Chinese Domestic Economy

Punishing the Righteous — How Lax Tax Compliance Distorts the Chinese Economy

1 Comment / July 23, 2013

The Chinese corporate tax system combines fairly high rates with low compliance. The result is that the companies that do pay all the tax legally owed will usually be at an enormous competitive advantage to the numerous competitors who pay little or nothing. Non-payers can either choose to earn fatter margins or undercut the price of their compliant competitors. Either way, the result is that profits flow to those least legally entitled to keep them.

This widespread tax avoidance is among the more serious distortions in the Chinese domestic economy. The government knows this, and so tries to level the field by giving special targeted tax breaks, subsidies, underpriced land (as well as awards of free land)  to the companies that do pay tax. But, this practice causes distortions of its own.

The corporate tax system in China is a cake of many layers. There is a VAT applied to most products along with a corporate profits tax of 25%, as well as a whole raft of other fees and levies, including taxes on real property and natural resources, and others to finance urban maintenance and construction.

In my experience, it’s exceeding rare to find a Chinese private company that obeys the rules and pays all that is asked of it. Doing so, in most cases, would render the company loss-making. The best payers are the private companies that have filed for an IPO, or have already been publicly-listed in China. It is the most critically important of all the prerequisites for IPO approval, that a company be fully compliant with all tax rules.

For companies we know, this process of becoming fully tax-compliant is the most painful and expensive thing they will ever undertake in business. In one case, a very successful retail jewelry company, has gone from paying almost nothing in tax to paying almost Rmb500mn (USD$80mn) during the three-year process of preparing to file the application for an IPO. An IPO in China is basically a way for a company to reclaim, from stock market investors, the cash it’s lost to the taxman over the preceding three to five years.

The government bestows favors on companies that do pay tax. Hanging prominently on the walls of many private companies I visit are plaques given to a locality’s largest tax-payers. The plaque is awarded for amounts paid, not amounts technically owed. So, it is possible to be both an award-winning local taxpayer and a world-class tax cheat at the same time.

Though there is no formal system of tax rebates, just about every business that pays some tax gets something back in return from the state. The more you pay the more you receive. The two most popular forms of rebate to companies are investment subsidies as well as the opportunity to buy land at concessionary price.

The investment subsidies can be very generous. Depending on industry and location in China, a companies will often get back one-third or more the cost of new factory machinery.  While this lowers breakeven cost and so improves a company’s profit margins, the investment subsidies help propel a system in China that often leads to rampant over-investment. This is especially noticeable in some favored high-tech areas like the manufacturing of LED chips or wind turbines. R&D spending is also often subsidized through a form of tax rebate.

Often, the best use of a company’s money would be to invest in marketing, or building its sales channels. The tax rebate system generally rewards none of this. So, arguably, companies can often end up worse off, with higher-than-needed outlay for fixed assets, because of the tax system.

The offer to purchase land at significant discount is a valuable perk, and one that’s available, in the main, only to Chinese companies that pay tax. It is probably the most frequent form of indirect tax rebate. I know of no specific formula, but the general principle is for every million in taxes you pay, you will be given a chance to buy land worth multiples above that, at a price at least 50% below market value.

Unlike factory equipment, which loses value every year, land is a scarce commodity in China. The government has lately tried to moderate price increases of land. But, overall, buying land in China, especially if done at a discounted price, is a winning one-way bet.

While a nice inducement to encourage tax compliance, the government’s offer of underpriced land to taxpaying companies also causes distortions. Chinese manufacturers, in general, are fixated on owning the land their factories sit on. Even if you can buy that land on the cheap, it is still a sink for capital that might be more efficiently invested elsewhere in your business. You also need to borrow the money, in most cases, to buy the land. Those interest payments can often lower your pre-tax profit margins.

There is also a problem of asyncrony.  You need to pay taxes for several years before you get a chance to buy land on the cheap. During that whole time, while you wait to make a profit on a land deal, your non-taxpaying competitors are enjoying much fatter margins than you. They can use this to steal lower prices, steal your customers and so lower your profits. This not only pushes you towards insolvency, it also reduces the ability to pay the taxes that generate the favors that offset the high tax rates.

From what I’ve been able to tell, nobody, including Chinese government officials, likes the current corporate tax system, with all its complexity and high headline rates. But, these same officials also argue that if they lowered taxes overall, there is no guarantee that the many tax-avoiding companies will then become taxpayers. They are probably right. From that simple standpoint, cutting corporate taxes may only lower the amount of money the government takes in each year. This, in turn, means less money to award to those who are paying.

China is likely stuck with its current corporate tax system. It punishes, then compensates, the righteous few who pay everything that’s owed.

 

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Private Equity in China 2013: the Opportunity & The Crisis — China First Capital Research Report

2 Comments / June 29, 2013

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Making money from private equity in China has become as challenging as “trying to catch a fish in a tree“*. The IPO exit channel is basically shut. Fundraising has never been harder. One hundred billion dollars in capital is locked up inside unexited deals. LPs are getting very anxious. Private companies are suffocating from a lack of new equity financing. PE firms are splintering as partners depart the many struggling firms.

Looking beyond today’s rather grim situation, there are some points of light still shining bright. China remains the world’s fastest-growing major economy with the world’s most enterprising private sector. Entrepreneurship remains China’s most powerful, as well as inexhaustible, natural resource. So long as these two factors remain present, as I’m sure they will for decades to come, China will remain an attractive place to put money to work. But, where? With whom?

China First Capital has published its latest survey covering China PE, M&A and capital markets. The report is titled, ” Private Equity in China 2013 — The Opportunity & The Crisis“. It can be downloaded by clicking here.

During the last year, as China PE first stumbled, then fell into a deep pit, a lot of people I talk to in the industry suggested this was a positive development, that the formation of funds and fundraising had both gotten out of hand. Usually, the PE firm partners saying this quickly added, “but this doesn’t apply to us, of course”.  In other words, as the American saying has it,  “Don’t blame you. Don’t blame me. Blame the guy behind the tree.” It’s all somebody else’s fault.

That’s an interesting take. But, not one that holds up to a lot of scrutiny. The reality is that everyone in the business of financing Chinese companies, myself included, got a little drunk and disorderly. China, in business terms, is the world’s largest punchbowl filled with the world’s most intoxicating liquor. Too many good companies. Too much money to be made. Too much money to be had.

It was ever thus. From the first time outside investors and dealmakers got a look at China, they all went a little berserk with excitement.  This was as true of Marco Polo in the 14th century as British opium houses in the 19th century and American endowments and pension funds in the last decade. The scale of the place,  of the market,  is just so stupefying.

The curse of all China investing is counting one’s fortune before it’s made.  In the latter half of the 19th century, for example, European steel mills dreamed of the profits to be made from getting Chinese to switch from chopsticks to forks and knives.

PE firms did a lot of similar fantasizing. Pour money in at eight times earnings, and pull it out a few years later after an IPO at eighty.   All the spreadsheets, all the models, all the market research and top-down analytics — in the end, it all came back to this intoxicating formula. Put a pile of chips on number 11 then spin the roulette wheel. There were a few winners in China PE, a few deals that hit the jackpot. But, the odds in roulette, at 36-to-one, turned out to be much more favorable.

For every PE deal that made a huge return, there are 150 that either went bust or now sit in this near-endless queue of unexited deals, with scant likelihood of an IPO before the PE fund’s life expires.

The China First Capital research report, rather than making any predictions on when, for example, IPOs will resume and at what sort of valuation,  delves more deeply into some more fundamental issues. These include ideas on how best to resolve the “principal-agent dilemma”, and the growing risks to China’s economic reform and rebalancing strategy caused by the drying up of IPO and PE financing of private sector companies.

We hope our judgments have merit. But, above all, they are independent. Unconflicted. That seems more and more like a rarity in our profession.

 

* A prize to the first person who successfully identifies the source of this quote. A hint: it was said by a former, often-maligned ruler of China.

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New capital drought threatens growth in China — China Daily

Leave a Comment / June 24, 2016

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Continued lack of IPO proceeds and private equity input will damage China’s economic reform

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By Peter Fuhrman

China’s private sector is experiencing an unprecedented shortage of new investment capital. The two predominant flows of growth capital for China’s private sector – initial public offering proceeds and new investments by more than 1,000 private equity firms active in China – have both dried up.

As recently as 2011, IPOs and PE firms pumped $20 billion (15 billion euros) to $30 billion a year of new capital into private companies in China. In the past nine months, that figure has dropped to almost zero.

Even when IPOs cautiously resume, the flow of capital to private companies will likely remain at levels far below recent years. If so, it will quite possibly damage the plans of the Chinese government, as well as the hopes of many of its citizens, to “rebalance” the Chinese economy away from reliance on state-owned enterprises and toward one oriented more toward meeting the needs and fulfilling the hopes of the country’s 1.3 billion people.

All companies need capital to grow. This is especially true among China’s private sector businesses. They operate in a particularly fast-growing market, where both opportunities and competitors are plentiful. Private sector companies are also the main source of new jobs in China, and an increasingly vital contributor to overall GDP growth.

Over the past decade, these Chinese companies became perhaps the world’s hottest investment targets. China’s PE industry, both dollar and yuan, grew from basically zero to become the second-largest in the world. PE firms raised more than $200 billion to invest in China and then put money in more than 10,000 Chinese companies. At the same time, Hong Kong, New York and China each year vied for the title of world’s largest IPO market, with most of the deals being new offerings by Chinese companies.

New capital drought threatens growth

China still has more of the world’s best, most talented private sector entrepreneurs than any country. Investing in their companies remains one of the best ways to make money anywhere. But, for the moment, only a few are willing to try.

This problem is at its core a market failure caused by the loss of investor confidence inside and outside China in the true financial situation of its private sector companies. Questions are raised about financial fraud inside Chinese private companies. Though the concerns are real, the problems are of limited scope, often technical, and the market’s reaction has been severely overblown.

The accounting issues first arose in the US, with the uncovering of several cases of phony accounts among Chinese private companies quoted there. The contagion of doubt spread first to other Chinese private sector companies already listed or seeking to IPO in the US, then to those waiting for an IPO in Hong Kong, until recently the largest market in the world for new IPOs.

Finally, from the summer of 2012, the stock markets on the Chinese mainland began shutting down new IPOs. When the IPOs stopped, most PE firms stopped investing.

The PE firms are sitting on more than $40 billion in capital that they say is for investing in China’s fast-growing private sector companies. But that money is now idle in bank accounts, not going to help good companies become better.

The longer China’s private sector goes without access to major new capital, the more unbalanced the Chinese economy may become.

I first came to China in 1981. During the past 32 years, China’s private sector has gone from non-existent to producing more than half of the country’s GDP. The private sector produces just about everything ordinary Chinese rely on to better the quality of their lives – not just more and better-paying jobs, but also new housing, shops, clothing, restaurants, tutoring for their children and a vibrant Internet and e-commerce industry.

As these private companies have gone from small mom-and-pops to some giant businesses, including virtually all China’s leading domestic consumer brands, the dependence on IPO proceeds and PE money has become almost absolute. So, the dramatic slowdown in the flow of capital to private companies will have an impact on these businesses, their customers and ultimately China’s GDP.

At this point, the only outside financing available for Chinese private companies are bank loans, which remain difficult and costly to arrange. The banking system is, however, fixated on lending to state-owned enterprises. That leaves only the so-called “shadow banking system”, where loan sharks provide short-term money at interest rates of at least 25 percent per year. But, recently, even many loan sharks have fled the marketplace.

The Chinese government has created a set of policies that allowed the private sector to flourish. It also encouraged the flow of capital from the PE industry and IPOs. The plan had been to rely on the private economy to shoulder much of the burden of restructuring the Chinese economy away from SOEs and exports, while creating new jobs and supplying the goods consumers most want.

But that planned rebalancing cannot happen without money, without new capital for the private sector. Instead of a rebalance, China’s economy is possibly headed toward a more lopsided reliance on the state sector and big-ticket government spending projects.

(The author is founder and chairman of China First Capital, a China-focused investment banking and advisory firm. The views do not necessarily reflect those of China Daily.)

 

Download PDF version.

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M&A in China — New China First Capital Research Report, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China”

Leave a Comment / June 18, 2013

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M&A in China is entering a new, more promising phase. At no previous time was the environment as favorable to identify and close, at attractive valuations, the acquisition of a profitable, high growth, well-run, larger private business in China.

This is the conclusion of a recently completed research study by China First Capital, as part of our M&A advisory work. (An abridged copy of the report is available by clicking here.) The report is titled, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China: Sourcing and executing successful corporate acquisitions and buyouts from unexited PE deals in China“.

The industrial logic of doing acquisitions in China has never been in doubt. The scale, high annual growth rate and fragmented nature of China’s domestic economy all create a powerful attraction for control investors. The challenge has traditionally been a negative selection bias on the sell-side, that the Chinese companies available for purchase are often troubled,  state-owned, inefficient or poorly-managed. China’s best corporate assets, its larger private companies, were not previously available to control investors.

As a result, M&A in China, for all the predictions of an impending take-off, has never gotten into gear. The theory behind most deals, if there was one, was to tie two stones together and see if they float.

The reason for the positive change in the environment for control deals in China is the serious degradation in the environment for minority ones. Specifically, China’s private equity industry is in a state of deepening crisis. Having financed the growth of many of China’s best private companies, the PE firms are now finding it increasingly difficult to engineer a liquidity event before the expiry of their fixed fund life. They are emerging as distress sellers of desirable assets — in this case, strong PE-backed companies that are left without any other viable means for investors to exit.

As elaborated in earlier research reports from China First Capital, (read  here, here, here) there is a large overhang of over 7,500 unexited private equity deals in China. Most of these deals were done on the expectation of exiting through an IPO within a few years. That was always statistically improbable. In no year did more than 150 PE-backed Chinese private companies IPO.

An IPO has gone from statistically improbable to virtually unattainable. This is not only impacting the thinking of PE firms, but of the entrepreneurs they back as well. The exit math for private company bosses in China has changed dramatically over the last 12 months. M&A looks more and more like the only viable path to exit.

For business owners, the challenge to getting a deal done are both psychological and practical. First, owners must accept that valuations are way below where they hoped them to be, as well as well below the level two years ago, when they topped out at over 100 times last year’s net income. Second, the number of companies looking to sell will quickly begin to outnumber the qualified and capable acquirers. This will put further downward pressure on valuations.

In other words, for private company bosses looking for a liquidity event, the pressure to consider selling the business is mounting. For investors, owners and acquirers, the result is the beginnings of a genuine market for corporate control for private sector businesses in China.

The new China First Capital report is directed towards all three classes of potential acquirers — 1) global businesses seeking China market entry; 2) corporate acquirers seeking market or margin expansion in China through strategic or tuck-in acquisitions; 3) China domestic or global buyout firms seeking quality operating assets that can be built up and sold.  Their methods, timetable, metrics and deal targets will often differ. But, all three will find the current situation in China more suitable than at any previous time for executing M&A transactions of USD$100mn and above.

While the number of attractive targets is increasing, the complexities of doing M&A in China remain. The invested PE firms are almost always minority investors. A control transaction will need to be structured and staged to incentivize the owner to sell at least a portion of his holding alongside the PE firm, and then likely remain for at least several years at the helm.

The report offers some possible deal structures and timing mechanisms, included using “blended valuation” to determine price. It also charts the all-important  “when does cash enter my pocket” timing from the perspective of a selling majority owner.

PE investment in China, the report concludes,  has altered permanently the business landscape in China. It has also prepared the ground for a surge now in M&A activity.

Over $150 billion in PE capital was invested to propel the growth of over 10,000 private businesses. PE finance helped create a more dynamic and powerful private sector in China. In quite a number of cases, the PE-invested businesses have emerged as industry leaders in their sectors in China, highly profitable, innovative, fast-growing, with revenues of $100mn and above.

These companies have the scale and established market presence to permit a strategic acquirer to substantially increase its activity in China, extending product range, customer relationships, distribution channels. For buyout firms or corporate acquirers, taking over a PE-invested company should offer satisfactory financial returns. Buyout ROE can be significantly enhanced in certain cases by using leverage to finance the acquisition.

The supreme irony is that this moment of opportunity in domestic M&A comes at the same time quite a number of PE firms are pursuing highly questionable “take private” deals involving troubled Chinese companies listed on the US stock market. (See earlier blog posts here, here, here, here.) The risks, and prices paid, are far higher than doing well-targeted domestic M&A in China.

When junk is priced like jewels — and vice versa — is there any doubt where the smart money should go?

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Smithfield Foods – Shuanghui International: The Biggest Chinese Acquisition That Isn’t

1 Comment / June 14, 2013


It is, if voluminous press reports are to be believed, the biggest story, the biggest deal, ever in China-US business history. I’m talking about the announced takeover of America’s largest pork company, Smithfield Foods, by a company called Shuanghui International. The deal, it is said in dozens of media reports, opens the China market to US pork and will transform China’s largest pork producer into a global giant selling Smithfield’s products alongside its own in China, while utilizing the American company’s more advanced methods for pork rearing and slaughtering.

One problem. A Chinese company isn’t buying Smithfield. A shell company based in Cayman Islands is. Instead of a story about “China buying up the world”, this turns out to be a story of a precarious leveraged buyout deal (“LBO”) cooked up by some large global private equity firms looking to borrow their way to a fortune.

The media, along with misstating the facts, are also missing the larger story here. The proposed Smithfield takeover is the latest iteration in the “take private” mania now seizing so many of the PE firms active in China. (See blog posts here, here, here and here.) With China’s own capital markets in crisis and PE investment there at a standstill, the PE firms have turned their attention, however illogically, to finding “undervalued assets” with a China angle on the US stock market. They then attempt an LBO, with the consent of existing management, and with the questionable premise the company will relist or be sold later in China or Hong Kong. The Smithfield deal is the biggest — and perhaps also the riskiest —  one so far.

This shell that is buying Smithfield has no legal or operational connection to Henan Shuanghui Investment & Development (from here on, “Shuanghui China”) , the Chinese pork producer, China’s largest, quoted on the Shenzhen stock exchange. The shell is about as Chinese as I am.

If the deal is completed, Shuanghui China will see no obvious benefit, only an enormous risk. Its Chinese assets are reportedly being used as collateral for the shell company to finance a very highly-leveraged acquisition. The abundant risks are being transferred to Shuanghui China while all the profits will stay inside this separately-owned offshore shell. No profits or assets of Smithfield will flow through to Shuanghui China. Do Shuanghui China’s Chinese minority shareholders know what’s going on here? Does the world’s business media?

Let’s go through this deal. I warn you. It’s a little convoluted. But, do take the time to follow what’s going on here. It’s fascinating, ingenious and maybe also a little nefarious.

First, the buyer of Smithfield is Shuanghui International, a Cayman holding company. It owns the majority of Shuanghui China, the Chinese-quoted pork company. Shuanghui International is owned by a group led by China-focused global PE firm CDH, with smaller stakes owned by Shuanghui China’s senior management,  Goldman Sachs, Singapore’s Temasek Holdings, Kerry Group, and another powerful PE firm focused on China, New Horizon Fund.

CDH, the largest single owner of Shuanghui International,  is definitively not Chinese. It invests capital from groups like Abu Dhabi’s sovereign wealth fund , CALPERS, the Rockefeller Foundation, one big Swiss (Partners Group) and one big Liechtenstein (LGT) money manager, along with the private foundation of one of guys who made billions from working at eBay. So too Goldman Sachs, of course, Temasek and New Horizon. They are large PE firms that source most of their capital from institutions, pension fund and endowments in the US, Europe, Southeast Asia and Middle East. (For partial list of CDH and New Horizon Fund Limited Partners click here. )

For the Smithfield acquisition, Shuanghui International (CDH and the others) seem to be putting up about $100mn in new equity. They will also borrow a staggering $4 billion from Bank of China’s international arm to buy out all of Smithfield’s current shareholders.  All the money is in dollars, not Renminbi.

If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But, nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part-owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.

Shuanghui International, assuming it’s borrowed the money from Bank of China for three years,  will need to come up with about $1.5 billion in interest and principal payments a year if the deal closes. But, since Shuanghui International has no significant cash flow of its own (it’s an investment holding company), it’s hard to see where that money will come from. Smithfield can’t be much help. It already has a substantial amount of debt on its balance sheet. As part of the takeover plan, the Smithfield debt is being assumed by Morgan Stanley, Shuanghui International’s investment bankers. Morgan Stanley says it plans then to securitize the debt. A large chunk of Smithfield’s future free cash flow ($280mn last year) and cash ($139 mn as of the first quarter of 2013) will likely go to repay the $3 billion in Smithfield debts owed to Morgan Stanley.

A separate issue is whether, under any circumstances, more US pork will be allowed into China. The pork market is very heavily controlled and regulated. There is no likely scenario where US pork comes flooding into China. Yes, the media is right to say Chinese are getting richer and so want to eat more meat, most of all pork. But, mainly, the domestic market in China is reserved for Chinese hog-breeders. It’s an iron staple of China’s rural economy. These peasants are not going to be thrown under the bus so Smithfield’s new Cayman Islands owner can sell Shuanghui China lots of Armour bacon.

Total borrowing for this deal is around $7 billion, double Smithfield’s current market cap. Shuanghui International’s piece, the $4 billion borrowed from Bank of China, will go to current Smithfield shareholders to buy them out at a 31% premium.  Shuanghui International owns shares in Shuanghui China, and two of its board members are Shuanghui China top executives, but not much else. So where will the money come from to pay off the Bank of China loans? Good question.

Can Shuanghui International commandeer Shuanghui China’s profits to repay the debt? In theory, perhaps. But,  it’s highly unlikely such an arrangement would be approved by China’s securities regulator, the CSRC. It would not likely accept a plan where Shuanghui China’s profits would be exported to pay off debts owed by a completely independent non-Chinese company. Shuanghui International could sell its shares in Shuanghui China to pay back the debt. But, doing so would likely mean Shuanghui International loses majority control, as well as flooding the Shenzhen stock market with a lot of Shuanghui China’s thinly-traded shares.

Why, you ask, doesn’t Shuanghui China buy Smithfield? Such a deal would make more obvious commercial and financial sense. Shuanghui China’s market cap is triple Smithfield’s. Problem is, as a domestic Chinese company listed on China’s stock exchange, Shuanghui China would need to run the gauntlet of CSRC, Ministry of Commerce and SAFE approvals. That would possibly take years and run a risk of being turned down.  Shuanghui International, as a private Caymans company controlled by global PE firms,  requires no Chinese approvals to take over a US pork company.

The US media is fixated on whether the proposed deal will get the US government’s go ahead. But, as the new potential owner is not Chinese after all — neither its headquarters nor its ownership — then on what grounds could the US government object? The only thing Chinese-controlled about Shuanghui International is that the members of the Board of Directors were all likely born in China. The current deal may perhaps violate business logic but it doesn’t violate US national security.

So, how will things look if Shuanghui International’s LBO offer is successful?  Shuanghui China will still be a purely-Chinese pork producer with zero ownership in Smithfield, but with its assets perhaps pledged to secure the takeover debts of its majority shareholder. All the stuff about Shuanghui China getting access to Smithfield pork or pig-rearing and slaughtering technology, as well as a Smithfield-led upgrade of China’s pork industry,  is based on nothing solid. The pork and the technology will be owned by Shuanghui China’s non-Chinese majority shareholder. It can, if it chooses, sell pork or technology to Shuanghui China. But, Shuanghui China can achieve the same thing now. In fact, it is already a reasonably big buyer of Smithfield pork. Overall, China gets less than 1% of its pork from the US.

If the deal goes through, the conflicts of interest between Shuanghui International and Shuanghui China will be among the most fiendish I’ve ever seen. Shuanghui China’s senior managers, including chairman Wan Long, are going to own personally a piece of Smithfield, and so will have divided loyalties. They will likely continue to manage Shuanghui China and collect salaries there, while also having an ownership and perhaps a management role in Smithfield. How will they set prices between the two fully separate Shuanghuis? Who will watch all this? Isn’t this a case Shuanghui China’s insiders lining their own pockets while their employer gets nothing?

On its face, this Smithfield deal looks to be among the riskiest of all the  “take private” deals now underway. That is saying something since several of them involve Chinese companies suspected of accounting frauds, while the PE firms in at least two cases (China Transinfo and Le Gaga) doing the PE version of a Ponzi Scheme by seeking to use new LP money to bail out old, severely troubled deals they’ve done.

Let’s then look at the endgame, if the Smithfield deal goes through. Shuanghui International, as currently structured,  will not, cannot, be the long-term owner of Smithfield. The PE firms will need to exit. CDH, New Horizon, Goldman Sachs and Temasek have been an indirect shareholders of Shuanghui China for many years — seven in the case of CDH and Goldman.

According to what I’m told, Shuanghui International is planning to relist Smithfield in Hong Kong in “two to three years”. The other option on the table, for Shuanghui International to sell Smithfield (presumably at a mark-up) to Shuanghui China, would face enormous, probably insurmountable,  legal, financial and regulatory hurdles.

The IPO plan, as of now, looks crackpot. Hong Kong’s IPO market has basically been moribund for over a year. IPO valuations in Hong Kong are anyway far lower than the 20X p/e Shuanghui International is paying for Smithfield in the US. A separate tactical question for Shuanghui International and its investment bankers: why would you believe Hong Kong stock market investors in two to three years will pay more than US investors are now paying for a US company, with most of its assets, profits and revenues in the US?

But, even getting to IPO will require Shuanghui International to do something constructive about paying off the enormous $4 billion in debt it is taking on. How will that happen? Shuanghui International is saying Smithfield’s current American management will stay on. Why would one assume they can run it far more profitably in the future than they are running it now? If it all hinges on “encouraging” Shuanghui China to buy more Smithfield products, or pay big licensing fees, so Shuanghui International can earn larger profits, I do wonder how that will be perceived by both Shuanghui China’s minority investors, to say nothing of the CSRC. The CSRC has a deep institutional dislike of related party transactions.

Smithfield has lately been under pressure from some of its shareholders to improve its performance. That may have precipitated the discussions that led to the merger announcement with Shuanghui International. Smithfield’s CEO, C. Larry Pope, stands to earn somewhere between $17mn-$32mn if the deal goes through. He will stay on as CEO. His fiscal 2012 salary, including share and option awards, was $12.9mn.

Typical of such LBO deals, the equity holders (in this case, CDH, Goldman, Temasek, Kerry Group, Shuanghui China senior management, New Horizon) would stand to make a killing, if they can pay down the debt and then find a way to either sell or relist Smithfield at a mark-up. If that happens, profits will go to the Shuanghui insiders along with the partners in the PE firms, CALPERS, the Rockefeller and Carnegie foundations, Goldman Sachs shareholders and other LPs. Shuanghui China? Nothing, as far as I can tell. China’s pork business will look pretty much exactly as it does today.

In their zeal to proclaim a trend — that of Chinese buying US companies — the media seems to have been blinded to the actual mechanics of this deal. They also seem to have been hoodwinked by the artfully-written press release issued when the deal was announced. It mentions that Shuanghui International is the ” majority shareholder of Henan Shuanghui Investment & Development Co. (SZSE: 000895), which is China’s largest meat processing enterprise and China’s largest publicly traded meat products company as measured by market capitalization.” This then morphed into a story about “China’s biggest ever US takeover”, and much else besides about how China’s pork industry will now be upgraded through this deal, about dead pigs floating in the river in Shanghai, about Chinese companies’ targeting US and European brands.

China may indeed one day become a big buyer of US companies. But, that isn’t what’s happening here. Instead, the world’s leading English-language business media are suffering a collective hallucination.

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China M&A: Three Recent Deals

Leave a Comment / June 4, 2013

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In the last month, three large takeovers were announced involving Chinese companies. In two of these, PE buyout firms (CITIC Capital and Blackstone)  are offering to take private Chinese companies (AsiaInfo-Linkage and Pactera) quoted on the US stock exchange. In the third, a Chinese acquirer (Shuanghui International) has offered to purchase all shares of US pork producer Smithfield Foods.

I’ve done a quick comparison of these deals across a range of financial variables — premium offered to current shareholders, p/e ratio, profit growth, last two years’ share price performance. I’ve also offered my own judgment on the risks and the industrial logic of the deal, on a scale of 1-10.

The results: the troubled deals, the ones with the highest risks and deepest uncertainties about future performance, with the most anemic share prices up to the date of the offer, with claims or investigations of accounting fraud, with the least industrial logic, are commanding the higher price.

Ah, the Mysterious Orient.

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Correction: I wrote this article based on the first day’s English-language media coverage of the Smithfield-Shuanghui International takeover. Big mistake. I took at face value the media’s account that this was a merger between China’s largest pork producer and America’s. Turns out the coverage was wrong, and so my conclusion was also. In the software business, it’s called GIGO, “Garbage in, garbage out.” The Smithfield-Shuanghui deal is every bit as precarious an LBO as the other two. The only improvement is that the target company, Smithfield, is a better and more transparent business than AsianInfo-Linkage or Pactera. For the real situation on this Smithfield deal, see this blog post.

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M&A Policy & Policy-making in China — A Visit to China’s Ministry of Commerce

Leave a Comment / May 28, 2013

(Me in borrowed suit* alongside Deputy Director General of the Policy Research Department, China Ministry of Commerce)

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China’s Ministry of Commerce invited me last week to give a private talk at their Beijing headquarters. The subject was the changing landscape for M&A in China. It was a great honor to be asked, and a thoroughly enjoyable experience to share my views with a team from the Policy Research Department at the Ministry.

For those whose Chinese is up to it, you can have a look at the PPT by clicking here.  The title translates as “China’s M&A Market: A New Strategy Targeting Unexited PE Deals”.

My China First Capital colleague, and our company’s COO, Dr. Yansong Wang offered our firm’s view that the current crisis of unexited private equity deals is creating an important opportunity for M&A in China to help strengthen, consolidate and restructure the private sector. Buyout firms and strategic acquirers, both China domestic and offshore, will all likely step up their acquisition activity in coming years, targeting China’s stronger private sector companies.

Potentially, this represents a highly significant shift for M&A in China, and so a shift in the workload and travel schedule of the Ministry of Commerce officials. M&A within China, measured both in number and size of deals,  has historically been a fraction of cross-border transactions like the acquisition of Volvo or Nexen. 

The Ministry of Commerce occupies the most prominent location of any government department in China, with the exception of the Public Security Ministry. Both are on Chang’an Avenue (aka “Eternal Peace Street” on 长安街）a short distance from Tiananmen Square. 

The Ministry of Commerce plays an active and central role in economic policy-making. Many of the key reforms and policy changes that have guided China’s remarkable economic progress over the last thirty years got their start there. The Ministry of Commerce is also the primary regulator for most M&A deals in China, both domestic and cross-border.

The key sources of growth for China’s economy have shifted from SOEs to private sector companies, from exports to satisfying the demands of China’s huge and fast-growing domestic market. In the future, M&A in China will follow a similar path. That was the main theme of our talk. More M&A deals will involve Chinese private sector companies combining either with each other, or being acquired by larger international companies eager to expand in China.

Ministry officials were quick to grasp the importance of this shift. They asked if policy changes were required or new administrative practices. We shared some ideas. China’s FDI has slowed recently. That is an issue of substantial concern to the Ministry of Commerce. M&A targeting China’s private sector companies represents a potentially useful new channel for productive foreign capital to enter China.

M&A, as the Ministry officials quickly understood, also can help ease some of the pain caused to private companies by the block in IPOs and steep decline in new private equity funding. In particular, they focused their questions on the impact on Chinese larger-scale private sector manufacturing industries.

I found the officials and staff I met with to be practical, knowledgeable and inquisitive. Market forces, and the exit crisis in China’s private equity industry, are driving this change in the direction of M&A in China. But, policies and regulatory guidance issued from the Ministry of Commerce headquarters can – and I believe will — also play a constructive role.

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* Three days before my visit,  the Ministry of Commerce suggested I should probably wear a suit, as senior officials there do.  By that time, I’d already arrived in Beijing, so needed to borrow one from a friend. The suit was tailored for someone 40 pounds heavier. As a result, as the above photo displays, I managed to be overdressed and poorly-dressed at the same time.

 

 

China private equity bitten again by Fang — Financial Times

Leave a Comment / May 1, 2014

FT

 

 

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By Simon Rabinovitch in Beijing

Financier Fang Fenglei is betting on private equity recovery

China’s unruly markets have vanquished many a savvy investor, but if one man knows how to play them it is Fang Fenglei.

From the establishment of the country’s first investment bank in 1995 to the complex partnership that brought Goldman Sachs into China in 2004 and the launch from scratch of a $2.5bn private equity fund in 2007, Mr Fang has been at the nexus of some of the biggest Chinese deals of the past two decades.

Even his abrupt decision in 2010 to start winding down Hopu, his private equity fund, was impeccably well timed. Since he left the scene, the Chinese stock market has been among the worst performers in the world and the private equity industry, once booming alongside the country’s turbocharged economy, has gone cold.

So the news that Mr Fang, the son of a peasant farmer, will return with a new $2bn-$2.5bn investment fund is more than a passing curiosity. The financier is betting that China’s beleaguered private equity industry will recover – a wager that at the moment has long odds.

The most immediate obstacle for the private equity industry in China is a bottleneck on exits from investments. Regulators have halted approvals for all initial public offerings since October, a tried and tested method for putting a floor under the stock market by limiting the availability of shares. But a side effect has been eliminating the preferred exit route of private equity companies.

Even before the IPO freeze, the backlog was already building up. China First Capital, an advisory firm, estimates that there are more than 7,500 unexited private equity investments in China from deals done since 2000. Valuations may have appreciated greatly but private equity groups are struggling to sell their assets.

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Anti-Dumping or Blatant US Protectionism? How the US Tried and Failed to Destroy a Great Chinese Entrepreneur

Leave a Comment / May 6, 2013

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Reckless or evil? You decide. In July 2009, the US Department of Commerce started an anti-dumping investigation of the “narrow woven ribbon with woven selvedge” industry. Never heard of it?  It’s the colored ribbon Americans use primarily in gift-wrapping. It’s not a particularly big industry, probably less than $500 million a year in retail sales in the US. But, adding ribbon to gift-wrapped packages is a staple of American culture. The major store chains like Target, Wal-Mart, Michael’s and Costco all stock a wide variety of ribbon in different colors and widths, and sell it for a few dollars per pack.

Back when I was a kid, the ribbon was made by American manufacturers. Gradually, of course, much of the production shifted to Asia, first Taiwan, then China. Lowering manufacturing costs also kept retail prices down, which has likely allowed more Americans to use more ribbon to decorate their gifts.  Who could complain about that?

There remains one large American manufacturer called Berwick Offray, based in Pennsylvania. They’ve been in the woven ribbon business for over 100 years. They launched the complaint that led to the US government action, claiming they were suffering “material harm” because of Chinese ribbon being dumped in the US. According to the official document issued by the Department of Commerce in July 2009, the US government’s preliminary investigations seemed to confirm Berwick Offray’s contention that Chinese manufacturers were receiving state subsidies as a way to flood the US market and steal market share, harming Berwick’s business. The US government signaled its intention to levy punitive tariffs on the Chinese imports.

In its 142-page 2009 preliminary report, (click here to download) the Department of Commerce offers a feedlot of industry data, manufacturing techniques and product descriptions, all of which are aimed to substantiate the claim that Chinese manufacturers, who now hold the largest share of the US market, are selling the ribbon in the US below cost, with the loss being covered through a variety of unspecified subsidies from the Chinese government. Keep in mind that the total amount of US imports of woven ribbon from China seemed then to be below $100mn. A lot of market share data in the report was blacked out, presumably for commercial secrecy reasons. A lot of other information was absent because the Commerce investigators said they couldn’t find people willing or able to answer its questions.

So, the entire US federal government investigation, and preliminary finding of Chinese ribbon dumping was based both on incomplete data, and the dubious premise that the Chinese government would actively intervene with subsidies in such a small market. Total Chinese exports to the US in 2011 exceeded $400 billion. So, if the data is right, Chinese woven ribbon represents about 0.025% of total Chinese exports. The manufacturers are mainly privately-owned Chinese companies, not big SOEs with political clout in Beijing.

Among those Chinese manufacturers, one stands out for its scale, its variety of products and leading market share in the US. The company is called Yama Ribbon. They are based in Xiamen and dominate the industry in China. Yama is named in the Commerce Department report as one of the major exporters to the US. Since Yama is the biggest Chinese exporter, and the US government is suggesting Chinese government subsidies allow Chinese manufacturers to sell their ribbon below cost, it stands to reason that Yama should be fingered in the report as the main beneficiary of these subsidies. Right? The US government couldn’t possibly allege the Chinese government is subsidizing a product unless they’ve already confirmed the main Chinese producer is receiving such subsidies. Right?

Wrong. Trade policy, anti-dumping actions, punitive tariffs are very often a political toy in the US. Too often, US companies can use lobbyists or friendly politicians to pressure the Commerce Department to initiate an investigation. That alone can often cause exporters, whether they are dumping or not, to increase their prices, just to try to avoid any unilateral action by Washington. This, then, boosts the competitive position, and so the profits, of the US company that started the anti-dumping ball rolling. It isn’t called corruption, but often it should be understood as such.

Is this the case with Berwick Offray and woven ribbon? Did it use the US political process to help its foundering business in the US? That seems the case to me. Here’s why. After its initial report in 2009, the Commerce Department launched a more detailed analysis to identify all the subsidies Yama Ribbon and other Chinese manufacturers were receiving from the Chinese government.

In July 2010, the US officials announced they could find no evidence of Yama receiving any subsidies whatsoever. Yama Ribbon products were assigned an “anti-dumping” duty of 0%. It was a complete victory for Yama and a repudiation of misguided US protectionist trade policies. It received about zero press coverage, in China and the US, which is a shame.  Next time you hear someone spouting off about “unfair China trade practicies” or “predatory pricing”, think about Yama.

Several other Chinese manufacturers were found to be receiving subsidies, and their products were slapped with punitive duty rates of 125% to 249%. But, Yama is the main producer and exporter. If it’s receiving no subsidies, then it is impossible to claim the Chinese government is rigging the market to the detriment of Berwick Offray and the few other remaining US producers of woven ribbon.

How, you might ask, could the US government have even issued the preliminary 2009 report before establishing beyond doubt that Yama was getting favors from the Chinese government? The same question occurred to Yama’s founder and CEO, Yao Ming. (Yes, same name, but no relation to — physically or by bloodline –  to the Chinese basketball star.)  When he heard about the 2009 investigation and preliminary finding, Yao understood immediately it had the potential to damage, if not ruin his entire business, with 2011 revenues of over USD$50mn and over 1,000 employees. The US is his key market, over 70% of total turnover.

I’m fortunate enough to know Yao Ming. He’s a modest, hard-working entrepreneur, among the best I’ve ever met. My guess is as a businessman he could run circles around the people who manage Berwick Offray.  He’s not a political creature, speaks very little English, and until then, was unschooled in the ways of US trade policy. The US government was asserting Chinese ribbon exporters were getting subsidies and yet Yao knew he was receiving nothing. Knowing, and proving it to Washington, of course, are very different stories. He tried getting help from the Chinese Ministry of Commerce. But, they told him, effectively, he would have to fight this one on his own. They have bigger trade battles to wage with the US than this tiny one over gift ribbon.

So Yao hired lawyers, both in China and the US, and fought back. He’s the only Chinese entrepreneur I’ve heard about with this kind of character and self-confidence to spend a not-small amount of money to fight back against the US government. Even more remarkably, he won a resounding and speedy victory.

He more or less dared the US government to prove he was getting subsidies, including indirect ones like loan subsidies, special deals to buy factory land or tax holidays. When the US government couldn’t find a thing, it gave up pursuing Yama. Justice, in this case, was served. But, Yao was also lucky. His business is unusual in China. At that time, he has no bank loans, and his factories are rented. Both are rare among manufacturers in China. For any other manufacturer in China, it would be far harder to prove as quickly an absence of subsidies, direct or indirect. Yao needed to act, before the threat of an anti-dumping action permanently damaged his business in the US.

As an American citizen, I’m more than a little disgusted by what the US government did in this case: it made that 2009 announcement, declaring a preliminary finding, without really checking its facts. Had Yao not acted quickly, hired lawyers and proved his case, his business would have been sunk, and Americans would end up paying much more to decorate their gifts.

Had Commerce wanted to, it would have taken almost no time or effort to establish that Yama, as the largest Chinese ribbon exporter, was likely getting nothing from the Chinese government. But, they didn’t bother. That’s the worst of it. People at the Department of Commerce know how damaging an investigation and preliminary finding like this can be to any businesses implicated in wrongdoing.

In the end, from what I can tell, Commerce cared more about placating Berwick Offray than in making sure it didn’t unjustly harm a company faraway in China. Everything, in the end, has turned out well for Yao Ming and Yama. His business, including exports to the US, continue to thrive. He has some of the highest net margins I’ve seen in a Chinese manufacturing company. His revenues this year will approach USD$100mn. He has opened an office now in New Jersey to help handle all the orders. His Chinese competitors are now largely shut out of the US market because of the punitive duties. None seems to have had the scale or cash to hire lawyers and go to court in the US, as Yao Ming did. So whether these punitive duties are justified is, to me, an open question.

Yama’s business is number one in the US not because it sells product at the lowest price. It doesn’t. It has a better business model, thanks to the business smarts of its founder Yao Ming. He keeps a large stock of ribbon in a huge array of sizes and colors in inventory in the US, to meet spot orders. While it increases his costs, because of the extra working capital needed to finance the inventory, distributors and retailers can get orders filled more quickly. So, they buy from Yama. The company’s scale and service allow it now to earn margins that would be the envy of just about every other manufacturer operating in China.

Yao Ming is Chinese. But, he is the kind of Horatio Alger entrepreneur many in the US most admire. He makes a good product, sells it at a fair price, is good to his workers, and fought back against knuckle-headed Washington bureaucrats and won.

 

 

Shenzhen: A beacon for private enterprises — China Daily

Leave a Comment / June 24, 2016


 

–A beacon for private enterprises

2013-04-20

By Hu Haiyan and Chen Hong ( China Daily)

Shenzhen bears a superficial resemblance to Shanghai. There are dozens of multinationals and gleaming skyscrapers casting their shadows over narrow lanes. Their respective economic performances last year were also similar: Shenzhen’s GDP hit 1.3 trillion yuan ($210 billion), gaining by 10 percent from 2012. Shanghai GDP reached 2 trillion yuan, increasing by 7.5 percent from 2011.

Both are testing grounds for China’s economic reform policies. Still, for Peter Fuhrman, 54, Shenzhen is a private-sector city, a city that has its face pointed toward the future.

In 2009, Fuhrman moved to Shenzhen from California. The chairman and CEO of China First Capital, an international investment bank and advisory firm focused on China, he is always struck by how similar Shenzhen and California are.

“Both are places where new technologies, and valuable new technology companies, are born and nurtured. I treasure the role Shenzhen has played over these last 30 years in helping architect a new China of renewed purpose and importance in the world,” Fuhrman says. “It is impossible to imagine a US without California. It is so much the source of what makes America great. Shenzhen, too, is a major source of what makes China great, what makes this country such a joy for me to live in. “

More…

Download PDF version.

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China’s GPs search for exits — Private Equity International Magazine

Leave a Comment / May 24, 2013

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Chinese GPs are running low on exit options, but the barriers to unconventional routes – like secondary sales to other GPs – remain high.

By Michelle Phillips

China’s exit woes are no secret. With accounting scandals freezing the IPO route both abroad and domestically, the waiting list for IPO approval on China’s stock exchanges has come close to 900 companies.  Fund managers have at least 7,550 unexited investments worth a combined $100 billion, according to a recent study by China First Capital. However, including undisclosed deals, the number of companies could be as high as 10,000, says CFC’s founder and chairman Peter Fuhrman.
CITIC Capital chief executive Yichen Zhang told the Hong Kong Venture Capital Association Asia Private Equity Forum in January that because many GPs promised high returns in an unrealistic timeframe (usually three to five years), LPs were already starting to get impatient. He also predicted that around 80 percent of China’s smaller GPs would collapse in the coming years. “The worst is yet to come,” he said.
What ought to become an attractive option for these funds, according to the CFC study, are secondary buyouts. Even if it lowers the exit multiple, secondaries would provide liquidity for LPs, as well as potentially giving the companies an influx of cash, Fuhrman says.

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Private Equity Secondaries in China: Hold Periods, Exits and Profit Projections

Leave a Comment / April 11, 2013

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How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital’s latest research note. An abridged version is available by clicking here. Titled, “Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity” the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.

This new report is, like the two preceding ones (click here and click here) the result of China First Capital’s path-breaking research  to measure the scale of the problem of unexited PE investments in China,  and to illuminate strategic alternatives for GPs investing in China.  China First Capital will publish additional research reports on this topic in coming months.

As this latest report explains, “these [hold period and investment return] models tend to support the thesis that “Quality Direct Secondaries“  currently offer the best risk-adjusted opportunities in China’s PE asset class.”  Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.

“Until recently,” the China First Capital report points out, “private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year.  Those assumptions on valuation differentials as well as hold period are no longer valid.”

There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China’s still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:

  1. IPO
  2. Trade sale / M&A
  3. Secondary sale
  4. Buyback / recapitalization

Our conclusion is the current exit crisis is likely to persist. “Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals.”

Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only,  option available for a PE firm with diminishing fund life. “Buyers of these direct secondaries will not avoid or outrun exit risk,” the report advises. “It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund’s hold period. ”

The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China “Quality Secondaries” offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.

Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.

Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure,  are not available in the abridged version.

 

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Goldman Sachs Predicts 349 IPOs in China in 2013 — Brilliant Analysis? Or Wishful Thinking?

Leave a Comment / April 5, 2013

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We’re one-quarter of the way through 2013 and so far no IPOs in China. Capital flows to private companies remain paralyzed. Never fear, says Goldman Sachs. In a 24-page research report published January 23rd of this year (click here to read an excerpt), Goldman projects there will be 349 IPOs in China this year, a record number. Its prediction is based on Goldman’s calculation that 2013 IPO proceeds will reach a fixed percentage (in this case 0.7%) of 2012 year-end total Chinese stock market capitalization.

This formula provides Goldman Sachs with a precise amount of cash to be raised this year in China from IPOs: Rmb 180bn ($29 billion), an 80% increase over total IPO proceeds raised in China last year. It then divvies up that Rmb 180 billion into its projected 349 IPOs,  with 93 to be listed in China’s main Shanghai stock exchange, 171 on the SME board in Shenzhen, and 85 on the “Chinext“ (创业板）exchange. To get to Goldman’s numbers will require levels of daily IPO activity that China has never seen.

The report features 35 exhibits, graphs, charts and tables, including scatter plots, cross-country comparisons, time series data on what is dubbed “IPO ratios (IPO value as % of last year-end’s total market cap)”. It’s quite a statistical tour de force, with the main objective seeming to be to allay concerns that too many new IPOs in China will hurt overall China share price levels. In other words, Goldman is convinced a key issue that is now blocking IPOs in China is one of supply and demand. The Goldman calculation, therefore, shows that even the 349 new IPOs, taking Rmb180 billion in new money from investors, shouldn’t have a particularly adverse impact on overall share price levels in China.

I’ve heard versions of this analysis (generally not as comprehensive or data-driven as Goldman’s) multiple times over the last year, as China IPO activity first slowed dramatically, then was shut down completely six months ago. The CSRC itself has never said emphatically why all IPOs have stopped. So, everyone, including Goldman,  is to some extent guessing. Goldman’s guess, however, comes accessorized with this complex formula that uses December 31, 2012 share prices as a predictor for the scale of IPOs in 2013.

I’m grateful to a friend at China PE firm CDH for sending me the Goldman report a few days ago. I otherwise wouldn’t have seen it. I’m not sure if Goldman Sachs released any follow-up reports or notes since on China IPOs. Goldman was the first Wall Street firm to win an underwriting license in China. It’s impossible to say how much Goldman’s business has been hurt by the near-year-long drought in China IPOs.

Goldman shows courage, it seems to me, in making a precise projection on the number of IPOs in China this year, and relying on their own mathematical equation to derive that number. Here’s how all IPO activity in China since 1994 looks when the Goldman formula is plotted:

 

 

 

 

 

 

 

 

 

 

 

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I’m not a gambling man, and personally hope to see as many IPOs as possible this year of Chinese companies. Even a fool knows the easiest way to lose money in financial markets is to be on the other side of a bet with Goldman Sachs. That said, I’m prepared to take a shot.  I’d be delighted to make a bet with the Goldman team that wrote the report. A spread bet, with “over/under” on the 349 number. I take the “under”. We settle up on January 1, 2014. Any takers?

My own guess – and that’s all it is -  is that there will be around 120 IPOs in China this year. But, this prediction admittedly does not rely on any formula like Goldman Sachs and so lacks exactitude. In fact, I approach things from a very different direction. I don’t think the only, or even main,  reason there are no IPOs in China is because of concerns about how new IPOs might impact overall share prices.

I put as much, or more, importance on rebuilding the CSRC’s capacity to keep fraudulent companies from going public in China. The CSRC seems to have had quite stellar record in this regard until last summer, when a company called Guangdong Xindadi Biotechnology got through the CSRC approval process and was in the final stages of preparing for its IPO. Reports in the Chinese media began to cast doubt on the company and its finances. Within weeks, the Xindadi IPO was pulled by the CSRC. The company and its accountants are now under criminal investigation.

The truth is still murky. But, if press reports are to be believed, even in part, Xindadi’s financial accounts were as fraudulent as some of the more notorious offshore Chinese listed companies like Sino-Forest and Longtop Financial targeted by short sellers and specialist research houses in the US.  The CSRC process — with its multiple levels of “double-blind” control, audit, verification —   was designed to eliminate any potential for this sort of thing to happen in China’s capital markets.

But, it seems to have happened. So, in my mind, getting the CSRC IPO approval process back on track is a key variable determining when, and how many, new IPOs will occur this year in China. This cannot be rendered statistically. The head of the CSRC was just moved to another job, which complicates things perhaps even more and may lead to longer delays before IPOs are resumed and get back to the old levels.

How far is the CSRC going now to try to make its IPO approval process more able to detect fraud? It has instructed accountants and lawyers to redo, at their own expense, the audits and legal diligence on companies they represent now on the CSRC waiting list.  Over 100 companies just dropped off the CSRC IPO approval waiting list, leaving another 650 or so stranded in the approval process, along with the 100 companies that have already gotten the CSRC green light but have been unable to complete their IPO.

A friend at one Chinese underwriter also told us recently that meetings between CSRC officials, companies waiting for IPO approval and their advisers are now video-taped. A team of facial analysis experts on the CSRC payroll then reviews the tapes to decide if anyone is telling a lie. If true, it opens a new chapter in the history of securities regulation.

If, as I believe,  restoring the institutional credibility of the CSRC approval process is a prerequisite for the resumption of major IPO activity in China, a statistical exhibit-heavy analysis like Goldman’s is only going to capture some, not all, of the key variables. Human behavior, fear of punishment, organizational function and dysfunction, as well as darker psychological motives also play a large role. An expert in behavioral finance might be more well-equipped to predict accurately when and how many IPOs China will have this year than Goldman’s crack team of portfolio strategists.

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China’s Beauty Revolution — Deng Xiaoping Deserves Some of the Credit

4 Comments / May 2, 2013

Rather than discuss again the state of Chinese private equity and billions of dollars in capital flows, this blog will turn now to an even weightier topic. Pretty women. Specifically, the increasing abundance of them in China.

To my eye,  Chinese women have undergone a spectacular makeover over the last 30 years every bit as dramatic as China’s economic growth and modernization. I first came to China 32 years ago, as a graduate student. At the time, China was still partly under the leaden pall of the Cultural Revolution, which had officially ended five years earlier. College girls dressed like soldiers, wore no makeup and kept their hair short, often in stumpy pigtails. Army caps and threadbare canvas sneakers were considered fashion accessories.

Coming to China in 1981 after four years at university in the US, a fair amount of it spent chasing coeds, Chinese college girls seemed adorned mainly for calisthenics and bayonet practice. I duly kept them at a distance. Just as well, since had I fallen for a Chinese girl, it would likely have brought her nothing but ceaseless political browbeating and struggle sessions from her peers and professors. Chinese girls were not to be fraternized with. The thought barely even occurred to me. Instead, I fell under the powerful spell of my very glamorous Italian female classmates, including one who became, for a brief time, a famous Chinese movie star and perhaps the most lusted-after woman in China. She finished her studies, left China when I did in 1982, and ended up marrying one of America’s most famous movie actors. But that, as they say, is another story.

What a difference 30 years of hypertrophic economic growth can make.  Deng Xiaoping is not short of praise or recognition. But, to his list of titanic accomplishments must be added that he did more to beautify Chinese women than any man who’s ever lived. He liberalized not only the economy, but social attitudes and unwound the straightjacket that had bound women’s fashion for decades. For, that he deserves the eternal gratitude of every man living now in China, myself included.

The magnitude of this change in women’s appearance, over the last 30 years, cannot be overstated. If there is another aspect of China’s modernization that created so many benefits, so much net happiness, with few if any offsetting disadvantages, I don’t know of it.

Women in China today have opportunities to express themselves in ways that were unthinkable a generation ago. This runs not only from the clothes they wear and ways they style their hair, but also including the many elements of accessorized femininity, all of which were basically unavailable 30 years ago. There was no make-up, no proper skin creams, no sunblock, no perfumes, no nail polish, no hair dye, no properly-engineered underwear. Chinese girls looked a lot like toy soldiers because they were wearing clothes and underwear designed to neutralize rather than accentuate their curves.

This is absolutely no longer the case. To choose one example, on my short walk home from the subway, I pass through a 50-meter long underground mall with five different underwear shops, all selling domestic brands, and all very far down the “skimpy spectrum”  towards the sexiest things for sale in a Victoria’s Secret. The customers cross all age barriers. There is a popularity, as well as exuberance in China to the buying of sexy underwear that I never saw elsewhere, including Italy. It is also much more of an everywoman’s activity in China.

From the little I can tell from glancing at the age of the customers in these underwear shops, Chinese mothers are almost certainly the world’s largest market for sexy underwear. As for the fashions that are more visible to casual onlookers, Chinese women generally display a sense of style, of trying to look their best, across all ages and income levels.  The most popular clothing comes from domestic brands no one outside China has heard of, not the famous Italian or French fashion houses. Chinese brands know how to design clothes to flatter the way Chinese are shaped.

I have one friend, who started and runs one of these larger domestic female clothing brands called Ozzo. He has over 400 stores across China and caters to middle class women over 30. He sees virtually unlimited capacity for growth for his brand across China.

While beauty is in the beholder’s eye, it seems to me an objective reality that women in China are more attentive to how they look in public than at any time in recent, as well as probably ancient, history. This is true from the smallest farming village to the largest metropolis.

My sense is that colors here are brighter and more varied than you see commonly in US and Europe, where women tend to wear black. It’s apparently meant to be “slimming”. That isn’t a major concern for the majority of Chinese women, from what I can tell. Food is plentiful, and appetites are large. I’ve personally yet to run across a Chinese women who engages in the self-mortification ritual known as dieting.

One small downside. Chinese women are smoking more than they used to. But, the number of women smokers is still a miniscule fraction of what it is in Europe and the US. One reason more Chinese women don’t smoke is they know it damages the skin.

I travel within China more than just about anyone here, excepting airline pilots and government officials. Along with all the new buildings, roads and the new sense of national pride over the last three decades, this focus among Chinese women on looking and dressing well is the most emphatic statement of how far the country has come.

I can already hear the “feminist critique” of what I’m writing here, to wit, that to beautify is to tyrannize, and to “objectify” — a word I still can’t quite define. But, the best proof of how much Chinese women themselves appreciate the changes, appreciate the freedom now to spend more of what they have to look their best,  is how very few Chinese women have rejected all this and stay dressed as Mao once obliged them to.

 

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Secondaries offer solution for US capital locked in China — AltAssets

Leave a Comment / May 24, 2013

The future of private equity and venture capital in China is threatened by a huge overhang of illiquid investments. US institutional investors and pension funds are at risk in a market that until recently was a source of significant investment profits. Private equity secondaries offer a potential way out, according to China First Capital.

China’s private equity industry, having grown in less than a decade from nothing into a giant rivaling the private equity industry in the US, is in the early stages of a unique crisis that could undermine the remarkable gains of recent years, according to a newly-published research report by China First Capital, an international investment bank. Over $100bn in private equity and venture capital investments is now blocked inside deals with no easy exit. A significant percentage of that capital is from limited partners, family offices, university endowments in the USA.

Private equity firms in China are running out of time and options. Exit through trade sale or M&A, a common practice elsewhere, is almost nonexistent in China. One viable solution, the creation of an efficient and liquid market in private equity secondaries in China where private equity firms could sell out to one another, has yet to develop. As a result, private equity general partners, their limited partner investors and investee companies in China risk serious adverse outcomes.

Secondary deals will likely go from current low levels to gain a meaningful share of all private equity exits in China, China First Capital said.

In all, over $130bn is now invested in un-exited private equity deals in China. The un-exited private equity and venture capital deals are screened and analysed across multiple variables, including date, investment size, tier of private equity firm, industry, price-earnings ratio.

Secondary deals potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments and return money to their limited partners, the report finds. The most acute need for exit will be investments made before 2008, since private equity firms generally need to return money to their limited partners within five to seven years. But, more recent private equity and venture deals will also need to be assessed based on current market conditions.

Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all slammed the door shut on IPOs for most Chinese companies. As a result, private equity firms can’t find buyers for illiquid shares, and so can’t return money to their Limited Partners.

“Many private equity firms are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve,” according to China First Capital’s chairman and founder, Peter Fuhrman. “The need for diversification is no less paramount for exits than entries,” he continues. “Many of the same private equity firms that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on a single path to exit: an IPO in Hong Kong or China. By itself, such dependence on a single exit path is risky. In the current environment, with most IPO activity at a halt, it looks even more so. ”

Secondary activity in China will differ significantly from secondaries done in the US and Europe, he added. Buyers will cherry-pick good deals, rather than buying entire portfolios, and escape much of the due diligence risk that plagues primary private equity deals in China. Sellers, in many cases, will be able to achieve a significant rate of return in a secondary sale and so return strong profits to their limited partners. Private equity-invested companies stand to benefit as well, since a secondary transaction can be linked to a new round of financing to provide additional growth capital to the business. In short, secondary deals in China should be three-sided transactions where all sides come out ahead.

But, significant obstacles remain. The private equity and venture capital industry in China has grown large, but has not yet fully matured. The industry is fragmented, with several hundred older dollar funds, and several thousand Renminbi firms launched more recently, some fully private and some state-owned with most falling somewhere in between.

Absent a significant and sustained surge in IPO activity in 2013, the pressure on private equity firms to exit through secondaries will intensify. According to the report, no private equity firm is now raising money for a fund dedicated to buying secondaries in China. There is a market need. As a fund strategy, private equity secondaries offer Limited Partners greater diversification across asset types and maturities in China.

Private equity has been a powerful force for good in China, the report concludes. Entrepreneurs, consumers, investors have all benefited enormously. Profit opportunities for private equity firms and Limited Partner investors remain large. Exit opportunities are the weak link. A well-functioning secondary market is an urgent and fundamental requirement for the future health and success of China’s private equity industry.

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