Chinese Domestic Economy

Ideally Matched: Client and Investor

I’m just back in Shenzhen from a visit to a client in Kunshan, near Shanghai. For me personally, it was a particularly poignant trip. 

It’s the first time I’ve been back to Jiangsu since 1982, when I left Nanjing University. Thinking as much with my stomach as my head, I immediately on arriving at 9:30pm on Wednesday night cajoled Nina, my partner, to go on a late-night search of great Jiangsu food. I eventually lost count, but by the time I left, I must have had enough xiaolongbao to feed a nursery school.

 As thoroughly enjoyable as this “Jiangsu homecoming” was, it was not even close to being the highpoint of the trip. We spent two full-days with our client, in meetings with a very select number of Private Equity firms. The meetings, from my standpoint, were truly outstanding – a text-book example of how great businesses and a great institutional investors should interact.

In fact, our client and the PE investors were, to my eye, as well-matched as this pair of Tang Dynasty horses. 

As I told one of the PE partners afterward, I’ve been in a lot of initial meetings between companies and PE or VC firms. But, never was I involved in a investment meeting that was conducted at such a uniformly high level, with both company and investor executing at the highest level of accomplishment and professionalism. 

For the PEs, this was the second-round of meetings, following earlier ones in Shenzhen, with our client’s CFO, that focused primarily on the company’s financial performance. Our client’s core leadership and ownership, however, are both based in Kunshan. So, there was even more to discuss in this second round meeting. 

For our client, this was on-the-job training. They’ve built an enormously successful business, with sales this year in excess of $120 million, and a strong likelihood of becoming, within five years, a multi-billion dollar enterprise. But, the client has done all this without equity finance, using only retained earnings and bank debt. So,  they’d never before presented themselves to sophisticated and experienced equity investors.  They don’t come any more sophisticated and experienced that these particular PE investors, with track records, both as individuals and as firms, that put them at the top of their profession. 

Our client more than exceeded our highest expectations, preparing exhaustively and answering comprehensively. 

China First Capital works to find the right investor for its clients. Not the investor offering the highest valuation, or the quickest path to IPO. We give this a lot of thought, matching the strengths of our client to the strengths of a particular PE firm. Done right, it’s transformational for both company and investor: a case of the total value created not being just larger than the sum of the parts, but exponentially so. 

It’s early yet in the process. We’re planning on several more meetings with PE firms. But, I left Kunshan even more optimistic about our client’s future, building a great partnership with a PE investor. 

It may not sound like it, but it’s meant to be my highest compliment to both our client and the PE firms we met with this week:  the xiaolongbao were good. The meetings were better. 

China and the USA – same bed, same dream

The world’s largest and soon-to-be second largest economies, the US and China, don’t seem at first glance to have very much in common. The USA is a new country with an old political system. It’s a little appreciated fact that the US political system, coupling a federal democracy with capitalism, is now arguably the world’s oldest, since it’s been going for 232 years without major changes. China, by contrast, is a very old country – indeed the oldest of all nation-states – but with very new, fast-evolving political and economic systems.

And yet, there are some powerful similarities, ones that appeal directly to me as a builder and financier of private companies. In terms of raw entrepreneurial talent and ambition, China and the US are all but identical. Now, granted, American and Chinese entrepreneurship can often take very different forms — the US is a mature economy that grows at a solid but hardly spectacular pace. Technology plays a key part in many of the best new entrepreneurial ideas. Think of Google or Facebook. China is booming, and every year, millions of move from subsistence farming to relative abundance, from have-nots to consumers.  Opportunities abound, in the most basic industries like agriculture and mining, all the way to biotech and semiconductors.

Even so, the entrepreneurial foundation of both China and the US is plainly, and remarkably, visible. A reverence for hard work, vigorous personal ambition, a keen eye for spotting opportunity, these are qualities shared by the people of both countries. It’s why I am so optimistic about the prospects of both countries. And also why I think that China and the US are the two best markets for private equity and venture investment. Entrepreneurship, more than capital, is what drives the process of private equity finance.

Dig still deeper, and you find other important commonalities. In both China and the US, the government does not, thankfully, cripple what my favorite economist, Gary Becker of University of Chicago, calls “the dynamic energies of the competitive private sector”. My hope and belief are that this will continue to be the case for many years to come, and that China and the US will continue to offer great opportunities for building great private companies like those we work with at China First Capital.

There’s always a conflict, in every large economy, between those who want to regulate and tax the private sector, and those who want to maximize the room for businesses to operate free of burdensome regulations and high taxation. Seen in the broadest terms, the US and China are together following one path, and Europe and Japan are following another. China and the US are still open to high-levels of commercial competition with limited government intrusion. This makes both countries more friendly toward the new ideas of entrepreneurs. Europe and Japan, by contrast, are more regulated, more taxed, more anti-competitive, and so less hospitable to the entrepreneurship that drives China and the US.

Entrepreneurs create wealth. Governments don’t. It’s a fundamental reality best understood and practiced in the US and China – and best understood, as well, by those whose capital is placed at risk in private equity deals. Capital goes to where the risk-adjusted returns are greatest. Today, that’s China and the US.

 It will be true tomorrow as well. 

Eight Eight Oh-Eight

Today is a day of immense satisfaction and pride for the Chinese, and for those of us who aspire for China’s success and progress. The 2008 Beijing Olympics have begun, and quite literally, the eyes of the world are on China. A remarkable four billion people, or nearly 2/3 of the inhabitants of this planet, are expected to watch the Olympics over the next two weeks. The image many will form of China will be of a proud and ancient civilization restored to greatness. 

I celebrate the day, and its wider significance. It was 37 years ago, in the spring of 1971,  that I, along with most Americans of my generation and older,  got their first live televised glimpses of China. Nine American ping-pong players, accompanied by a larger number of American journalists, became the first official delegation to China since the founding of the People’s Republic in 1949. 

Less than a year later, Richard Nixon paid his historic visit. I was just a boy, but can still remember the excitement and awed wonder on seeing my first live images of the Great Wall, Tiananmen Square and the Summer Palace. It was also deeply inspiring. I was totally (and as it turns out, permanently) fascinated by China from the earliest age, and these images on the TV gave direction and purpose to my life even then. I had to learn Chinese and get to China!

It took a decade, but in 1981, I arrived in China for the first time, crossing the Lowu bridge on foot, arriving in a Shenzhen that was then a small border village of 30,000. Today, it is a city of over 13 million.  It was one of the happiest days of my life. I’d fulfilled that childhood goal of going to China. My goal changed that day, to one I’m still pursuing – building a deeper personal understanding of China, and a commitment to its future.  

I went straight to Beijing, and remember instructing the taxi driver at Beijing Station (in my very clumsy Chinese) to drive direct to Tiananmen. I spent the next few days, from my base at the Friendship Hotel out by Beida, riding trams and visiting the same places I’d seen on American TV 10 years earlier. I later took the train from Beijing to Nanjing, to do postgraduate work at Nanjing University.

It didn’t take long for me to realize that China’s greatest attraction wasn’t its historical sites, but its people. 

Then, as now, I felt deeply at home in China. The lesson: home is not just the place one is from, but where one feels the strong sense of belonging, comfort and happiness. For me, that makes China home, even when I’m far away, as now, in California.

Over the next two weeks, hundreds of millions of people will see their first live televised images of China. Some surely will form a goal similar to mine long ago – to study the culture and language of the country, and plan a visit someday.

I’m American by birth. Yet, my own ambitions, personal and professional with China First Capital, are to contribute to the continued transformation of China into a nation of great progress and prosperity. There is no greater reward than working for something larger than oneself.

For me, 8-8-08 is primarily a day to celebrate China’s achievement. It’s also a day when I celebrate the opportunity to work alongside smart and talented people committed as well to building and financing  the next generation of world-class Chinese businesses. 

 

IPO Exit Window — as it slams shut for US companies, it opens ever wider for Chinese ones

That sound you just heard was the IPO window slamming shut for venture and PE-backed companies in the US. In the second quarter of this year, not a single US company went public. This is the first time this has happened since 1978, when the US VC and PE industry was 1% its current size. In other words, these are unusually tough times for the US venture and PE community.

 

Will China soon follow suit? Not likely, in my view. In private equity, as in so many other industries, China and the US are becoming more and more decoupled. Chinese companies will continue to go public, on the US market, as well domestically and in other Asian markets, including Hong Kong and Singapore.  I remain very optimistic about the prospects of Chinese companies now getting PE and venture finance – and no less optimistic about how well many of these investments will do for the PE firms that are investing. For Chinese companies, IPOs and other exits, including trade acquisition,  will continue, at exit values that will reward those investing at typical pre-IPO multiples in China of 6-9x last year’s earnings.

 

Why the different path for Chinese and US companies backed by PE and VC firms? Start with the economy. The US is going through a period of very slow growth, close to, but not yet in, a recession. This, plus the effect of high oil prices, have weighed heavily on the US stock market, which in turn, limits the appetite among investors for IPOs by US companies. IPOs are traditionally far more difficult to arrange during a time of falling stock prices.

 

China’s stock market – as well as those of Singapore and Hong Kong – have followed the US down. That correlation between stock markets still exists. But, even during a down market, Chinese companies can still succeed with a public offering. In Hong Kong, whose overall market has fallen by 18% so far this year, Chinese companies are still going public at a rate of about one a day.

 

What explains this? A big part of it, in my view, is that too much venture and equity capital in the US has gone into technology and biotech, and less to established and profitable businesses. Don’t get me wrong. The technology market in the US is great, and I’m still active in the US venture community. But,  this heavy concentration on two sectors, technology and biotech, is itself a cause of the IPO drought of 2008. Those two industries tend to be both hyper-competitive and volatile. For every Google that goes public, there are dozens of tech companies that take VC funding and then disappear without a trace. A huge percentage of the venture funding goes to early-stage businesses, with zero or limited revenues, and perhaps only some untested IP.

 

So, while American VCs bet heavily on two high-risk/high-reward industries, the overall stock market is made up of many different sectors, with different rates of growth, maturity and different capabilities to respond to competition. In fact, the vast majority of companies listed on the US exchanges aren’t in the technology or biotech industries.

 

Let’s look now at Chinese companies getting PE and VC funding and going public. They are drawn from a far wider range of industries than their US counterparts. The Chinese PE market doesn’t focus on technology companies, or biotechs, or indeed on any single industry. This is a great strength. Chinese companies getting equity finance and then an IPO exit reflect, far more broadly, the overall composition of the stock market, and so the overall investor demand.

 

The other key differentiator  – the Chinese economy continues to grow strongly. It’s increasingly powered by domestic consumption, and will be for decades to come. This, in itself, creates enormous opportunities for the creation of very valuable businesses serving the Chinese domestic market – example:  consumer goods and the businesses that supply those producers.  We are working with a client that manufactures a key component used in disposable diapers, a market that will likely grow by upwards of 50% a year. Fewer than 15% of China’s babies are being swaddled in disposable nappies, compared to over 90% in most middle income countries.

 

My conclusion – as long as private equity capital in China continues to flow into great companies in a wide variety of industries, particularly ones that service the domestic economy, the Exit Window will remain not only open, but ever-larger.