Chinese Domestic Economy

The Harshest Phrase in Chinese Business

Leave a Comment / April 1, 2010

Shou screen from China First Capital blog post

What are the most reckless and self-destructive words to use while doing business in China? “Let’s skip lunch and continue our meeting.”  Of course, I’m kidding, at least partly. But, there’s nothing frivolous about the fact food is a vital ingredient of business life in China. This is, after all, the country where people for hundreds of years have greeted each other with not with “Hello” but with the question “Have you eaten?”. 

China is no longer a country where food is in any way scarce. But, perhaps because of memories of years of scarcity or just because Chinese food is so damn delicious, the daily rhythms of life still revolves around mealtimes in a way no other country can quite match. This is as true in professional as personal life. 

It’s a certainty that any business appointment scheduled within 1-2 hours of mealtime inevitably will end up pausing for food. In practical terms, that means the only times during working hours that a meeting can be scheduled without a high probability of a meal being included is 9-10am, and 1:30-2:30pm.

At any other time, it’s understood that the meeting will either be shortened or lengthened so everyone participating can go share a meal together.  Any other outcome is just about inconceivable. Whatever else gets said in a meeting, however contentious it might be, one can always be sure that the words “我们吃饭吧” , or “let’s go eat”, will achieve a perfect level of agreement.  

Everyone happily trudges off to a nearby restaurant, and talk switches to everyone’s favorite topic: “what should we order?” Soon, the food begins to pile up on the table. Laughter and toasts to friendship and shared success are the most common sounds. The host gets the additional satisfaction and “face” of providing abundant hospitality to his guests.  

And yet, there are some modern business people in China that can and do conceive of meetings taking precedence over mealtime. Thankfully, they are quite few in number, probably no more than a handful among the 1.4 billion of us in China. I just happen to know more of them than most people. 

In my experience, those with this heterodox view that meals can be delayed or even skipped are mainly Chinese who’ve spent time at top universities in the US. There, they learn that in the US it’s a sign of serious intent to work through mealtimes. It’s a particularly American form of business machismo, and one I never much liked in my years in businesses there. Americans will readily keep talking, rather than break for food. Or, as common, someone will order takeout food, and the meeting will continue, unbroken, as pizza or sandwiches are spread out on the conference room table. 

Heaven help the fool who tries to change the subject, as the takeout food is passed around, to something not strictly related to the business matters under discussion. If as Americans will often remind you, “time is money”, the time spent eating is often regarded as uncompensated, devoid of value and anything but the most utilitarian of purposes. 

Is it any wonder I’m so happy working in China? I love food generally, and Chinese food above all else. It’s been that way since I was a kid. These days, I often tell Chinese that adjusting to life in China has had its challenges for me, but I know that every day I will have at least two opportunities for transcendent happiness: lunch and dinner. 

So, not only do I accept that business meetings will usually include a break for a nice meal, I consider it one of the primary perks of my job. But, I do meet occasionally these US-educated Chinese who don’t share my view. They will ask if meetings can be scheduled so there won’t be the need to break for a meal, or if not, to make the mealtime as short and functional as possible, so “work can resume quickly”. 

This is misguided on so many levels that I worry how these folks, who I otherwise usually like and admire, will ever achieve real career success in China. The meals are often the most valuable and important part of a business meeting – precisely because they are unrushed, convivial and free of any intense discussion of business. 

Trust is a particularly vital component of business in China. Without it, most business transactions will never succeed, be it a private equity investment, a joint venture, a vendor-supplier relationship. Contracts are generally unenforceable. The most certain way to build that trust is to share a meal together — or, preferably, many meals together. 

To propose skipping a meal is a little like proposing to use sign language as the primary form of negotiation for a complex business deal: it’s possible, but likely to lead to first to misunderstanding, frustration and then, inevitably, to failure.


Zhejiang Province: Why It’s China’s Richest and Will Be Richer Very Soon

4 Comments / March 26, 2010

QIng Dynasty vase, from China First Capital blog post

Geography is destiny. Nowhere is this more true, of course, than in China. The country is the world’s fourth-largest, in terms of territory. But, much of the country is inhospitable: with deserts, mountains,  loess and other areas less fit for human habitation. In a population of 1.4 billion, over 550 million are peasants and farmers. Yet, only 14.86% of the land in China is well-suited for cultivation. Too many hands with too little land to hoe. That basically sums up China’s vast agricultural economy.    

The most fertile agricultural areas are also the ones that have had the highest rate of industrial and overall economic development in the last 30 years. The three richest provinces in China also have the highest concentrations of fertile land: Guangdong, Zhejiang and Jiangsu. Together, these three coastal provinces have a population of about 230 million, or 17.5% of China’s total. But, their combined share of China’s gdp is almost twice that. 

When economic reform got underway, these provinces were already relatively well-off, because of the high quality and productivity of its farm output. They were not as heavily industrialized as more northern parts of China, which got the major share of government investment and attention during the first 30 years after the 1949 revolution. 

This lack of industrial infrastructure turned out to be a decisive advantage for the three provinces, especially Guangdong and Zhejiang.  As reform took hold, they weren’t weighed down by the bloat of forced industrialization. The rich farmland and relatively high living standards helped create a greater sense of economic security and this, in turn, bred more of an entrepreneurial mindset.

As the Chinese government relaxed controls on private business, Guangdong and Zhejiang were the first to seize the opportunities. Capital from private sources was more readily available because of the profitability of farming in the region. Entrepreneurship flourished. To this day, one can travel around Zhejiang and Guangdong and rarely, if ever, come across a state-owned business. Their economies are almost entirely in the hands of private business, with larger, private SME in the lead. 

Travel north or west and the situation is markedly different. Here, subsistence farming was often the norm. There were no large agricultural surpluses to finance the growth of private business. State-owned companies, often of the “we pretend to work and they pretend to pay us” variety,  have predominated. The private sector still fights for its share of resources in these other regions of China. Those with entrepreneurial flair often emigrate. Shenzhen is particularly full of such transplants, drawn from every corner of China. I’ve met many successful entrepreneurs here from inland provinces, especially Jiangxi, Hunan, Sichuan and Hubei.  

I’m in Zhejiang as I write this, and am stuck struck by the beauty of its scenery as well as the industriousness and wealth of its people. It reminds me most of Northern Italy, where I’ve spent a lot of time, earlier in my life. Northern Italy is one of the world’s most prosperous places, as well as among its most visually stunning.

In both places, mountains are close by nearly everywhere, and over recent decades, much of the rich farmland has been plowed under to build factories. Northern Italy includes most of that country’s (and the world’s) most successful private-sector companies and brands, including Benetton, Luxottica, Armani. The food is also particularly excellent, another trait it shares in common with Zhejiang. 

Northern Italy, statistically, is the richest area, per capita, in Europe – richer even than next-door Switzerland. Zhejiang, similarly, is the richest place in China, per capita. While Zhejiang can’t yet claim its home to any internationally-renowned brands, it does have China’s strongest nucleus of SME businesses. Many of these, in coming decades, will likely grow into large businesses that dominate their markets. One Chinese auto brand, Geely, which is about to complete its purchase of Volvo from Ford, is based in Zhejiang.                                               

Zhejiang is unique among provinces in China. It has three cities that vie for commercial and entrepreneurial supremacy. Wenzhou, Ningpo and Hangzhou act like separate pumps, channeling energy and wealth into the province’s circulatory system. I spent time recently in Fuyang, the area about 30 miles to the south of Hangzhou. We’re now lucky to have an outstanding client SME in that city. Fuyang is mainly mountainous. Thin strips of flat richly-fertile land hold much of the population, transport infrastructure and industry. 

It’s hard to imagine there could be a more productive slice of our planet than this flat land in Fuyang, including in Northern Italy. In a hectic 36 hours, I visited six different companies in Fuyang, each from a different industry, and each already of a scale that puts it in the top flight of all China’s SME. They are a very small sample of the great entrepreneurial output of this area of Zhejiang.  I was very impressed with each company, and with each “laoban” (老板）, Chinese for “boss”. 

These companies, and Zhejiang itself, embody the two most powerful forces that are now reshaping the Chinese economy: the twin reliance on private sector SME, and on producing for China’s domestic market rather than manufacturing OEM products for export.   

Zhejiang started out with a lot of natural advantages that other regions in China could only envy: the fertile land, an abundance of fresh water, inland waterways (including the Grand Canal) and plentiful rainfall, proximity to the coast and the major ports in Ningpo and nearby Shanghai. But, it’s richest blessing is a population of talented, instinctive entrepreneurs. They’ve taken what nature provided and augmented it, building a thriving, vibrant industrial economy in an area that 20 years ago was still mainly farmland and rice paddies. 

Other people’s idea of a perfect holiday is a week on some beach, or a visit to a tourist city like Rome or Paris. Mine is to spend time in a place with great food and great entrepreneurs, visiting their factories, hearing their strategies to conquer new markets and seize new opportunities to make money. 

Zhejiang really is my kind of place.

  

Smart Commentary on China from Washington Post

3 Comments / March 7, 2010

John Pomfret article Washington Post in China First Capital blog post

From his perch at the Washington Post,  John Pomfret is one of the better-known American journalists writing about China. He is also, coincidentally, one of my oldest and closest friends. I quibble with him often about his take on China, particularly now that I’m living here and he isn’t. He moved back to the US five years ago, and wrote a well received book about China called “Chinese Lessons”.  Quite a lot of it was written in my dining room in LA. 

For a change, I actually agree with the main thrust of one of John’s articles on China. It’s an opinion piece, co-written with his colleague Steve Mufson, published recently in the Post. It’s title: “There’s a new Red Scare. But is China really so scary?” Read it here.

The key insight is that America, in the midst of a deep and long recession,  is undergoing one of its periodic bouts of self-laceration. The widespread anxiety that America is in decline is exacerbated by a sense that China is now better, smarter, faster in many important ways. A lot of this is plain silliness, as John’s article points out. 

America’s problems are home-grown. China’s rise over the last 30 years is overwhelmingly positive, for its own citizens first and foremost, but also for the rest of the world, US included. 

There’s a lot for an American to admire, even envy, about China. Two examples: even while remaking most aspects of its society, the family has retained its primacy in Chinese life, as a source of stability, happiness, and purpose. China also remains the most “kid friendly” country I know, measured by the care and affection lavished on the young Chinese, particularly infants and preschoolers. 

Americans, in the main,  have always had a special fondness for China, regardless of the state of the political relationship between the leaders of the two countries. But, that fondness doesn’t stop many of them from perpetuating simplistic notions about the place. Once, China was seem as hopelessly backward and poverty-stricken. Now, it’s seen as a novice superpower, outmuscling the US across the globe. 

John’s article cites a quote from Sun Tzu, “If ignorant both of your enemy and yourself, you are certain to be in peril.”


Carlyle Goes Native: Renminbi Investing Gets Big Boost in China

2 Comments / March 1, 2010

 

Qing Dynasty lacquer box from China First Capital blog post

My congratulations, both personal and professional, to Carlyle Group, which announced last week the launch of its first RMB fund, in partnership with China’s Fosun Group. I happen to know some of the people working at Carlyle in China, and I’m excited about the news, and how it will positively impact their careers. 

Carlyle is the first among the private equity industry’s global elite to take this giant public step forward in raising renminbi in partnership with leading Chinese private company. It marks an important milestone in the short but impressive history of private equity in China, and points the way forward for many of the private equity firms already established in China. 

The initial size of the new renminbi fund is $100mn. By Carlyle’s standards, this seems almost like a rounding error – representing a little more than 0.1% of Carlyle’s total assets of $90 billion.  But, don’t let the size fool you. For Carlyle, the new renminbi fund just might play an important role in the firm’s future, as well as China’s. 

The reason: Carlyle will now be able to use renminbi to invest more easily in domestic companies in China, then help take them public in China, on the Shanghai or Shenzhen stock markets. Up to now, Carlyle’s investments in China, like those of its global competitors, have been mainly in dollars, into companies that were structured for a public listing outside China. Carlyle has a lot to gain, since IPO valuations are at least twice as high in China as they are in Hong Kong or USA. 

That means an renminbi investment leading to a Chinese IPO can earn Carlyle a much higher return, likely over 300% higher, than deals they are now doing.  By the way, the deals they are now doing in China are anything but shabby, often earning upwards of five times return in under two years. Access to renminbi potentially will make returns of 10X more routine.  Carlyle has ambitious plans to keep raising renminbi, and push the total well above the current level of $100mn. 

As rosy as things look for Carlyle, the biggest beneficiary may well turn out to be the Chinese companies that land some of this Carlyle money. PE capital is not in short supply in China, including an increasing amount of renminbi. But, smart capital is always at a premium. Capital doesn’t get much smarter – or PE investing more disciplined — than Carlyle. They have the scale, people, track record and value-added approach to make a significant positive impact on the Chinese companies they invest in. 

This is the key point: the best opportunities in private equity are migrating towards those firms that have both renminbi and a highly professional approach to investing. That’s why the leading global PE firms will likely join Carlyle in raising renminbi funds. Blackstone is already hard at work on this, and rumors are that TPG and KKR are also in the hunt. 

Carlyle now joins a very select group of world-class PE firms with access to renminbi. The others are SAIF, CDH, Hony Capital, Legend Capital and New Horizon Fund. These firms are all focused primarily (in the case of SAIF) or exclusively on China. While they lack Carlyle’s scale or global reach, they more than make up for it by commanding the best deal flow in China. SAIF, CDH, Hony, Legend and New Horizon have all been around awhile, starting first as dollar-based investors, and then gradually building up pool of renminbi, including most recently funds from China’s national state pension system. 

Like Carlyle, they also have outstanding people, and very high standards. They are all great firms, and are a cut above the rest. Up to now, they have done more deals in China than Carlyle, and know best how to do renminbi deals. Carlyle and other big global PE firms will learn quickly.  As they raise renminbi, they will elevate the overall level of the PE industry in China, as well as increase the capital available for investment. 

The certain outcome: more of China’s strong private SMEs will get pre-IPO growth capital from firms with the know-how and capital to build great public companies.


Life in the Fast Lane – Driving China’s Expressway Network

Leave a Comment / February 27, 2010

Bamboo painting

 

“Do Not Drive Tiredly”  That’s the message, in English, on large highway signs spanning the roadway in Jiangxi. I was charmed by the idiosyncratic English, and even more by the fact that almost all highway signs in China, including mundane ones announcing upcoming exits or defining the hard shoulder, are all bilingual, Chinese and English.

Based on my recent highway travels through part of Jiangxi Province, I was probably the only one who could get much value from the English. That’s because almost all the other traffic on the highway consisted of very large and heavily-loaded long-distance Chinese trucks. Passenger cars are few and far between. 

Highways are a recent phenomenon in China, of course. I’ve never seen anything quite like them, in my +30 years of driving around the US and lot of the rest of the developed world. The Chinese highways are mainly well-built and usually in pristine condition. Besides the English-language signs, another source of frequent delight are the life-size plastic policemen, pointing plastic radar guns at oncoming traffic. They’re planted in the highway’s central meridian as not-so-subtle reminders to avoid speeding– or as the sign calls it, again in English, “Overspeeding”.

It’s those large trucks, though, that really define for me the current experience of highway driving in China. Despite their huge size – the trailers often have 20-wheels, and seem to stretch the length of seven or eight passenger cars – the trucks are often buckling under the weight of their loads. Most of the time, the cargo hold is open at the top, and covered with a very large tarpaulin, in various colors, intricately tried to the bottom of the flatbed. The trucks have a tendency to wobble and weave as they move along the road – the result of either unbalanced loads or, more likely, less-skilled drivers.

Long-distance trucking may be among the fastest-growing new professions in China. It’s a safe bet few of today’s drivers have been behind the wheel for more than two or three years. Many have their own particular style of driving. Heavy, slow-moving trucks often canter along, 30mph below the speed limit,  in the left-hand passing lane. Their side-view mirrors – the only way the drivers can see traffic behind or alongside them – are often tilted at angles that seem to defeat the purpose.  

Few of the trucks have any kind of marking on them. The concept of a truck as a moving billboard is still an alien one in China. Not so the ordinary highway billboard, which is very common, as are advertisements posted on overpasses. 

China produces so much, including a huge percentage of the world’s manufactured goods, that it’s hard to imagine how all this stuff moved around before the expressway network was built. The traffic on many expressways, including the ones I was on in Jiangxi, must be over 90% trucks. That’s only going to increase, as more production in China is moved to cheaper, inland areas.

The expressways are already quite crowded. Often, they are only two lanes wide in each direction – which may have seemed more-than-adequate 10 years ago when first designed, but now seem to belong in the Pleistocene Age. Within ten years, these roads will almost certainly all need to be widened. That can cost almost as much, per kilometer, as building new expressways. 

China’s toll fees are among the highest ones I’ve seen. In Jiangxi, it’s 0.4 Renminbi ( or around five US cents) per kilometer for passenger cars, and more for trucks. So, financing all this construction won’t necessarily put a big dent in state revenues.  

Even with all the slow-moving truck traffic, the expressway network in China is a godsend. It makes distances much less foreboding than they used to be in China. It’s possible to average over 100 kilometers-an-hour. On the older, ordinary road network, you’d be lucky to average half that speed. Where the trucks thin out, you can “overspeed” at around 160kph, and rustle the plastic policemen in your backdraft.

The Changing Formula of PE Investing in China: Too Much Capital ÷ Too Few PE Partners = Bigger Not Always Better Deals

Leave a Comment / February 16, 2010

Yuan tray


In the midst of one of the worst global recession in generations and the worst crisis in recent history in the global private equity industry, China looks like a nation blessed. Its economy in 2009 outperformed all others of any size, and the PE industry has continued, with barely a hitch,  on its path of blazingly fast growth.

In 2009, over $10 billion  of new capital was raised by PE firms for investing in Asia, with much of that targeting growth investments in China. For the first time, a significant chunk of new PE capital was raised in renminbi, a clear sign of the future direction of the industry. 

This year will almost certainly break all previous records. A good guess would be at least $20 billion in new capital is committed for PE investment in China. For the general partners of funds raising this money, the management fees alone (typically 2% of capital raised) will keep them in regal style for many years to come. 

In such cases, where money is flooding in, the universal impulse in the PE industry is to do larger and larger deals. But, in China especially, bigger deals are almost always worse deals on a risk-adjusted basis. Once you get above a $20 million investment round, the likelihood rises very steeply of a bad outcome. 

The reasons for this are mostly particular to China. The fact is that the best investment opportunities for PE in China are in fast-growing, successful private companies focused on China’s booming domestic market. There are thousands of companies like this. But, few of these great companies have the size (in terms of current revenues and profits) to absorb anything much above $10mn. 

It comes down to valuation. Even with all the capital coming in, PE firms still tend to invest at single-digit multiples on previous year’s earnings. PE firms also generally don’t wish to exceed an ownership level of 20-25% in a company. To be eligible for $20 million or more, a Chinese company must usually have last year’s profits of at least $15 million. Very few have reached that scale. Private companies have only been around in China for a relatively short time, and have only enjoyed the same legal protection of state-owned businesses since 2005. (see my earlier blog post)

Seeing this, a rational PE investor would adjust the size of its proposed investment. In most cases, that will mean an investment round of around $10 million – $15 million. But, rational isn’t exactly the guiding principle here. Instead of doing more deals in the $10 million – $15 million range, PE firms flush with cash most often look to up the ante.  Their reasoning is that they can’t increase the number of deals they do, because they all have a limited number of partners and limited time to review investment opportunities. 

This herd mentality is quite pervasive. The certain outcome: these same cash-rich PE firms will bid up the prices of any companies large enough to absorb investment rounds of $20 million or more. This process can be described as “paying more for less”, since again, there are very few great private Chinese companies with strong profit margins and growth rates, great management, bright prospects and  profits of $20 million and up. 

Some day there will be. But, it’s still too early, given the still limited time span during which private companies have been free to operate in China. There are, of course, quite a few state-owned enterprises (SOEs) with profits above $20 million. Most, however, are the antithesis of an outstanding, high-growth Chinese SME. They are usually tired, uncompetitive businesses with bloated workforces, low margins, clapped-out equipment and declining market shares. They would welcome PE investment, and are likely to get it because of this rush to do larger deals. Some SOEs might even get a new lease on life as a result of the PE capital. 

The certain losers in this process: the endowments, pension funds and other institutions who are shoveling the money into these PE firms as limited partners. They probably believe, as a result of their own credulity and some slick marketing by PE firms,  their money is going to invest in China’s best up and coming private businesses. Instead, some of their money is likely to go to where it’s most easily invested, not where it’s going to earn the highest returns. 

Bigger is clearly not better in Chinese PE. I say this even though we are fortunate enough now to have a client that is both very large and very successful. It is on track to raise as much as $100 million. It is every bit as good (if not better) than our smaller SME clients. Unlike PE firms, we don’t seek bigger deals. We just seek to work with the best entrepreneurs we can find. Most often for us, that means working for companies that are raising $10 million – $15 million, on the strength of profits last year of at least $5 million. 

Our business works by different rules than the PE firms. We aren’t using anyone else’s capital. There’s no imperative to do ever-larger deals. We have the freedom to work with companies without much considering their scale, and can instead choose those whose founders we like and respect, and whose performance is generally off-the-charts. 

The ongoing boom in PE investment in China is likely to continue for many, many years. This is due largely to the strength of the Chinese economy and of the private entrepreneurs who account for a large and growing share of all output. 

But, the push to do larger deals will cause problems down the line for the PE industry in China. It will result in capital being less efficiently allocated and returns being lower than they otherwise would be. PE firms will collect their 2% annual management fee, regardless of how well or poorly their investments perform. 

Raising private capital for PE investment in China is a good business. And, at the moment, it’s also an easier business than finding great places to invest bigger chunks of capital. 

Is This China’s Worst New Brand? Cambridge University Clothing

2 Comments / February 9, 2010

store

 

In a recent blog post, I discussed how and why Chinese brands are not just holding their own in China, but winning against global titans like P&G, Nike, Unilever, Coca-Cola. A big reason is that there are Chinese entrepreneurs with a great feeling for what kind of brand messaging works best in China. 

But, of course, success is not automatic. China can also produce its share of Edsel brands, clunkers that seem from the start preordained to fail.

One such case has some special resonance for me. There’s a new retail clothing brand in China called “University of Cambridge”. It was just launched a few months ago, and there are already about ten stores across China, including one in the Shenzhen shopping mall closest to where I live. The parent company is also based in Shenzhen. 

I was more than a little surprised to see the Cambridge clothing shop open. For one thing, my guess is that I’m one of probably fewer than fifty graduates of the English university living in Shenzhen (Cantab. M.Phil 1985) . So, the “captive population” is going to be very small. What’s more, from a quick look around, I wouldn’t be caught dead wearing any of their clothing , best described as a slinky, polyester mélange of “Ye Olde England” and futuristic Chinese design. 

But, the bigger reason I was surprised to see the University of Cambridge store open is that I can’t believe the university would grant a license to a Chinese retailer to use the University of Cambridge name. Yet, on the walls of the store, as well as on the label of the apparel, it says that this company does, indeed, have the official license from Cambridge. Also, stuck into a lot of the clothing on display are pins emblazoned with the Cambridge emblem: cantab2If anyone can verify that this is legit, that this university did give this Chinese entrepreneur a license, I’d certainly like to know. The store is so brazen in claiming to have the license it’s hard to believe they’re making it all up. But, it could be. 

The store claims they are the first ever to get this kind of license from the university, and that it was granted in 2009, the 800th anniversary of Cambridge’s founding. They also say they have big plans for global expansion. If they don’t have a valid license to use the Cambridge name, then of course any such plan is going to fail from the outset. 

But, if they do have the license, I’d suggest someone at Cambridge should be doing a better job controlling how its name is being used. The clothing is really atrocious. If it were just t-shirts and sweatshirts with the Cambridge logo, it would be one thing. But, the store only has its own designs, both men’s and women’s, and nothing that really connects the styles to the university. 

The store is not without its sources of amusement. In describing the university, it provides a list of famous alumni, based on various categories. My favorite among these: “Politicians: Charles, Mandela, Lee Kuan Yew”.  I’m guessing they mean Prince Charles, though it’s clearly a stretch to describe him as a politician. 

I’m a particularly bad “one man focus group” to evaluate which brands are going to be successful in China. On most things, my tastes are way out of whack with those of the host population. But, I’m pretty confident the Cambridge University retail chain is going to sputter and die. Associating yourself with a famous European institution is not a bad idea by itself, and lots of successful Chinese brands look to capture a kind of European cache. But, this stuff is just too ugly, and too expensive, to catch on. 

The target market seems to be very affluent middle-aged Chinese of both sexes. They have much better, safer and more tasteful choices in the same mall: including Ralph Lauren, Zegna, Lacoste, Louis Vuitton, Canali, Gucci.

Ford marketed its Edsel brand for two years, before killing it off in what is still the biggest and fastest failure for any mainstream auto brand. My guess is that University of Cambridge retail chain won’t survive even that long.


 

Sino-American Relations – Some Overblown Analysis from the USA

Leave a Comment / February 4, 2010

Ge Vase from China First Capital blog post

Is China’s reaction to last week’s announced US arms sale to Taiwan really all that more strident than in the past? Should America be worried? To read some of the recent American news reporting, citing the usual ragbag of US-based “China experts”, you might conclude so.

http://www.washingtonpost.com/wp-dyn/content/article/2010/01/30/AR2010013002443.html
 http://www.nytimes.com/2010/02/01/world/asia/01china.html?scp=1&sq=helene%20cooper&st=cse

I don’t buy it. China is not set, contrary to such reports, firmly on a course to antagonize America. It is, however, a great power with legitimate national interests to assert and protect. Sometimes those will clash with America’s national interests. But, the bilateral relationship also has a root system of common goals and shared admiration. 

I also don’t buy the line by American “China experts” about rising Chinese “triumphalism” , due to continued strength of Chinese economy. China’s economy has been outgrowing the US by eight to ten percentage points just about every year for the last 30 years. Same was true in 2009. The only difference: China grew by 8% while the US economy shrunk by over 5%. A similar net result as in the past, but one that highlighted a dramatic lessening of China’s economic dependence on the US. 

Do Chinese officials realize they now can maintain high economic growth without single-minded focus on exports to US, but look to domestic market instead? Yes. But, as you’ve also read, from Premier Wen Jiabao on down, there’s frequent public declarations on all the many problems and inefficiencies in China’s economy. 

Yes, China is getting stronger every year in every respect. But, is the tone now on arms sales to Taiwan really all that different? I don’t see it, and wonder how much others here see it, or whether it’s just the usual conventional US wisdom on China, a cousin of the “China expert” analysis that Chinese economic growth is a fraud, only resulting from cooked gdp numbers. 

China is mainly busy being China, just as America, most of the time is also mainly busy being America.  Both are continental powers with huge populations and vast domestic markets. Both also have a long history of being more inward- than outward-looking, quite patriotic, even occasionally xenophobic.

They often view the world with a similar sense of aloof distrust. There will always be points of friction between the US and China. But, time is gradually wearing down those points of friction, not sharpening them, as much of the US press would have us believe.

 

China’s Brand New Brand Names

2 Comments / January 30, 2010

Ming Jiajing jar from China First Capital blog post

1837. That’s when the first and still grandest of all consumer brand companies got its start.  Procter & Gamble started off selling soap and candles, then in 1879, introduced its first major branded product, Ivory soap, which quickly became the leading soap brand in the US. P&G then gradually, over the next 130 years, added other brands that became market leaders, including Tide, Crest, Pampers, Gillette, Olay, Head & Shoulders. 

This same slow-and-steady pace characterizes most other well-known consumer brand companies, including: Unilever, Coca-Cola, McDonalds, Mercedes-Benz, Gucci, Tiffany, Nike, Hershey, Crayola (http://www.chinafirstcapital.com/blog/archives/927), etc. 

The lesson: building brands takes time. Lots and lots of time. 

Except, that is, in China. Here, brands go from drawing board to market dominance in a matter of a few years, or less. The reason? Like so much else in China, economic and social change occurs so rapidly that time seems compressed. Three years of economic growth in China is faster than a generation’s economic growth elsewhere. No major economy in modern times has grown as fast, for as long, as China has over the last 30 years.

gdp

 The other reason, peculiar to China, is that there were few brands of any kind before the 1980s. Back then, a stolid proletarian China had a depressingly small number of equally stolid proletarian brands. Many have since disappeared. Those that are still around have often been overwhelmed into irrelevance by newer Chinese brands, or ones imported from abroad.

Good examples of this are Flying Pigeon bicycles and Bee & Flower soap. They were once near-monopolies in China, during Mao’s time. Today, they are bare remnants of their former, dominant selves. Neither has more than a 1% market share, if that. It’s hard to find any other examples outside China during the last 25 years of once-dominant brands losing so much market share so quickly. 

In the US and Europe, older brands often have cache. In China, they are toxic, for the most part, because they are the products of an era of scarcity and little to no consumer choice. So, the tens of thousands of Chinese consumer brands created over the last 25 years entered a market with few, if any, well-established incumbents. A few foreign brands have also done well in China’s mass market over this time: P&G has a great business here with Crest, Tide, Olay, Pantene. Other winners include junk food giants McDonalds & KFC, along with Coca-Cola, Nokia, Apple, Nike, Marlboro, Loreal.

But, in many cases, new Chinese brands have fought and won against competition from well-known imports. Protectionist trade rules have played some part in this, of course. But, a lot of the credit really belongs to smart Chinese entrepreneurs. Thanks to them, China’s consumer market has gone from brand-less to branded in less than a generation.

P&G’s kingpins, like Crest, Pantene and Tide, face a proliferation of Chinese competitors, priced both lower and higher than the global brands. In many other product markets, Chinese brands stand alone, including tissues and toilet paper (sold here in bulky ten-roll packs), bed linen, men’s and women’s underwear, and most food products.

Overall, there are few dominant brands with market shares large enough to discourage new competitors. In fact, new brands arrive all the time. In evolutionary terms, China is in the middle of a kind of Cambrian Explosion, with the rapid appearance of all kinds of new brands. Inevitably, the huge number of brands will shrink, as winners emerge, and has-beens die out. This process took decades in the US and Europe. It will almost certainly happen far more quickly in China. 

One reason for the especially rapid pace: lots of capital is now available to create and support new brands. Why? There is so much to be gained for any company that establishes a dominant brand in China. China will soon have the largest domestic market in the world. Grabbing a few points of market share in China will often equate to billions of dollars in revenue over the next five to ten years. 

In many of the most promising consumer markets, no brand has even emerged yet, with national scope and distribution. Here, smart entrepreneurs can build a brand in fertile virgin turf, rather than trying to force their way into an already crowded patch. If done right, you can turn a new brand into a billion-dollar household name in a short-time. 

I see this process very clearly with one of our clients. It’s still quite a ways from being that billion-dollar colossus, but it has a real potential to become one. The entrepreneur spotted a huge market opportunity five years ago, to create a brand to sell designer accessories to Chinese women from 20 to 35 years-old.

His key insight: the process of urbanization in China is creating an enormous group of working women in this age bracket, with the spare income to spend on not-too-expensive, but well-designed earrings, bracelets, necklaces, sunglasses. 

His business is now growing very fast, with over 100 stores in most of China’s major cities. Sales should double in 2010 to about $50mn, and keep doubling every 18 months for a long time to come. The best part: he faces no real competition, and so every day, his brand grows more and more known, and so less and less vulnerable to whatever competitors may one day come along. My guess is that this brand will be one of the quickest new consumer product companies in Chinese history to reach Rmb 1 billion in sales. 

Like many of the best entrepreneurs, this one makes it look very easy. It isn’t. He takes hands-on responsibility for the four key disciplines needed to build and sustain the brand: marketing, design, management and manufacturing.

That’s the other part about brand-building in China: it not only happens fast, it often happens inside smaller founder-run companies without the input of “specialists” or ad agencies.  I don’t know how many people in China have studied product marketing in school, but my guess is not many.

 

 

PE-backed firms in China make huge contribution to Chinese economy and development

Leave a Comment / January 20, 2010

Yellow snuff bottle from China First Capital blog post

Here’s an excellent article from AltAssets on the contributions of PE-backed companies in China. According to the study, Chinese firms receiving at least $20 million in private equity are leaders in contributing to job creation and economic growth in China.  


Chinese PE-backed companies have more positive social impact than listed firms 

The study compared 100 companies that received at least $20m US private equity investments between 2002 and 2006 with 2,424 publicly listed companies having major operations in China to determine their social impact.

The results of the study show that private equity firms support the development of inland provinces, contribute to foster domestic consumption, transfer management know-how to businesses in their portfolios and improve corporate governance. The study further shows that private equity-backed companies in China had a job creation rate 100 per cent higher and a profit growth rate 56 per cent higher than their publicly-listed peers during the study period of 2002 to 2008.

The survey, conducted by Bain & Company and the PE and Strategic Mergers & Acquisitions Working Group of the European Union Chamber of Commerce, also found that private equity-backed companies spent more than two-and-a-half times that of their publicly-listed counterparts on R&D.

Reflecting on their relatively stronger financial performance, private equity-backed companies yielded tax payments that grew at a 28 per cent rate compounded annually, ten percentage points higher than their benchmark peers in the study. 

Andre Loesekrug-Pietri, chairman of the European Chamber’s PE and Strategic M&A Working Group, said, “China has emerged as one of the leading destinations for private equity capital. This trend is continuing through the current turbulence.”

China is generating lots of interest in the private equity industry, with major firms setting up yuan-denominated funds in the country. Earlier this week Carlyle, the second biggest buy-out house, announced that it has signed a memorandum of understanding with Beijing city authorities to establish a fund there, to be known as the Carlyle Asia Partners RMB Fund.

http://www.altassets.net/private-equity-news/article/nz17691.html

Navigating China’s Treacherous IPO Markets

Leave a Comment / January 11, 2010

Song plate from China First Capital blog post

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC). 

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  


The New Equilibrium – It’s the Best Time Ever to be a Chinese Entrepreneur

1 Comment / January 7, 2010

China Private Equity blog post

As I wrote the last time out, the game is changed in PE investing in China. The firms most certain to prosper in the future are those with ability to raise and invest renminbi, and then guide their portfolio companies to an IPO in China. For many PE firms, we’re at a hinge moment: adapt or die. 

Luckily for me, I work on the other side of the investment ledger, advising private Chinese companies and assisting them with pre-IPO capital raising. So, while the changes now underway are a supreme challenge for PE firms, they are largely positive for the excellent SME businesses I work with.

They now have access to a greater pool of capital and the realistic prospect of a successful domestic IPO in the near future. Both factors will allow the best Chinese entrepreneurs to build their businesses larger and faster, and create significant wealth for themselves. 

As my colleagues and me are reminded every day, we are very fortunate. We have a particularly good vantage point to see what’s happening with China’s entrepreneurs all over the country. On any given week, our company will talk to the bosses of five and ten private Chinese SME. Few of these will become our clients, often because they are still a little small for us, or still focused more on exports than on China’s burgeoning domestic market. We generally look for companies with at least Rmb 25 million in annual profits, and a focus on China’s burgeoning domestic market. 

For the Chinese companies we talk to on a regular basis, the outlook is almost uniformly ideal. China’s economy is generating enormous, once-in-a-business-lifetime opportunities for good entrepreneurs.

Here’s the big change: for the first time ever, the flow of capital in China is beginning to more accurately mirror where these opportunities are. 

China’s state-owned banks have become more willing to lend to private companies, something they’ve done only reluctantly in the past. The bigger change is there is far more equity capital available. Every week brings word that new PE firms have been formed with hundreds of millions of renminbi to invest.

The capital market has also undergone its own evolutionary change. China’s new Growth Enterprise Market, known as Chinext, launched in October 2009. In two months, it has already raised over $1 billion in new capital for private Chinese companies. 

In short, the balance has shifted more in favor of the users rather than the deployers of capital. That because capital is no longer in such short supply. This is among the most significant financial changes taking place in China today: growth capital is no longer the scarcest resource. As recently as a year ago, PE firms were relatively few, and exit opportunities more limited. Within a year, my guess is the number of PE firms and the capital they have to invest in private Chinese companies will both double. 

Of course, raising equity capital remains a difficult exercise in China, just as it is in the US or Europe. Far fewer than 1% of private companies in China will attract outside investment from a PE or VC fund. But, when the business model and entrepreneur are both outstanding,  there is a far better chance now to succeed.

Great business models and great entrepreneurs are both increasingly prevalent in China. I’m literally awestruck by the talent of the Chinese entrepreneurs we meet and work with – and I’ve met quite a few good ones in my past life as a venture capital boss and technology CEO in California, and earlier as a business journalist for Forbes. 

So, while life is getting tougher for the partners of PE firms (especially those with only dollars to invest), it is a better time now than ever before in Chinese history to be a private entrepreneur. That is great news for China, and a big reason why I’m so thrilled to go to work each day.  


The End of the Line for Old-Style PE Investing in China

2 Comments / January 4, 2010

Ming Dynasty flask, from China Private Equity blog post

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

chart1









If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.


China’s Party Apparatus

Leave a Comment / December 28, 2009

China First Capital blog post -- Qing dynasty peach bowl

Christmas has passed, but the reindeer antlers are still out in force. At my local supermarket in Shenzhen, the checkout team began sporting plastic antlers in late November. We’re a long way from the North Pole, and even farther, culturally, from the parts of the world where Christmas is traditionally celebrated. But, if there’s a party going on anywhere,  the Chinese want to be part of it. 

It’s not just the reindeer horns. A good 30% of all other shops’ sales force, as well as restaurant wait staff, are wearing those droopy red Santa caps. Most lobbies of the larger office buildings have Christmas trees, lit and ornamented. Mine also has a small crèche, that looks like a gingerbread house big enough to sleep three adults.  

Incongruous? Sure. But, one grows inured very quickly in China to things that don’t seem to make a lot of sense culturally. Red wine is increasingly the drink of choice among urban, upwardly-striving Chinese. Never mind that most of the wine is domestically produced, and has a thin, sour watered-down flavor a bit like salad dressing, and doesn’t compliment well the salty and spicy foods favored in much of China. 

Other examples: pajamas are occasionally used as outdoor-wear in China. The slowest-moving trucks on China’s expressways tend to putter along at one-third the speed limit in the left passing lane. Many ads for infant formula feature fat blond-haired babies. 

Christmas in China does not involve gift-giving, carol-singing, church-going. It’s a reason to decorate buildings, wear odd outfits, and send tens of millions (by my guesstimate) of SMS messages wishing other Chinese “圣诞快乐” ，literally “Happy Holy Birth”.  Santa Claus? His plastic likeness is plastered everywhere. In China, though, he is known as “圣诞老人“，or “Holy Birth Old Guy”. 

Not only is Christmas part of China’s holiday calendar now, so is Halloween in some of the bigger cities. But, it’s a Halloween celebrated only by adults wearing scary costumes to restaurants and bars that night. There’s no candy, no trick-or-treating. 

Much as China’s government still describes the economy as “socialism with Chinese characteristics”, there’s a lot of my daily life here that can be understood as “Western civilization with Chinese characteristics”. Much is broadly familiar, but most things have a strikingly and singularly Chinese flavor. 

Thursday night is New Year’s Eve. It’ll be my first in China. Logic tells me it should mainly pass unnoticed. Chinese New Year, which falls this year on Valentine’s Day, is the most important holiday of the year, and is so deeply engrained in the consciousness that when Chinese say “next year”, they usually mean some time after Chinese new year, which has no fixed date on the Gregorian calendar. It begins either in January or February, depending on cycles of the moon. The New Year holiday lasts seven days in China. 

So while there’s no cultural imperative to celebrate New Year’s Eve, I do expect restaurants, bars and shopping areas to be unusually raucous on Thursday night, much as they were on Christmas and Halloween. Like a college fraternity, China seems determined to seize any excuse to throw a party. 

 

 

Not Accountable: Why Brilliant 15th-Century Italian Accounting Rules Are Sometimes of Limited Use in China

Leave a Comment / December 21, 2009

 

Luca Pacioli

Luca Pacioli

 

In the history of business, there are no innovations more important, transformative, valuable and widely-used than Luca Pacioli’s. Yet, few know his name. He never made a fortune and likely spent most of his adult life in prayer and cloistered meditation. 

Pacioli was a 15th century Italian mathematician and monk who first codified the system of double-entry bookkeeping. This made modern corporate management possible, by providing a standardized and generally foolproof system for summarizing a business’s financial condition. Pacioli’s system of offsetting credits and debits remains very much the basis of all modern corporate accounting. 

I looked around, but couldn’t discover when double-entry bookkeeping, Pacioli’s brainchild, was first introduced to China. It is certainly pervasive now. The principles of corporate accounting, like mathematics,  don’t change as you move across national borders. In private equity investing, the process of assessing a company’s performance and attractiveness as an investment will be a function, ultimately, of its profitability and net asset value. Pacioli’s methods are the tools to determine both. 

Yet, there are times when I think Pacioli’s accounting principles are no more useful a tool in private equity investment in China than his fellow Italian Marco Polo’s travelogues are to current-day tourists visiting the Great Wall. They are better than nothing. But, you will still need to do a lot of your own strenuous legwork. 

The reason is that accounting principles are not widely applied in the management of many of the better private SME in China. They are entrepreneur-led businesses. Usually the most complete statement of the businesses financial worth is not to be found on a company balance sheet, but in the mind  of the entrepreneur. Some of this is by habit, other by design, to thwart any unwanted outsider, especially the taxman, from knowing exactly what is going on in a company. 

One example from my own work: I made a first visit to an excellent company, with a thriving retail business and brand that’s both well-established and well-known in large parts of China. I was immediately impressed and asked the finance director for the company’s last year’s revenues and profits. “I don’t know,” she replied. Quickly, it became clear she wasn’t being coy or secretive. She genuinely did not know. “Only the boss knows”, she explained, looking over at him. 

He looked momentarily baffled, as if the question had never been posed before, and then did the calculation aloud. He knew precisely how many products he manufactured last year, the average selling price, and unit profit. So with a little multiplication, we were able to get to a number. Turned out, revenues were well north of USD$65mn, and net profits over $7mn. Very solid numbers. We later brought in an accounting firm to do a trial set of financials, and in fact, the true figures were about 15% higher than that first calculation by the boss. Apparently, he hadn’t fully consolidated the results from an outsourced production facility. 

It’s a great company from every perspective – except if you’re trying to evaluate it quickly, using a statement prepared using Luca Pacioli’s principles. Anyone attempting to assess the company using such methods is going to hit a wall, right at the outset. 

The company, like many others of China’s best private firms, does not track its performance with a set of financials, or commission an annual audit. Management stays rigorously attuned to operational details, to cash in the bank, to inputs and outputs, to seizing any available economies to fatten its profit margin. Most often, none of this is ever summarized in a P&L or balance sheet. The boss doesn’t need it. He lives and breathes it every day. 

Any PE firm looking to evaluate the company needs to do the same  – spend time at the company, with the boss, in the factory, and get a feel for how the business is running. If you make it a precondition before any visit to have a set of financials, you’re going to be spending a lot of time anchored to your desk, or visiting only companies that are so hard-up for cash that they’ve spent a good chunk of money getting financials done, to please potential investors. Even in China, an audit done by a local Chinese accounting firm can cost well over USD$50,000. I’d rather have that money spent where it can do more good, like building the business.  

Some good private Chinese companies do have audited financials. They are usually the ones with sizable bank loans. An annual audit is often a covenant of such loans. But, in my experience, most good Chinese companies, with little or no debt and no urgent need to attract investors will not have the sort of financials that some PE firms want to see at the start. 

In China, a set of financials should not be an absolute prerequisite for PE investors. The first step should be to understand the business operationally, and then pay a visit, if the industry and business model both seem attractive. You learn more in two hour site-visit than you would in two days combing through financials.  Besides, any PE firm will commission its own audit, usually by a Big Four accounting firm, before it invests, during the due diligence phase. So, no one is committing money blindly. Eventually, Luca Pacioli’s principles will be put to work. The only issue is whether this is a first step, or one that comes later in the process. 

Accounting rules have enormous value.  Double-entry bookkeeping has never been improved upon, in the 500 years since Pacioli wrote the rules. But, in private equity investment in China, an over-reliance on financial statements, especially as a first-step in getting to know a company, will distort more often than it clarifies. As brilliant as he was, Luca Pacioli could not have anticipated the singular conditions and management style of the current generation of China’s successful private entrepreneurs.Â