Chinese Domestic Economy

An Inflationary Epoch – “ a period of extremely rapid exponential expansion”

Leave a Comment / December 13, 2009

China First Capital blog post -- cloisonne censer

It’s been a particularly busy, gratifying workweek. Reaching for a metaphor from the Big Bang’s cosmological model, it felt like we entered an Inflationary Epoch, a period of extremely rapid and exponential expansion.  One measure: the traffic of outstanding “laoban” (company boss, in Chinese) in and out of our office was heavier than any other time in our company’s history. In all, six came by this past week. I expect most, or all, of these companies to become our clients. 

Our recent visitors run businesses with cumulative revenues of well over Rmb 3.5 billion ($500mn). Four are industry leaders in China.  My best guess would be that within five years, their combined revenues will exceed $3 billion, and cumulative market cap exceed $5 billion. To reach these levels, they need nothing more than to do precisely what they’re doing now – seeking out large market opportunities, and then having the products and discipline to prevail over any competitors. 

Raising private equity capital will accelerate the process and heighten the growth trajectory. But, like many of the best private businesses in China, they’ve shown they can succeed when investment capital is limited and very hard to come by. That’s another commonality among the six companies that visited us this week. None has raised equity capital thus far. All are large, successful and well-managed enough to put capital to effective use. But, raising money is not compulsory. 

It may be a bad recipe for success, but my strong preference is for clients like this, ones that don’t really need us. If we have a value, it’s being able to help laoban prioritize and plan over  a longer time frame. In first meetings, I often ask laoban a question along these lines: “If capital were not a problem, and you could invest in areas of your business with the greatest likelihood of success and highest rates of return over the next three years, what would you do?” 

The answers usually come back with little time wasted for deliberation. A good laoban knows where to go without needing to consult a spreadsheet financial model or market research studies. In today’s China, the answer is usually some variation on, “We need to grow larger and be in more areas of China where there is a clear demand for what we are selling”. 

It’s hard for me to comprehend sometimes given their size, but the best private companies in China are often still in their “test marketing phase”. China’s market is so huge, and growing so quickly, that few if any businesses have penetrated more than a fraction of it. The six companies that visited this week are typical. None of them now serves more than 5% of their current easily-addressable market. At the same time, their potential customer base is also increasing quickly every year. A business needs to grow by 30-40% a year just to stay in place, to hold onto existing market share. 

Of course, none of these six laoban would be content with that, with just growing at the speed of the overall market. They need and want to dominate their industries. That’s where capital can make the biggest difference – especially if it’s supplied by an experienced private equity investor that knows how to help, guide, encourage and finance rapid growth. 

These six companies, like our existing clients, are all so good that I envy the investor that gets to own a share of the business. Investment opportunities this good should be much harder to come by. Instead, as this past week has shown,  great private businesses exist in startlingly large numbers in present day China. 

I’ll only get to know about a small portion of them, and will work with an even smaller number. After a week like this one, it’s impossible not to feel extremely positive about China’s economic prospects, and deeply privileged to know some of the laoban who are doing so much to assure that bright future. 

It was a great week. If the coming one is a little quieter, I think me and my China First Capital colleagues will all be quite content. It’s a challenge to keep up with the pace, and to contribute as much as we aim to. We too are in “test marketing phase”, with so much yet to build and to accomplish with clients across China.

 

Going Private: The Unstoppable Rise of China’s Private-Sector Entrepreneurs

1 Comment / December 7, 2009

Qing Jun-style, from China First Capital blog post

China’s private sector economy continues to perform miracles. According to figures just released by China’s National Bureau of Statistics, private companies in China now employ 70 million people, or 80 percent of China’s total industrial workforce. These same private companies account for 70% of all profits earned by Chinese industry. Profits at private companies rose 31.4% in 2008 over a year earlier, while those of China’s state-owned enterprises (so-called SOEs) fell by 16%. 

The rise of China’s private sector is, in my view, the most remarkable aspect of China’s economic development. When I first came to China in 1981, there were no private companies at all. SOEs continued to be favored sons, until recently. Only in 2005 did the Chinese government introduce a policy that gave private companies the same market access, same treatment in project approval, taxation, land use and foreign trade as SOEs. During that time, over 150,000 new private companies have gotten started and by 2008 had annual sales of over Rmb 5 million.   

These statistics only look at industrial companies, where SOEs long predominated. By last year, fully 95% of all industrial businesses in China were privately-owned. In the service sector, the dominance of private companies is even more comprehensive, as far as I can tell. While banks and insurance companies are all still largely state-owned, most of the rest of the service economy is in private hands – shops of all kinds, restaurants, barbers, hotels, dry cleaners, real estate agents, ad agencies, you name it. 

Other than the times I fly around China (airlines are still mainly state-owned) and when I pay my electric bill, I can’t think of any time my money goes directly to an SOE. This is not something, of course, I could have envisioned back in 1981. The transformation has both been so fast and so thoroughgoing. And yet, it still has a long way to go, as these latest figures suggest. Almost certainly, private company business formation and profit-generation will continue to grow strongly in 2009 and beyond. SOE contribution to the Chinese economy, while still significant,  grows proportionately less by the day. 

There once were vast regional disparities in the role of the private sector. Certain areas of China, for example the Northeast and West of the country, were until recently still dominated by SOEs. But, the changeover is occurring in these areas as well, and every year more private companies will reach the size threshold (revenues of over Rmb 5mn) where they will be captured by the statisticians. 

Equally, every year more of these private companies will reach the sort of scale where they become attractive to private equity investors. That happens when sales get above Rmb 100mn.  

Never in human history has so much private wealth been created so fast, by so many, as it has in China over the last 20 years. And yet, all this growth happened despite an almost complete lack of outside investment capital, from private equity and other institutional sources. This shows the resourcefulness of China’s entrepreneurs, to be able to build thriving businesses with little or no outside capital. Imagine how much faster this transformation would have happened if investment capital, and the expertise of PE firms, was more widely available. It is becoming more available by the day. 

China is primed, as it’s never been, for spectacular growth in PE investment over the coming 20 years.

Will Bad Money Drive Out Good in Chinese Private Equity?

2 Comments / December 1, 2009

Qing Dynasty jade boulder, from China First Capital blog post

The financial rule first postulated by Sir Thomas Gresham 500 years ago famously holds that “bad money drives out good”. In other words, if two different currencies are circulating together, the “bad” one will be used more frequently. By “bad”, what Gresham meant was a currency of equal face value but lower real value than its competitor. A simple way to understand it: if you had two $100 bills in your wallet, and suspected one is counterfeit and the other genuine, you’d likely try to spend the counterfeit $100 bill first, hoping you can pass it off at its nominal value. 

While it’s a bit of a stretch from Sir Thomas’s original precept, it’s possible to see a modified version of Gresham’s Law beginning to emerge in the private equity industry in China. How so? Money from some of “bad” PE investors may drive out money from “good” PE investors. If this happens, it could result in companies growing less strongly, less solidly and, ultimately, having less successful IPOs. 

Good money belongs to the PE investors who have the experience, temperament, patience, connections, managerial knowledge and financial techniques to help a company after it receives investment. Bad money, on the other hand, comes from private equity and other investment firms that either cannot or will not do much to help the companies it invests in. Instead, it pushes for the earliest possible IPO. 

Good money can be transformational for a company, putting it on a better pathway financially, operationally and strategically. We see it all the time in our work: a good PE investor will usually lift a company’s performance, and help implement long-term improvements. They do it by having operational experience of their own, running companies, and also knowing who to bring in to tighten up things like financial controls and inventory management. 

You only need to look at some of China’s most successful private businesses, before and after they received pre-IPO PE finance, to see how effective this “good money” can be. Baidu, Suntech, Focus Media, Belle and a host of the other most successful fully-private companies on the stock market had pre-IPO PE investment. After the PE firms invested, up to the time of IPO, these companies showed significant improvements in operating and financial performance. 

The problem the “good money” PEs face in China is that they are being squeezed out by other investors who will invest at higher valuations, more quickly and with less time and money spent on due diligence. All money spends the same, of course. So, from the perspective of many company bosses, these firms offering “bad money” have a lot going for them. They pay more, intrude less, demand little. Sure, they don’t have the experience or inclination to get involved improving a company’s operations. But, many bosses see that also as a plus. They are usually, rightly or wrongly,  pretty sure of themselves and the direction they are moving. The “good money” PE firms can be seen as nosy and meddlesome. The “bad money” guys as trusting and fully-supportive. 

Every week, new private equity companies are being formed to invest in China – with billions of renminbi in capital from government departments, banks, state-owned companies, rich individuals. “Stampede” isn’t too strong a word. The reason is simple: investing in private Chinese companies, ahead of their eventual IPOs, can be a very good way to make money. It also looks (deceptively) easy: you find a decent company, buy their shares at ten times this year’s earnings, hold for a few years while profits increase, and then sell your shares in an IPO on the Shanghai or Shenzhen stock markets for thirty times earnings. 

The management of these firms often have very different backgrounds (and pay structures) than the partners at the global PE firms. Many are former stockbrokers or accountants, have never run companies, nor do they know what to do to turn around an investment that goes wrong. They do know how to ride a favorable wave – and that wave is China’s booming domestic economy, and high profit growth at lots of private Chinese companies. 

Having both served on boards and run companies with outside directors and investors, I am a big believer in their importance. Having a smart, experienced, active, hands-on minority investor is often a real boon. In the best cases, the minority investors can more than make up for any value they extract (by driving a hard bargain when buying the shares) by introducing more rigorous financial controls, strategic planning and corporate governance. The best proof of this: private companies with pre-IPO investment from a “good money” PE firm tend to get higher valuations, and better underwriters, at the time of their initial public offering. 

But, the precise dollar value of “good money” investment is hard to measure. It’s easy enough for a “bad money” PE firm to claim it’s very knowledgeable about the best way to structure the company ahead of an IPO.  So, then it comes back to: who is willing to pay the highest price, act the quickest, do the most perfunctory due diligence and attach the fewest punitive terms (no ratchets or anti-dilution measures) in their investment contracts. In PE in China, bad money drives out the good, because it drives faster and looser.

The Billion-Dollar Product In Search of an Inventor

4 Comments / November 18, 2009

China First Capital blog post -- Ming Dynasty lacquer screen

Too many inventive minds over too many years have focused on trying to solve environmental problems that may be insoluble: like a internal-combustion engine that gets +100mpg, or a new fuel that will burn cleaner and cost less than gasoline. Of course, a solution to either of these would earn its inventor a multi-billion fortune. That’s a very powerful motivator.

But, let’s face it. Some of these bigger problems may be beyond the wit of man and the realms of molecular science. There are so many smaller, more manageable problems to be solved that will both lower pollution and earn its inventor a very tidy sum. Case in point: a new water cooler for China. 

Here’s a problem crying out for a solution. Solve it and you could build one of the largest consumer products companies in the world, much like how Sony’s Akio Morita got his start inventing a small, portable transistor radio in the 1950s. 

Most offices, as well as a large percentage of urban households in China, have a water cooler. They look like the kind you see in the US, but with one addition: Chinese water coolers also have a hot water spigot. The machines keep hot water, as well as cold water, on tap. They do this by having a small in-built heating system to keep about one liter of water continuously heated to around 80-degrees centigrade (176-degrees Fahrenheit). The reason is obvious: many Chinese still like drinking tea. 

When I first came to China almost 30 years ago, cold potable water and bottled water were both all but nonexistent. Today, they are both pervasively common. Tea often seems like a dying brand in China, except as an accompaniment to a cooked meal. 

But, most Chinese water coolers still offer the hot water function, and will likely continue to do so for many long years to come. There are two problems with the current design in China. First, the hot water is produced continuously, even outside of working hours, at enormous cost in wasted electricity. Since in China most electricity is produced by burning coal, this equates to a lot more coal being mined and burned than is necessary. 

Problem number two: though heated, the water is kept at a temperature too low to make a decent cup of tea.  For that, you need water at or about boiling point. It’s not a difference discernible only by tea connoisseurs. You need the hotter water to get the flavor, as well as get the tea leaves to sink to the bottom of the cup. All tap water needs to be boiled, for health reasons in China. But, the water coolers use bottled water (in 18.9 liter jugs). Each jug weighs over forty pounds. The massive infrastructure to deliver these water bottles, mainly done by guys riding specially-configured bicycles that can hold four of the jugs over the back wheel, is another problem crying out for a solution. But, we’ll leave that one be, for the time being.   

China needs a better water cooler. The person who can invent one, and can protect it from copycats with patents,  is going to become very rich. Two relatively small changes would achieve the goal: (1) incorporate a timer so that the machine will waste less energy;  and (2) design a system that will bring water to a boil and then dispense it. Better air and better tea. Both marketing messages should resonate deeply with a large part of China’s urban population.   

I’m no engineer, but assume there will be a positive energy trade-off here. The new system will likely use more power to get water 25% hotter, to boiling point.  But, the timer would shut down the hot water production, in most cases, for at least 40% of the time, outside of office hours. 

How big is the potential market? My guess would be it’s quite big. In most of the larger hypermarkets in China like Wal-Mart or Carrefour, the section devoted to water coolers is quite large, with at least ten models on display – more space than is given to vacuum cleaners, for example. This gives some approximation of overall sales volume. The current models are all roughly equivalent. Top-of-the-line models not only have the hot water, but refrigerate the cold water before dispensing. These generally cost around $150-$200. An eco- and flavor-friendly model should be in the same price range. If so, it would likely become market leader. 

Inventors mostly like to tackle life’s biggest problems. But, there’s a lot of money to be made in “gradual innovation”, particularly when it delivers improvements on a product that is a ubiquitous in a country as large as China.


Why Is China Booming? Surprise, It’s Not the Stimulus

1 Comment / November 13, 2009

China First Capital blog post -- Qing Dynasty stupa

Launched amid much worldwide rejoicing when the financial crisis struck last year, China’s Rmb 4 trillion ($585 billion) stimulus package is given much of the credit for China’s continued strong economic performance this year. China’s GDP growth is likely to exceed 8%, and the domestic stock market is up by over 70% since the start of the year. 

A Keynesian miracle? To read a lot of the financial commentary on China, you might well conclude this is so, that government spending has single-handedly kept the economy jaunty, while both firms and consumers sank into a deep funk. It’s a great story, and provides a simple explanation for how China dodged the bullets that struck all other major economies. Other countries looked on enviously, and urged China to continue the fiscal pump-priming to help out the overall world economy. 

Problem is, the analysis is flawed. China’s stimulus plan is not all it’s cracked up to be. While the additional government spending has clearly played a part, it is not the only reason why China’s economy has remained so sound this year. The unsung heroes of China’s economic success this year are its ordinary consumers. It’s their continued confidence and increased spending that have really made the difference. 

Economic statistics are notoriously iffy in China. The further one gets from the economic lever-pullers in Beijing, the harder it becomes to track economic activity. That’s another reason why the stimulus plan was so often singled out as the main spur to China’s growth. It’s easier to calculate how much additional the Chinese government is spending building expressways than it is to see how many pairs of socks or bowls of noodles Chinese are buying. 

Another reason: a lot of the economic commentary comes from folks who believe that governments really are responsible for what happens, good and bad, in an economy. Again, it’s just so much simpler to view things this way, that powerful government men can pull out their checkbooks and spend their way to national prosperity. These are often the same people who will tell you, wrongly, that Roosevelt’s New Deal spending lifted the US out of Depression.

China’s supporters and detractors both give the government too much credit. There are those who are convinced China’s economic growth is all some kind of fraud, cooked up by the central government, and that once the extra government spending is dialed down, the economy is certain to crash. 

Again, pure hogwash. 

In China, the government rightly deserves credit for excellent economic management, for creating the circumstances, both marco and micro,  that allow the Chinese economy to continue to thrive. I’ve said it frequently, including in public forums: China is the best-managed major economy in the world. 

But, again, let’s also commend the country’s one-billion-plus consumers, too often seem as miserly skinflints, saving up all their money for their great-grandchildren’s rainy days. It just ain’t so. China’s consumers, with an ever-increasing choice of products, services and shops, are spending ever-increasing sums on improving the quality of their lives. Newer and better housing. New cars. Holidays. New wardrobes. You name it. 

I see it every day here, the untethered exuberance of the Chinese consumer. It’s true that in the early part of this year, there was a relative lull. Back then, shops were working harder to attract customers, by putting a lot of their goods on sale at steep discounts. About four months ago, the situation began to change markedly. No more major knockdowns. Prices now all seem to carry list price, and the prices for many common consumer products are as high, or higher, than in the US. 

Not much of this, it goes without saying, gets noticed by the world’s financial commentariat. Car sales in China are at an all-time high, and China is now the world’s largest car market. But, listen to the commentators, and they’ll tell you it’s the result of some small government tax breaks on new car purchases. Helpful, yes. The main spur? No. Car prices in China are still, in dollar terms, generally much higher than in the US. Based on a percentage of average disposable income, car prices in China are probably among the most expensive in the world. Same goes for property prices. Yet, Chinese keep buying. 

They will keep buying, at or near this record pace, long after any tax breaks phase out.  Chinese want the new cars to drive on the new expressways to carry them to the new shopping malls to buy the new furniture for their new apartments. 

Of all the economic statistics I’ve seen lately, the one that best captures what is going on now in China is this: revenues in China’s restaurant industry were up 18% during the first half of 2009, to over $120 billion. That’s not due to stimulus, or bank loans, or tax concessions, or a government mandate to entertain more. It’s largely because Chinese are out having a good time, more often, and spending a lot more doing so than they did a year ago. 

It’s one of the best barometers of a nation’s mood, restaurant spending. In China, the mood is buoyant, the outlook bright, and the woks are working overtime.

 


 

Private Equity in China: Blackstone & Others May Grab the Money But Miss the Best Opportunities

1 Comment / November 11, 2009

China First Capital blog post -- Song Jun vase

Blackstone, the giant American PE firm, is now trying to raise its first renminbi fund. Its stated goal is to provide growth capital for China’s fast-growing companies. Blackstone isn’t the only international private equity firm seeking to raise renminbi to invest in China.  In fact, many of the world’s largest private equity firms, including those already investing in China using dollars, are looking to tap domestic Chinese sources for investment capital.

Dollar-based investors are increasingly at a serious disadvantage in China’s private equity industry: investing is more difficult, often impossible, and deals take longer to close than competing investors with access to renminbi.

Blackstone enjoys a big leg up in China over other international private equity firms looking to raise renminbi. Its largest institutional shareholder is China’s sovereign wealth fund, CIC. Knowing how to get Chinese investors to open their wallets is a skill both highly rare and highly advantageous in today’s global private equity industry.  

There are two reasons for this stampede to raise renminbi. First, more and more of the best investment opportunities in China are SME with purely domestic structure – meaning they cannot easily raise equity in any other currency except renminbi. The second reason is the most basic of all in the financial industry: if you want money, you go where there’s the most to spare. Right now, that means looking in China.   

In theory, the big international private equity companies have a lot to offer Chinese investors – principally, very long track records of successful deal-making that richly rewarded their earlier investors.

The international PE firms have more experience picking companies and exiting from them with fat gains. They also do a good job, in general, of keeping their investors informed about what they’re doing, and acting as prudent fiduciaries. 

So far so good. But, there’s one enormous problem here, one that Blackstone and others presumably don’t like talking about to prospective Chinese investors. Their main way of making money in the past is now both broken, and wholly unsuited to China. They’re trying to sell a beautiful left-hand drive Rolls-Royce to people who drive on the right. 

Blackstone, Carlyle, KKR, Cerberus and most of the other largest global private equity companies grew large, rich and powerful by buying controlling stakes in companies, using mainly money borrowed from banks. They then would improve the operating performance over several years, and make their real money by either selling the company in an M&A deal or listing it on the stock market.

The leverage (in the form of the bank borrowing) was key to their financial success. Like buying a house, the trick was to put a little money down, borrow the rest, and then pocket most of any increase in the value of the asset. 

It can be a great way to make money, as long as banks are happy to lend. They no longer are. As a result, these kinds of private equity deals – which really ought to be called by their original name of “leveraged buyouts”, have all but vanished from the financial landscape.  It was always a rickety structure, reliant as much on access to cheap bank debt as on a talent for spotting great, undervalued businesses. If proof were needed, just look at Cerberus’s disastrous takeover of Chrysler last year, which will result in likely losses for Cerberus of over $5 billion. 

In his annual letter to shareholders this year, Warren Buffett highlighted the inherent weaknesses in this form of private equity: “A purchase of a business by these [private equity] firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.” 

On their backs at home, it’s no wonder Blackstone, Carlyle, KKR are looking to expand in China, All have a presence in China, having invested in some larger deals involving mainly State-Owned Enterprises. But, to really flourish in China, these PE firms will need to hone a different set of skills: choosing solid companies, investing their own capital for a minority position, and then waiting patiently for an exit. 

There’s no legal way to use the formula that worked so well for so long in the US. In China, highly-leveraged transactions are prohibited. PE firms also, in most cases, can’t buy a controlling stake in a business. That runs afoul of strict takeover rules in China. 

I have little doubt Blackstone, KKR, Carlyle can all succeed doing these smaller, unleveraged deals in China. After all, they employ some of the smartest people on the planet. But, these firms all still have a serious preference for doing larger deals, investing at least $50mn. This is also true in China.

There are few good deals on this scale around. Very few private companies have the level of annual profits (at least $15mn) to absorb that amount of capital for a minority stake. Private companies that large have likely already had an IPO or are well along in the planning process. As for large SOEs, the good ones are mostly already public, and those that remain are often sick beyond the point of cure. In these cases, private equity investors find it tough to push through an effective restructuring plan because they don’t control a majority on the board seats. 

Result: some of the companies best-positioned to raise renminbi funds, including Blackstone, have an investment model that seems ill-suited to Chinese conditions. They may well succeed in raising money, but then what? They’ll either need to learn to do smaller deals (of $10mn-$20mn) or bear the heavy risk of making investments in the few larger deals around in China.  

Any prospective Chinese LP should be asking Blackstone and the other large global private equity firms some very searching questions about their investment models for China. True, these firms all have excellent track records, by and large. But, that past performance, based on the leveraged buyouts that went well, is of scant consequence in today’s China. What matters most is an eye for spotting great entrepreneurs, in fast-growing industries, and then offering them both capital and the knowledge that comes from building value as investors in earlier deals. 

Prediction: raising huge wads of cash in China will turn out to be easier for Blackstone and other large global PE firms than putting it to work where it will do the most good and earn the highest returns.

Shenzhen’s Place in China’s Long History Mixing Sex and Commerce

Leave a Comment / November 1, 2009

Shenzhen night time, from China First Capital blog post

Shenzhen is such a relentless modern city that it’s often hard to discern the influence of 3,000 years of Chinese history and culture. The skyline is so futuristic that it often resembles the home planet of a higher civilization.(See photo above, of the City Center and buildings near CFC’s office). 

But, of course, this is still a part of China, with all its embedded messages and references to a history longer and richer than any other. It just takes a little wisdom to perceive it. I can’t lay claim to any such wisdom. Luckily, though, I have a friend here who has both the historical knowledge and scholar’s temperament to properly put modern Shenzhen into a more classically Chinese context. 

This friend, Zhen Qinan, has had a exemplary career in the financial industry, first as part of the working team formed in 1990 to establish the Shenzhen Stock Exchange, and then as head of a joint venture between four Chinese financial firms and Merrill Lynch, where he worked with leading Chinese companies like Huawei and Taitai Pharmaceutical. 

These days, Qinan is semi-retired. I try to spend time with him whenever I can. He’s warm and thoughtful, and I know now from experience that he’ll offer astoundingly wise insights to even my most mundane questions. How mundane? Over a meal at one of Shenzhen’s better Sichuan places, I commented on how lucky we were to be in a city with so many good restaurants, even by Chinese standards. 

If I had to come up with reasons why, I would settle for the fact Shenzhen is richer than other cities, and has a population drawn from all parts of China. Qinan, however, offered a much richer explanation, rooted in his learning and respect for Chinese history. 

Shenzhen is part of an unbroken tradition, reaching back at least 1,200 years, of commercial centers in China having the best food and also the most beautiful women. So, in their day, the great trading cities along the Grand Canal — Hangzhou, Suzhou, Yangzhou — were particularly renowned as places with the finest and most varied cuisine, and the most desirable women. This reputation has remained largely intact in those cities, even as the commercial locus of China shifted elsewhere. 

The reason then, and the reason now, is the same: in wealthier commercial cities, there’s a heightened appreciation, as well as larger audience, for the pleasures that money can buy. Qinan is from Xian, and to drive home the point, he drew the comparison for me between Shenzhen and his home city.

Xian was always a center of learning and political power, rather than a city with vibrant trade and a large, successful merchant class. As a result, the food, though still quite delicious, has always been a little more basic, less expensive, less intricate, less subtle than that of the trading centers to the east, along the Grand Canal. There’s just not enough money around to support a thriving community of top-quality chefs and restaurants. They migrate to where the money is. 

The same logic, of course, applies to why beautiful women are more prevalent in rich commercial cities in China. Traditionally, beautiful women went to Suzhou, Hangzhou or Yangzhou to find a rich patron to take them as a subsidiary wife. They then produced better-looking children, on average, so creating a virtuous cycle. Let the process run, uninterrupted, for several centuries and the results would be that the cities gained a reputation, probably grounded in fact, for having particularly good-looking ladies. 

To this day, Chinese will always aver that Suzhou has the most beautiful women in the country. I haven’t been to Suzhou in over 25 years, so I can’t say if the reputation is deserved or not. But, I do know that most Chinese believe this to be true of Suzhou, even though, of course, few will have ever been there to see for themselves. 

While concubinage is officially no more in China, there is still a similar process at work in today’s Shenzhen. Concubines are no more. Polygamy is outlawed. Today, the term is 二奶 “er nai”, or “second lady”. It’s analogous to a mistress. Shenzhen, I’m told, has more “er nai” than any other city in China. These tend to be pretty girls in their early 20s who come to Shenzhen from all over China, and often end up clothed, housed, fed and otherwise supported financially by an older, usually married man. Nowhere else in the world (not Paris, Milan, or other centers of mistress culture) have I ever seen so many dreary older men in the company of stunningly beautiful women. 

Shenzhen has more “er nai” both because it’s the richest city in China, and also because there are a lot of men from neighboring Hong Kong who either live or work here, during the week. Part of the standard “expat package” would seem to be taking a Chinese girl as a mistress. I’m told the going rate, in terms of monthly cash stipend, is at least $1,000 a month, with apartment, car and clothing budget extra. That’s about five times more than a woman of similar age can make working in one of Shenzhen’s factories.

One other difference from the China of yore: these women will usually return to their home village with quite a nice nest-egg, marry locally and start a family. This then creates a “job opening”. The man will now find a new “er nai” and so start again the process of clothing, feeding and housing an attractive woman new to Shenzhen.   

Food and sex. They are life’s two most basic drives, as well as the fuel that has kept China’s commercial centers buzzing for well over a thousand years.

 

 

From China, a Plan to Topple One of America’s Most Dominant Brands

2 Comments / October 31, 2009

China First Capital blog post -- China private equity

Every list of America’s most valuable brands includes the same parade of names, year after year – Coca-Cola, McDonalds, Disney, Google. Every year, these lists also ignore what could be the single most dominant brand of all. This brand is known by everyone in America, enjoys a higher market share than any of those on the list, and is able to charge a price premium as much as 300% above its competitors. The brand? Crayola Crayons. 

That’s right, that most humble and low-tech of children’s toys. No one outside the company knows Crayola’s exact market share. A good estimate is at least 80% of the US crayon market. Maybe higher. In other words, Crayola is dominant enough not just to warrant an anti-trust investigation, but to be broken up as a monopoly. 

Of course, I’m partly joking here – about the anti-trust part, not about the market share. Heaven forbid the US Department of Justice should ever decide to police kids toys. But, Crayola really is astoundingly powerful and dominant in its market. It enjoys, according to the company’s own research, 99% brand recognition in the US. Its name is not only synonymous with crayons, but has more or less shut down any lower-cost competitor from grabbing much of its market share. How it does this is also something of a miracle, since as far as I can tell, they do comparatively little advertising to sustain this. In other words, they are not only the most dominant brand, they are also the thriftiest, in terms of how much is spent each year sustaining that position in parents’ minds and kids’ playrooms. 

We don’t know exactly how big Crayola is, or any other fact about its financial performance, because it’s a private company. In fact, even more impenetrably, it’s a private company inside a private company. Binney & Smith, the original manufacturer, was sold to famously-secretive Hallmark in 1984. It’s all educated guesswork. 

But, I’m lucky to know a Chinese boss whose guesswork is far more educated than most. David Zhan is boss and majority shareholder of Wingart, a manufacturer of children’s art supplies based in Shenzhen. David is one of the smartest, savviest and most delightful businesspeople I know. Wingart is also one of my very favorite companies – though they are not a client, nor an especially large and fast-growing SME. But, Wingart is exceptionally well-run and focused, with well-made and well-designed products, as well as the most kaleidoscopically colorful assembly line I’ve ever seen. 

Wingart makes crayons. They are better than Crayola’s. That’s not David’s pride speaking, but the results of some side-by-side testing done by one of the larger American art supply companies. I personally have no doubt this is true. I’ve seen Wingart’s crayon production. Not only are they better, but they are much cheaper too. 

Still, it’s almost impossible for Wingart to gain any ground on Crayola. Wingart mainly sells under other companies’ brand names in the US, including Palmers, KrazyArt and Elmer’s. They have good distribution for many of their products at Wal-Mart and Target. But, not crayons. Wal-Mart would like to start selling Wingart’s crayons – not just, presumably, because they are better than Crayola. But, Wal-Mart, famously, does not like to be reliant on a single brand, a single supplier, for any of the products it carries. 

For the time being, Wingart’s factory is too small to produce crayons in the quantity Wal-Mart requires. This should change within a year or so, when Wingart moves to a new and larger factory about two hours from Shenzhen. Then, perhaps for the first time ever, Crayola will begin to face some real competition. I can’t wait. I think Wingart has a realistic chance to build a crayon business, worldwide, that will compete in size with Crayola, which is pretty much a US-dependent company. 

I have a lot of admiration for Crayola – not so much the crayons, but the fact that a 106 year-old brand could be so predominant in its market, and enjoy such unrivaled – and largely uncelebrated — supremacy for so long. But, I’d still like to see Wingart knock them down a few notches, or more. Crayola has it too good for too long.  American kids deserve the best crayons – as, for that matter,  do European, Chinese and other kids on the planet.

International Investors Miss The Boat in China – Because They’re Not Allowed Onboard

Leave a Comment / October 31, 2009

China First Capital blog post Ming jar

Despite my fourteen years living in London,  I needed to fly all the way back to that city this week, from China, to finally get a look at Westminster Central Hall, a stately stone pile across the street from the even statelier, stonier pile that is Westminster Abbey. Central Hall does double duty, both as a main meeting place for British Methodists, and also as an impressive venue for conferences, including the first meeting of the United Nations in 1946. 

This week, it was site of the annual Boao Forum for Asia International Capital Conference. I flew in to attend, and participate in a panel discussion on private equity in China. The Boao Forum is something like the more renowned Davos Forum, but with a particular focus on Asia and China. This annual meeting focused on finance and capital, and drew a large contingent of about 120 Chinese officials and businesspeople, along with an equal number of Western commercial bankers, lawyers, accountants, investors, politicians, academics and a few other investment bankers besides me. 

Central Hall is crowned by a large domed ceiling, said to be the second-largest in the world. I enjoyed sending back a brief live video feed to my China First Capital colleagues in Shenzhen, whirling my laptop camera up towards the dome, and then down to show the conference. It was also the first time any of my colleagues had seen me in a suit. 

The weather was a perfect encapsulation of British autumn climate, with blustery and frigid winds, occasional radiant sunshine and torrential rain. It was my first trip back to London in over two years, and nothing much had changed. What a contrast to China, where in two years, most major cities seem to undergo a radical facelift. 

“How can a non-Chinese invest in Chinese private company?” It was a straightforward question, by a London-based money manager, for the panel I was on. Straightforward, even obvious, but it was actually one I’d never really considered before, to my embarrassment. In my talk (see Powerpoint here: http://www.chinafirstcapital.com/blog/wp-content/uploads/2009/08/trends-in-private-equity.pdf) , I made the case about why Chinese SME are among the world’s best investment opportunities for private equity firms.  It’s an argument I’m used to making to conference audiences in China. This is the first time I’ve done so anywhere else. The question, though, made me feel a bit like a guy telling his friends about the new Porsche Carrera for sale for $8,000, but then saying, “unfortunately, you’re not allowed to buy one.” 

The reality is that it’s effectively impossible for a non-Chinese investor, other than the PE firms we regularly work with,  to buy into a great private Chinese SME. For one thing, the investor would need renminbi to do so, and there’s no legal way to obtain it, for purposes like this. Even if you found a way around that problem, you’d face an even steeper one when you wanted to exit the investment and convert your profits back into dollars or sterling. 

The money manager came up to me later, and I could see the vexation in her eyes. I had persuaded her there were great ways for investors to make money investing in SME in China. Disappointingly, her clients aren’t allowed to do so. Cold comfort was all I could offer,  pointing out the same basic problem exists for any non-Chinese seeking to buy shares quoted on the Shenzhen and Shanghai stock markets. 

It’s a reasonable bet that China eventually will liberalize its exchange rate controls and ultimately allow freer convertibility of the renminbi. But, that doesn’t exist now. As a result, financial investment in renminbi in China is, for the most part, reserved exclusively for Chinese. Unfair? It must seem that way to the sophisticated, well-paid money managers in London, who these days have few, if any,  similarly “sure fire” investment options for their clients. 

China is, itself, awash in liquidity, and sitting on a hoard of over $2 trillion in foreign exchange reserves. So, there really is no shortage of capital domestically. Allowing foreign investors in, of course, would increase the capital available to finance the growth of great companies. But,  it will also add to the mountain of foreign reserves and put more upward pressure on the renminbi. That’s the last thing Chinese authorities need at the moment. So, most of the best investment opportunities in China are likely to remain, for quite a lot longer, open only to Chinese investors. 

Overall, this is a very good time to be Chinese. By my historical reckoning, it’s the best since at least the Tang Dynasty over 1,000 years ago. China has changed out of all recognition over the last 30 years, creating enormous material and social gains. That beneficial change, if anything, is accelerating. The fact Chinese also have some of the world’s best investment opportunities to themselves is just another dividend from all this positive change. 

If I were a money manager, I’d also be asking myself “how can I get some of this?” But, I’m not a money manager, and I formulate things very differently. I’m so happy and privileged to have a chance to help some of China’s great private entrepreneurs. Me and my team invest all our waking hours and all our collective passion in this. We are rewarded daily, by the trust put in us by these entrepreneurs, and by our very small contribution to their continued success. That’s more than adequate return for me.

I guess I’m not cut out for purely financial investing. 

 

Field Report from Guizhou – Where Cement Turns Into Gold

Leave a Comment / October 31, 2009

Blue vase in China First Capital blog post

 

While writing this, I was more than a little the worse for drink. Over dinner, I drained the better part of a bottle-and-a-half of Maotai, China’s most celebrated rock-gut spirit, which sells for a price in China that French brandy would envy, upwards of $80 a bottle. It’s one of the more pleasant occupational hazards of life in China for a company boss. As far as I can tell, some Chinese seems to view it as a matter both of national pride and infernal curiosity to get a Western visitor plastered. By now, I know well the routine. I sit at a table surrounded by people generally drawn together with a common purpose – to treat me solicitously while proposing enough toasts to render me wobbly and insensate.  

As far as career liabilities go, this is one I can happily live with. I always try to eat my way to relative sobriety.  I’m in Guizhou Province. (I’ll wait five minutes while most readers consult an online atlas.) The food here is especially yummy – intense, concentrated flavors, whether it’s a chicken broth (I’m informed it’s so good because local chickens have harder bones than elsewhere in China), pig ear soup, a simple stir-fried cabbage, or a dizzily delicious dish of corn kernels from cobs gathered nearby. So, with each glass of Maotai (which started as thimble-sized and then were upgraded to proper shot-glasses) I tried as best as I could to wolf down enough solid material to hold at bay the nastier demons of drunkenness. 

Did I succeed? I believe so. At least in part. My Chinese didn’t sputter and seize up like a spent diesel engine, and my brain could just about keep up with the typhoon of sounds, smells and data points of the humongous cement factory I toured after dinner. 

If you can find a way to get to Eastern Guizhou, or Western Hunan, do. You’ll likely travel, as I did, along an otherwise empty but fantastically beautiful motorway, past the squat two-stored dwellings of the local Miao people, and the inspiringly eroded prongs that make up the local mountain-scape. If you are even luckier, and share my peculiar taste of what constitutes an ideal weekend, you might just end up, as I did, at the largest private cement company in Guizhou. It’s called Ketelin, and it’s to capitalism what a Titian portrait is to fine arts: drop-dead gorgeous. 

With Maotai bottles drained, and dinner inhaled, I went on a walking tour of the Ketelin factory, on a warm, breezy and clear summer night unlike any I’ve ever witnessed lately in smoldering Shenzhen and Shanghai. My host here is the company’s founder and owner, 宁总, aka Ning Zong. If I had to specify a single rule to determine how to discern a great entrepreneur, it might be “his favorite form of exercise is to walk 20 laps around his humming factory every night after dinner.” Such is the case with Ning Zong. Another great indicator, of course, is to have a business where customers are lined up outside your door, 24 hours a day, waiting to buy your product. That’s also true here. There is a queue of large trucks outside the front gate at all hours, waiting to be filled with Ketelin cement.  

Ning Zong is out here, in what is considered the Chinese “back-of-the-beyond”, and has built the largest private company in the province. And that’s just for starters. His only goal at this point is to build his company to a scale where it can serve all its potential customers, with the highest-quality cement in this part of China. This being China, that’s a very substantial, though achievable vision. He’s already built a state-of-the-art factory, on a scale that few can match anywhere else. And yet, there’s still so much unmet demand, not just in Guizhou, but in nearby provinces of Sichuan, Hunan and Hubei that Ning Zong’s burning desire, at this phase, is to expand his business by several-fold. 

That’s why I’m here, to work with him to find the best way to do so, by bringing in around $15 million in private equity. I have no doubt whatsoever that his plans and track record will prove a perfect match for one of the better PE firms investing in China. Whichever one of them gets to invest in Ketelin will be very fortunate. This facility, and this owner, are both pitchforks perfectly tuned to the key of making good money from the boom in China’s infrastructure development. Among other customers, Ketelin supplies cement to the big highway-construction projects underway in this area of China. 

 Is Ketelin an exception, here in Guizhou?  I don’t really have the capacity to answer that. Guizhou is generally considered by Chinese to be the also-ran in China’s economic derby, poorer, more hidebound and more geographically-disadvantaged than elsewhere in southern China. Water buffalo amble along the middle of local thoroughfares, and field work is still done largely without machines, backs stooping under the weight of newly-gathered kindling. While Guizhou is poor compared to neighboring Hunan and Sichuan, poor regions often produce some of the world’s best companies:  think of Wal-Mart and Tyson’s, both of which got started and are based in Arkansas, which is as close as the US has to a province like Guizhou.  

Guizhou, from what I’ve seen of it, is breath-takingly beautiful, with clean air and little of the ceaseless hubbub that marks the cadence in big cities like Shenzhen and Shanghai. This is China’s true hinterland, the part of this vast country that eminent outsiders have long said was impossibly backward and so beyond the reach of modern development.  

They are wrong, because what’s right here is the same thing that has already generated such stupendous growth in coastal China. It’s the nexus of vision and opportunity, of seeing how much money there is to be made and then doing something about it, to claim some of that opportunity and money as your own. Ning Zong has done so, on a scale that inspires awe in my otherwise Maotai-mangled mind. 

Come see for yourself.

 

A Step in The Right Direction – But Capital Allocation Remains Highly Inefficient in China

Leave a Comment / October 31, 2009

Vrard Watch from China First Capital blog post

Capital is not a problem in China. Capital allocation is. 

Expansionary credit policies by the government has created a boom in bank lending. This rising tide of bank credit is also lifting Chinese SMEs. Through the first half of this year, loans to SME have increased by 24.1% , or 2.7 trillion yuan ($400bn).  All that new lending, though, has not substantially altered the fact that bank lending in China is still directed overwhelmingly  towards state-owned companies.  So, while lending to SME rose by nearly a quarter, that equates to only a tiny 1.5% increase in the share of all bank loans going to SME. 

State-owned banks and state-owned companies are locked in a mutual embrace. It’s not very good for either of them, or for the Chinese economy as a whole. Faster-growing, credit-worthy private companies find it much harder and more costly to borrow.  Over-collateralization is common. An SME owner must often put up all this company’s assets for collateral, then throw in his personal bank accounts and property, and finally make a cash deposit equal to 30% to 50% of the loan value. 

China isn’t the only country, of course, with inefficient credit policies. Japan’s banking system still puts too much cheap credit in the hands of favored borrowers.  But, the problem is more damaging in China that elsewhere, for two reasons: first, many of China’s best companies are small and private. They are starved of capital and so can’t grow to meet consumer demand. Second, the continuing deluge of credit for state-owned companies distorts the competitive landscape, keeping tired, often loss-making incumbents in business at the expense of better, nimbler and more efficient competitors. 

In other words, China’s credit allocation policies are actually stifling overall economic growth and inhibiting choice for Chinese consumers and businesses. 

State-owned banks everywhere, not just in China, have the same fatal flaw. They like an easy life, which means lending to companies favored by their controlling shareholder, not those that will earn the greatest return.  They can turn a deaf ear to profit signals because, ultimately, profit isn’t the only purpose of their labors. They allocate credit as part of some larger scheme, in China’s case, maintaining output and employment in the country’s less competitive,  clapped-out industries.  

There’s a regional dimension to this too. China’s richest, most developed areas are in South,  particularly the powerhouse provinces of Guangdong, Zhejiang and Fujian.  The economy here is driven by private, entrepreneurial companies, not the state-owned leviathans of the North. As a result, a credit policy that discriminate against private SME also ends up discriminating against the parts of China with the highest levels of private ownership and per capital wealth. 

That’s not sound banking, or sound policy. The good news is that the situation is changing. SME are gradually taking a larger share of all lending. The change is still too slow, too incremental, as the latest figures show. But, with each cautious step, the private sector, led by entrepreneurial SME, gains potency, gains scale and gains more of the resources it needs to provide the products and services Chinese most want to buy.  


No Preference: Disallowing Preferred Shares for Private Companies is Hobbling China’s Venture Capital and Private Equity Industry

Leave a Comment / October 31, 2009

 

Ming Dynasty mother-of-pearl from China First Capital blog post

Chinese securities regulations do not allow private domestic companies to issue preferred shares.  It does not sound particularly problematic, since preferred shares are not all that common anywhere. And yet, this regulatory quirk has serious unintended consequences. It is holding back the flow of private equity and venture capital investment into promising Chinese companies, particularly those with more than one shareholder. 

Preferred shares earn their name for a reason. These shares enjoy certain preferences over common shares, most often greater voting power and better protection in the event of bankruptcy. Preferred shares are the main mechanism through which venture capital and private equity firms invest in private companies. In general, when a PE or VC firm invests, the company receiving the investment creates a special class of preferred shares for the PE or VC. These preferred shares will have a raft of special privileges, above and beyond voting rights and liquidation preference. The theory is, the preferred shares level the playing field, giving the PE or VC firm more power to control the actions of the company, particularly how it uses the VC money,  and so protect its illiquid investment. 

Take away the ability to issue preferred, as is the case in China, and things begin to get much trickier for PE and VC investment. PE and VC firms are loathe to invest in ordinary common shares, since this gives them little of the protection they need to fulfill properly their fiduciary duty to their Limited Partners. There are, of course, all kinds of clever solutions that can be and often are employed to get around this problem in China. For example, the PE or VC firm can ask their very clever lawyers to craft a special shareholders agreement, to be signed by the company it’s investing in, that gives the PE or VC firm the same special treatment conferred by preferred shares. 

The problem here, though, is the legal enforceability of a shareholder agreement is not cut-and-dried.  A basis of most securities law, in China and elsewhere, is that all shareholders holding the same class of shares must be treated equally. In other words, if a PE or VC firm has ordinary common shares, it can’t get better treatment and more rights than any other common shareholder. 

What happens if a PE or VC firm’s shareholder agreement conflicts with this principle of equal treatment? China’s legal system is evolving, and precedent is not unequivocally clear. But, in general, the law takes precedence over any contract. In other words, if it comes down to a court fight, the PE or VC firm might find its shareholders agreement invalidated. 

This is not some remote likelihood, particularly if the company has more than just the founder and the PE or VC firm as shareholders. The “unpreferred” common shareholders have every right and many reasons to feel disadvantaged if they are deprived the same rights enjoyed by a VC firm also holding common shares.

There are many scenarios when this could lead to litigation, not just if the company runs into trouble, and shareholders end up fighting over how to divide whatever assets remain There’s also a big chance of legal mischief if the company does splendidly well. Let’s say the company is preparing for an IPO, and a shareholders agreement gives the VC firm special rights to have their shares registered and fully tradeable. This is a fairly common element in shareholders agreements. Other common shareholders would have ample reason to object, if their shares can’t be liquidated at the same time.  

Sometimes in business, legal uncertainty can be useful In this case, though, there are no clear winners. Anything that makes PE or VC firms less likely to invest disrupts the flow of capital to worthy businesses. That’s the situation now in China, with preferred shares disallowed and much uncertainty surrounding the legality of shareholders agreements. 

I have no special insight into why Chinese regulators have outlawed preferred shares for private domestic companies, or whether they are contemplating a change. But, a change would be beneficial. Most likely, the prohibition of preferred shares was designed to stop private companies from fleecing their unsuspecting equity-holders. In other words, the motive is sound. But, if the result is less growth capital available for successful young Chinese companies, the medicine ends up occasionally killing the patient. That doesn’t serve anyone’s interests: not entrepreneurs, nor investors, nor the country as a whole. 

 There are ways to give common shareholders some protection while still allowing private companies to create preferred shares. Ultimately, these common shareholders will likely benefit from the injection of PE or VC money into a company they’ve also invested in.  A shortage of capital is always a problem for growing companies, but it’s a particularly acute one in China. The PE or VC firm will also usually play a much more active role than other shareholders in building value, giving these other shareholders a free ride. 

Like most, I invest to make money, not exercise voting rights. So, my preference as a common shareholder will be to let the preferred have whatever rights they deem important – as long as they are doing the heavy lifting and pushing hard to build profits. They bring the capital, track record and expertise that often makes all the difference between a successful company and a has-been. I prefer to invest for success, and that often means preferring the presence of preferred investors.

Most Thankless Well-Paid Job in China: Market Forecaster

Leave a Comment / August 14, 2009

Calligraphy from China First Capital blog post

 

Looking for a new career with plenty of growth potential, and low standards for success? Here’s one to consider: China market forecasting. Rapid economic growth and urbanization are both creating huge demand for market research predicting future areas for opportunity and profit. Pay is good. But, there’s another aspect to the job that will appeal to many: repeated failure is no obstacle. 

Market research is, of course, a treacherous profession anywhere. Predicting the future always is. But, in China, market forecasting is particularly hard. It’s mainly been distinguished by how often, and by how much, the predictions turn out to be wrong.  Market segments in China grow so quickly, so explosively, that it makes a fool of just about anyone trying to guess its economic future. 

I’m reminded frequently of this these days. We’re working on a complicated infrastructure financing. One of the central components of the deal is a now two-year-old forecast of car purchases and driving patterns in China. The forecast was prepared by a respectable outfit in Hong Kong, and my guess is that they charged quite a lot to do it. But, looking at the numbers now, they seem ridiculous, like numbers pulled out of thin air – which is probably what they were. The actual growth of car traffic and car purchases over the last two years in China has been much higher than these predictions. In other words, the forecasts weren’t off by a mile, but by a light year. 

Given that track record, it’s surprising these market forecasters can continue to pay the rent, let alone prosper. And yet they do. It’s a familiar paradox: we know projections are often wrong, and yet many business decisions, often with billions of dollars at stake, are made on them. It’s probably connected to what’s sometimes called “the scientific theory of management”, which tried to systematize complex business decisions into quanta of data.

It’s the same approach taught in business schools, and is certainly one of the reasons so few MBAs make successful entrepreneurs. A hunch is often a better tool in business than a spreadsheet. Indeed, I’ve yet to meet a successful entrepreneur who ran his business, or started out in life, based on a market forecast. 

In our case, we’re stuck using the projections on auto traffic, because there’s nothing else available. So, we send them out to investors with the guidance to take the projections with a grain of salt. If not a fistful. This creates its own set of problems, including frequently the request to do a new set of “up-to-date” projections. In other words, the solution to bad projections is – you guessed it — to commission more projections. As I said, it’s a great job, being a market forecaster. 

The errors in a bad projection become cumulative. The longer the time line, the more distorted the projections will usually become.  In our case, we’re using a 25-year projection. So, these sizable errors in the first years will propagate across time. Year by year, the forecast becomes less and less tethered to reality, like the NASA space probe that escaped its flight path, lost contact with Mission Control and ended up, as far as we know, drifting in galactic space. 

Most markets outside China are more stable, so projections, even when they are wrong, don’t diverge quite so much from the actual situation.  Car sales are a great example. They are booming in China. Everyone I meet in Shenzhen, across all social classes, either has a car, is taking driving lessons or plans to begin soon. GM just announced its car sales in July in China rose 77% from a year earlier. 

For several months this year, China has been the world’s largest car market, outpacing the US. A quick web search turns up a supposedly highly credible forecast, from 2008, claiming that China is “on track to become the world’s largest car market by 2020, according to J.D. Power.” In other words, J.D. Power said it would take 12 years. It didn’t even take two. 

The recession in the US is a contributing factor, of course. But, the forecasts also, quite obviously, guessed very wrong about the growth rate of auto sales in China.   These wrong guesses have real-world consequences, because they can impact today’s decisions on investment and employment. In our case, by underestimating the growth rate of auto sales over the last two years, the projected revenues over 25 years from a $300mn toll expressway project in China also come in much lower. How much lower is anyone’s guess. Mine is that the revenue projections are off by at least 80% over the 25 years, and that this particular project will generate a profit of over $2 billion over that time, rather than the $1.2bn in the forecast built on the Hong Kong market researcher’s two year-old guesses. If so, the annual return on investment goes from the outstanding  to stratospheric. 

Here are my two projections: despite a record often unblemished by success, market forecasters in China will continue to ply their particular craft, collect their fees, sell their reports, and mainly miss the mark. Meanwhile, markets in China will continue to grow very fast, for a very long time. 

 

 

.

In Global Private Equity, It’s China as #1

Leave a Comment / July 21, 2009

Qing ceremonial ruyi in China First Capital blog post

 

I spent the day in Shanghai on Friday, attending a private equity conference, and giving one of the keynote speeches. I’d thought about giving my talk in Chinese, but in the end, the discretion/valor calculus was too strong in favor of using my native language. I was one of only two speakers who used English — or in my case, a kind of half-bred version of miscegenated Mandarin and English. The rest of the conference participants — including two other Westerners and dozens who participated in panels – all spoke in Chinese.  It was quite humbling, and I’m determined to use only Chinese next time around. 

Shanghai has, so rapidly, become a truly international city. It’s one thing to say, as Shanghai’s leadership has been doing over the last decade, that Shanghai will surpass Hong Kong as Asia’s largest, most vibrant international financial center. It’s quite another to achieve this, or even make significant headway, as Shanghai has done. So many of the factors aren’t under the control of government authorities. They can only create the legal and tax framework. In the end, the process is driven by individual decisions made by thousands of people, who commit to learning English and mastering the basics of global finance. All are staking their careers, at this point, on Shanghai’s future as a financial center. 

It’s a version of what economists like to call “network effects”: the more individuals who commit to building Shanghai as a financial center, the more each benefits as the goal comes closer to fruition. On Friday, in Shanghai, I could see this process vividly displayed in front of me, of how widespread knowledge of English has become: of the 200 or so people who heard my talk, at a glance 99% were Chinese, and only a handful needed to use the translation machines.

My talk was titled “Trends in Private Equity: China as #1”.  In Chinese, it’s “私募股权投资：中国成为第一”

The basic theme was how “decoupled” China has become from private equity and venture capital investment in the rest of the world.  China is in the ascendant, and will remain that way, in my opinion, for the next ten years at least. It will be years before the PE and VC industries in the US reach again the size and significance they enjoyed a year ago. China, meanwhile, is firing on all cylinders.

There are many reasons for China’s superior current performance and future prospects. In my talk, I focused on just a few, including principally the rise over the last decade of a large number of outstanding private SME. They are now reaching the scale to raise successfully private equity and venture capital funding.

It’s another example of positive network effects: the Chinese economy is undergoing a shift of breathtaking significance: from dependence on the public sector to reliance on the private sector, or in my shorthand, “from SOE to SME”. The more successful SME there are, the more embedded this change becomes, and the more favorable overall circumstances become for newer SME to flourish. 

Here’s one of the slides from my PPT that accompanied the talk: 

—  Global Private Equity: in trouble everywhere except China
 全球私募股权投资：除了中国以外的其它市场都陷入困境

—  Recession; Credit Crisis; Over-leveraged ; closing IPO window

—  经济衰退，信贷危机，杠杆率过高，几近停止的IPO

—  Most PE firms dormant, can’t raise new equity or new debt; industry contracting

—  PE公司无法进行股权和债权融资，几乎处于休眠状态，行业萎缩

—  China is the exception:  strong economic fundamentals; shift from export to domestic market;  shift from state-owned to private sector;  rise of world-class SME

—  中国的独特之处：强劲的经济增长，从出口导向到关注国内市场的转变，经济从国有企业到私营企业的迁移， 富有成为世界级企业潜力的中小企业

 For anyone interested, the whole speech is available, in Chinese, at http://news2.eastmoney.com/090717,1117,1134998.html

 

 

.

 

Trusting the Free Market — China Betters the US

Leave a Comment / July 8, 2009

chart for China First Capital blog post

“Chimerica”, “the world’s most important bilateral relationship”, “the G2”. These are phrases now in vogue to describe the relationship between China and America. The two countries tower over much of the rest of the world, accounting for over 25% of its population and 60% of global economic growth over the last five years. While China and the US continue to have their squabbles, economic and political relations are better than at any time in my lifetime.

My own life has been one long and fulfilling love affair with both countries, They represent twin poles of attraction. I grew up as a typical American kid, except in one respect. As far back as I can remember, I was completely fascinated by China. I believed that if I dug a deep enough hole in my backyard, I’d eventually come out in China. I kept starting the hole, especially when I was frustrated with my parents, but don’t recall ever getting very far. To me , the best thing about going off to university was that I could finally begin studying Mandarin. The most exciting day of my life (and I’ve had my fair share) was the day I walked across the Lowu Bridge in Hong Kong and into China for the first time in 1981.

My life’s goal became first to learn more about China, to study there and finally, after a lot of interesting career twists, to contribute whatever experience and talents I have to help China’s continuing economic transformation. That is why, two years ago, I started building China First Capital, a boutique investment bank that works with China’s private SME to arrange pre-IPO private equity finance.

I’m now lucky enough to call both countries home, dividing my time between Los Angeles and Shenzhen. Of course, there are more differences than similarities. For one thing, the food is better in China, and the summer weather is better in Los Angeles. But, all the same, I’m often struck by the deep affinities between China and the US – both are self-confident, continental-sized nations, with a shared sense of patriotism and optimism.

But, there is one important way in which the countries are moving in opposite directions. In this case, there is going to be a clear winner and a clear loser.

Americans are drifting further from their once unshakable belief in free markets. Chinese, meantime, are becoming ever more certain that the free enterprise system is the best way to organize society and fulfill the goals of its citizens. This is a very worrying development for the US, and a wholly positive one for China.

This remarkable shift is born out in the chart at the top of this post. It shows how Americans’ faith in free market system has been eroding, while Chinese are ever more certain of its superiority.

As someone working with some of China’s better entrepreneurial companies, I’m tremendously heartened by this change in China. The belief in free markets is affirmed by many daily interactions I have there, whether it’s with the boss of a successful private Chinese company, or the family that serves me steamed dumplings for breakfast. Chinese see opportunities everywhere for self-advancement, and want only the freedom to pursue it. Americans, by contrast, have grown more disillusioned, fearful. They are looking to the government, more than at any time I can recall, to solve their problems, to soothe what ails them.

How did China get it so right, while America is getting it so wrong? Recent history plays a big part. China has experienced unprecedented economic growth over the last 30 years, largely through a rolling program of reform that liberalized ever larger parts of China’s once hidebound economy. China’s economy has grown ten-fold over that time. Each additional increment of market freedom has brought with it improvements in the wellbeing of most Chinese citizens.

In the US, people are still reeling from the economic shocks of the last year – the credit crisis, recession, unemployment at a 27-year high, bailouts and bankruptcy of some of the country’s largest and most well-known businesses. Americans are looking for something to blame. Unfortunately, too many are blaming the free market system. Mistakenly, they look to government to restore growth and prosperity.

In China, on the other hand, the economy is vibrant, and Chinese have more opportunities than ever before, If they are looking to government for anything it’s to continue to maintain a steady course by continuing to liberalize.

I’m no pollster. But, I do notice, as I move between two countries, that not only is the belief in free markets stronger in China these days, but the overall business climate is more favorable as well. Competition is increasing, delivering more choice, better service, lower prices.

The US, meanwhile, is experiencing the largest increase in the size and scope of the government in peacetime history. Most people are smart enough to know that this will eventually mean more intrusive regulation and higher taxes — the twin forces that most choke a laissez faire system.

My sense is that the pendulum will eventually swing back in the US. People will be reminded soon enough that government cures are often worse than the underlying disease.

In China, economic liberty is increasing steadily, and life continues to get better for the vast majority of China’s vast population. If anything, this process is accelerating. China is, of course, still far less economically developed than the US. There are economic challenges, and issues on the horizon like an aging population to deal with.

But, at this particular moment in China, the population is growing more confident that solutions will come with freer markets, not greater centralized control. That is great news for everyone, including the companies we work for in China. The sooner Americans start thinking the same, the better.

.