China Investment

Private Equity Firms in China in the Firing Line – Ratcheting Up the Criticism of Performance Ratchets

Ming Dynasty Cloisonne

In an interesting discussion this week in Shenzhen with a very smart and capable lawyer (Ke Luo of Fangda Partners), I learned about a small, but growing backlash against the Top Tier private equity firms working China. Evidently there have been some articles in the Chinese press voicing criticisms of their approach and methods, and comparing them unfavorably with Chinese domestic investment companies. 

Upfront disclosure: we choose to work only with the 70 or so Top Tier private equity firms active in China, as we believe they are the best investors for companies with the greatest potential, adding more value, beyond just capital, than any other source of investment. 

A main point of contention: the ratchet and performance provisions of most of the top private equity investment deals in China (and everywhere else in the world). These are the provisions, incorporated into the final closing share purchase agreement, through which the PE firm gains greater ownership in a company they’ve invested in if the company fails to meet previously agreed revenue, profit or margin targets.   

It’s a penalty for underperformance. And a very effective and focusing one. It’s not uncommon for these ratchets provisions to specify that the PE firm can gain an additional 10-15% ownership, at no additional cost,  in a company that fails to meet the annual targets. 

In good economic times and in solidly-run companies, ratchet provisions are very rarely put into effect. So, they are a generally just a ghoulish contingent presence in every PE investment contract, the stick that compliments the carrot of a PE firm investing in your business. I know from personal experience that the concept can seem very off-putting – even frightening – to some Chinese bosses: that the PE firm will, for example, go from owning 25% of his company to 40% of his company if the owner has one year that falls below the projected levels of profit and revenue. 

We’re not in good economic times at the moment, so it’s a certainty that more ratchet provisions will be triggered this year. This is what is behind some of the complaining in the Chinese press about international PE firms. Chinese investment firms apparently don’t often include ratchet provisions. The implication of the articles is that a Chinese company is better off taking money from a Chinese investment company, and so free itself from the possibility of a sort of “takeover by stealth”, as the PE firm’s ownership ratchets upward with each year of under-target performance. 

On the surface, ratchet provisions are a very fat, very easy target. So, no surprise some in the Chinese press are attacking them. But, it’s a very incomplete, unfair – and even financially illiterate – criticism to say that because of performance ratchet provisions, a Chinese company is better off taking money from a Chinese investment company. 

Chinese investment firms may not use performance ratchets, but they have a variety of other serious weaknesses. Believe me, I’m no fan of ratchets of any kind, and work hard in negotiations with PE firms to eliminate their potential for causing harm to our clients’ businesses.  But, I still think, in almost all cases, a good Chinese private company is far better off taking money from a reputable PE firm than from a more loosely-run Chinese investment business. 

The reasons are many. But, the most deep-seated are based on an appreciation of what an outside investor can and should provide a strong Chinese SME company besides just capital. Money, famously, all spends the same. So, taking $10mn from a rich uncle or from a leading private equity firm is no different, in terms of what the money can buy – a new factory perhaps, or expanded marketing and sales, or an acquisition. 

The key difference is that the best PE firms are going to do a lot more than just write a check and then wait for the riches to flow three years later at IPO. They are going to get deeply involved assisting the company to improve all areas of its operations, implementing best practices in areas like financial accounting and corporate governance, as well as providing real expertise on hard core sales and operational issues. They also know, from past successful experience, how best to guide a private company towards a successful IPO, whether on China’s domestic stock market, or abroad.

A Chinese investment company, from what I can gather, does not have the experience, the management talent – or even the inclination – to be involved in such a detailed fashion with the companies it invests in. 

I believe, based on my own practical experience,  that the good PE firms often really do make a significant difference inside a company, enabling it to get further faster than it otherwise would. Of course, PE firms can be a pain to work with. This goes way beyond the potential for a ratchet provision to be triggered. The good PE firms act as fiduciaries for their Limited Partners, and so require a massive amount of due diligence before investing, and no less enormous information flows (generally on financial performance) after an investment is made. They want quarterly board meetings, and often hold veto rights on any spending above $500,000 or so. 

But, in return, the PE firm will go to the furthest limits of its collective abilities to make sure the Chinese company succeeds above and beyond even what the boss of that company could expect. A domestic Chinese investment company? Most likely, they have had little experience with leading good companies toward successful IPOs, little operational knowledge, little desire to commit so thoroughly to adding value inside a company. 

So, yes, performance ratchet provisions are nasty. However, they should never come into effect – if the company and the PE firm are doing everything in their power to keep the business growing. The PE firms, contrary to the way it may appear, do not  want performance ratchets triggered any more than the company’s owner does. It’s also going to reflect badly on the PE firm’s judgment and abilities, and so make it harder for them to continue to raise money for future investment.

In other words, every time a performance ratchet is triggered, it gets harder for that PE firm to continue to thrive. They would rather own a smaller share of a solid company that’s meeting its targets, than a bigger share of one that isn’t.

 

Chinese Language Report on Private Equity in China 2009: 中国的私募股权投资与战略并购

Following on from the publication of the China First Capital report, 2009 Private Equity and Strategic M&A Transactions in China — A Preview , the Chinese version is now completed. It’s more than just a change in language.

It incorporates a different but complimentary perspective to the English report, one enriched by the deep knowledge, insights and experience of my China First Capital colleague, Amy Bai. 谢谢白海鹰。

Here’s the first section. 

China First Capital Chinese language report on Private Equity, Venture Capital in China 2009

 

 

概  览chinese-balance

 

危机创造机遇

2008 年对于中国是不平凡的一年。2008年带给我们骄傲和欢乐,也带给我们挫折和悲伤。北京奥运会使我们感到前所未有的骄傲和自豪。刚刚战胜了冰冻灾害的我们又遭遇了汶川大地震。

从经济领域来看,2008年同样也是不平凡的一年。在年初,上海、深圳和香港的股市都出现了长势良好的喜人景象。IPO形势大好。然而,在2008年夏,股市开始暴跌 ,IPO也开始枯竭。到年底,上海、深圳和香港的股市均下跌了60%左右。 

中国的私募股权投资和风险投资出现了与股市涨跌相应的波动变化。在年初,投资活动非常活跃。上半年,私募股权投资和风险投资在中国的投资总额超过了100多亿美元。随着金融风暴的影响,私募股权投资和风险投资也放缓了在中国的投资步伐。到去年底的时候,基本上已经停止了所有投资活动。 

中国,美国和全球其他国家均以前所未有的方式采取了一系列干预措施,以期稳定经济。然而, 

当我们跨入2009年时,全球经济进入衰退期已成为不争的事实。 

大家所关心的问题是,经济复苏期何时来临?何时开始新一轮的投资比较合适?我公司愿与您们分享就上述问题的一些观点和想法。 

作为中国首创投资的董事长,凭借在资本市场,私募股权投资和商业领域20余年的经验,我经历过数次商业周期,并且成功地带领我的企业幸存了下来。例如,我曾经担任美国加州一家风险投资公司的首席执行官,目睹了网络泡沫的破灭, 当时的情形和现在类似,所有的私募股权投资活动几乎都停止了。 但是,仅仅两年以后,交易活动和企业估值又呈现回升趋势。 

所以,我们认为,就整体投资环境而言,2008年的金融风暴将会继续影响中国经济的发展,中国目前仍旧会经受各种考验。但是,对于私募股权投资、风险投资和兼并收购而言,2009年是个充满着无限机会的一年。机会与风险并存。只要你抓住了机会,成功就近在咫尺。 

2009年,企业所有人和私募股权投资公司可以期待商业主题中的下列几点。 

行业整合与“质的飞跃”

在2009年新年伊始,我们就感受到了中国经济所面临的严峻局面。经济增长速度减慢,成千的工厂倒闭和数以万计的人失业。中国许多经济领域已经出现了一种所谓“超饱和”状态,也就是很多企业在一个经济领域竞争,但是每个企业的市场份额都很小。这种情况下,中国企业进行合并的时机已经成熟。

在市场经济的自由竞争规律下,缺乏竞争力的企业会逐渐被淘汰。然而,具有竞争力的企业会不断赢取市场份额。并且,在良性循环下会不断发展壮大。产量不断提高,成本继续降低,从而,提高利润。企业将所赚取的盈余再度投到生产中以降低成本,进而形成一个良性循环。 

从消费者的角度来说,一个优秀的企业,由于其管理完善、生产效率高和销售策略适当,吸引着无数消费者。除此之外,强有力的主导品牌将会适时并购其他品牌。在这种状况下,企业间的合并已经成为不可避免的趋势。 

在中国,这种合并的势头刚刚开始。中国拥有仅次于美国的巨大的国内市场。在中国的许多纵向市场(包括金融服务,消费品,分销和物流,零售,时尚等),只要多争取一分的市场份额,销售收入就能增加上千万美元。 

通常,相对于企业所处行业,中国企业的规模都相对较小。在一些国营企业和半国营企业不占主导地位的区域,优秀民营企业抢先出击,兼并和收购其他区域内的竞争者,进而成为国内行业的领军企业。

对于投资者来说,这种帮助企业进行并购活动的机会将是空前的。企业在并购后的兴盛是投资者和企业共同期待的。即使在经济衰退期,并购案中 的优胜企业也会呈现销售收入和利润长期持续增长的现象。 

利润增长为IPO的

重现提供了平台

 

在过去的五年里,对于投资中国市场的私募股权投资者和风险投资者来说,IPO无疑是最可靠的退出途径。 

下面的图显示,IPO交易量在2007年达到了高峰。在2008年初,IPO交易量继续呈现高增长趋势。然而,到2008年的下半年,IPO交易量急转直下,直到2009 年年初。

 chart-1

 

 

众所周知, IPO市场与股票市场紧密相连。当股票市场整体表现不好时,企业发行新股票的欲望也会相应减弱。所以,只要中国股票市场和香港股票市场继续呈现薄弱趋势,IPO活动就不会呈现上升趋势。 

对于私募股权投资者和风险投资者来说,这意味着他们需要做出巨大的改变。 

为适应当前形势,私募股权投资公司和风险投资公司需要改变他们的投资方向。较之前而言,企业IPO前的短期投资机会已大大减少。换言之,私募股权投资公司或风险投资公司以18倍的估值投资于中国企业, 18个月后,再以20倍的价值发行上市的简单套利的机会已经一去不复返了。 

取而代之的是,在中国进行投资活动的私募股权投资公司应该从价值投资者的角度考虑他们在中国的投资,而不是从套利的角度去衡量他们在中国的投资。这说明了,私募股权投资公司在中国寻找目标企业时,应以企业的长远高回报为目标注入投资基金。 

企业的利润增长为中国市场的IPO重现提供了平台。具体而言,私募股权投资的重点应该集中在帮助企业提高运作效率和利润率上。 

这是一个值得强调的财务理念,尤其是在现今中国。企业估值归根结底是一个与公司盈利能力相关的函数,而不是一个投资者愿意为公司盈利能力而支付的价格函数。在市盈率倍数的公式中,“收益”部分是关键,而不是“价格”部分。在过去的五年时间里,IPO股票价格市盈率可谓差距巨大。IPO股票价格市盈率高至超过100, 低至少于5。 

对于中国市场来讲,情况可以瞬息万变。IPO股票价格市盈率很有可能出现回升趋势。什么时候会发生?我们无法给您一个准确的答案。但是我们可以确定的是,一个优秀的私募股权投资者想要投资于有明确目标和有能力实现目标的中国优秀企业。

 换言之,企业有计划和具体步骤去提升利润和利润率。那么,选择正确的中国企业进行投资,选择适当的额度进行投资和帮助企业提升整体价值,是私募股权投资公司和风险投资公司在未来几年内成功的关键所在。

 私募股权投资公司和风险投资公司提升企业价值的方式有很多。可以通过向企业提供市场营销,业务发展,金融工程,运营效率,企业治理,审计,战略兼并和收购等方面专业人才,来帮助企业迅速提高企业价值。

无论通过上述哪种方式,企业的收益都有可能被大大提高。关键点是,帮助企业保持强劲的利润增长态势。这样,在股市复苏的时候,IPO的时机再一次到来时,我们的客户企业会从中脱颖而出,赢得最高收益。 

2009年,一个有着投资重点和帮助企业成长的私募股权投资公司会脱颖而出。

 

 


American and Chinese entrepreneurs: they are very different, but the best are equally good at making their investors rich

han-dynasty-coin

Held each year in Los Angeles, the technology conference organized by the investment bank Montgomery & Co. is one of the best of its kind, anywhere. It brings together about 1,000 people from the top American venture capital and private equity firms along with senior management at some of the most accomplished privately-owned technology companies in the US. It provides a very focused snapshot of some of the strongest new tech business models and where venture capital and private equity firms are looking to invest this year.  

I was at the conference from start to finish, in meetings and panels. It was a great gathering in every respect, with a level of optimism that runs counter to much of the economic gloom that dominates the headlines. One reason: good technology can thrive in bad times. Corporate budgets are getting squeezed and each purchase is more tightly scrutinized. This means that many new tech solutions, offering good or better performance at lower price, have a great opportunity to gain market share against more lumbering competitors. 

I saw some interesting companies with interesting business models, in particular several that were focused on SaaS (“Software-as-a-Service”) solutions that can dramatically lower for businesses large and small the cost (both hardware and software) of implementing enterprise software. SaaS makes so much sense because companies can switch to a powerful software solution, but without the need to buy and install any of the software or hardware to run it. It’s all done using an internet browser as the main interface. The software is hosted and managed on a central server by the company that developed it. Users pay a monthly or annual fee to use the software. 

SaaS is an area where I have a special interest. I’m lucky enough to be CEO of Awareness Technologies (www.awarenesstechnologies.com), which develops and sells SaaS-based corporate security software. Awareness also has as its founders two of the best entrepreneurs I’ve ever met, Ron and Mike. They are superstars.

Great entrepreneurs are rare, even in a conference of hot technology companies. Of the 100 tech companies at the Montgomery conference, very few – by my very unscientific study — seemed to have a great entrepreneur at the controls. Most are venture-backed, and so tend to have very experienced professional managers at the top. Often, the founding entrepreneurs have been pushed out, or given different roles, after the venture capital money arrives. One obvious reason for this: the venture capital and private equity partners are usually from similar backgrounds as the professional managerial class, with gold-plated resumes and MBA degrees from the best universities in the US.  Institutional investors often look for a safe pair of hands, and not a visionary, to run a company once their money is committed. This is sometimes the right choice.

That’s the usual pattern in the US. I was struck, not surprisingly, by the differences in China. Great entrepreneurs are no less rare, but it’s almost impossible for me to imagine a situation where the founder of a Chinese company is pushed aside by the venture capital or private equity firm after its put its money in. That would, in most cases, be sheer madness. First, there is no large “professional managerial class” in China at this point, with experienced managers who have run successful businesses previously, and then either sold them or led them to IPO.

Second, and perhaps even more important, good Chinese companies, in my experience and to an extent rarely seen in the US, are one-man shows. There is usually as boss and owner one superbly talented, charismatic, driven and shrewd individual, who saw a market opportunity and seized it. Against unimaginable odds – including the severe ack of capital, continually changing regulations, predatory officials, the primitive market economy of ten years ago in China, and the fiercest competitors – these successful Chinese business owners managed to build large and thriving companies. Single-handedly. There is usually no “management team” to speak of — just one man of outsized abilities and an equally outsized will to succeed.

Another difference with the US: the best entrepreneurs in China, and so the best investment opportunities for venture capital and private equity firms,  aren’t likely in the technology business. They most often are in what are considered, in the US, old-line, low-growth businesses like manufacturing, retailing, branded consumer goods. In the US, companies in these sectors find it nearly impossible to raise money from venture capital and private equity companies. In China, it’s where most of the VC and PE investment goes.

It’s what makes China such an interesting place to be for venture capital and private equity, and why I feel so lucky to have a business there in that field. China has both the most sophisticated global investors and the most well-run, entrepreneurial smokestack industries.

Of the 100 companies at the Montgomery conference, I can’t think of a single one that runs a factory and manufactures a tangible product. The guys who run these companies are almost certainly all college graduates, often with advanced degrees, looking for money to complete or market a website, a software application, an internet advertising platform. In China, conversely, a conference filled with some of the better, more promising private companies would have 100 men, most with only a high-school education, looking for money to expand their factories, fulfill more customer orders and so double their revenues and profits in the next year or  two.

As someone who has spent a big part of his life managing technology and venture capital businesses, I see great opportunities to make money investing in both China and the US. The big difference is that in the US, the biggest risks for venture capital and early stage private equity investors tend to be technological, that the company you’ve invested in may not succeed because its product or service doesn’t work as planned, or isn’t as good as a competitor’s. In China, technology risk is usually minimal. The big risk for venture and private equity firms is that the rules may change, and the company you’ve invested will not be able to freely operate in the domestic market in China.

How do I manage risk personally? I try to eliminate it, by working with the best entrepreneurs. I’m confident Awareness Technologies will widen its technological lead, become the dominant SaaS-based security software company and make its investors a ton of money. Equally, I’m confident the Chinese companies we work with at China First Capital will become dominant in their industries in China and make their investors a ton of money. Along the way, the men running these Chinese businesses will continue to do what they’ve always done: find ingenious ways to stay one step ahead of competitors and any changes in the country as a whole.

AltAssets writes on China First Capital’s Report on Private Equity in China 2009

AltAssets is among the world’s leading sources for news and analysis on the global private equity industry. They just published a summary of my firms report, 2009 Private Equity and Strategic M&A Transactions in China — A Preview“. 

AltAssets is based in London, and provides news and research to more than 1,000 institutional investors and 2,000 private equity and venture capital firms worldwide.

Here is what they wrote about the China First Capital report:

 

altassets_logo

CHINA THE MOST ROBUST EMERGING MARKET FOR PRIVATE EQUITY AND VENTURE CAPITAL SAYS REPORT”


China continues to be the world’s most robust emerging market for private equity and venture capital finance, even in a difficult global economic environment, according to the Private Equity and Strategic M&A Transactions in China 2009 report just released by China First Capital, a boutique investment bank with offices in China, Hong Kong and the USA.

Peter Fuhrman, China First Capital’s chairman and the report’s author, said, “While the overall investment environment remains challenging and the effects of 2008’s turbulence are still being felt, 2009 will be a year of unique opportunity for private equity, venture capital and M&As in China.” 

China’s economy continues to grow, powered largely by successful small and medium private businesses, many of which are among the fastest-growing companies in the world. Private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1bn in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market. 

“In 2009, China should rightly be among the most attractive and active private equity investment markets in the world,” the China First Capital report predicts. “Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.” 

The report identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are: the drive for industrial consolidation; profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA; increased importance of convertible debt and other hybrid financings; opportunities for strategic M&As; well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market. 

“The pathways to success in China are fewer and narrower than in recent years. But, for the entrepreneurs and private equity investors that can navigate their way in 2009, this will be a year of abundant opportunity,” Fuhrman added. 

Copyright © 2009 AltAssets

Requiem For A Tough Year – 2008 Was the Most Challenging Time in a Generation in China

tang-bowls

As the Chinese National Congress meets this week in Beijing to plot the course of the Chinese economy in 2009 and beyond, it’s worth reflecting what an exceptional, juddering year 2008 was. Sure, the Olympics stole most of the headlines, and provided the lasting images of Chinese progress and triumph. But, those images also dulled, in many respects, our perceptions of the brunt force of the economic blows China sustained during 2008. Make no mistake, 2008 was a year of challenge, disruption and dislocation not seen in China for a generation or more. 

The year started with the worst winder storms in decades. This was followed, just months later, by the cataclysmic Wenchuan Earthquake in Sichuan. Beyond the colossal loss of life and destruction, the earthquake had a much broader, unprecedented social impact across China. There was an enormous outpouring of national compassion and grief. While wholly positive as an expression of China’s rightful growing self-confidence, this vast prolonged period of national mourning also had a very direct and negative impact on economic activity. For weeks if not months, as I saw firsthand, there was a tangible unwillingness to spend as freely, to enjoy life as unabashedly as in the years previously. It was as if much of China received some intimation of their own mortality in the wake of the Sichuan Earthquake. 

Next came an accelerated fall in property values across much of China. Alongside this, the stock market fell sharply. These two, the property and stock markets, are the main stores of wealth for many middle class Chinese. People felt poorer because they were poorer. The fall of both property and share prices wiped away billions of dollars in national household wealth. People in their hundreds of millions were suddenly poorer, as household net worth plummeted, and Chinese pulled back even more strongly from their spending. Then, in late summer, came the financial tsunami in the USA, with the credit crisis, the collapse of Lehman Brothers, and the intensifying recession. 

Any basic college economics textbook – to say nothing of common sense — could foretell the next step: a fall in overall confidence levels among Chinese consumers. This further muffled already depressed levels of personal spending. 

We’re now well into the first quarter of 2009, and my own sense, after spending these last three weeks in China, is that the cumulative impact of all of 2008’s bad news is still being felt, acutely. However, my sense is that the worst may indeed be over, and that 2009 will be a year of rebuilding and reasserted economic confidence in China. 

Of course, when talking about general economic trends in the world’s third largest economy, a lot of the clarifying detail gets lost. But, we have a real sense, in our day-to-day work, of just what an extraordinarily difficult year 2008 was for even the best Chinese businesses. Our firm, China First Capital,  has focused on serving China’s middle market private Small and Medium Enterprises (SMEs), assisting them with capital-raising strategic M&A and other financial transactions.

Unlike traditional investment banks reliant mainly on short-term transactions, China First Capital’s role as financial and strategic advisor to Chinese SMEs often begins at early stages of corporate development and continues through the capital raising process from private equity to a successful IPO and beyond to global leadership. 

Even our strongest clients had a tough time in 2008. In one example, a business that is one of China’s leading consumer fashion brand, maintained outstanding growth last year in overall revenue, with domestic sales rising by 30%.  That’s mainly testament to the company’s no less outstanding management and brand-positioning. But, the bottom line was less stellar. Profit margins were squeezed, and the company earned half as much in 2008 as it expected to as late as July 2008. That represents a shortfall against plan of almost $6mn. That equates, of course, to having less money to invest in building on that growth rate in 2009.  

They remain a great company, and there’s little doubt 2009 will be a better year. But, when we met with them recently, the company’s financial management are still reeling from the brutal effects of 2008. If nothing else, it drives home as little else can the importance of fortifying the company’s balance sheet, which has been overly-reliant on retained earnings and short-term bank loans to finance growth. This client, like the Chinese economy, has weathered the once-in-a-generation turmoil of 2008. Better days lie ahead — my bet is sooner, rather than later.  

Houlihan Lokey Founding Partner James Zukin Sets His Sights on China

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I had the good fortune, while in LA, to have lunch recently with James Zukin. Jim is one of the name partners of the premier middle-market investment bank in the US, Houlihan Lokey Howard & Zukin. Jim and his partners were so far ahead of the curve, in spotting market opportunities, that they had to wait years for the curve even to appear behind them.

Over lunch, Jim explained how the firm stayed clear of Wall Street, both literally and figuratively, locating its headquarters in Los Angeles, and making the astute strategic decision to build a highly-focused and well-differentiated fee-based investment banking franchise, rather than an “all-purpose financial supermarket” that mixes advisory work with proprietary trading, market-making and IPO underwriting. We all know now how that supermarket model holds up over a full cycle: it doesn’t. The biggest of that breed, Merrill Lynch, sold out to Bank of America, and two other titans, Bear Sterns and Lehman Brothers, are both kaput.

Meantime, Houlihan Lokey (“HL”) has built and sustained a very successful business based first on providing fairness opinions and other valuation work, and then built up its lucrative practice advising on restructuring and M&A, and doing private placements. Even in dire financial times like now, HL continues to perform, doing solid, high-quality work a range of middle-market and SMB clients. HL again ranked as the number one firm in M&A advisory work in 2008 in deals of $2 billion or less, beating out Credit Suisse, Goldman Sachs, and others.

The race is won by the smart and focused, not the “supermarketized”.

Jim Zukin, no surprise, is the embodiment of the strategic qualities that have made his firm a consistent, anomalous success. A self-described “outsider”, he is by turns smart, charming, witty and modest. (Like me, he also likes a good burger.)

We met to talk about China, where Jim has personally spearheaded HL’s activities over the last few years, traveling back and forth frequently from LA, and opening offices in Beijing and Hong Kong. He speaks with palpable joy when discussing his visits to China. His workload at home in the US means fewer trips to China now, but he still refers to China, with heartfelt passion, as his “mistress.” It’s a description I’ve now shamelessly lifted from him, to describe my own long-term, requited love affair with China.

Jim Zukin is the one remaining “name partner” of Houlihan Lokey Howard & Zukin. He remains the chairman of Houlihan Lokey Asia. That’s a concrete sign of the company’s commitment to build a dynamic and durable business there.

HL has built a solid platform for growth in China. Its areas of expertise – and entrepreneurial outlook – position it well there. I know from my own experience that there is a sizable opportunity, to cite one example, to provide financial opinion, M&A and restructuring advisory work to the leading international PE firms active in China.

I have every reason to expect HL to succeed in China, with the same sort of approach that has worked so well for the firm in the US. How do they do it? Simple: Don’t run with the herd. Run with a better map.

A New Year of Challenges and Opportunities in China’ Private Equity Industry

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Looking purely at the economic news from China of late, this has not been the happiest of Chinese New Years. The Chinese government is estimating that 16% of the huge migrant labor force of 200 million will have no job to return to after the New Year.  Factories are continuing to close, or cut employment, across the country. Guangdong province, where China First Capital has its base in China, is particularly hard hit, because it’s still the primary production base for much of China’s better private factories. While factories are being moved out of Guangdong to less expensive, inland locations like Jiangxi, overall industrial employment in factories in Guangdong is still huge, and hugely reliant on migrant labor. There’s no solid date, but ten million or more workers may have lost their jobs in Guangdong over the last six months. 

The picture is no less bleak in terms of projections for corporate profits in China in 2009. Larger companies are reporting profit falls of over 50% in 2008, and forecasting even worse results this year. This matters crucially in China. Over 40% of total economic output is generated by business investment. This, in turn,  is intimately tied to corporate profits, since most of that business investment is financed out of retained profits. According to a recent report in the Wall Street Journal, “official statistics show that 63% of investment in China last year was financed by what are called “internally generated” funds, which include retained profits. That’s up from just below 50% a decade ago.” 

In other words, as corporate profits decline, they take Chinese GDP growth with them. This falling economic output, in turn, influences consumer sentiment, and so takes personal spending down with it. 

Good economic news is a scarce commodity this Chinese New Year. But, I see one bright glimmer of hope here. Chinese companies have been excessively reliant on retained earnings and expensive bank debt to finance their growth, rather than equity capital. The difficult economic environment, in China and indeed worldwide, provides a good opportunity for better Chinese companies to reorient their method of financing capital investment and growth. It’s the right time to take on equity capital, and use it as a platform to continue to invest and grow, even if corporate profits are in cyclical decline. 

The Chinese companies that can raise equity finance will enjoy a significant financial advantage over competitors, and so be able to gain market share. Adding equity finance lets a company both lower its overall cost of capital, and also increase the amount of capital it can put to work in its business. Both of these factors equate to a very real competitive advantage. 

Equity investors, principally PE firms, will need to change their orientation as well. The opportunities to do shorter-term “pre-IPO” financing are far fewer than they were, because stock market valuations are way down and IPO activity has slowed to a crawl. So, the simple arbitrage of a PE firm buying into a Chinese company at a valuation, say, of 10x and selling out 18 months later in an IPO at 20x are gone. 

Instead, PE investors in China need to think more like value investors, and less like arbitrageurs. This means looking for opportunities to deploy capital into good businesses offering high rates of return on that invested capital. Equity investment is then used to expand output, lower unit costs, gain market share, and so expand both profits and profit margins. Build profits and valuation will take care of itself. If a Chinese company can put equity capital to work well, and accelerate profits in 2009 and beyond, that business will be worth a lot more money when the IPO market revives than if it simply cut back on investing to ride out the bad times. 

This year is going to be difficult, challenging, but also potentially highly rewarding for all of us participating in the financing of private companies in China. It’s a year when good companies should be able to get even better. And smart-money PE firms will make far more, over the medium-term, than fast-money valuation arbitrageurs ever did. 

 

Fraud in Private Equity Investing in China

A partnership at a successful Private Equity firm is one of the most rewarding, interesting, reputation-enhancing and lucrative jobs available anywhere. But, it’s not without its perils.

 

This was brought home rather dramatically recently. A partner I know at a China-based PE firm (one of the best, incidentally) recently found out that one of the companies he recently invested in may, in fact, be fraudulent. I didn’t ask for the details, and they weren’t volunteered. I offered my commiserations, and expressed my hope that everything would work out satisfactorily for him and his firm.  

 

This is not an isolated instance. Just recently, the four directors representing foreign investors’ interests in a Shenzhen-based credit company called Credit Orienwise Group, resigned from their directorships following the disappearance of its chairman, Zhang Kaiyong, in early September. Facts are still hard to come by, and may never become widely known. Credit Orienwise is a private company, and the investors are also under no obligation to disclose to the public just how much money has been lost in this fraud.  

 

On paper, Credit Orienwise looked to be a good company. It bills itself as one of the largest private credit guarantee companies and lenders to small and medium enterprises in Southern China.  

 

But, it now looks certain that some of the most experienced and well-managed PE investors in the world may have been defrauded.  

 

Credit Orienwise had received more than US$63 million from four of the largest and most experienced PE investors operating in Asia: the Asian Development Bank, GE Capital Equity Investments Ltd., Citigroup Venture Capital International and The Carlyle Group. It’s hard to find a business in China with a more gold-plated group of investors. Could it really be possible that all four failed in their DD to uncover any actionable evidence, or strong suspicions that would have steered them away from making the investment? And then, once having done so, where was the corporate governance?  

 

This looks to be a failure by investors of very dramatic proportions.  

 

Of course, investors – even the best – sometimes lose money. I recall someone once asking Warren Buffett for his worst investment decision. He smiled and said, “How much time do you have?”  

 

Markets change quickly.A management group can pursue a flawed strategy or fail to execute efficiently. All these “operational risks” are present, to some extent, in any investment. But, the risk of being defrauded is something else. It’s precisely the one risk that’s meant to be neutralized through effective DD and deal structure.  

 

It’s likely over 20 senior professionals – from PE firm partners to accountants and lawyers – were directly involved in the Credit Orienwise DD. Could all of them been swindled by Credit Orienwise’s Mr. Zhang? Perhaps. But, one thing is sure: those closely involved with this deal will never–should never — recover from this stain on their careers.  

 

Is investment fraud more widespread in China?  Circumstantial evidence might suggest so. It’s probably the biggest career threat to a PE and VC investor working in China. 

 

In my own experience as a VC, I’ve not had personal experience with an investment that turned out to involve fraud. I suspect this is true of most VCs and PEs. Fraud is rare, just because it is usually fairly easy to detect ahead of time – if not in the DD materials, than in the comments and character of the company’s leadership. 

 

 

Greed and prudence are the two core principles that guide the actions of a VC or PE investor. Which of these is the most important? As stories like this one involving Credit Orienwise suggest, it’s better for the PE or VC investor, especially in China, to let prudence be the final arbiter. 

Infinite Opportunities ÷ Finite Capital

To a hammer, every problem is a nail. Equally, to many fine entrepreneurs, seeing abundant opportunities for profit, the only problem is capital. Not markets. Or competition. Or industry cycles. 

In other words, good entrepreneurs usually plan big, to build big new businesses that will generate huge returns. That’s great. The only limiting factor they perceive is access to adequate capital to build big enough and fast enough to earn the largest potential return. The problem here, as we say in America, is that such an approach can be “assbackward”. Companies usually need to adjust their plans to the capital they can raise — not decouple the two entirely. 

We had a series of meetings this week with Chinese companies interested in working together with China First Capital to secure private equity funding. These meetings are usually long, detailed, and for the most part, highly enjoyable. We’re lucky to have so many outstanding companies approach China First Capital. They come from a very wide range of industries. For example, this past week, we met with one business in the high-tech synthetic fiber industry, and another that owns a large-scale sugar refinery. 

I’ve learned, over many years, first as a Forbes Magazine reporter and then as a venture capitalist, how to form a quick (and one hopes, accurate) assessment of a business’s potential. With both of these companies, the assessment is very positive. In both cases, though, the laoban clearly hadn’t thought very deeply about how much capital they both should and could raise. There was, at least at the start, this disconnect between the size of their plans, and their ability to finance them with equity capital. 

So, we needed quite a bit of time to explain things. Opportunities in business are infinite, but capital is finite resource. Investors want to achieve the highest risk-adjusted return possible. But, equally, they will determine how much capital to invest not purely, or even primarily, based on the potential return. They will also give strong consideration to issues of corporate control, valuation, ROI, even asset coverage. 

So, while investors will applaud a company with a solid plan to build a new division with annual profits of over $25mn within three years, they won’t be rushing to invest the $50mn that’s required to get there, if the current business is worth $70mn. That would require the investor, in most circumstances, to take a controlling stake in the overall business. The $50mn investment represents over 70% of the current company value. Few investors want to own that much of a portfolio company, even if they foresee great returns. 

There are all kinds of proven and effective ways to raise larger sums, two of the most common are using a mix of debt and equity, or staging the investment in tranches. The starting place for any business seeking equity finance is to ask “how much money can we best raise now?” rather than “how much money do we want to achieve most quickly our business goals?” The answer to the first determines not only which businesses opportunities a company can pursue, but at what scale. 

Capital – its cost and availability — is often among the last considerations for an entrepreneur. Part of our role as merchant bankers is to bring the entrepreneur’s plans down to earth, to keep those plans and the ability to finance them in harmony. The appropriate-sized tool for the appropriate-sized task. This idea is beautifully expressed by this ancient carved image of Chinese rice threshing machinery.