China Private Equity

China’s Capital Markets Go From Feast to Famine and Now Back Again, China First Capital New Research Report

Leave a Comment / January 19, 2014

China First Capital 2014 research report cover

–

The long dark eclipse is over. The sun is shining again on China’s capital markets and private equity industry. That’s good news in itself, but is also especially important to the overall Chinese economy. For the last two years, investment flows into private sector companies have dropped precipitously, as IPOs disappeared and private equity firms went into hibernation. Rebalancing China’s economy away from exports and government investment will take cash. Lots of it. Expect significant progress this year as China’s private sector raises record capital and China’s state-owned enterprises (SOEs) gradually transform into more competitive, profit-maximizing businesses.

These are some of the conclusions of the most recent Chinese-language research report published by China First Capital. It is titled, “2014民企国企的转型与机遇“, which I’d translate as “2014: A Year of Transformation and Opportunities for China’s Public and Private Sectors”. You can download a copy by clicking here or visiting the Research Reports section of the China First Capital website, (http://www.chinafirstcapital.com/en/research-reports).

We’re not planning an English translation. One reason:  the report is tailored mainly to the 8,000 domestic company bosses as well as Chinese government policy-makers and officials we work with or have met. They have already received a copy. The report has also gotten a fair bit of media coverage over the last week here in China.

Our key message is we expect this year overall business conditions, as well as capital-raising environment,  to be significantly improved compared to the last two years.  We expect the IPO market to stage a significant recovery. Our prediction, over 500 Chinese companies will IPO worldwide during this year, with the majority of these IPOs here in China.

We also investigate the direction of economic and reform policy in China following the Third Plenum, and how it will open new opportunities for SOEs to finance their growth and improve their overall profitability, including through carve-out IPOs and strategic investment. SOEs will become an important new area of investment for PE firms and global strategics.

The SOEs we work with are all convinced of the need to diversify their ownership, and bring in profit-driven experienced institutional investors. For investors, SOE deals offer several clear advantages: scale is larger and valuations are usually lower than in SME deals; SOEs are fully compliant with China’s tax rules, with a single set of books; the time to IPO or other exit should be quicker than in many SME deals.

As financial markets mature in China, we think one unintended consequence will be a drop in activity on China’s recently-established over-the-counter exchange, known as the “New Third Board” (新三板）.  The report offers our reasons why we think this OTC market is a poor, inefficient choice for Chinese businesses looking to raise capital. While the aims of the Third Board are commendable, to open a new fund-raising channel for private sector companies, the reality is that it offers too little liquidity, low valuations and an uncertain path to a full listing on China’s main stock exchanges.

Over the last three years, China has had the highest growth rate and the worst performing stock market among all major economies. In part, the long stock market slide is both necessary and desirable, to bring China’s stock market valuations more in line with those of the US and Hong Kong. But, it also points to a more uncomfortable reality, that China’s listed companies too often become listless ones. Once public, many companies’ profit growth and rates of return go into long-term decline. IPO proceeds are hoarded or misspent. Rarely do managers make it a priority to increase shareholder value.

A small tweak in the IPO listing rules offers some promise of improvement. Beginning this year, a company’s control shareholder, usually the owner or a PE firm, will be locked-in and prevented from selling shares for five years if the share price stays below the original IPO level.

Spare a moment to consider the life of a successful Chinese entrepreneur, both SOE and private sector. In two years, access to capital went from feast to famine. And now maybe back again. An IPO exit went from a reachable goal to an impossibility. And now maybe back again. Meanwhile, markets at home surged while those abroad sputtered. Government reform went from minimal to now ambitious.

2014 is going to be quite a year.

–

Private Equity in China 2014: A Dialogue

1 Comment / January 19, 2014

pendant

–

PE in China is changing. But, from what and into what?

Over the last week, I had an email discussion with a managing director in China of one of the world’s five largest private equity firms. He wrote to tell me about the fund’s recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China.

I’ll share an edited version here. I’ve taken out the firm’s name and any references that might make it identifiable.

Think it’s easy to be a private equity boss in China, to keep your job and keep your LPs happy? It’s anything but.– – –

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn’t just reply, “sounds fine to me”.

Here’s my view of it, after a day’s thought. If I didn’t know it was from [your firm], or didn’t focus on the larger check size, I’d say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys — you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that’s your opportunity, to be the ” thoroughly professional, experienced, global, proper fiduciary” version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group,  can gain an IPO in next two years. The English idiom here is “making yourself a hostage to fortune”. In other words, the only way a PE could consistently achieve the goal of “IPO exits within 24 months” is based more on luck than planning and deal execution.

If you asked me, I’d think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It’s kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can “free ride”, to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn’t change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don’t cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can’t be faulted. In a nutshell, it’s “Get in, get out, get carry and get new capital allocations from one’s LPs.”

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don’t see them. I’m just one guy feeling the elephant’s tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically,  to raise outside PE money from a dollar fund at a discount to public markets.  Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That’s the part I’ll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you’re someone who looks at deals through a special, somewhat contrarian prism. Your firm’s new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We’re finishing up now a “What’s ahead in 2014″ Chinese-language report that we’ll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database.  I’ll send a copy when it’s done. You’ll see we’re basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors.  Your role: supply the fuel, supply the ammo.

–

—   –

IPO rules overhauled for PE and VC firms — China Daily

Leave a Comment / May 1, 2014

China Daily article

–

Shanghai stock exchange trading floor

–

Friday, January 3, 2014

Private equity and venture capital firms will have to conduct their business differently in China in 2014, after regulators overhauled initial public offering rules.

Chinese PE and VC companies used to evaluate the companies by the standards of the China Securities Regulatory Commission for quicker IPOs, but now the market will play a more important role, said Peter Fuhrman, chairman, founder and chief executive officer at China First Capital.

“Under the new IPO system, the share pricing of an IPO company is decided by its strength and competitiveness, so investors will choose companies with real potential to invest in and provide them with the resources of strategy, management and market development to make their own return the best,” said Fuhrman *.

Private equity and venture capital firms will not find it easy to earn money any more after the new share-listing reform plan is carried out, because even if the companies they invested in get listed, they will still face the risk of losses, said Jin Haitao, chairman of leading Chinese equity investment firm Shenzhen Capital Group Co Ltd.

Jin said PE and VC institutions should cultivate real investment capabilities including those in value-discovery and negotiating. Pre-IPO deals cannot be guaranteed to earn money any more.

A total of 83 Chinese companies completed the examination and received approval from the China Securities Regulatory Commission. About 50 are expected to have finished all IPO procedures and be listed before the end of January. More than 760 companies are in line for approval. It will take about a year to audit all the applications.

In the IPO reform plan announced at the end of November, information disclosure has become more important and the China Securities Regulatory Commission will only be responsible for examining applicants’ qualifications, leaving investors and the markets to make their own judgments about a company’s value and the risks of buying its shares.

More and more Chinese companies applying for IPOs asked for cooperation with multinational accounting institutions, according to Hoffman Cheong, an assurance leader at Ernst & Young China North Region.

Cheong said the information disclosed can be different after the IPO reform plan is carried out.

According to the IPO reform plan, so long as an issuer’s prospectus is received by the commission, it will be released on the commission’s website. The company should buy back shares if there is a false statement or major omission. Also it should compensate investors if they lose money in certain situations.

http://www.chinadailyasia.com/business/2014-01/03/content_15109395.html

–

(* Note: I never spoke to the reporter. As far as I can tell, the quote was translated into English, rather clumsily, from a Chinese-language commentary of mine published recently in a Chinese business publication. If asked, I would have said that companies need to choose PE investors carefully, and vice versa.)–

–

–

SOE Reform in China — Big Changes On the Way

Leave a Comment / December 24, 2013

Qianlong emperor calligraphy

–

China’s state-owned enterprises (SOEs) are a lucky breed, or so conventional wisdom would have it. They have lower cost of capital and less competitive pressures of private sector competitors. China’s big banks (also state-owned) are always happy to lend, and if things do turn sour, China’s government will bail everyone out.

The reality, however, is substantially different and substantially more challenging. SOEs live in a different world than they did ten, or even three years ago. They are more and more often under intensifying pressure to achieve two incompatible goals: to continue to expand revenues by 15%-25% a year, but to do so without corresponding large increases in net bank borrowing. The result, over time, will be that SOEs will need to rely increasingly on private sector capital to finance their future growth.

This message came through especially loud and clear in the policy document published by the Chinese leadership after the recent Third Party Plenum in November.  SOEs are told they need to become more attuned to the market and less dependent on government favors and protection. This new policy pronouncement is reverberating like a cannon blast inside the state-owned economy, based on conversations lately with the top people at our large Chinese SOE clients.

No one at these SOEs is entirely sure how to fulfill the orders from above. But, they are all certain, from long years of experience, that the environment SOEs operate in is going to undergo some significant change, likely the most significant since the “Great Cull” of the mid-1990s when thousands of SOEs were pushed into bankruptcy.Too many of the surviving SOEs have done little more than survive over the last twenty years. They managed to stay in the black, sometimes by resorting to rather idiosyncratic accounting that ignored depreciation.

The Chinese leadership is embarking on a tricky, somewhat contradictory, mission:  to simultaneously shake up the SOE sector, make it more efficient and responsive to market forces,  while keeping SOEs embedded in the foundation of China’s economy.  Much has changed about the way Chinese leaders view and manage SOEs. But, a key principle remains intact. The architect of the policy, Deng Xiaoping, put it this way, ” As long as we keep ourselves sober-minded, there is nothing to be feared. We still hold superiority, because we have large and medium state-owned enterprises.”

In other words, SOE privatization is not on the menu, at least not in any large-scale way. SOEs, particularly the 126 so-called “centrally-administered SOEs” (央企)  will remain majority-owned by the government. The government is suggesting, however, it wants these SOEs, as well as the other 100,000 or so smaller ones active in most parts of the Chinese economy, to be run better and more profitably. But how? That’s the a topic of discussions I’ve been having over the last month with the bosses at our SOE clients.

The rate of return (as measured by return on assets) at SOEs has, in almost all cases, drifted down over the last ten years, and is now probably under 3% a year.  If bank borrowing and depreciation were more properly amortized, the rate of return would likely turn negative at quite a lot of SOEs.

In some cases, this reflects the cruel reality that many SOEs operate in low-margin highly-commoditized industries. But, another key factor is that the government body that acts as the owner of most SOEs, SASAC (国资委), is not your typical profit-maximizing shareholder.

SASAC manages the portfolio of SOE assets like the most risk-averse executor. It demands three things above all from SOEs: don’t lose money;  don’t pilfer state assets and keep revenues growing.

When your owner sets the bar a few inches off the ground, you don’t try to break the Olympic high jump record. No SOE manager ever got a bonus, as far as I’ve heard, from doubling profits, or improving cash flow. Pay-for-performance is basically taboo at SOEs. The whole SOE system, as it’s now configured, is designed to produce middling giants with tapering profits.

Rather than shake-up SASAC, the country’s leaders have given SOEs a green light to seek capital from outside sources, including private equity and strategic investors. They should provide, for the first time, a voice in the SOE boardroom calling for higher profits, higher margins, bigger dividends.

It’s a wise move. SOEs need to carry more of the load for China’s future gdp growth. You can’t do that when you are achieving such low return on assets. Among the SOEs we work with, there’s a genuine excitement about bringing in outside investment, and operating under a new, more strenuous regime. Surprised? The SOEs I know are run by professional managers who’ve spent much of their careers building the business and take pride in its scale and professionalism. They, too, see room for improvement and see the downsides of SASAC’s approach.

Outside capital can help these SOEs finance their future expansion.  It could also open new doors, especially in international markets. The big question: can — will — private equity, buyout firms, global strategic investors seek out investments in Chinese SOEs? It’s unfamiliar terrain.

Earlier this year, I arranged a series of meetings for twelve of the world’s-largest PE firms and institutional investors to meet a large SOE client of ours. These firms collectively have over $700 billion in capital, and each one has at least ten years’ experience in China. They are all keen on this particular deal. Yet, none of these firms have invested in any SOE deals over the last five years. For many of the visiting PEs, it was their first time ever meeting with the boss of a profitable and successful SOE to discuss investing.

In this case, it looks like a deal will get done, and so provide a blueprint for future PE investing in Chinese SOE.  The Chinese leadership ordered a shakeup to the state owned sector. It’s getting one.

 

The Big Churn — How High Partner Turnover Damages China’s Private Equity Industry

Leave a Comment / December 12, 2013

China PE partner turnover –

What’s the biggest risk in China private equity investing?  Depends who you’re asking. If you ask LPs, the people who provide all the money that PE firms live off, you will often hear a surprising answer: turnover at PE firms. Nowhere else in the PE and VC world do you find so many firms where partners are feuding, quitting or being thrown off the bus.

A partnership at a PE firm was meant to be a long-term fiduciary commitment. In China, it rarely is. The result is billions of dollars of LP money often gets stranded, and possibly wasted. That’s because when a partner leaves, it often creates a bunch of orphaned investments. The departing partner is generally the only solid link between the PE firm and the investee company. Everyone left behind is harmed — the PE firms, the companies they invest in, and the LPs whose money is trapped inside these deals.

As the CEO one of Asia’s largest and most professional LPs told me recently, “Before committing to a new China fund, we spend more of our time trying to figure out how the partners get along than just about anything else. Will they hang on together through the life of the fund? We know from experience how damaging it is when partners fall out, when key people leave. We know turnover can mean we lose everything we’ve invested. And yet, we still often get stung. ”

In my nearly-twenty years in and around the PE and VC industry in the US, Europe and Asia, I’ve never seen anything quite like what happens here in China. A quick look through my Outlook contacts reveals that almost half the PE partners I know working in China have changed firms in the last five years. One reason you don’t see this elsewhere is that partners expect to earn carried interest on the deals they’ve made. If they leave, they forgo this.

Carry is a kind of unvested pay. On paper, it’s often quite sizable, and should represent the majority of a PE partner’s total comp, as well a kind of golden handcuff. The only reason for partners to leave is they believe they won’t get any of this money, either because of failed deals or, more commonly, large doubts that the head partner, the person running the firm, will share the rewards from successful deals.

Most China PE firms are partnerships in name only. There is usually one top dog, usually the founder and rainmaker. This person can unilaterally decide who stays, who goes, who gets carry and who gets a lump of coal. Top Dog tends to treat partners like overpaid, somewhat undeserving hired hands.

So, why have partners at all? Often it’s because LPs insist on it, that they want PE and VC firms in China to be structured like those elsewhere. The business card says “Partner” but the attitude, expectations and level of commitment say “Employee”.

Senior staff (VPs, Managing Directors) also frequently depart. In the US, you don’t often see that much, since these are the people in line to become partners, which is meant to be the crowning achievement of a long successful career in the trenches. They leave because they don’t believe they’ll be promoted, or if they are, that they’ll see any real change in their current status as wage-earners.

At a party celebrating a recent IPO of a PE-backed Chinese company, I ran into the PE guy who led the original investment, did all the heavy lifting. He had since left and joined another firm. He laughed when I asked why he would leave before the IPO, with his old firm certain to earn a big profit on his deal. “I don’t know who will get the carry, but I was sure it wouldn’t include me,” he explained.

Partners jump ship most often because someone is offering a higher salary, a higher guaranteed amount of pay. Their new firm will usually also offer them carry. Both sides will negotiate fiercely over the specific terms, what percent with what hurdle rate. And yet, more often than not, it seems to be a charade.

From day one, the new partners may already thinking about their next career move, how to trade up. Emblematic of this: here in China, when PE partners join a new firm, they almost always refer to it as “joining a new platform”. Note the choice of words: platform, not firm.

The LPs — and I speak to quite a lot of them — acknowledge, of course, that there are other big risks in China, that individual investments or even a whole portfolio turns sour. But, this is a risk inherent in all PE investing everywhere. High partner turnover is not.

If you’re interested, you can click here and read the email exchange I had recently with a newly-departed partner at one of China’s better-known VC firms. As I write there, I hate to sound like a scold. I know PE partners also want to earn a good living, and should work where they are happiest and best compensated. But, China’s PE industry serves a deeper economic purpose and holds in trust the assets of both investors and companies. “Looking out for Number One” should not be the only career goal of those working in senior levels in the industry.–

 

 

Private Equity Secondaries in China — PEI Magazine Whitepaper

Leave a Comment / December 5, 2014

–Secondaries

 

 

PEI Secondaries Cover–

title2

 

 

 

 

Private equity dealflow continues to stall in China – but so far it hasn’t yet prompted the hoped-for explosion in secondary market activity

–

Secondaries specialists have been busy in Asia lately. While firms such as LGT Capital Partners and Paul Capital have been doing secondaries deals from Hong Kong since 2007, in the last 18 months other firms such as Greenpark Capital, AlpInvest Partners and Lexington Partners have all been enhancing their Asia presence.

So far, secondary market activity in Asia has been more of a gradual flow than a wave of deals. But the changing macroeconomic conditions are increasing pressure on GPs – and that could result in more opportunities, particularly in China. Asia’s largest and most attractive market is losing some of its shine, thanks to a sustained slowdown in annual GDP growth and a frozen IPO market that has left GPs holding assets that they need to exit.

“If you could do [secondaries] at this moment – wow,” says Peter Fuhrman, chairman and chief executive of China First Capital. “In this market, some LPs could sell out for 10 cents on the dollar. For LP secondary buyers, it is nirvana: a distressed exit market, portfolios with solid growing businesses inside of them, and a group of somewhat distressed LPs. A lot of these LPs, even bigger ones who have their money in China, have lost faith.”

–

Click to Read Full Article
Click To Read Full PEI Whitepaper Report on Private Equity Secondaries

–

Chinese IPOs Try to Make a Comeback in US — New York Times

Leave a Comment / June 24, 2016

––NYT

 

I.P.O./Offerings

Chinese I.P.O.’s Try to Make a Comeback in U.S.

BY NEIL GOUGH

HONG KONG — Chinese companies are trying to leap back into the United States stock markets.

The return, still in its early days and involving just a handful of companies, comes after several years of accounting scandals that pummeled their share prices and prompted scores of companies to delist from markets in the United States.

But the spate of recent activity suggests investors may be warming once more to Chinese companies that seek initial public offerings in the United States.

Qunar Cayman Islands, a popular travel website owned by Baidu, China’s leading search engine company, began trading on Nasdaq on Friday and nearly doubled in price. On Thursday, shares in 58.com, a Chinese classified ad website operator that is often compared to Craigslist, surged 42 percent on the first trading day in New York after its $187 million public offering.

The question now — for both American investors and the companies from China waiting in the wings to raise money from them — is whether these recent debuts are an anomaly or have truly managed to unfreeze a market that was once a top destination for Chinese companies seeking to list overseas.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm based in Shenzhen, China, said that for both sides, the recent signs of a détente between American investors and Chinese companies is “a matter of selectively hoping history repeats itself.”

“Not the recent history of Chinese companies dogged by allegations, and some evidence, of accounting fraud and other suspect practices,” he added. “Instead, the current group is looking back farther in history, to a time when some Chinese Internet companies with business models derived, borrowed or pilfered from successful U.S. companies were able to go public in the U.S. to great acclaim.”

That initial wave of Chinese technology listings began in 2000 with the I.P.O. of Sina.com and later featured companies like Baidu, which has been described as China’s answer to Google. In total, more than 200 companies from China achieved listings on American markets, raising billions of dollars through traditional public offerings or reverse takeovers.

But beginning about 2010, short-sellers and regulators started exposing what grew into a flurry of accounting scandals at Chinese companies with overseas listings. In some cases, such accusations have led to the filing of fraud charges by regulators or to the dissolution of the companies. Prominent examples include the Toronto-listed Sino-Forest Corporation, which filed for bankruptcy last year after Muddy Waters Research placed a bet against the company’s shares in 2011 and accused it of being a “multibillion-dollar Ponzi scheme.”

Concerns about companies based in China were reinforced in December when the United States Securities and Exchange Commission accused the Chinese affiliates of five big accounting firms of violating securities laws, contending that they had failed to produce documents from their audits of several China-based companies under investigation for fraud.

In response, American demand for new share offerings by Chinese companies evaporated, and investors dumped shares in Chinese companies across the board. It became so bad that the tide of listings reversed direction: Delistings by Chinese companies from American markets have outnumbered public offerings for the last two years.

Despite the renewed activity, it is too early to say whether Chinese stocks are back in favor. The listing by 58.com was only the fourth Chinese public offering in the United States this year, according to Thomson Reuters data. LightInTheBox, an online retailer, raised $90.7 million in a June listing but is trading slightly below its offering price. China Commercial Credit, a microlender, has risen 50 percent since it raised $8.9 million in August. And shares in the Montage Technology Group, based in Shanghai, have risen 41 percent since it raised $80.2 million in late September.

Still, this year’s activity is already an improvement from 2012, when only two such deals took place, according to figures from Thomson Reuters. Last month, two more Chinese companies — 500.com, an online lottery agent, and Sungy Mobile, an app developer — submitted initial filings for American share sales.

But the broader concerns related to Chinese companies have not gone away. In May, financial regulators in the United States and China signed a memorandum of understanding that could pave the way to increased American oversight of accounting practices at Chinese companies. But the S.E.C.’s case against the Chinese affiliates of the five big accounting firms remains in court.

The corporate structure of many Chinese companies is another unresolved area of concern. Because foreign companies and shareholders cannot own Internet companies in China, both 58.com and Qunar rely on a complex series of management and profit control agreements called variable interest entities. Whether such arrangements will stand up in court has been a cause for concern among foreign investors in Chinese companies.

And short-sellers continue to single out companies from China, often with great success.

In a report last month, Muddy Waters took aim at NQ Mobile, an online security company based in Beijing and listed in New York, accusing it of being “a massive fraud” and contending that 72 percent of its revenue from the security business in China last year was “fictitious.”

NQ Mobile has rejected the accusations, saying that the report contained “numerous errors of facts, misleading speculations and malicious interpretations of events.” The company’s shares have fallen 37 percent since the report was published.

(http://dealbook.nytimes.com/2013/11/01/chinese-i-p-o-s-attempt-a-comeback-in-u-s/?_r=1)
 
Download PDF version.
 

–

–

 

Hong Kong IPO Today for China First Capital Client Hydoo

Leave a Comment / October 31, 2013

Hydoo Prospectus

–

Welcome good news today from Hong Kong’s capital markets. The Chinese commercial real estate developer Hydoo (Chinese name 毅德) successfully IPOs on the Hong Kong Stock Exchange, raising over USD$200mn in new capital. With IPO channels for Chinese companies mainly blockaded, it’s especially welcome to see a Chinese private sector company raising so much from the stock market.  In this case, the delight is greater because Hydoo is a client of China First Capital. We acted as Hydoo’s investment bankers raising USD$80mn from Chinese private equity firm Hony Capital.  Hony’s 2011 investment, based on today’s IPO price, is now worth USD$150mn.

In addition to Hony, China’s giant financial services group Ping An also invested before IPO.  In total, Hydoo raised USD$140mn (Rmb 860mn) of institutional capital before IPO. Over 60% of the IPO shares (worth over $120mn) were sold by underwriters ahead of time to so-called “cornerstone investors“, including two large Chinese SOEs, Huarong and China Taiping Insurance, as well as retailer Suning (in which Hony owns a share).

I’m happy for Hony and the other investors, but happier still for Hydoo founders, particularly its chairman, Wang Zaixing, known to friends and family  as “Laowu”, literally “Venerable Fifth”. He is the fifth-born of ten children all of whom played a part in building Hydoo. The family is originally from Chaozhou in Guangdong, and speak the distinctive Chaozhou dialect. But, they ended up after 1949 in Ganzhou, Jiangxi Province.

The business Laowu started 18 years ago is now worth over $1 billion. The first time I met him, I told Laowu my goal as his investment banker, and my emphatic expectation,  was that his company would be worth at least that much at the time of its IPO. Another priority of mine was that he and his family members would still hold majority control after IPO.  That too has been achieved.  They hold almost 60% of the now publicly-traded business.

For me, Laowu personifies in many ways the large economic changes China has undergone in the last 30 years. He started life as a long-distance truck driver and from that humble start saw and grasped an opportunity to build wholesale trading centers for the emerging army of small businesspeople in China.

I first met Laowu and his company in 2009. The business was then called Haode (豪德). It was then still an old-school Chinese family business. There was no corporate structure in the traditional sense. Laowu and his brothers, sister and nephews would pair up, or act independently, to do individual large wholesale trading centers around China. When I met them, the family had already done 19 such projects. All had done very well. At the time, I’d never met a Chinese private company as profitable over as many years as Haode.

Over the last three years, the company has been transformed into a more professional enterprise. Hydoo provides a useful excellent template for how a Chinese family-owned business can make this transition to a publicly-traded company. Part of that process was splitting up the family’s existing business between a group that would follow Laowu and become shareholders of Hydoo, and five other siblings who chose not to participate, but remain active in some cases building their own wholesale trading centers.

As the IPO prospectus puts it,  this division was “a complex, delicate process involving the allocation of assets or interests in the existing businesses among a group of closely connected family members, who decided to split up into two independent groups with diverging goals going forward. Under the special circumstances, no written agreements were entered into in respect of the Family Allocation and no valuation appraised by independent valuers was undertaken when negotiating the Family Allocation. Instead, the Wang Family Group placed their focus on more subjective, personal factors.”

Me and my firm played a small part by advising Laowu and his siblings on the pros and cons of being part of a company planning for an IPO. But, as you’d expect, most of this was done within the private confines of a large, closely-knit family.  Along the way, though, I gained a deeper appreciation of the unique ways Chaozhou people do business.

Chaozhou natives are rightly famous both in China and throughout much of Southeast Asia for their business acumen. They are often described by other Chinese as “the Jews of China”.  As a Jew in China, I tend to think the description flatters my people. Chaozhou people seem to have an instinctive and unsurpassed talent for making money and entrepreneurship. Look around the world at the most successful Chinese business people, including the leading business families in Thailand, Indonesia, Singapore, Malaysia and Hong Kong, and a large percentage, including Asia’s richest magnate, Li Ka-shing, Thailand’s richest businessman Dhanin Chearavanont  and Indonesia’s top tycoon, Mochtar Riady, are either from Chaozhou or are descended from people who immigrated from there.

As this suggests, Chaozhou people are able and willing to uproot themselves and chase opportunities. Laowu didn’t leave China, but in building Hydoo, he did venture far afield from where he and his family were raised. He saw very early and profited richly from an economic shift within China that few others noticed 15 years ago. At the time, much of China’s economic growth was centered in southern China, and large coastal cities like Shanghai, Shenzhen, Xiamen. Laowu looked inland, especially in Shandong Province, one thousand miles north of Chaozhou.

As the economies of Shanghai and big southern coastal cities began to cool, inland areas, led by Shandong, began to boom. Shandong’s GDP growth, over the last ten years, has been among the highest of any part of China. Shandong is a huge market to itself (population 95mn) as well as a vital crossroads for commerce between north and south, east and west in China. Laowu built large wholesale parks to accommodate thousands of small traders, creating new clusters of small-scale commerce and entrepreneurship.

When you visit one of these centers, you get the impression that half of Shandong’s gdp is going in and out the doors. It’s crowded and vibrant. Even the smallest traders own their own small shop inside the Hydoo centers. That’s Hydoo’s model: they build the buildings, and as they do, sell off most of the units to thousands of individual small traders. Hydoo helps them get mortgages and often acts as guarantor on the loans. This lets thousands of small businesspeople become property-owners. As the Hydoo centers thrive (and they all do, as far as I know) the value of the real estate rises.

I know of no other businessman in China that has done as much as Laowu to build wealth and provide an entrepreneurial hub for such a large number of people in China. Hydoo is now spreading across more areas of China. It’s is building huge new wholesale parks in Sichuan, Hunan, Guangxi, Gansu.

I see Laowu infrequently these days. But, I’m as impressed now as I was when I first met him by his accomplishments. He and his family founded a business back when China was a different and less developed place. They stuck with it, kept reinvesting and now, through today’s IPO,  own shares worth more money than I can imagine. But, more important for me is that they still own the business, still own the majority and so answer to no one else. As an entrepreneur who helped create and sustain so many other entrepreneurs, Laowu deserves nothing less.

–

 

Private Sector Capital for China’s SOEs — China First Capital Press Release

Leave a Comment / July 16, 2014

China First Capital press release

Hong Kong, Shenzhen, China:  China First Capital, an international investment bank and advisory firm focused on China, today announces it has received a pioneering mandate from a large Chinese State-Owned Enterprise (“SOE”) holding company to manage a process to revitalize and privatize part of the group by bringing in private capital.

“The investment environment for SOE deals in China is undergoing a significant and exciting change,” commented China First Capital chairman and founder Peter Fuhrman. “We are proud to play a role as investment bankers and advisors in this change, by working with some of China’s SOEs to complete restructuring of unquoted subsidiaries and then raise private sector capital to finance their future expansion. We see these SOE investment deals as the next significant opportunity for institutional investors eager to allocate more capital to China.”

By some estimates, China’s SOEs account for over 60% of total Chinese GDP. Yet, up to now, they have only rarely done private placements or spinoffs to access institutional investment, including from private equity firms. But, according to China First Capital’s internal research, an increasing number of China’s SOEs will face a funding gap in coming years. SOEs, in most cases, have ambitious expansion plans fully supported by the Chinese government. Yet, the SOEs are restricted in their ability to raise large amounts of new bank loans. They are under pressure from Chinese government to maintain or lower their debt-to-equity ratios.

More…

Neue Zurcher Zeitung Interview

 

Better and Worse Investment Ideas For China’s Future

Leave a Comment / October 16, 2013

–tablescreen Where is China headed and how to make money by getting there first? If you were to ask professional China investors, almost without exception you’ll be offered an identical vision of the China of 2020 and beyond:  retired Chinese in their tens of millions living in assisted-living housing spending their days on their smartphones buying clothes, playing games and booking European vacations.

It follows, the pros will tell you, that the best places to put your money today are with Chinese companies building retirement and assisted living housing, mobile apps and online shopping websites. Indeed, these are the sectors getting by far the most attention and seeing the most substantial flows of new investment capital these days.

I happen to think the “smart money” is wrong and here’s why. First, in my experience across 30 years of business life, whenever you get so much agreement about where the future is headed and where money should be staked, the predictions usually prove wrong and the money usually lost.

In this case, the basic analysis is fine. Yes, China is getting older and yes it needs more places to house and care for the elderly. And, yes, Chinese will buy more stuff online since prices are often much lower than in shops. But, only a fraction of the projects now receiving funding will be successes.

The assisted living, online shopping and mobile services businesses already seem over-invested. And yet the money keeps pouring in. It reminds me very much of the last “can’t miss” investment idea in China: group shopping. Two years ago, PE and VC firms poured billions into at least a dozen different group shopping sites in China Most, if not all of that, will be lost.

There are formidable hurdles in the way of all three of the currently-favored business models. For assisted living and retirement housing, it’s not clear Chinese retirees in significant numbers will want to move into these kinds of places, even if their kids are paying. Nor is it clear how these projects will make equity investors money, since Chinese banks remain loathe to lend money to any kind of real estate project.

Online shopping? Great business, but all the companies getting investment have to compete with a few powerhouses with huge market shares. The list includes Alibaba’s Taobao business, Yihaodian (part-owned by Wal-Mart), Amazon China, 360buy.com. I see little reason to believe these newer PE-backed entrants will make any serious dent against these competitors.

As for mobile services, yes Chinese have all switched en masse to smartphones. And, yes, they use the mobiles to do lots of stuff online, including shopping, chat, games. Problem is, in the overwhelming number of cases, Chinese don’t pay for any of it. In my view, they never will. Any investment predicated on the theory that eventually Chinese will start paying fees to mobile service-providers is usually based on not much more than a hope and a prayer. Nothing solid.

So, where else to put money now to be best-positioned for the China of 2020? I can think of two places. One is organic foods and the other is health supplements and what are called “functional foods” in the US.

As of now, both are tiny industries in China, a fraction of their size in the US and Europe. My guess is that the market in China will eventually dwarf those two other places. I’ve read about a few PE investments in these industries. But, in general, the so-called “smart money”  has stayed out.

So, why do I think organic, “functional foods” and supplements will become huge businesses in China? In general, the same forces will prevail in China that have propelled the growth of these industries in the US and Europe: a wealthier population, more interested in their health, more distrustful of traditional commercially-prepared foods, and also more interested to improve their health, fitness and life expectancy by exercising, eating well (including vitamins and supplements) while keeping away from doctors.

In China, this distrust of commercial foods and commitment to a more healthful lifestyle, though still in a comparatively early stage,  is already strong, deep and widespread. So is the lack of trust in the quality of medical care received from doctors.

As anyone who lives in China can attest, there are very good reasons for all of this. Food scandals are common. There seems to be a lot of unhealthy and unhygienic food circulating.  Doctors don’t enjoy a very high standing any longer. They are often seen as fee-grubbing predators, ever willing to make phony diagnoses as a way to put more money in their pockets from their share of fees paid for tests, medicines, surgery, hospital care.

In short, the conditions couldn’t be riper for the development of organic foods, and health supplements of all kinds. Chinese traditional medicine shares quite a few principles in common with the OTC health supplements sold in the US. Chinese, in a way Westerners generally do not, have always accepted that Western pharmaceuticals should often be taken as a last resort. They worry greatly about side effects. If there’s a more “holistic” way to treat a condition, Chinese will often prefer it.

China, as of today, has no vitamin and supplement shops like GNC in the US, nor do mainstream pharmacies give such products any shelf space. When you can find them, vitamins are sold at very high prices in China, usually at least double the US level. There are no good domestic brands, no winning products or packaging formulated specifically for Chinese consumers.

One data point: it’s more and more widely known in China that fish oil is beneficial for digestion and circulation. And yet, it’s hard to find the product anywhere in China. When you do, it is usually stuff imported from the US, in old-looking packaging, with English-language  labels, and prices three to four times higher than in America.

Whether the world has enough cod livers to meet future Chinese demand for fish oil is another story. But, I’m confident the China market should eventually rival the US’s in size.

As for organic and healthy foods, China has lots of conventional supermarkets. But, so far no one has tried to follow the path blazed by Whole Foods Market in the US. Nor are there large, established organic food brands like Organic Valley, Applegate.

It will all happen. When, and which investors will make the big money is hard to say. Even now, the demand for genuine organic fruits, vegetables and dairy outstrips the available supply. There’s yet no real standard in China for what can be called organic, and so Chinese consumers often view products labeled that way with suspicion. That too represents a business opportunity in China — providing standards and credentials for the organic farming industry.

The lesson here: in China, the best business opportunities are often hiding in plain sight, often unseen by professional investors. Nowhere is contrarian investing more warranted and more potentially profitable.

–

The China IPO Embargo: How and When IPOs May Resume

Leave a Comment / September 26, 2013

–

–

China IPO

China first slowed its IPO machinery beginning July 2012 and then shut it down altogether almost a year ago. Since then, about the only thing stirring in China’s IPO markets have been the false hopes of various analysts, outside policy experts, stockbrokers, PE bosses, even the world’s most powerful investment bank.  All began predicting as early as January 2013 the imminent resumption of IPOs.

So here we are approaching the end of September 2013 with still no sign of when IPOs will resume in China. What exactly is going on here? Those claiming to know the full answer are mainly “talking through their hat“. Indeed, the most commonly voiced explanation for why IPOs were stopped — that IPOs would resume when China’s stock markets perked up again, after two years of steady decline — looks to be discredited. The ChiNext board, where most of China’s private companies are hoping to IPO, has not only recovered from a slump but hit new all-time highs this summer.

Let me share where I think the IPO process in China is headed, what this sudden, unexplained prolonged stoppage in IPOs has taught us, and when IPOs will resume.

First, the prime causal agent for the block in IPOs was the discovery in late June last year of a massive fraud inside a Chinese company called Guangdong Xindadi Biotechnology.  (Read about it here and here.)

This one bad apple did likely poison the whole IPO process in China, along with the hopes of the then-800 companies on the CSRC waiting list. They all had underwriters in place, audits and other regulatory filings completed and were waiting for the paperwork to be approved and then sell shares on the Shenzhen or Shanghai stock exchanges. That was a prize well worth queuing up for. China’s stock markets were then offering companies some of the world’s highest IPO valuations.

After Xindadi’s phony financials were revealed and its IPO pulled, the IPO approval process was rather swiftly shut down. Since then, the CSRC has gone into internal fix-it mode. This is China, so there are no leaks and no press statements about what exactly is taking place inside the CSRC and what substantive changes are being considered. We do know heads rolled. Xindadi’s accountants and lawyers have been sanctioned and are probably on their way to jail, if they aren’t there already A new CSRC boss was brought in, new procedures to detect and new penalties to discourage false accounting were introduced.  The waiting list was purged of about one-third of the 800 applicants. No new IPO applications have been accepted for over a year.

IPOs will only resume when there is more confidence, not only within the CSRC but among officials higher up, that the next Xindadi will be detected, and China’s capital markets can keep out the likes of Longtop Financial and China MediaExpress, two Chinese companies once quoted on NASDAQ exchange. They, along with others, pumped up their results through false accounting, then failed spectacularly.  Overall, according to McKinsey, investors in U.S.-listed Chinese companies lost 72% of their investment in the last two years.

China’s leadership urgently does not want anything similar to occur in China. That much is certain. How to achieve this goal is less obvious, and also the reason China’s capital market remains, for now, IPO-less.

If there were a foolproof bureaucratic or regulatory way for the CSRC to detect all fraudulent accounting inside Chinese companies waiting to IPO in China,  the CSRC would have found it by now. They haven’t because there isn’t. So, when IPOs resume, we can expect the companies chosen to have undergone the most forensic examination practiced anywhere. The method will probably most approximate the double-blind testing used by the FDA to confirm the efficacy of new medicines.

Different teams, both inside the CSRC and outside, will separately pour over the financials. Warnings will be issued very loudly. Anyone found to be book-cooking, or lets phony numbers get past him,  is going to be dealt with harshly. China, unlike the US, does not have “country club prisons” for white collar felons.

The CSRC process will turn several large industries in China into IPO dead zones, with few if any companies being allowed to go public. The suspect industries will include retail chains, restaurants and catering, logistics, agricultural products and food processing. Any company that uses franchisees to sell or distribute its products will also find it difficult, if not impossible, to IPO in China. In all these cases, transactions are done using cash or informal credit, without proper receipts. That fact alone will be enough to disqualify a company from going public in China.

Pity the many PE firms that earlier invested in companies like this and have yet to exit. They may as well write down to zero the value of these investments.

Which companies will be able to IPO when the markets re-open? First preference will be for SOEs, or businesses that are part-owned by or do most of their business with SOEs. This isn’t really because of some broader policy preference to favor the state sector over private enterprise. It’s simply because SOEs, unlike private companies, are audited annually, and are long accustomed to paper-trailing everything they do. In the CSRC’s new “belt and suspenders” world, it’s mainly only SOEs that look adequately buckled up.

Among private companies, likely favorites will include high-technology companies (software, computer services, biotech), since they tend to have fewer customers (and so are easier to audit) and higher margins than businesses in more traditional industries. High margins matter not only, or even mainly, because they demonstrate competitive advantage. Instead, high margins create more of a profit cushion in case something goes wrong at a business, or some accounting issue is later uncovered.

The CSRC previously played a big part in fixing the IPO share price for each company going public. My guess is, the CSRC is going to pull back and let market forces do most of the work. This isn’t because there’s a new-found faith in the invisible hand. Simply, the problem is the CSRC’s workload is already too burdensome. Another old CSRC policy likely to be scrapped: tight control on the timing of all IPOs, so that on average, one company was allowed to IPO each working day. The IPO backlog is just too long.

The spigot likely will be opened a bit. If so, IPO valuations will likely continue to fall. From a peak in 2009, valuations on a p/e basis had already more than halved to around 35 when the CSRC shut down all IPOs.  IPO valuations in China will stay higher than, for example, those in Hong Kong. But, the gap will likely go on narrowing.

What else can we expect to see once IPOs resume? Less securitized local government borrowing. Over the last 16 months, with lucrative IPO underwriting in hibernation,  China’s investment banks, brokerage houses and securities lawyers all kept busy by helping local government issue bonds. It’s a low margin business, and one not universally approved-of by China’s central government.

How about things that will not change from the way things were until 16 months ago? The CSRC will continue to forbid companies, and their brokers, from doing pre-IPO publicity or otherwise trying to hype the shares before they trade. If first day prices go up or down by what CSRC determines is “too much”, say by over 15%, expect the CSRC to signal its displeasure by punishing the brokerage houses managing the deals.  The CSRC is the lord and master of China’s IPO markets, but a nervous one, stricken by self-doubt.

China needs IPOs because its companies need low-cost sources of growth capital. When IPOs stopped, so too did most private equity investment in China. It’s clear to me this collapse in equity funding has had a negative impact on overall GDP, and Chinese policy-makers’ plans to rebalance its economy away from the state-owned sector. It’s a credit to China’s overall economic dynamism, and the resourcefulness of its entrepreneurs,  that economic growth has held up so well this past 18 months.

IPOs in China are a creature of China’s administrative state. Companies, investors, bankers, are all mainly just bystanders. Right now, the heaviest chop to lift in China’s bureaucracy may be the one to stamp the resumption of IPOs. So, when exactly will IPOs resume? Sometime around Thanksgiving (November 24, 2013) would be my guess.

–

 

 

Investors Vs. Asset Managers: A Dysfunction at the Heart of China Private Equity

1 Comment / September 12, 2013

4a

–

Assuming the same level of risk, would you rather make $100 from investing $10 or from investing $50? Easy, right? Who wouldn’t choose to make ten times your money, rather than just double it? There is one group I know. Private equity firms active in China. At least some of them. They care more about the amount they can invest in a deal than the profits they stand to make.

The illogic at work here is the direct result of some particular, not very appealing characteristics,  of the PE industry in China. PE firms lately have more confidence in their ability to raise money than to invest it profitably by achieving a timely exit. To raise money, though, a PE firm needs first to spend most of what it already has. Result: a rush to get money out the door and parked in deals.

In industry parlance, “check size” is often more important than potential risk-adjusted returns.This is one reason for the recent rash of “take private” PtP deals of Chinese companies quoted in the US. (See previous articles, including here, here, here. ) The transactions seem to me ill-considered. PEs have invested billions of dollars in such deals but there is not a single successful example they can point to of such PtP deals done in the US making money for investors. This must be a PE industry first — so much LP money put at risk against an investment idea that is totally unproved.

Who’s most harmed from focus on “check size” over deal quality and prospective returns? Of course it’s the LPs whose money is put into these deals. They want and need high returns, not bigger deals done using their money to aid PE firms’ future fund-raising.

But, Chinese entrepreneurs also suffer in this environment, because many PE firms now simply won’t look at deals where they can’t invest at least $25mn for around 25% of the company. There are few deals out there in that size range, meaning deserving entrepreneurs can’t find investors.

The big picture here: PE in China has become more and more a business dominated by asset managers not investors. How to tell the two apart? An asset manager enjoys the comfort and certainty of making a steady 2% a year managing other people’s money. The more money they raise, the more money they keep. Good markets or bad, the money keeps rolling in.

An investor, on the other hand, is a whole different animal. They share some DNA with the entrepreneurs they back. They love the sport of finding and evaluating deals, spotting where big money can be made, putting money at risk. When it works, they make big sums for their investors, and keep a nice chunk themselves.

Needless to say, LPs give money to PE firms in hopes they have chosen investors not asset managers. PE firms know this, of course, and tailor their money-raising pitch accordingly. They stress their deal-making prowess, not the fact that over the life of a typical 10-year fund, an LP will start with a 20% cumulative loss, because of the typical annual management fee deductions.

In China, it used to be fairly easy to make money in PE. But, over the last three years, returns began to head south. More recently,  over the last 18 months, the performance has mainly been dismal, with few successful deals exiting with big profits. It’s getting harder and harder for LPs to make money in China PE, after those accumulated management fees have been deducted.

But, there’s a time lag — as well as an information asymmetry — at work here. While recent performance has been, on the whole, lousy, there’s still appetite among LPs to allocate more money to China. A big reason is that China’s economy, and capital markets, are both the second-biggest in the world. Most LPs are seriously underweight China and want to change that.

And so we arrive at the current paradoxical situation, where it’s still comparatively easier to collect money to invest in China than to make money deploying it. Now, of course, PE firms can only succeed in raising capital if they can point to some successful past deals. Here too there’s an information asymmetry at work. Many PE firms did well from 2005-2010, and so their fund-raising documents emphasize deals done during this era. But, the game has changed out of all recognition since then.

Few, if any, PE firms have shown they can continue to earn investors good money when markets become less accommodating. It’s no longer possible to play the game of valuation arbitrage, of investing in China deals at single digit p/e multiples, and exiting them soon after at 5-10 times higher multiples through an IPO.

Earning a profit on an investment takes preparation, luck and time. Making money by convincing people to pay you a fee to manage theirs, by contrast, is a much simpler proposition, as well as a no-lose one.

And so the gulf widens between the objectives of PE firms and the fiduciary responsibilities and performance goals of the institutions whose money they manage.

This can be a problem everywhere in the PE and VC industry, as well as more broadly wherever people get paid to manage assets owned by someone else. (See principal-agent dilemma.)   But, it’s probably especially pernicious in China PE.

The industry is staffed mainly be ex-investment bankers, who by background and temperament understand more about fee-based, than performance-based, compensation. Few have a background of actually managing a company, investing its capital to produce a return. Without this first-hand understanding, it’s far harder as an investor to plot how to make an operating business more valuable. The result: PE firms in China will often opt for an easier path: making money by raising money from, and managing for,  other financial professionals.

–

–

–

Why China PE will rise again — Interview in China Law & Practice Annual Review 2013

2 Comments / March 11, 2014

—CLP

 

–

Download complete text

–

Peter Fuhrman, chairman of China First Capital, talks to David Tring about his company’s disciplined focus, what the IPO freeze means for PE investors and how a ruling from a court in China has removed a layer of safety for PE firms

What is China First Capital?

China First Capital is a China-focused international bank and advisory firm. I am its chairman and founder. Establishing, and now running, China First Capital is the fulfilment of a deeply-held ambition nurtured for over 30 years. I first came to China in 1981, as part of a first intake of American graduate students in China. I left China after school and then built a career in the US and Europe. But, throughout, I never lost sight of the goal to return to China and start a business that would contribute meaningfully and positively to the country’s revival and prosperity.

China First Capital is small by investment banking industry standards. Our transaction volume over the preceding twelve months was around $250 million. But, we aim to punch above our weight. China First Capital’s geographical reach and client mandates are across all regions of China, with exceptional proprietary deal flow. We have significant domain expertise in most major industries in China’s private and public sector, structuring transactions for a diversified group of companies and financial sponsors to help them grow and globalise. We seek to be a knowledge-driven company, committed to the long-term economic prosperity of Chinese business and society, backed by proprietary research (in both Chinese and English), that is generally unmatched by other boutique investment banks or advisory firms active in China.

What have been some of the legislative changes to the PE sector this year that are affecting you?

The recent policy and legislative changes are mainly no more than tweaks. There has been some sparring within China over which regulator would oversee private equity. But, overall, the PE industry in China is both lightly and effectively regulated. A key change, however, occurred through the legal system within China, when a court in Western China invalidated the put clause of a PE deal done within China, ruling that the PE firm involved had ignored China’s securities laws in crafting this escape mechanism for their investment.  While the court ruled on only a single example, the logic applied in this case seems to me, and many others, to be both persuasive and potentially broad-reaching. For PE firms that traditionally added this put clause to all contracts they signed to invest in Chinese companies, and came to rely on it as a way to compel the company to buy them out after a number of years if no IPO took place, there is now real doubt about whether a put clause is worth the paper it’s printed on. Simply put, for PE firms, it means their life-raft here in China has perhaps sprung a leak.

What are some of the hottest sectors in China that are attracting PE investors?

At the moment, with IPOs suspended within China and Chinese private companies decidedly unwelcome in the capital markets that once embraced them by the truckload – the US and Hong Kong – there are no hot sectors for PE investment in China now. The PE industry in China, once high-flying, is now decidedly grounded and covered in tarpaulin. What is perhaps most unfortunate about this is that what we are seeing mainly is a crisis within China’s PE industry, not within the ranks of China’s very dynamic private entrepreneurial economy. In other words, while financing has all but dried up, China’s private companies continue, in many cases, to excel and outperform those everywhere else in the world. The PE firms made a fundamental miscalculation by pouring money into too many deals where their only method of exit, of getting their money back with a profit, was through an IPO. By our count, there are now over 7,500 PE-invested deals in China all awaiting exit, at a time when few, if any exits are occurring. Since PE firms themselves have a finite life in almost all cases, this means over $100bn in capital is now stuck inside deals with no high-probability way to exit before the PE funds themselves reach their planned expiry. The PE industry has never seen anything quite like what is happening now in China.

What is a typical day like for you at China First Capital?

We are lucky to work for an outstanding group of companies, mainly all Chinese domestic. Indeed, I am the only non-Chinese thing about the business. I am in China doing absolutely what I love doing. There are no aspects of my working day that I find tedious or unpleasant. Even at my busiest, I am aware I am at most a few hours away from what the next in an endless series of totally delicious Chinese meals. That alone has a levitating effect on my spirit. But, the real source of pleasure and purpose is in befriending and working beside entrepreneurs who are infinitely more skilled, more driven and wiser to the ways of the world and more successful than I ever could hope to be.

We are quite busy now working for one of China’s largest SOEs. It’s something of a departure for us, since most of our work is with private sector companies. But, this is a fascinating transaction that provides me with a quite privileged insider’s view of the way a large state-owned business operates here in China, the additional layers of decision-making and the unique environment that places far greater onus on increasing revenues than profits.

What do you find are some of the major issues or concerns for foreign PE clients when doing deals in China?

All investors looking to make money in China, whether on the stock market or through private equity and venture capital,  must confront the same huge uncertainty – not that China itself will stop its remarkable economic transformation and stop growing at levels that leave the rest of the developed world behind in the dust. This growth I believe will continue for at least the next 20 years. The big unknown has to do with the actual situation inside the Chinese company you are buying into. Can the financial statements and Big Four audits be relied on? Are the actual profits what the company asserts them to be? How great is the risk that investors’ money will disappear down some unseen rat hole?

Some frightening stories have come to light in the last two years. How widespread is the problem of accounting fraud in China? Part of the problem really is just the law of big numbers. With a population almost triple that of the US and Western Europe combined, China has a lot of everything, including both remarkable businesses run by individuals who are the entrepreneurial equal of Henry Ford and Steve Jobs, and well as some shady operators.

What is your outlook for China’s PE sector in the coming 12 months?

I believe the current crisis will abate, and stock markets will once again welcome Chinese private sector companies to do IPOs. The IPOs will be far fewer in number than in 2010, but still the revival of IPO exits will also thaw the current deep-freeze that has shut down most PE activity across China. PE firms will again start to invest, and put a dent in the $30 billion or more in capital they have raised to invest in China but have left untouched. The PE industry in China, since its founding a little more than a decade ago, grew enormously large but never really matured. There are now too many PE firms. By some count, the number exceeds 1,000, including hundreds of Renminbi PE firms started and run by people with no real experience investing in private companies. Their future appears dire. At the same time, the global PE firms that bestride the industry, including Carlyle, Blackstone, TPG, KKR, have yet to fully establish they can operate as efficiently and profitably in China as they do in Europe and the US.

While the China PE industry struggles to recover from many self-inflicted wounds, China’s private sector companies will continue to find and exploit huge opportunities for growth and profit in China, as the nation’s one billion consumers grow ever-richer and ever more demanding.

–

 

Preying on China’s distress — IFR Asia

Leave a Comment / June 24, 2016

–IFR

Preying on China’s distress

–

IFR Asia 806 – July 27, 2013 | By Timothy Sifert

Global advisory firms are beginning to allocate more resources to China in a bet that slowing economic growth and tighter credit conditions will lead to a rise in restructuring opportunities.

Slowing growth and mounting debt burdens are creating an environment that is, in theory, ripe for turnaround specialists and distressed debt investors. A number have been adding senior staff in China, a market that remains largely untapped relative to the rest of Asia.

Investors, however, warn that restructuring specialists may find doing business in China a lot more difficult than they anticipated.

AlixPartners has doubled the size of its team in Asia to about 70 in the last two years. Alvarez & Marsal appointed Yansong Xue and Bing Liu as directors in Beijing this month. Both firms plan to continue expanding in China and elsewhere in Asia.

“Most of our work is done when you have a leveraged Chinese company with some kind of private-equity firm backing it and it’s in default,” said Ivo Naumann, managing director, AlixPartners, Shanghai. “We are engaged by equity owners and creditors to help with leadership in the process, and are often brought in as an interim manager.”

Turnaround shops, however, are also targeting the underperforming China operations of multinational corporations.

“For many Western companies, five or 10 years ago, you just had to be in China irrespective of profitability, and that was fine when you were making a lot of money in Europe and the US, but it’s not working now,” Naumann said.

Chinese growth has slowed in nine of the past 10 quarters, and data last week showed that the country’s production lost momentum for the third straight month.

At the same time, companies are facing a tougher time accessing financing as regulators force banks to reform their risk management and rein in off-balance-sheet lending. A liquidity squeeze in China’s money markets has pushed up the cost of bonds, and no domestic IPO has priced since October 2012.

Refinancing pressures in China have rarely led to the kind of restructuring or turnaround opportunities that are common in the US and Europe. No domestic bond issue has defaulted, while local politics and laws related to restructuring have often frustrated international investors, adding to general linguistic and cultural differences.

Advisers, however, believe the renewed focus on reform under Premier Li Keqiang will lead to more opportunities for conventional workouts.

Predator and saviour

Many on China’s long list of PE-backed companies are already feeling the pressure, they say.

Over the past decade, the market for Chinese PE has grown rapidly, only to decrease just as rapidly as the local PE markets offered few exit opportunities. PE investments in China are on pace to reach US$6.4bn for the full year 2013 – that is a 64.2% decline from the 2011 peak. (See Chart.)

This ebb in new investments means fund managers are spending more time on existing portfolios.

“[R]unning a private equity fund has become much more of a value-add business in that funds now have to manage their portfolio companies,” said Oliver Stratton, co-head of Alvarez & Marsal Asia, a turnaround firm. “They’re not only investors, and they can’t be passive. So, they’re thinking, ‘we actually have to grow earnings now and fix up the balance sheet’.”

What is more, foreign firms have not always committed the necessary local resources – or had the patience – to address the full scope of the market. The effect is a missed business opportunity.

“Broadly speaking, there is an almost-unimaginably huge money-making opportunity available for turnaround/restructuring firms to act as predator and saviour for PE portfolios in China,” said Peter Fuhrman, chairman and CEO of China First Capital, an international investment bank focusing on China.

“But – and it’s a very big but – there really are few if any firms with that capability, experience, focus. It is, therefore, a great example of why often the best and easiest opportunities to make money in China are overlooked or not acted upon.”

Meanwhile, in part because China’s bank loan market is opaque, potential investors have had to go to greater lengths to get basic information on local assets. On a few occasions, investors have called on risk consultancies to vet PRC loans and the parties backing them.

“We don’t help clients source investments, but we see growing demand to investigate non-performing loans in China,” said Tadashi Kageyama, senior managing director at Kroll Advisory Solutions in Hong Kong. “Interest in these assets should grow after the liquidity squeeze this year.”

Out of court

The Chinese court system, and the way it deals with bankruptcy, can be both a benefit and a hurdle to restructurings. Turnaround specialists said that judges were often quick to liquidate a defaulted firm, rather than engage in a lengthier workout process that could have benefits for debtors and creditors.

“China has a modern bankruptcy code that’s fine and as good as in Europe,” said AlixPartners’ Naumann. “It’s just that the courts and creditors have limited experience in executing it. Their intentions are good, but, in mainland China, a judge’s performance is often measured by the number of cases decided. So, for a judge to engage in a lengthy and highly complex turnaround process, it is challenging. This may sometimes lead to a situation where a liquidation is given priority over a turnaround process.”

As a result, sources said, PE-backed companies – their managers, debtors and creditors – often wanted to settle things out of court. That is where restructuring firms can come in to turn things around.

Yet, to be a relative success in this market is probably going to take a bigger commitment than firms have demonstrated in the recent past. Not a lot of money has been made in China restructuring relative to the rest of the world, sources say.

“It is not particularly difficult for foreign or domestic firms to make money in China, but why no turnaround firms? It starts from simple, humble, unsexy things like none of these guys have real offices in China with significant Chinese-speaking teams with experience in fixing what’s broken inside a Chinese company,” CFC’s Fuhrman said. “They will quickly gravitate to better-paying jobs in PE or investment banking.

“Without teams, you can’t do squat.”

 

Download PDF version.