Chinese Domestic Economy

“The Great Unwind” — Jim Zukin’s Masterly Analysis of Global Financial Crisis & Opportunities for Chinese Companies to Benefit Through M&A

Leave a Comment / May 11, 2009

Ming Dynasty

Readers of this blog will know I’m a big fan of Jim Zukin, a founding partner of the investment bank Houlihan, Lokey, Howard and Zukin. We met again for lunch last week, in Los Angeles. 

I’ve had the pleasure of meeting, and befriending, quite a few smart, and highly successful businessmen and entrepreneurs. It’s probably been the most rewarding part of my career. But, even among such pretty stellar company, Jim Zukin stands out. I’m truly awestruck – which is not a quality I often exhibit — by his intellect, his charisma, his business savvy, his warmth and humor, his love for his family, his clear and incisive thinking on the largest issues of our time. 

Jim is also much, much better at investment banking than I will ever be. I tend to be somewhat stubborn and used to being in charge. But, Jim’s judgment as an investment banker is so much more thoroughgoing than my own, that he is one of the very few people I’ve known who, metaphorically,  I would follow unquestionably into battle. Like a good junior officer, I would,  “Salute, shut up, and do what I was told.” 

Jim shares with me a deep affection for China, and a great delight in doing business there. He spotted big potential opportunities for his firm in China several years ago, and personally traveled there frequently to get Houlihan Lokey’s office started and on a solid footing, which is where it is today. Jim is one of those people who seems to know more about more things than should be possible, let alone for a guy who’s also occupied with “minor” tasks like staying very close to his five kids and grandchild, while helping to run the thriving global investment bank he founded. 

Among the things Jim understands well (better than anyone I’ve run across) the remarkable moment in financial history we’re now living through – the US is struggling to rebuild its banking sector and recover from a serious credit crisis and recession, while China is awash in liquidity. Most experts look at this and see just one dimension – that China’s government will continue to use its massive foreign exchange reserves to buy US government debt, thereby providing some additional stability to US interest rates and the dollar. 

Jim Zukin sees beyond this – indeed well beyond the current horizon –  to another important aspect of the financial symbiosis between the US and China. Chinese companies, as Jim sees it,  now have the scale, the ambition, the growth potential and the financial resources, to acquire assets in the US. This could have transformational effects for the Chinese companies able to acquire businesses in the US, and no less of an impact on parts of the ailing US industrial base. China could, and should, become a buyer of quality Middle Market companies in the US. There are good reasons why: because these US assets will help the Chinese firm accelerate its growth,  improve distribution and customer base in the US, upgrade technology. One other reason: US Middle Market companies are comparatively cheap, at the current valuation multiples (often around 5x)  and dollar-renminbi exchange rate. 

Jim sees this opportunity earlier and more clearly than most of us. He does so, in part,  because he holds more substantive knowledge and insight about the US, China and the financial tsunami that has changed the world over the last year. He condensed some of this knowledge and insight into a Powerpoint called “The Great Unwind and Its Impact”. 

I recommend it as essential reading, for anyone who wants to understand better the current financial crisis and some longer-term impacts on China and the US.  There’s a large amount to chew on in Jim’s report, not just the section on China. It shows a breadth of understanding that help explain why Jim was able to build a perennially successful investment banking firm, as well as perhaps the only one that’s come through the current financial crisis stronger than ever. 

You can view it here:

http://www.scribd.com/doc/15194564/The-Great-Unwind-and-Its-Impact-By-Jim-Zukin

 

 

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To See China Transforming: Go to a Chinese Bookstore

Leave a Comment / April 28, 2009

Ming Dynasty Portrait of Emperor

“Go to a Chinese bookstore”. This is my advice to anyone who wants to get a quick, accurate and comprehensible sense of what’s happening, and what’s most remarkable about this almost unfathomably large and complex country. 

Why a bookstore? Well, first, all of us have been to these in our own cities and countries. So, we have a good enough idea of what to expect in a boostore. It’s usually a quiet, not overly well-trafficked location, with people milling around in silence. Even in the larger US chains like Borders and Barnes & Noble, there’s always a somnolent feeling about the place, like the paying customers are too few to support the cost of the lease. Sadly, that’s often been the case and Borders, for one, has run into huge financial problems. 

Now, let me take you – at least in words – to the bookstore closest to my home when I’m in Shenzhen. It’s called Shenzhen Book City, and even from the outside doesn’t look like any bookstore I’ve ever seen elsewhere. It’s a seven-story blue-glass tower the size of an office building. A typical big-box two-story Borders looks like some kind of cutesy toy compared to Shenzhen Book City. 

It’s on the city’s main thoroughfare, Shennan Road, and just above ground from a subway station. It’s open from 10am to 10pm daily. Just approaching it, you have the happy feeling of being pulled into a giant vortex of human activity, as big crowds of people quickly move into the store, or head out of it. 

Inside, it’s more crowded and generating a more palpable sense of buzz than the crowd at a baseball game. There are readers everywhere, moving from section to section, floor to floor, or stopped in an aisle deeply concentrating on some book they’ve taken from the shelves. This is a picture of China in the process of continued self-improvement. It’s very inspiring, and bears only the faintest resemblance to any other bookstore I’ve been to, in the 70 of more countries I’ve visited. 

The checkout lines are long, at any hour of the day. There’s a huge staff spread around the place, answering questions, guiding people to the section they’re looking for. Of course, this being China, there are also places to eat – quite a few of them – in the bookstore itself. It’s also more than just a retailer. There are classrooms on the upper floors where people come to take paid classes on all kinds of subjects aimed at self-improvement, like foreign languages, or accounting. 

The Shenzhen Book City, single-handedly, restores my faith that a love of books and the pursuit of intellectual inquiry has not been completely deadened by YouTube, video games and chat rooms. 

Shenzhen has other Book Cities, spread around the city. The others I’ve been to are no less crowded – and my guess, no less successfully financially than the one in my neighborhood, which must be making a small fortune every day. Books aren’t all that cheap in China. They used to be. But, the quality and choice have both improved enormously over the years. Some of the cover art is as good as anything I’ve ever seen. 

Anyone from outside China would have some immediate familiarity on entering the place. It looks like other bookstores, with lots of aisles and bookshelves, grouped in sections by topic,  stacked with books. But, what isn’t going to be familiar is the sheer exuberance of the place. It’s more like a jam-packed department store on Xmas eve than a staid bookstore.  It’s got that same air of  “I’m here to spend money, now”. 

It’s somehow raucous and purposeful at the same time. 

Standing by the entrance one day, a woman approached, seemingly intent on discovering why I was so obviously awestruck by the whole scene.  I couldn’t convince her there was anything worthy of note – as what seemed like thousands of people surged in and out of a book store. As it turned out, she also provided a nice small lesson on the state of Shenzhen’s economy at the moment. Until recently, she’d been working in 外贸, “waimao”, or foreign trade in English. It’s a catch-all term for a lot of the economic activity in Shenzhen until recently, embracing trading, sourcing, import-export. 

With the sudden downturn in the world economy last year, many of the easiest opportunities to make money from foreign trade more or less evaporated, as did many of the small companies that carried out this kind of work. The woman lost her job, and just a short time later, found a new one as a clerk in the bookstore. In other words, she made the transition, quite smoothly by all appearances, from earning a living off exports to earning a living from the domestic economy. 

I wandered some more and found my way to the section selling business, management and career-guidance books. It was particularly jammed with people, heads down, buried in their books, as if cramming for a big exam. In their urgency, their evident hunger to learn, to improve, you could catch a glimpse of just what lies deepest within the remarkable economic transformation of China over the last 30 years. 

It’s all there for the viewing, in an ordinary Shenzhen bookstore. 

 

 

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China’s government — an example for the world on competent economic management

1 Comment / April 11, 2009

Yuan Dynasty blue-and-white porcelain vase

China’s government is managing very ably the global financial crisis, and continuing to deliver to its people a better standard of living. Yes, the economy in China is growing more slowly than it has over much of recent history, at around 7%-8%. But, overall, the country continues to bustle as nowhere else does. People still have spring in their step, and the same sense of boundless potential.

This is a measure of just how many things the Chinese government has done right economically. It’s a fact that’s too rarely remarked upon outside China, where the major talking points about China’s economy tend to be pollution, corruption and what’s seen to be the artificially-low level of the renminbi. This does a huge disservice to what’s been highly successful and competent management by China’s economic policy-makers. 

How good a job has the Chinese government done? Consider this: the country has managed, with relatively limited economic dislocation, the huge contractions in China’s export markets over the last year. Yes, factories have closed and workers have lost their jobs. This is a familiar enough boom-and-bust story in every country where manufacturing plays a big part in the overall economy. But, not long ago, most of China’s economic well-being was tied to its manufacturing exports. There was little other fuel for economic growth. 

China today is a very different place, economically, than it was even three years ago. The domestic market, not exports, is now the locomotive that’s pulling 1.4 billion people down the track. This shift was managed so deftly by the Chinese government that it’s hardly even been noticed outside China – and often inside as well. I run into a lot of Chinese who still believe that the fate of the nation is determined by the output of its assembly lines. Exports and manufacturing are still important, hugely so. But, they matter less than they did just a while back, and in the future, they will matter less. 

This shift away from manufacturing has caused huge ructions in other countries – just think of the endless labor strife in France, or Britain on the 1970s, and the persistent high unemployment in most other European countries. They have stumbled along, economically, as their competitive advantage in manufacturing was lost. 

In China, it’s a very different – and better – picture. There is so much economic opportunity here that people can, with far less disruption to their lives than in Europe, find new places to work and build a future. The Chinese government creates the circumstances that allow all this economic opportunity to occur. Again, the contrast with Europe is particularly marked. In Europe, economic activity is stifled by excessive regulations that set out who can do what, where, for how much. In China, the government, wisely, takes a much lighter approach to regulation, always with an eye focused on creating circumstance that will lead to new jobs, more activity, and more competition in most sectors of the economy. 

China’s government, rightly, does get credit internationally for the economic changes over the last 30 years that have lifted some 500 million people out of poverty. This is, unquestionably, the most important economic achievement of the last century, if not the last millennium. 

But, the policies that are generating China’s continued prosperity — the uplift that is carries as many Chinese into the middle class as were taken out of poverty — is much less well-followed and less-praised. That’s wrong. Arguably, it’s no less significant an achievement.

 

 

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

Leave a Comment / March 24, 2009

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

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

Here’s the first section. 

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

 

 

概  览chinese-balance

 

危机创造机遇

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

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

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

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

当我们跨入2009年时，全球经济进入衰退期已成为不争的事实。 

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

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

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

2009年，企业所有人和私募股权投资公司可以期待商业主题中的下列几点。 

行业整合与“质的飞跃”

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

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

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

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

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

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

利润增长为IPO的

重现提供了平台

 

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

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

 chart-1

 

 

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

对于私募股权投资者和风险投资者来说，这意味着他们需要做出巨大的改变。 

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

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

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

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

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

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

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

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

2009年，一个有着投资重点和帮助企业成长的私募股权投资公司会脱颖而出。

 

 


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

Leave a Comment / March 27, 2009

han-dynasty-coin

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

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

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

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

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

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

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

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

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

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

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

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

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

1 Comment / March 14, 2009

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

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

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

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

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

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

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

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

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

Private Equity and Strategic M&A Transactions in China 2009: A New Dawn

Leave a Comment / March 8, 2009

China First Capital, a boutique investment bank, releases comprehensive analysis of five key trends for 2009 in Private Equity, Venture Capital and M&A markets in China.jpg

My firm, China First Capital, just completed our annual report on Private Equity, Venture Capital and Strategic Mergers and Acquisitions in China. I had the biggest hand in writing it, so the opinions expressed are my own. My view, overall, is one of realistic optimism. China will continue to be the world’s most robust emerging market for private equity and venture capital finance, even in a very difficult global economic environment. A big reason for this is the continuing strong performance of many private SME companies in China, especially those focused on the domestic market, rather than exports. 

China First Capital has a special affinity for these strong private SMEs. They are the only companies we choose to work with. There a few reasons for this. A big one is my personal conviction that the most important predictor of a success in private equity investing is putting money into a company with a truly outstanding boss. Ideally, the boss will also be the entrepreneur who founded the company. 

You can do all the spreadsheet modeling and projections you want, but nothing else matters quite as much as the quality and drive of the leadership at the top. In many of the good Chinese SMEs, the boss is a first-class business strategist and opportunity-seeker. Give him a dollar and he’ll bring you back five. In many of China’s larger state-owned, or partially state-owned companies in China, the boss is often more a political animal, appointed to the job as much for skills as a bureaucratic infighter as for talents at managing a business. Give him a dollar and he’ll come back in a while and ask you to lend him another three. 

SMEs, no surprise, usually run circles around their state-owned competitors in China. That’s a big reason we choose to work exclusively for SMEs. Another reason: we prefer long-term partnerships with our clients rather than one-off deal-making of larger investment banks. We act as a financial and strategic advisor to Chinese SMEs in a long-term process that often begins at early stages of corporate development and continues through the capital raising process from private equity to a successful IPO and beyond to global leadership. 

Thanks to these Chinese SMEs,  China should be among the most attractive – and active – private equity investment markets in the world in 2009. Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Indeed, private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1 billion in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market.

Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.

The report, titled “Private Equity and Strategic M&A Transactions in China 2009”, identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are:

  1. the drive for industrial consolidation;
  2. profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA;
  3. increased importance of Convertible Debt and other hybrid financings;
  4. opportunities for strategic mergers and acquisitions;
  5. well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market.

Here’s the report’s first section. I’ll add more of it in later posts.

 

 Overview  chinese-balance

       

Turbulence creates opportunity

2008 was a year of extremes in China. Extremes of joy and pride, during the Beijing Olympics. Extremes of sadness and shock following the Sichuan earthquake. Even the climate reached extremes, during China’s crippling winter storms early in 2008. 

Financially, 2008 was also a year of extremes. The stock markets in Hong Kong, Shanghai and Shenzhen rose strongly in the first months of the year, and IPOs were plentiful. By mid-year, the markets began plunging, and IPOs dried up. By year-end, Shenzhen, Shanghai and Hong Kong were all down 60% for the year. 

China’s private equity and venture capital investments followed a similar turbulent course, beginning strongly, with over $10 billion invested in Chinese companies in the first half of the years, and then the pace of new investments slowed to a crawl.   

Governments in China, the USA and around the world intervened in an unprecedented fashion to stabilize the economy and the credit markets. As we enter 2009, there is no longer any doubt that the world economy is in recession. 

The question now is when will the recovery begin and when will be a good time to begin investing again? I want to offer a personal perspective to our valued relationships, both clients and the private equity firms we work with. As Chairman of China First Capital,  Ltd, with over 20 years of experience in the capital markets, private equity and business analytics, I’ve survived my share of business cycles. One example, I was CEO of a California venture capital company during the Dot-Bust years, the last time private equity investing came to a similar standstill. Within two years, deal activity and valuations resumed their upward momentum. 

My view: the overall investment environment in China remains challenging and the effects of 2008’s turbulence are still being felt. But, 2009 will be a year of unique opportunity for private equity, venture capital and mergers and acquisitions in China. Tough times can be the best time to make money. 

Consolidation and “flight to quality”

 

 

The Chinese economy is under significant strain as 2009 begins, with growth decelerating, factories closing by the thousands and unemployment rising. Many areas of China’s domestic economy are “over-saturated”, with too many companies competing with small market shares. China is ripe for consolidation. 

In the freely competitive markets, the weakest companies will perish. The stronger competitors will be able to add market share and enjoy the virtuous cycle of increasing volumes lowering unit costs, thus boosting profits that can be re-invested to lower still further costs of production.

Chinese consumers will respond as well, and reward with more of their money the better managed companies with the most efficient manufacturing and distribution. Out of this, stronger dominant brands will emerge, and this too will push for greater consolidation.

This process is just beginning in China. China’s domestic market is huge, second only to the US. In many vertical markets (including financial services, consumer goods, distribution and logistics, retailing, fashion), each point of additional market share in China can equate to tens of millions of dollars in additional revenue.

Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate Strong regional companies will acquire competitors elsewhere in China to become national powerhouses.   

For investors, the opportunities will be unparalleled to back the Chinese companies that will thrive during this process of consolidation.  The winners will be able to increase revenues and profits strongly and sustainably, even in a weak economy.

 

 

 

 

 

 

 

 

 

 

 

Stairway to Hell? IPO Activity in China Falls Off a Cliff

Leave a Comment / March 9, 2009

 

Not quite “a staircase to hell”, but the graphic below shows the steep fall in IPO activity in China in 2008. It looks pretty scary, doesn’t it? Chinese IPO activity in 2008 was at its lowest level since 2004. IPO activity basically came to a halt towards the end of last year. 

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No one looking at the table will see much room for optimism. But, it’s worth remembering that though down by almost 80% from the year earlier, IPOs of Chinese companies in 2008 still did manage to raise $20 billion of new capital. The key thing now is that this money is used well and wisely, to build profits and market share at these now-publicly-traded Chinese companies. By doing so, these companies will provide an impetus for companies and investors to get back into the IPO market. 

In other words, the IPO market in China is most attractive vibrant not when a company sees a big price jump in its first days of trading. This does little for company, and benefits mainly those who claimed an allocation of shares ahead of the IPO. The key driver for the IPO market should be that the capital raised in an IPO is used wisely, to put companies on a higher growth path. 

Higher profits will boost company valuation, and also allow newly-listed companies to more easily raise additional equity capital in the future. As I sometimes remind the Chinese laoban we work with, “an IPO should not be just a goal in itself, but also the cheapest way to raise additional capital to build your business even faster.” 

Take the money from a public listing to make more money: that’s the quickest way in which Chinese companies can do their part for reviving the IPO market and start building again the “staircase to heaven”, with annual gains every year in the amount of money raised through IPOs. 

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China M&A: 2008 Is A Record Year, And The Strong Growth Will Continue

Leave a Comment / March 8, 2009

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Even as IPO activity all but came to a standstill in 2008, China’s M&A market reached an all-time high in 2008, with almost USD$160 billion in deals completed, according to Thomson Reuters. This makes China the biggest M&A market in Asia, for the first time ever. 

This is an important development, and I expect China’s role as Asia’s largest M&A market will continue into the future, despite the current economic slowdown. The reasons: M&A deals in China will continue to make business and financial sense. China’s M&A activity in 2008 was almost equally split between purely domestic deals – where one Chinese company buys or merges with another – and the cross-border acquisitions where Chinese and foreign firms join together – either with the Chinese firm buying into the overseas business, or the foreign firm taking a stake in a Chinese one.  

I see huge scope for growth in both areas. China’s economy, though growing more slowly now than in recent years, is still expanding. Despite its vase size (China is now the world’s third-largest economy, trailing only Japan and the US) Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate. China’s private sector is filled with minnows, not whales. 

The result: there is ample room for consolidation in virtually every industry. Smaller firms will continue to merge, to gain both market share and scale economies. Strong regional companies will acquire competitors elsewhere in China to become national powerhouses. 

The M&A market, more than IPO activity, tends to holds up well even during sour economic times, or when stock markets fall. As share prices drop, the lower valuations make it cheaper for acquirers to act. We had evidence of this recently in the US, where one of the biggest M&A deals of all-time was recently announced: Pfizer’s planned acquisition of Wyeth Labs. 

In China, valuations for both quoted and private companies are lower than they were a year ago. That lowers the cost of acquiring a competitor. The cheapest way to build market share, at this point in China, will often be to buy it. 

All M&A transactions have risk. Very often, the planned-for gains in efficiency never materialize from combining two similar businesses. In China, the complexities go above and beyond this. There is due diligence risk – the difficulty of getting accurate financial information about an acquisition target – and management risk as well.  Good Chinese companies are  usually owned and run by a single strong Chairman, with scarce management talent around him. In a merger, the boss of the acquired company will often step aside, leaving a big hole in that company’s management, and so making it harder for the acquiring company to integrate its new acquisition. 

How to do M&A right in China? Good deal-structure and good advice are crucial. Structure can anticipate and resolve some of the larger post-acquisition headaches. Advice is important to make sure that the price and strategic fit are right. Just as China’s SMB’s need specialized merchant banks to serve their needs in raising capital, these SMBs, as they grow, will also need competent M&A advisors to identify target companies, manage the DD, do the valuation work, help negotiate the price, and assist with post-acquisition integration. 

Last year was a strong one for M&A in China. But, the future should be even brighter, once current economic uncertainty begins to abate.  Looking ahead, I see a real possibility that China’s M&A market will overtake America’s as the world’s largest. I’m planning for my company to play a part in this. 

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

Leave a Comment / March 9, 2009

chin-amulet-wanli-taichang

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

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

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

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

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

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

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

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

 

Home Is Where the Money Is: China Focuses on its Domestic Economy

Leave a Comment / March 8, 2009

It was President Richard Nixon who somewhat infamously remarked, “We’re all Keynesians now” in 1971, just about the time he launched a series of disastrous economic policies, including wage and price controls. This was right before Nixon’s fabled trip to China. 

Nixon is, of course, long gone, and a lot of Keynesianism theory has been discredited. But, China recently introduced its own brand of Keynesian-style economic stimulus package, totaling almost $600 billion. The purpose is to shore up the slowing Chinese economy, by increasing government spending by something like 15% of current annual gdp. That’s a very big chunk of change. 

Most of the money is meant to go towards infrastructure and poverty alleviation programs. It should help shield China’s economy from some of the ill effects likely to come from a recession in the US and Europe  – which for China, will mean slowing growth, if not an actual decline,  in exports and direct investment. 

The $600 billion stimulus package is an important sign of a larger change now underway in China’s economy. The huge domestic market, rather than exports, will be the main engine of growth from here on. This, in turn, bolsters the most compelling investment case for private equity investors in China.

The best investment opportunities will be those companies that have the products, services and potential to dominate in China’s domestic market. How to find these companies? The ideal businesses are those that already established themselves as high-quality producers for export markets, and are now turning their primary focus to the home market.  These companies already built manufacturing expertise and scale through exports. Ideally, they also continued to upgrade their OEM production to serve good global brands with higher-priced products, rather than as simply a low-cost, low-value producer.

An interesting comparison: this is the opposite of the strategy many of the best Japanese companies followed: they first achieved dominance in the very-competitive Japanese domestic market, then, battle-hardened, set out to conquer the world. Great examples of this are Toyota, Honda, Sony, Matsushita, Takeda Chemicals, Canon, Kao.

The Chinese approach is different, but no less powerful. Good Chinese companies have already mastered, through their OEM business, short product cycles and the importance of anticipating changing consumer taste.  Both are central to success in China’s domestic market as well.

At China First Capital, we’re fortunate to work with one client, Harson, that exhibits all the best characteristics of a Chinese business now building a dominant position in China’s domestic market. Harson began as an OEM manufacturer, and continually upgraded its manufacturing and product design to serve some of the best international brand names in its industry. Under its very able and far-sighted chairman, Harson then began, almost five years ago, to use that foundation to build its own domestic brand business in China.  That domestic business is now thriving, and moving forward, should account for over 60% of Harson’s projected $300mn in total revenues within two years.  

There will be no faster-growing large market in the world than China’s domestic market. The Chinese government will play a role, by spending on improving education and infrastructure. But, the great entrepreneurs, like Harson’s, will do even more to remake China over the next two decades and beyond by selling Chinese more of what they want and crave. 


Fraud in Private Equity Investing in China

Leave a Comment / March 8, 2009

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

Good article on improving the flow of bank lending to China’s strongest SMEs

Leave a Comment / February 10, 2009

This is the right approach to direct greater bank lending to China’s best and most credit-worthy small businesses. A more efficient loan market will improve the overall returns for private equity investors, as it will lower the cost of capital, during early phases of growth, for the best SMEs. 

 

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China’s Monetary Paradox

By PAUL CAVEY | From today’s Wall Street Journal Asia

China yesterday did what many economists expected it to, and cut both the lending rate and the reserve requirement on banks. The move is intended to serve as a classic monetary stimulus as China faces its biggest economic test since 1978. But a different, paradoxical, strategy might be better: a stimulative tightening.

On the face of it, China’s problems don’t look all that unusual in the region. Real export growth has slowed to around 10%, although the turmoil overseas suggests this is about to get much worse. The bigger problem is the domestic real estate market, the other main driver of Chinese growth, with sales contracting more than 50% in recent months. China is at risk of its first real simultaneous downturn in external and domestic demand growth since 1996.

The solution in a normal economy would be an interest rate cut. Indeed, Beijing yesterday cut the lending rate to 6.9% while also reducing bank reserve requirements by 0.5 percentage points (exact requirements vary by bank size), both moves intended to boost liquidity. The underlying structural cause of these economic problems is unique to China, however. Despite 30 years of economic reform, the most important price in the economy — the price of money — is still controlled.

The undervaluation of the yuan, which can be inferred from the tremendous build-up of foreign exchange reserves, has sparked overseas calls for revaluation. Beijing has responded, allowing the yuan to appreciate 8% or so this year. That rise has only encouraged further inflows, however, so Beijing has held interest rates low to avoid exacerbating the inflow problem. Combined, these policies are the classic recipe for a bubble. The liquidity inflow creates an excess supply of money, and low nominal interest rates — 7.2% at the moment, well below nominal GDP growth of 20% — create the excess demand.

Beijing’s response has been to cap loan growth through regulation. Banks have been ordered not to lend, instructions which in particular this year have been backed up with sterilization, the government’s soaking up of excess yuan. Bank lending growth is now around 15% a year. That’s a big number in absolute terms, but not in the context of China’s rapid growth. The stock of outstanding credit has fallen relative to the size of the economy, closing in on 100% of GDP now from 125% of GDP in 2003. In the same period credit in the U.S. has ballooned to almost 180% of GDP — not even including the liabilities of the super-leveraged financial sector.

At first blush it looks like China’s banking straightjacket has protected the banks from themselves and the economy from the banks, in contrast to events elsewhere. The problem is that these policies are preventing banks from developing the risk management and other skills needed to make them self-supporting commercial institutions.

It is the government that decides how much lending occurs. Within what are effectively credit quotas it would in theory make sense for the banks to lend to companies that have the best ability to repay. In practice, though, there is little value in being too choosy. Banks can fulfil their quota with profitable firms by lending to pretty much any company that walks into the bank on Jan. 1 each year. In this environment, it is likely that the banks lend almost exclusively to the customers they are most familiar with.

One consequence is that smaller start-ups in the private sector find it harder to get credit, despite relatively low interest rates. This is why it is so important for Beijing to raise rates to replace the banking straightjacket, the regime of administrative measures and sterilization that has controlled lending growth so far. Under this new policy, credit growth would be controlled via the price rather the quantity of money. Only then will China’s banks begin to learn how to judge risk, and thus wean themselves away from state-owned enterprises and start lending to the more dynamic private sector.

This transition would have huge economic consequences. Most evidence suggests the small private firms are the most productive in China, and are also the most employment-intensive. Their development is stunted because credit rationing denies them money from the banks. Instead, they are pushed to the informal credit market, where interest rates can be as high as 40%. Indeed, even a borrowing rate in the formal banking sector of 15%, more than double the current rate, would be low for the army of small and medium-sized enterprises.

Which is why a nominal tightening via an interest rate hike wouldn’t necessarily be a tightening in practice at all, if banks in the meantime are released from their straightjacket of administrative controls and sterilization. By encouraging banks to think for themselves and thus potentially giving smaller enterprises access to relatively more affordable bank credit, a policy of easing by tightening might end up being just what China needs.

Mr. Cavey is head of China economics at Macquarie Capital Securities.

 

 

Moving From Transaction-Based to Relationship-Based in China’s PE Business

Leave a Comment / February 10, 2009

The PE industry in China is growing up. Fast. There are two key factors are at work. The first is the onrush of cash. The second is the onrush of talent.

 

Billions of new money is flowing into the Chinese PE industry. This is in marked contrast with the situation elsewhere. There’s not a lot of appetite for committing capital for any purpose except to invest in China. Other, traditional large PE markets (US and European buyout funds) are in cyclical decline, owing largely to the problems in global credit markets. Then, too, there’s the announced intention of the China’s $75 billion social security  fund to begin investing more freely in private equity firms in China.   

 

The weight of all this new money entering the China PE market is having an interesting effect on valuations. While valuations have certainly come down over the last year, they arguably would have fallen faster and farther if not for all the new money looking for opportunities. It’s what financial markets like to call “the weight of money” argument – the more cash there is around, the higher prices will rise. 

That’s one side effect of the new money entering the market. The other is that the level of professionalism, across the board, is rising in the PE industry. There’s a good reason for this. As the pool of capital grows, so too does the demand for higher levels of fiduciary responsibility and accountability. This is evident not just in tightening DD procedures, of course, but also in the involvement in the PE investment process in China of some the world’s leading professional service firms. 

This past week, I met with a Hong Kong-based partner at one of America’s largest and best law firms. This firm has been very active in China’s IPO market the last five years, and served as lead counsel for many of the larger public offerings by Chinese companies in US exchanges. This is a great business, with very fat fees. But, it’s also a highly cyclical one. The IPO market has cooled this year. So,  this firm has now made the shrewd decision to work on some smaller PE deals, rather than just the +$100mn IPOs they’ve relied on in the past.  The upfront transaction fees are, of course, lower. But, by getting involved earlier in a company’s financing process, at the time of PE financing, this law firm believes that it will be building a very solid base for the future. 

The calculation is very sound. By working on a PE financing today, the law firm will be ideally-positioned to serve as IPO counsel several years down the line. In other words, the firm is moving from being “transaction-based” to “relationship-based” , from targeting only high-dollar one-off IPO transactions, to building a longer-term relationship with a select number of very promising pre-IPO Chinese companies. Over time, this should yield far more revenue for the law firms that follow this path. There’s money to be made advising on PE investment rounds, on Board matters, on M&A work, and litigation. 

In principle, it’s an obvious shift to make, and more closely reflects best practices in the legal profession. In fact,  a good law firm, like a good merchant bank, should choose its clients wisely, and then commit to serving and advising them over the long-term. 

For us, at China First Capital, this is very much at the heart of our operating ethos. For larger law firms, it can sometimes be a tougher shift to make. For one thing, their existing fee structures make it harder to work with smaller clients.  The law firms will often need to cut fees as a way of building these longer-term relationships. That’s not always easy to do in a large law firm, where all partners are expected to generate maximum revenues. 

But, this change in mindset is happening. I know from experience, since this big US firm has offered to work with several of our clients, on their PE financings, and to cap their fees at an appropriate level. This is a great thing for our clients, since it gives them access to the best legal counsel possible, at a time when it will make a significant positive difference. The PE firms stand to benefit as well, since it should raise standards overall. 

This shift from transactional focus to relationship-building is more proof that China’s PE market is coming of age, and building the infrastructure on which to prosper for many decades to come. 

Infinite Opportunities ÷ Finite Capital

Leave a Comment / March 8, 2009

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

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

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

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

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

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

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

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