Start with the fact, of course, its cities are huge and subway ridership dwarves that of most Western cities. But, as important, the newspaper industry in China is relatively new. Chinese aren’t imprinted in the way that so many Americans and Europeans are about what newspapers are for. The popular ones see themselves, unashamedly, as for-profit vehicles: an effective advertising medium. Not as a civic trust.

The editorial goal is to get enough people reading articles at the top of the page to deliver big audiences, efficiently, for the advertisers renting space at the bottom. For 8 O’clock, the advertisers are mainly large auto brands, hospitals, realtors and big chain stores all of whose businesses are thriving in China’s booming domestic economy. 

In cities like Shenzhen, Shanghai and Beijing, purchasing power, along with property prices, are reaching first world levels. There’s massive net migration into large cities in China, compared with stagnant, or declining populations in most big Western cities. The subway systems are themselves mainly new, with extensive networks – 14 lines in Beijing, 11 in Shanghai, five in Shenzhen, with two more on the way. As the systems grow, so too will the profits of the free subway newspapers like 8 O’clock.

A generation ago, there was basically only one newspaper of any importance and readership in China, the Communist Party’s People’s Daily (“人民日报”).  It’s still published, and has changed little down the years, a slim sheaf of turgid and often theoretical writing barely leavened by photos or ads. Meanwhile, thousands of newspapers and magazines have entered the market with a broad range of content.

All major media in China are still subject to censorship and, in theory, under the control of the Party’s propaganda department. But, 8 O’clock has ample scope to provide what Shenzhen’s subway commuters are after, at a price they can’t argue with.  A financially healthy newspaper serving a financially prospering city– 8 O’clock will keep waltzing compared to the wretched papers in the US and Europe.

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Song Dynasty Deal-Sourcing

1 Comment / December 5, 2011

I get asked occasionally by private equity firm guys how CFC gets such stellar clients. At least in one case, the answer is carved fish, or more accurately my ability quickly to identify the two murky objects (similar to the ones above) carved into the bottom of a ceramic dish. It also helped that I could identify where the dish was made and when.

From that flowed a contract to represent as exclusive investment bankers China’s largest and most valuable private GPS equipment company in a USD$30mn fund-raising. It’s in every sense a dream client. They are the most technologically adept in the domestic industry, with a deep strategic partnership with Microsoft, along with highly-efficient and high-quality manufacturing base in South China, high growth and very strong prospects as GPS sales begin to boom in China.

Since we started our work about two months ago, several big-time PE firms have practically fallen over themselves to invest in the company. It looks likely to be one of the fastest, smoothest and most enjoyable deals I’ve worked on.

No fish, no deal. I’m convinced of this. If I hadn’t correctly identified the carved fish, as well as the fact the dish was made in a kiln in the town of Longquan in Zhejiang Province during the Song Dynasty, this company would not have become our client. The first time I met the company’s founder and owner, he got up in the middle of our meeting, left the room and came back a few minutes later with a fine looking pale wooden box. He untied the cord, opened the cover and allowed me to lift out the dish.

I’d never seen it before, but still it was about as familiar as the face of an old teacher. Double fish carved into a blue-tinted celadon dish. The dish’s heavy coated clear glaze reflected the office lights back into my eyes. The fish are as sketchily carved as the pair in the picture here (from a similar dish sold at Sothebys in New York earlier this year), more an expressionist rendering than a precisely incised sculpture.

It’s something of a wonder the fish can be discerned at all. The potter needed to carve fast, in wet slippery clay that was far from an ideal medium to sink a knife into. Next came all that transparent glaze and then the dish had to get quickly into a kiln rich in carbon gas. The amount of carbon, the thickness and composition of the glaze, the minerals dissolved in the clay – all or any of these could have contributed to the slightly blue-ish tint, a slight chromatic shift from the more familiar green celadons of the Song Dynasty.

All that I knew and shared with the company’s boss, along with remarking the dish was “真了不起”, or truly exceptional. It’s the finest celadon piece I’ve seen in China. Few remain. The best surviving examples of Song celadon are in museums and private collection outside China. I’m not lucky enough to own any. But, I’ve handled dozens of Song celadons over the years, at auction previews of Chinese ceramic sales at Sotheby’s and Christie’s in London and New York. The GPS company boss had bought this one from an esteemed collector and dealer in Japan.

The boss and I are kindred spirits.  He and I both adore and collect Chinese antiques. His collection is of a quality and breadth that I never imagined existed still in China. Most antiques of any quality or value in China sadly were destroyed or lost during the turbulent 20th century, particularly during the Cultural Revolution.

The GPS company boss began doing business in Japan ten years ago, and built his collection slowly by buying beautiful objects there, and bringing them home to China. Of course, the reason Chinese antiques ended up in Japan is also often sad to consider. They were often part of the plunder taken by Japanese soldiers during the fourteen brutal years from 1931 to 1945 when they invaded, occupied and ravaged parts of China.

Along with the celadon dish, the GPS boss has beautiful Liao, Song, Ming and Qing Dynasty porcelains, wood and stone carvings and a set of Song Dynasty paintings of Buddhist Luohan. In the last few months, I’ve spent about 20 hours at the GPS company’s headquarters. At least three-quarters of that time, including a visit this past week, was spent with the boss, in his private office, handling and admiring his antiques, and drinking fine green tea grown on a small personal plantation he owns on Huangshan.

I’ve barely talked business with him. When I tried this past week to discuss which PE firms have offered him money, he showed scant interest. If I have questions about the company, I talk to the CFO. Early on, the boss gifted me a pretty Chinese calligraphy scroll. I reciprocated with an old piece of British Wedgwood, decorated in an ersatz Chinese style.

Deal-sourcing is both the most crucial, as well as the most haphazard aspect of investment banking work. Each of CFC’s clients has come via a different route, a different process – some are introduced, others we go out and find or come to us by word-of-mouth.  Unlike other investment banking guys, I don’t play golf. I don’t belong to any clubs. I don’t advertise.

Chinese antiques, particularly Song ceramics,  are among the few strong interests I have outside of my work.  The same goes for the GPS company boss. His 800-year old dish and my appreciation of it forged a common language and purpose between us, pairing us like the two carved fish. The likely result: his high-tech manufacturing company will now get the capital to double in size and likely IPO within four years, while my company will earn a fee and build its expertise in China’s fast-growing automobile industry.  

 

Xinjiang Is Changing the Way China Uses and Profits From Energy

Leave a Comment / December 6, 2011

 

Two truisms about China should carry the disclaimer “except in Xinjiang”. China is a densely-populated country, except in Xinjiang. China is short on natural resources, except in Xinjiang. Representing over 15% of the China’s land mass, but with a population of just 30 million, or 0.2% of the total, Xinjiang stretches 1,000 miles across northwestern China, engulfing not only much of the Gobi Desert, but some of China’s most arable farmland as well. Mainly an arid plateau, Xinjiang is in places as green and fertile as Southern England.

Underneath much of that land, we are beginning to learn, lies some of the world’s largest and richest natural resource deposits, including huge quantities of minerals China is otherwise desperately short of, including high-calorie and clean-burning coal, copper, iron ore, petroleum.  How, when and at what cost China exploits Xinjiang’s natural resources will be among the deciding issues for China’s economy over the next thirty years. Already, some remarkable progress is being made, based on two past visits. I return to Xinjiang tomorrow for five days of client meetings.

Because of its vast size and small population, Xinjiang hasn’t yet had its mineral resources fully probed and mapped. But, every year, the size of its proven resource base expands. Knowing there’s wealth under the ground, and finding a cost-effective way to dig out the minerals and get them to market are, of course,  very different things. Until recently, Xinjiang’s transport infrastructure – roads and railways – was far from adequate to provide a cost-efficient route to market for all the mineral wealth.

That bottleneck is being tackled, with new expressways opening every year, and plans underway to expand dramatically the rail network. But, transport can’t alter the fact Xinjiang is still very remote from the populated core of China’s fast-growing industrial and consumer economy. Example:  it can still be cheaper to ship a ton of iron ore from Australia to Shanghai than from areas in Xinjiang.

Xinjiang’s key resource, and the one with the largest potential market, is high-grade clean-burning coal. Xinjiang is loaded with the stuff, with over 2 trillion tons of proven reserves. Let that figure sink in. It’s the equivalent of over 650 years of current coal consumption in coal-dependent China . The Chinese planners’ goal is for Xinjiang to supply about 25% of China’s coal demand within ten years.

Xinjiang’s coal is generally both cleaner (low sulphur content) and cheaper to mine than the coal China now mainly relies on, much of which comes from a belt of deep coal running through Inner Mongolia, Shanxi and Shandong Provinces. Large coal seams in Xinjiang can be surface mined. Production costs of under Rmb150 a ton are common. The current coal price in China is over four times higher for the dirtier, lower-energy stuff.

For all its advantages, Xinjiang coal is not going to become a primary source of energy in China. The Chinese government, rightly, understands that the cost, complexity and long distances involved make shipping vast quantities of Xinjiang coal to Eastern China unworkable. Moving coal east would monopolize Xinjiang’s rail and road network, causing serious distortions in the overall economy.

Instead, the Xinjiang government is doing something both smart and innovative. It is encouraging companies to use Xinjiang’s abundant coal as a feedstock to produce lower cost supplies of industrial products and chemicals now produced using petroleum. All kinds of things become cost-efficient to manufacture when you have access to large supplies of low-cost energy from coal. Shipping finished or intermediate goods is obviously a better use of Xinjiang’s limited transport infrastructure.

I’ve seen and met the bosses of several of these large coal-based private sector projects in Xinjiang. The scale and projected profitability of these projects is awesome. In one case, a private company is using a coal mine it developed to power its $500mn factory to produce the plastic PVC. The coal reserve was provided for free, in return for the company’s agreement to invest and build the large chemical factory next to it. The cost of producing PVC at this plant should be less than one-third that of PVC made using petroleum. China’s PVC market, as well as imports, are both staggeringly large. The new plant will not only lower the cost of PVC in China but reduce China’s demand for petroleum and its byproducts.

Another company, one of the largest private companies in China,  is using its Xinjiang coal reserve, again supplied for free in return for investment in new factories, to power a large chemical plant to produce glycerine and other chemical intermediates. This company is already a large producer of these chemicals at its factories in Shandong. There, they run on petroleum. In the new Xinjiang facility, coal will be used instead, lowering overall manufacturing costs by at least 20% – 30% based on an oil price of around $50. At current oil prices, the cost savings, and margins, become far richer.

The key, of course, is that the companies get the coal reserve for free, or close to it. True, they need to build the coal mine first, but generally, that isn’t a large expense, since it can all be surface-mined.  This means that the cost of energy in these very energy-intensive projects is much lower than it would be for plants using petroleum or, to be fair, any operator elsewhere who would need to purchase the coal reserve as well as build the capital-intensive downstream facilities.

The Xinjiang projects should lock-in a significant cost advantage over a significant period of time. As investments, they also should provide consistently high returns over the long-term. While the capital investment is large, I’m confident the projects are attractive on risk/return basis, and that in a few years time, these private sector “coal-for-petroleum” projects will begin to go public, and become large and successful public companies.

The Xinjiang government keeps close tabs on this process of providing free coal reserves for use as a feedstock.  Since in most cases, these projects are looking to enter large markets now dominated by petroleum and its byproducts, there is ample room for more such deals to be done in Xinjiang.

Deals are getting larger. This summer, China’s largest coal producer, Shenhua Group, announced it would invest Rmb 52 billion ($8 billion) on a coal-to-oil project in Xinjiang. The company plans to mine 70 million tons of coal a year and turn it into three million tons of fuel oil.

Remote and sparsely-populated as it now is, Xinjiang is going to play a decisive role in China’s industrial and energy future, just as the development of America’s West has helped drive economic growth for over 100 years, and created some of America’s largest fortunes.  My prediction:  China’s West will produce more coal and mineral billionaires over the next 100 years than America’s has over the past hundred.

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Investment Banking in China — What I’ve Learned & Unlearned

4 Comments / November 2, 2011

Anyone seeking to succeed in investment banking in China should live by one rule alone: it’s not who you know, but how well you know them. In China, more than any other country where I’ve worked, the professional is also the personal. Comradeship, if not friendship, is always a necessary precondition to doing business together. If you haven’t shared a meal – and more importantly, shared a few hundred laughs – you will never share a business deal. Competence, experience, education and reputation all matter, of course. But, they all play supporting roles.

The stereotypical hard-charging pompous Wall Street investment banker wouldn’t stand much of a chance here. A “Master of the Universe” would need to master a set of different, unfamiliar skills. Personal warmth, ready humor and a relaxed and somewhat deferential attitude will go a lot farther than spreadsheet modeling, an Ivy League MBA and financial dodges to increase earnings-per-share.

I’ve been around a fair bit in my +25 year business career, doing business is over 40 countries and managing companies in the US, Europe and Asia. Everywhere, it helps to be likeable, attentive, courteous. We all prefer working with people we like.  But, since moving to China and opening a business, I’ve learned things work differently here. Making money and making friends are interchangeable in China. You can’t do the first without doing the second.

Investment banking is so personal in China because most private Chinese companies, from the biggest on down, are effectively one-man-shows, with a boss whose authority and wisdom are seldom challenged. Usually, there is  no “management team” in the sense this term is applied in the US and Europe. A Chinese boss is the master of all he (or often she, as women entrepreneurs are common here) surveys.

A substantial percentage of my time is spent getting to know, and winning the friendship, of Chinese bosses. This alone makes me a lucky guy. Without fail, the bosses I meet are smart, gifted, able, hospitable, warm. We don’t select for these qualities. They are prerequisites for success as a private business in China.

Bosses are also usually guarded about meeting new people. It comes with the territory. Anyone with a successful business in China is going to be in very large demand from a very large “catchment pool”, including just about everyone in the extended circle of the boss’s friends, relatives, employees, suppliers, political contacts. Everyone is selling or seeking something. Precious few will succeed. Being a boss in China requires enormous stamina, to deal with all those making a claim on your time, and a gift for saying “No” in ways that don’t offend.

For investment bankers, successful deal generation in China will usually follow an elliptical path. The biggest mistake is to start pitching your company, or a transaction, the moment you meet a prospective client. You need first to win the boss’s trust and friendship, then you can discuss how to work together. In my working life in China, it’s axiomatic that in a first meeting with a company boss, one or the other of us will say, “我们先做朋友”,  or “let’s become friends be first”. It’s not some throwaway line. It’s an operating manual.

The Chinese use a specific word to define the engagement between an investment banker and client. It speaks volumes about the way new business is won here. It’s “合作” or cooperation. You don’t work for a Chinese company, you cooperate with it. There’s got to be a real personal bond in place, a tangible sense of shared purpose and shared destiny.

I could probably teach a class in the cross-cultural differences of investment banking in China and the US. I’ve not only been active in both places, I’ve been on both sides of the table. Before starting CFC, I was CEO of an American company that retained one of the most renowned investment banks in the US to handle an M&A deal for us. At that company, we had a deep senior management team, including two supremely capable founders. We dealt individually and collectively with the investment bank, which had a similarly-sized team assigned to the project.

The relationships were professional, cordial. But, the investment bankers never made any real effort to become my friend, nor did I want them to. Rarely, if ever, did discussions veer away from how to create the conditions to get the best price. The bankers were explicitly pursuing their fee, and we were pursuing our strategic goal.

The deal went pretty smoothly, following a tightly-scripted and typical M&A process. The investment bank’s materials and research were first-rate, and they had no difficulty getting directly to decision-makers at some of the largest software companies in the world. They performed with the intricate precision and harmony of the Julliard Quartet.

I can count the number of times I sat down with the bankers for a nice meal where business was not discussed. Or the number of times when the meeting room rang with peals of friendly laughter. Zero. Both would be unthinkable in China.

Here, a deal is more than just a deal. Price is not the only, or even the main objective. Instead, as an investment banker, you must knit souls together, their lives, fortunes, careers, goals and temperaments. There is no spreadsheet, no due diligence list, no B-school case study, no insider jargon to consult.

Be likeable and be righteous. But. above all, do not be transparently or subliminally motivated mainly by personal greed. A successful Chinese boss will smell that coming from miles away, and recoil. You’ll rarely get past “ 您好” , the polite form of “hello”.

 

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What is the Major Source of China’s Economic Competitiveness? Surprise, it’s Not Labor Prices

Leave a Comment / October 17, 2011

 

True of false? The basis of China’s global economic competitiveness is cheap labor? False. It’s cheap factory land.

No doubt,  until a few years ago, China’s low labor costs were a vital part of its economic growth story. That is no longer the case. Labor costs have risen sharply in the last five years. There are now many countries with a decided labor cost advantage over China. And yet China remains the “factory of the world”. For one thing, its workers have higher productivity than those earning lower wages in countries like Vietnam, India or Indonesia.

But, there is a more fundamental, and most often overlooked, reason for China’s global economic competitiveness. Factories, and other productive assets like mines or logistics centers, are built on land that is either free of close to it. The result is that in China land costs usually represent an inconsequential component of overall manufacturing and operating costs. This, in turn, gives China an inbuilt edge and, when added to the productivity of its workers, an insurmountable cost advantage over the rest of the world.

There is no good international data on the percentage of a company’s fixed costs that come from purchase or rental of land. But, it is certainly the case that in China, this percentage will be far lower than in any developed – and many developing – countries. This isn’t because land is cheap in China. It isn’t. The market price, in most areas, is often on par with land costs in the US. But, good businesses in China don’t pay market price. Often they pay nothing at all.

This has two useful aspects for the favored Chinese business. First, it means the cost of expanding operations is limited primarily to the cost of new capital equipment and factory construction. Second, the business given a plot of land is thus endowed with a valuable asset it can use as collateral to secure more funding from banks. Even better, if the business runs into trouble or later goes bust, the owner will be able to sell the land at market price and pocket a huge personal gain.

It can’t be overstated just how important this is to a business owner’s calculation of risk, and so the success of Chinese entrepreneurial companies. Owners know that if all goes bad, they still hold land acquired for little or nothing for that is worth millions of dollars.

All land in China belongs to the Chinese government. Every year, a fraction of it is released on a long-term lease (usually forty years or longer) for development into commercial or residential land. While there is no official central policy to make land available at low prices to successful businesses, in practice, this is the way the system works. Land is sold at deeply-discounted prices, or given outright, to businesses that are seeking to expand, often by building a new factory or office building.

Land in China, it goes without saying, is in very high demand. It’s a crowded country, and only 15% of the land is flat or fertile enough to be suitable for cultivation. This “good land” is also where most new factories get built.

There isn’t enough new land released every year to meet the enormous demand. This is true both for residential land, a key reason why housing prices are so high, and commercial land. For most businessmen, it’s impossible to get new land, at any price. A privileged group, however, not only gets land to expand, but gets it at artificially low prices. In China, land prices are elastic. Different levels of government have ways to transfer land to companies at prices equal to 5%-15% of its current market value.

Officially, the land allocation system in China is meant to work in a more market-oriented way, with new land for development being auctioned publicly, and selling prices controlled and verified by higher levels of government. In other words, the system is meant to discourage, if not prohibit, land being given to insiders at low prices. In practice, these rules are often more observed in the breach. Local governments have ways to control the outcome of land auctions and so guarantee that favored businesses get the land they want at attractive prices.

These below-market sales deprive the local government of revenue it might otherwise earn from a land deal done at closer to market prices. But, there is some economic logic at work. The sweetest of sweetheart land deals are generally offered to successful companies whose growth is being stifled by insufficient factory space. The new land, and the new factories that will be built there, will increase local employment and, down the road, tax revenues.

Note, the deeply-discounted land prices are available mainly to companies that are already successful, and straining at the leash to maintain growth and profits. Both private and state-owned companies are eligible. It’s a rare example of even-handed treatment by officials of state-owned and private companies.

Is corruption also a factor? Are cheap land deals really not all that cheap when various under-the-table payments are factored in? My personal experience, though limited, suggests such payoffs, if they happen,  are not compulsory.

I’ve played a walk-on part in several below-market land deals. My role is to meet with local officials, usually the mayor or party secretary,  to urge them to provide my client with the land needed for expansion. All local government officials in China are also motivated by, and rewarded for, having local companies go public. I stick to that point in my discussions with the local officials – my client needs land to grow and so reach the scale where the business can IPO.

In each case, the deal has gone forward, and clients have gotten the land they were seeking, at a price 5-15% of its then-market value. My client wins the trifecta: the business grows larger, unit costs remain low because of scale economies and the cheap land, and the balance sheet is strengthened by a valuable asset purchased on the cheap.

In all respects, this system of commercial land acquisition is unique to China. It is also a key component in the country’s economic policy, though it never has been proclaimed as such. The government at all levels is keen to keep GDP growing smartly. This process of rewarding good companies with cheap land for growth plays a key part in this, everywhere across China. China’s government (at national, provincial and local levels) is not hurting for cash, unlike for example America’s. Tax revenues are growing by upwards of 30% a year. So, maximizing the value of land released for development is not a fiscal priority.

Who loses? There are likely incidences where peasants are thrown off land with little or no compensation to make way for new commercial district. But, that way of doing things is becoming less common in China.

Mainly, of course, the losers are the international competitors of Chinese companies getting cheap land to expand. It’s hard enough to stay in business these days when facing competition from China. It verges on hopeless when the Chinese companies can build output and lower unit prices because of land they get for free or close to it.


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Chengdu — Great City, but Where Are the Great Food Companies?

Leave a Comment / October 4, 2011

Ge dish from China First Capital blog post

Among major cities in China, Chengdu takes the prize as most pleasant, livable,  comfortably affluent, relaxed and charming. I arrived back here today. I’m reminded immediately there’s much to like about Chengdu, and one thing to love: the food.

Chengdu is famed for its “小吃”, (“xiaochi”) literally “small eats”. To translate 小吃 as “snack”, as most dictionaries do, doesn’t even remotely begin to do it justice. A 小吃  is a often one-bowl wonder of intense, jarring flavors. They not only take the place of a full meal with rice, they make the Chinese staple seem almost superfluous, a waste of precious space in the stomach.

There are about a dozen小吃 that can stop me in mid-stride, any time of day. These include several varieties of cold noodles, including the bean jelly ones called 凉粉, literally “cold powder”，as well as dandan noodles served dazzlingly hot, in both senses of the word.

My favorite 小吃 , by a wide margin, is 抄手 , literally, “to fold one’s arms”. It’s an odd name, since the last thing I’d ever do when I see a bowl of抄手 in Chengdu is fold my arms. They are always thrust outward, in anticipation.  抄手 is a bowl of wontons steeped in a fire-engine red soupy sauce, optimally with enough Sichuan pepper corn to numb the tongue all the way down the gullet. This frees up the nose to do the real work of decoding all the subtle flavors.

Offiically, Chengdu has a per capital income of around $5,200, about half Shanghai’s. But, I’d prefer living and working in Chengdu any day. So would many Chinese I know. The economy is doing well, despite some geographic disadvantages. Chengdu is the most westerly of China’s large cities, and so isolated from the most developed regions of China. It’s over 1,000 miles to Shanghai, Beijing, and almost as far to Shenzhen.

Chengdu is doing well economically – though you don’t always have a sense this ranks as high on the list of civic priorities as drinking tea and playing mahjong. The electronics and telecom industries are both doing well. Quite a few companies have received PE investment.

The one industry, however, that is still relatively undeveloped is the food business. This is odd. By logic, Chengdu should be a center of China’s food processing and restaurant industry. Not only is it a great food town, situated in a very region valley producing some of China’s best fruits and vegetables, but it is also capital of Sichuan Province.

Sichuan food is almost certainly the most popular “non native” cuisine across China. Within a mile of where I live in Shenzhen, there are probably over 50 Sichuan restaurants. It’s the same in Beijing, Shanghai and most other major cities.

There’s an innate association in Chinese minds between Sichuan and good food. In this, Sichuan reminds me a lot like Italy. Italian food is prized across all of the Western world, and as a result, some of the Western world’s biggest and most successful food companies are based in Italy. Among the larger ones are Barilla, Bertolli, Buitoni, Parmalat, Ferrero. These, and thousands of smaller ones making wine, cheese, salami, all benefit from the widespread popularity of Italian food, and the high market value of associating a food brand with Italy.

Chengdu and Sichuan should be no different. It should be the capital of China’s food processing industry. But, as far as I can tell, there are as of yet no great food companies or food brands based there.  If you shop around in Chengdu, the food products being marketed as “authentic Sichuan food ” are mainly an assortment of beef jerky, along with sweet and savory biscuits made from beans and peanuts.

There’s nothing wrong with any of these products, but there isn’t a big brand national brand among them. The mass market is going unserved.

Let’s look at two of the biggest food product categories where Sichuan brands should predominate: chili sauce and instant noodles. Each of these product areas have sales of billions of dollars a year in China. Yet, the leading brands come from outside Sichuan. In the case of instant noodles, the leaders are mainly Taiwanese and Japanese.

In chili sauce, the biggest brands all seem to come from Guizhou province. This, particularly, should cause a collective loss of face across Sichuan. Their spicy food  “owns” the palettes of hundreds of millions of people and yet the main brands of chili sauce in supermarkets come from the poorer province to its south.

The companies selling bottled pre-made Sichuan sauces (for popular dishes like Gongbao Jiding, Mapo Toufu and Yuxing Rousi) mainly come from Taiwan, Shanghai, even Hong Kong. It’s as if the most popular brands of spaghetti sauce were made in Brazil. Chinese food companies all over are eating Sichuan’s lunch.

This situation is unnatural and, I’d hope, unsustainable. Sichuan companies should by rights eventually dominate the market for many food products in China, much as Italian food companies are among the largest in Europe.

Some lucky PE investors should someday make a lot of money backing Sichuan food companies. Me and my company would love to play our part in this. Ambitious food entrepreneurs in Chengdu, call us anytime — 0755 33222093. If ever there were a billion-dollar unfilled market opportunity in China, this would be it.

 

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M&A in China – China First Capital’s New Research Report

Leave a Comment / April 7, 2013


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CFC’s latest Chinese-language research report has just been published. The topic: M&A Strategy for Chinese Private Companies. Our conclusion: propelled by rapidly-growing domestic market and the continuing evolution of China’s capital markets, China will overtake the USA within the next decade as the world’s largest and most active market for mergers and acquisitions.

The report, titled “ 并购- 中国企业的成功助力”，can be downloaded by clicking here.

The report identifies five key drivers that fueling M&A activity among private sector companies in China.  They are: (1) a once-in-a-business-lifetime opportunity to seize meaningful market share in the domestic market; (2) the coming generational shift as China’s first generation of entrepreneurs moves toward retirement age; (3) a widening valuation gap between private and publicly-traded companies; (4) regulatory changes that will make it easier to pay for acquisitions using shares as well as cash; (5) increased access to IPO market in China for companies that have augmented organic growth through strategic M&A.

Several case studies from our work feature in the report, including a cross-border M&A deal we are doing, and one purely domestic trade sale. We take on a select number of M&A clients, and work as a sell-side advisor.

M&A in China has myriad challenges that do not often arise in other parts of the world. One we see repeatedly is that few Chinese acquirers have in-house M&A teams or investment banks on call to provide help with structure and valuation. Talking with anyone less than the company chairman is often a waste of time.

Another unique hurdle: “GIGO DD” or, more prosaically, “garbage in, garbage out due diligence.” Potential acquirers unfortunately will often start their industry research by doing a Chinese language web search using Baidu. There is a lot of dubious stuff out there that is given some credence, including phony websites and bizarre claims posted to people’s personal blogs or chatrooms.

In the cross-border deal we’re working on, several companies backed out of the process after finding Chinese companies claiming on their corporate website to make equipment identical to our client’s. This convinced these potential bidders that our client had technology and assets of little value. We actually took the time, unlike the potential acquirers, to call the phone numbers on these websites, posing as potential customers. None of the companies had any similar equipment for sale or in development. The material on their websites was bogus.

Market data from online sources is also usually specious. Few people, including lawyers, have working knowledge of how an M&A deal might impact a company’s plans for domestic IPO in China.

I’ve been inside some M&A deals in the US,  with their online data rooms, cloak-and-dagger codenames, and a precisely orchestrated bidding process. In China, the process is more unscripted.

Until recently, the only Chinese companies able and willing to do M&A were larger State-Owned Enterprises (SOE). The deals were done to buy oil and other natural resources on the stock market, or to acquire European brand names to put on Chinese-made products. Those deals include Sinopec’s purchase of shares in Canadian company Addax， CNOOC’s failed acquisition of UnoCal, TCL’s purchase of Thomson TVs and Alcatel phones, and Nanjing Automotive’s buying the MG brand.

These kind of deals will likely continue. But, in the future, M&A deals will become more numerous, more necessary for private entrepreneur-founded companies and have more complex strategic goals.

M&A is one of only two ways for founders and shareholders to achieve exit. The other is IPO. But, the number of private companies who can IPO in China will always be limited. At the moment, the number is about 250 per year. Compare that to the 70 million or so private companies in China.

The IPO process creates a special competitive dynamic in China. The first company in an industry to become publicly-traded usually has a huge advantage over competitors. They disrupt the previous equilibrium in an industry.

This means there are only two choices for many entrepreneurs. Both choices involve M&A. If you aren’t going to become a public company or a competitor has already gone public, you need to consider selling your company. If you want to become a public company,  you will need to become an expert at buying other companies.

The economic destiny of China, and many of its better private companies, is M&A.

 

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Cease and Desist on Delist-Relist — Wall Street Journal Op-Ed

1 Comment / June 25, 2016

WSJ1

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It’s only a moderate exaggeration to say that everything I’ve learned of value and enduring truth about politics and economics over the last 25 years came from the editorial pages of the Wall Street Journal. For just as long, the one writing goal I’ve held onto was having an op-ed published there. Today’s the day.

“Cease and Desist on Delist-Relist“” is running in today’s Asian edition. I’m delighted. I owe a huge debt of thanks to the Journal’s Joe Sternberg who encouraged me to submit the piece, and then did masterful work shaping and reworking the text from earlier blog posts. 

I’ve known my fair share of editors. When I was at Forbes Magazine many years ago, I had the good fortune to have a fair percentage of my stories edited directly the then Editor-in-Chief, Jim Michaels, who richly deserves the reputation as one of the finest ever in business journalism. He was a maestro. Other Forbes editors? Often klutzes. Joe’s editing work is of Michaels quality. I have no higher standard, or stouter praise.

The full text as published by the Journal is copied below. For anyone who’d like to read the earlier draft, about 15% longer than this version, you can click here. 

  
  
 

 

  • The Wall Street Journal

Cease and Desist on Delist-Relist

 

 

 

By PETER FUHRMAN

Foreign private-equity firms have a history of running into trouble in China. Generally consigned to buying minority stakes instead of the traditional buy-out-and-turn-around model they mastered back home, several big-name firms have become collateral damage in various corporate fraud sagas. Yet now some PE investors look set to jump into what could be the worst China investment move of all: the “delist-relist” deal.

The theory is simple. Hundreds of Chinese companies have gained listings in the U.S. via reverse takeovers, injecting all of their assets into a dormant shell company with shares traded on NASDAQ, AMEX or, more commonly, over-the-counter. Only then do the Chinese firms discover the enormous compliance costs associated with being listed in America, not to mention the low valuations for U.S.-traded shares relative to what a Chinese company could pull from equity markets back in China.

Enter PE investors to buy out the American shareholders, delist in the U.S., and then cash out by relisting in China. Several such deals have already been hatched, including one by Bain Capital to spend $100 million taking private NASDAQ-listed China Fire & Security Group; two deals orchestrated by Hong Kong-based Abax Capital, the planned buyouts of NASDAQ-listed Harbin Electric and Fushi Copperweld for more than $700 million; and Fortress Group’s financing to take Funtalk Holdings’ private. Conversations with market participants suggest quite a few other PE firms are now actively looking at such transactions.

Yet while the superficial appeal is clear, the risks are enormous and unmanageable, and have the potential to mortally wound any PE firm that tries.

The first problem relates to the aspect that most excites PE firms about delist-relist deals: the low share price in the U.S. The assumption generally is that this is simply bad luck. Many Chinese companies ended up trading over-the-counter or at low valuations on NASDAQ as a result of their reverse mergers. Share prices stay depressed, the theory goes, because American investors don’t understand the company’s business or trust its accounting.

That may be too generous to the Chinese executives. Those managers were foolish to have done a reverse merger in the first place. One can infer the boss has little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing that has probably cost the firm at least $1 million in fees to complete and ongoing regulatory compliance. An “undervalued asset” in the control of someone misguided enough to go public this way may not be undervalued after all.

Next, there are the complexities of taking a company private. For instance, class-action lawsuits have become fairly common in any kind of merger or acquisition deal in the U.S., with minority shareholders often disputing the valuation. With Chinese companies, distance, differences in accounting rules, and unusual corporate structures are likely to lead to bigger disputes over what a company is actually worth.

As if all that weren’t bad enough, it is far from certain that these Chinese companies, once taken private, will be able to relist in China. Any proposed initial offering in China must gain the approval of the China Securities Regulatory Commission. There is a low chance of success. No one knows the exact numbers, but from my own conversations with Chinese regulators, it seems likely that only 10%-15% of the more than 150 companies per month that applied to list last year gained listings. Companies whose U.S. listings failed will almost certainly suffer a serious stigma in the CSRC’s eyes. PE firms could end up owning firms that are delisted in the U.S. and unlistable in China.

Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its limited partners for breach of fiduciary duty. Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to raise money. In other words, PE firms that do delist-relist deals may be taking an existential risk.

Why, then, are PE firms considering these deals? Because they appear easy. The target company is usually already trading on the U.S. stock market, and so has a lot of disclosure materials available. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog requiring extensive due diligence. Delist-relist seems like an easy way in, especially for smaller, less experienced PE firms.

By some counts, America’s largest export to China is now trash and scrap for recycling. These delist-relist deals have a similar underlying logic, that PE firms can turn American muck into brass in China. But that’s a big and very dangerous gamble. The only people certain to do well out of these deals are U.S. investors who sell out now at a small premium in the “take private” part of the deal.

Mr. Fuhrman is chairman and chief executive of China First Capital. This column is adapted from a report recently published by CFC.

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China: The World’s Best Risk Adjusted Investment Opportunity

1 Comment / August 21, 2011

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Seoul, Korea. At the Harvard Project for Asia and International Relations’ annual conference, I gave a talk today titled “China, The World’s Best Risk-Adjusted Investment Opportunity”. A copy of the PPT can be downloaded by clicking here. 

The slides are mainly just talking points, rather than fully fleshed-out contents. The idea was to work backwards from the conclusion, as propounded in the title, to the reasons why. My argument is that a confluence of factors are at work here, to create this agreeable situation where investing in Chinese private companies offers the highest returns relative to risk.

Those factors are:

  1. China’s current stage of six-pronged development (Slide 2)  
  2. A large group of talented entrepreneurs tested and tempered by the difficulties of starting and managing a private business in China (Slide 5)
  3. Plentiful equity capital (from private equity and venture capital firms) with clearly-articulated investment criteria (Slide 6)
  4. An investment strategy that offers multiple ways for capital to impact positively the performance of a private company,  lowering the already-minimal risk an investment will tank (Slide 7)
  5. The returns calculus (Slide 8 ) – the formula here is profits (in USD millions) multiplied by a p/e multiple, producing enterprise valuation. The first equation is an example of investor entry price, pre-IPO, and the second is investor exit price, after a round PE investment and an IPO. The gain is twenty-fold.  Thus do nickels turn into dollars
  6. Downsides – best risk-adjusted returns does not mean risk-free returns. Here are some of the ways that a pre-IPO investment can go bad (Slide 9) 

Since the audience in Seoul was largely non-Chinese, I also included two slides with the same map of China, illustrating the progression of economic development in China, from a few favored areas on China’s eastern seaboard during the early phases, to the current situation where economic growth, and entrepreneurial talent, is far more broadly-spread across the country.

As a proxy to illustrate this diffusion of economic dynamism across China, slide 4 shows, in gold, the areas of China where CFC has added clients and projects in the last 18 months. Slide 3 shows the original nucleus of economic success in China – Guangdong, Fujian, Zhejiang, Shanghai, Jiangsu and Beijing. We also have clients in these places. 

On seeing Slide 4, I realized it also displays my travel patterns over the last year.  I’ve been everywhere in red or gold, except Gansu, but adding in Yunnan, during that time. That’s a big bite out of a big country. This trip to Korea is my first flight outside China in two years, excepting a couple of short trips back to the US to see family. 

In the next two weeks, after returning from Korea, I’ll make three separate trips, to Henan, Jiangsu and Beijing, to visit existing clients and meet several potential new ones. While Chinese private SME provide the best risk-adjusted investment returns anywhere, you can’t do much from behind a desk. Opportunity is both widespread and widely-spread.

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