Chinese Government Policy

IPO rules overhauled for PE and VC firms — China Daily

Leave a Comment / May 1, 2014

China Daily article

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Shanghai stock exchange trading floor

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Friday, January 3, 2014

Private equity and venture capital firms will have to conduct their business differently in China in 2014, after regulators overhauled initial public offering rules.

Chinese PE and VC companies used to evaluate the companies by the standards of the China Securities Regulatory Commission for quicker IPOs, but now the market will play a more important role, said Peter Fuhrman, chairman, founder and chief executive officer at China First Capital.

“Under the new IPO system, the share pricing of an IPO company is decided by its strength and competitiveness, so investors will choose companies with real potential to invest in and provide them with the resources of strategy, management and market development to make their own return the best,” said Fuhrman *.

Private equity and venture capital firms will not find it easy to earn money any more after the new share-listing reform plan is carried out, because even if the companies they invested in get listed, they will still face the risk of losses, said Jin Haitao, chairman of leading Chinese equity investment firm Shenzhen Capital Group Co Ltd.

Jin said PE and VC institutions should cultivate real investment capabilities including those in value-discovery and negotiating. Pre-IPO deals cannot be guaranteed to earn money any more.

A total of 83 Chinese companies completed the examination and received approval from the China Securities Regulatory Commission. About 50 are expected to have finished all IPO procedures and be listed before the end of January. More than 760 companies are in line for approval. It will take about a year to audit all the applications.

In the IPO reform plan announced at the end of November, information disclosure has become more important and the China Securities Regulatory Commission will only be responsible for examining applicants’ qualifications, leaving investors and the markets to make their own judgments about a company’s value and the risks of buying its shares.

More and more Chinese companies applying for IPOs asked for cooperation with multinational accounting institutions, according to Hoffman Cheong, an assurance leader at Ernst & Young China North Region.

Cheong said the information disclosed can be different after the IPO reform plan is carried out.

According to the IPO reform plan, so long as an issuer’s prospectus is received by the commission, it will be released on the commission’s website. The company should buy back shares if there is a false statement or major omission. Also it should compensate investors if they lose money in certain situations.

http://www.chinadailyasia.com/business/2014-01/03/content_15109395.html

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(* Note: I never spoke to the reporter. As far as I can tell, the quote was translated into English, rather clumsily, from a Chinese-language commentary of mine published recently in a Chinese business publication. If asked, I would have said that companies need to choose PE investors carefully, and vice versa.)–

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SOE Reform in China — Big Changes On the Way

Leave a Comment / December 24, 2013

Qianlong emperor calligraphy

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China’s state-owned enterprises (SOEs) are a lucky breed, or so conventional wisdom would have it. They have lower cost of capital and less competitive pressures of private sector competitors. China’s big banks (also state-owned) are always happy to lend, and if things do turn sour, China’s government will bail everyone out.

The reality, however, is substantially different and substantially more challenging. SOEs live in a different world than they did ten, or even three years ago. They are more and more often under intensifying pressure to achieve two incompatible goals: to continue to expand revenues by 15%-25% a year, but to do so without corresponding large increases in net bank borrowing. The result, over time, will be that SOEs will need to rely increasingly on private sector capital to finance their future growth.

This message came through especially loud and clear in the policy document published by the Chinese leadership after the recent Third Party Plenum in November.  SOEs are told they need to become more attuned to the market and less dependent on government favors and protection. This new policy pronouncement is reverberating like a cannon blast inside the state-owned economy, based on conversations lately with the top people at our large Chinese SOE clients.

No one at these SOEs is entirely sure how to fulfill the orders from above. But, they are all certain, from long years of experience, that the environment SOEs operate in is going to undergo some significant change, likely the most significant since the “Great Cull” of the mid-1990s when thousands of SOEs were pushed into bankruptcy.Too many of the surviving SOEs have done little more than survive over the last twenty years. They managed to stay in the black, sometimes by resorting to rather idiosyncratic accounting that ignored depreciation.

The Chinese leadership is embarking on a tricky, somewhat contradictory, mission:  to simultaneously shake up the SOE sector, make it more efficient and responsive to market forces,  while keeping SOEs embedded in the foundation of China’s economy.  Much has changed about the way Chinese leaders view and manage SOEs. But, a key principle remains intact. The architect of the policy, Deng Xiaoping, put it this way, ” As long as we keep ourselves sober-minded, there is nothing to be feared. We still hold superiority, because we have large and medium state-owned enterprises.”

In other words, SOE privatization is not on the menu, at least not in any large-scale way. SOEs, particularly the 126 so-called “centrally-administered SOEs” (央企)  will remain majority-owned by the government. The government is suggesting, however, it wants these SOEs, as well as the other 100,000 or so smaller ones active in most parts of the Chinese economy, to be run better and more profitably. But how? That’s the a topic of discussions I’ve been having over the last month with the bosses at our SOE clients.

The rate of return (as measured by return on assets) at SOEs has, in almost all cases, drifted down over the last ten years, and is now probably under 3% a year.  If bank borrowing and depreciation were more properly amortized, the rate of return would likely turn negative at quite a lot of SOEs.

In some cases, this reflects the cruel reality that many SOEs operate in low-margin highly-commoditized industries. But, another key factor is that the government body that acts as the owner of most SOEs, SASAC (国资委), is not your typical profit-maximizing shareholder.

SASAC manages the portfolio of SOE assets like the most risk-averse executor. It demands three things above all from SOEs: don’t lose money;  don’t pilfer state assets and keep revenues growing.

When your owner sets the bar a few inches off the ground, you don’t try to break the Olympic high jump record. No SOE manager ever got a bonus, as far as I’ve heard, from doubling profits, or improving cash flow. Pay-for-performance is basically taboo at SOEs. The whole SOE system, as it’s now configured, is designed to produce middling giants with tapering profits.

Rather than shake-up SASAC, the country’s leaders have given SOEs a green light to seek capital from outside sources, including private equity and strategic investors. They should provide, for the first time, a voice in the SOE boardroom calling for higher profits, higher margins, bigger dividends.

It’s a wise move. SOEs need to carry more of the load for China’s future gdp growth. You can’t do that when you are achieving such low return on assets. Among the SOEs we work with, there’s a genuine excitement about bringing in outside investment, and operating under a new, more strenuous regime. Surprised? The SOEs I know are run by professional managers who’ve spent much of their careers building the business and take pride in its scale and professionalism. They, too, see room for improvement and see the downsides of SASAC’s approach.

Outside capital can help these SOEs finance their future expansion.  It could also open new doors, especially in international markets. The big question: can — will — private equity, buyout firms, global strategic investors seek out investments in Chinese SOEs? It’s unfamiliar terrain.

Earlier this year, I arranged a series of meetings for twelve of the world’s-largest PE firms and institutional investors to meet a large SOE client of ours. These firms collectively have over $700 billion in capital, and each one has at least ten years’ experience in China. They are all keen on this particular deal. Yet, none of these firms have invested in any SOE deals over the last five years. For many of the visiting PEs, it was their first time ever meeting with the boss of a profitable and successful SOE to discuss investing.

In this case, it looks like a deal will get done, and so provide a blueprint for future PE investing in Chinese SOE.  The Chinese leadership ordered a shakeup to the state owned sector. It’s getting one.

 

China’s IPO Freeze to Melt in Midwinter

Leave a Comment / December 2, 2013

Kesi embroidery

IPOs are returning to China. The China Securities Regulatory Commission this weekend announced its long-awaited guidelines on a new, somewhat liberalized process for approving IPOs. The rush is now on to get new IPOs approved and the money raised before Chinese New Year, which falls on January 31st, less than two months from now. Ultimately, the CSRC hopes to clear within one year the backlog of over 800 Chinese companies now with IPO applications on file. Thousands of other Chinese companies are waiting for the opportunity to submit their IPO plans. The CSRC stopped accepting new applicants almost 18 months ago.

From what I can tell, the CSRC has concluded, rightly, its old IPO approval process was broken beyond repair. The regulator used to take primary responsibility for determining if a Chinese company was stable enough, strong enough, honest enough to be trusted with the public’s money. No other securities regulator took such a hands-on, the “buck stops with me” approach to IPO approvals. The CSRC now seems prepared to pass the buck, in other words, to put the onus where it belongs, on IPO applicants, as well as the underwriters, lawyers and accountants.

This should eliminate the moral hazard created by the old system. Companies, as well as their brokers and advisors, had a huge amount to gain, and much less to lose, by submitting an application and hoping for a CSRC approval. They could cut corners knowing the CSRC wouldn’t. For the successful IPO applicants who got the CSRC green light, valuations were sky-high, and so were underwriting and advisory fees.

Going forward, the CSRC seems determined to switch from security guard to prosecutor. Rather than trying to detect and prevent all wrongdoing, it is now saying it will punish severely companies, and their outside advisors, where there’s a breach in China’s tough securities laws. The CSRC’s powers to punish any wrongdoing are significant. Heaven help those who end up being convicted of criminal negligence or fraud. As I noted before,  there are no country club prisons in China for white collar offenders.

While baring its sharp teeth, the CSRC is also now using its more soothing voice to tell retail stock market investors they will need to do more of their own homework. It wants more and better disclosure from companies. It hopes investors will read before buying. And, the CSRC also hopes the stock market will itself begin to provide investors will clearer signals, through share price movements, on which companies may not be suitable for the more risk-averse.

Up to now, companies going public in China did so with a kind of “CSRC Warranty”. That’s because the CSRC itself said it had already done far more detailed, forensic scrutiny of the company than just reading through its public disclosure documents. The approval process could take two years or more, with company execs, lawyers and accountants being called frequently to meetings at the CSRC headquarters to be grilled. All this to give comfort to investors that nothing was awry.

The warranty has effectively been revoked. This may make some investors more nervous, but it represents a significant and positive breakthrough for the CSRC.

It needs to lighten its grip. Markets need regulation, need rules and effective mechanisms for punishing bad actors. But, the CSRC took on too much responsibility for assuring the orderly functioning of China’s stock market. This was always going to be difficult. China’s stock markets are far more prone to speculative frenzy than stock markets in the US, Europe. Shares on the Shanghai and Shenzhen stock markets are bought and sold mainly by retail investors, or as the Chinese say, “old granddads and grannies” (老爷爷老奶奶）. Institutional investors are a minority. As for investment fundamentals, on China’s stock market there are mainly just two:  “Buy on rumor. Sell on rumor”.

Over the last year, I’ve written about problems at the CSRC that helped cause and prolong this long freeze in IPOs. The CSRC’s first instinct back in 2012 was to try to toughen its regulation, toughen its own internal systems and procedures for rooting out fraud. It then switched tracks, and decided to let the market play more of a role.  This is a major concession, as well as important proof that China’s larger process of economic transformation, of freeing rather than freezing markets, is headed in the correct direction.

As if on cue, this past week’s Wall Street Journal last week digested a section from the Nobel Prize acceptance speech by economist Friedrich Hayek.

“To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm…Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. ”

I’m delighted China’s IPO market is going to re-open. My own prediction here a couple of months ago was that it IPOs would resume around now, rather than next month. This just goes to show all forms of market timing — whether it’s trying to guess when a stock price has hit its peak or when a stock market itself will change course, and its once omnipotent regulator change its entire approach — is a fool’s errand.

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Private Sector Capital for China’s SOEs — China First Capital Press Release

Leave a Comment / July 16, 2014

China First Capital press release

Hong Kong, Shenzhen, China:  China First Capital, an international investment bank and advisory firm focused on China, today announces it has received a pioneering mandate from a large Chinese State-Owned Enterprise (“SOE”) holding company to manage a process to revitalize and privatize part of the group by bringing in private capital.

“The investment environment for SOE deals in China is undergoing a significant and exciting change,” commented China First Capital chairman and founder Peter Fuhrman. “We are proud to play a role as investment bankers and advisors in this change, by working with some of China’s SOEs to complete restructuring of unquoted subsidiaries and then raise private sector capital to finance their future expansion. We see these SOE investment deals as the next significant opportunity for institutional investors eager to allocate more capital to China.”

By some estimates, China’s SOEs account for over 60% of total Chinese GDP. Yet, up to now, they have only rarely done private placements or spinoffs to access institutional investment, including from private equity firms. But, according to China First Capital’s internal research, an increasing number of China’s SOEs will face a funding gap in coming years. SOEs, in most cases, have ambitious expansion plans fully supported by the Chinese government. Yet, the SOEs are restricted in their ability to raise large amounts of new bank loans. They are under pressure from Chinese government to maintain or lower their debt-to-equity ratios.

More…

Neue Zurcher Zeitung Interview

 

The China IPO Embargo: How and When IPOs May Resume

Leave a Comment / September 26, 2013

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China IPO

China first slowed its IPO machinery beginning July 2012 and then shut it down altogether almost a year ago. Since then, about the only thing stirring in China’s IPO markets have been the false hopes of various analysts, outside policy experts, stockbrokers, PE bosses, even the world’s most powerful investment bank.  All began predicting as early as January 2013 the imminent resumption of IPOs.

So here we are approaching the end of September 2013 with still no sign of when IPOs will resume in China. What exactly is going on here? Those claiming to know the full answer are mainly “talking through their hat“. Indeed, the most commonly voiced explanation for why IPOs were stopped — that IPOs would resume when China’s stock markets perked up again, after two years of steady decline — looks to be discredited. The ChiNext board, where most of China’s private companies are hoping to IPO, has not only recovered from a slump but hit new all-time highs this summer.

Let me share where I think the IPO process in China is headed, what this sudden, unexplained prolonged stoppage in IPOs has taught us, and when IPOs will resume.

First, the prime causal agent for the block in IPOs was the discovery in late June last year of a massive fraud inside a Chinese company called Guangdong Xindadi Biotechnology.  (Read about it here and here.)

This one bad apple did likely poison the whole IPO process in China, along with the hopes of the then-800 companies on the CSRC waiting list. They all had underwriters in place, audits and other regulatory filings completed and were waiting for the paperwork to be approved and then sell shares on the Shenzhen or Shanghai stock exchanges. That was a prize well worth queuing up for. China’s stock markets were then offering companies some of the world’s highest IPO valuations.

After Xindadi’s phony financials were revealed and its IPO pulled, the IPO approval process was rather swiftly shut down. Since then, the CSRC has gone into internal fix-it mode. This is China, so there are no leaks and no press statements about what exactly is taking place inside the CSRC and what substantive changes are being considered. We do know heads rolled. Xindadi’s accountants and lawyers have been sanctioned and are probably on their way to jail, if they aren’t there already A new CSRC boss was brought in, new procedures to detect and new penalties to discourage false accounting were introduced.  The waiting list was purged of about one-third of the 800 applicants. No new IPO applications have been accepted for over a year.

IPOs will only resume when there is more confidence, not only within the CSRC but among officials higher up, that the next Xindadi will be detected, and China’s capital markets can keep out the likes of Longtop Financial and China MediaExpress, two Chinese companies once quoted on NASDAQ exchange. They, along with others, pumped up their results through false accounting, then failed spectacularly.  Overall, according to McKinsey, investors in U.S.-listed Chinese companies lost 72% of their investment in the last two years.

China’s leadership urgently does not want anything similar to occur in China. That much is certain. How to achieve this goal is less obvious, and also the reason China’s capital market remains, for now, IPO-less.

If there were a foolproof bureaucratic or regulatory way for the CSRC to detect all fraudulent accounting inside Chinese companies waiting to IPO in China,  the CSRC would have found it by now. They haven’t because there isn’t. So, when IPOs resume, we can expect the companies chosen to have undergone the most forensic examination practiced anywhere. The method will probably most approximate the double-blind testing used by the FDA to confirm the efficacy of new medicines.

Different teams, both inside the CSRC and outside, will separately pour over the financials. Warnings will be issued very loudly. Anyone found to be book-cooking, or lets phony numbers get past him,  is going to be dealt with harshly. China, unlike the US, does not have “country club prisons” for white collar felons.

The CSRC process will turn several large industries in China into IPO dead zones, with few if any companies being allowed to go public. The suspect industries will include retail chains, restaurants and catering, logistics, agricultural products and food processing. Any company that uses franchisees to sell or distribute its products will also find it difficult, if not impossible, to IPO in China. In all these cases, transactions are done using cash or informal credit, without proper receipts. That fact alone will be enough to disqualify a company from going public in China.

Pity the many PE firms that earlier invested in companies like this and have yet to exit. They may as well write down to zero the value of these investments.

Which companies will be able to IPO when the markets re-open? First preference will be for SOEs, or businesses that are part-owned by or do most of their business with SOEs. This isn’t really because of some broader policy preference to favor the state sector over private enterprise. It’s simply because SOEs, unlike private companies, are audited annually, and are long accustomed to paper-trailing everything they do. In the CSRC’s new “belt and suspenders” world, it’s mainly only SOEs that look adequately buckled up.

Among private companies, likely favorites will include high-technology companies (software, computer services, biotech), since they tend to have fewer customers (and so are easier to audit) and higher margins than businesses in more traditional industries. High margins matter not only, or even mainly, because they demonstrate competitive advantage. Instead, high margins create more of a profit cushion in case something goes wrong at a business, or some accounting issue is later uncovered.

The CSRC previously played a big part in fixing the IPO share price for each company going public. My guess is, the CSRC is going to pull back and let market forces do most of the work. This isn’t because there’s a new-found faith in the invisible hand. Simply, the problem is the CSRC’s workload is already too burdensome. Another old CSRC policy likely to be scrapped: tight control on the timing of all IPOs, so that on average, one company was allowed to IPO each working day. The IPO backlog is just too long.

The spigot likely will be opened a bit. If so, IPO valuations will likely continue to fall. From a peak in 2009, valuations on a p/e basis had already more than halved to around 35 when the CSRC shut down all IPOs.  IPO valuations in China will stay higher than, for example, those in Hong Kong. But, the gap will likely go on narrowing.

What else can we expect to see once IPOs resume? Less securitized local government borrowing. Over the last 16 months, with lucrative IPO underwriting in hibernation,  China’s investment banks, brokerage houses and securities lawyers all kept busy by helping local government issue bonds. It’s a low margin business, and one not universally approved-of by China’s central government.

How about things that will not change from the way things were until 16 months ago? The CSRC will continue to forbid companies, and their brokers, from doing pre-IPO publicity or otherwise trying to hype the shares before they trade. If first day prices go up or down by what CSRC determines is “too much”, say by over 15%, expect the CSRC to signal its displeasure by punishing the brokerage houses managing the deals.  The CSRC is the lord and master of China’s IPO markets, but a nervous one, stricken by self-doubt.

China needs IPOs because its companies need low-cost sources of growth capital. When IPOs stopped, so too did most private equity investment in China. It’s clear to me this collapse in equity funding has had a negative impact on overall GDP, and Chinese policy-makers’ plans to rebalance its economy away from the state-owned sector. It’s a credit to China’s overall economic dynamism, and the resourcefulness of its entrepreneurs,  that economic growth has held up so well this past 18 months.

IPOs in China are a creature of China’s administrative state. Companies, investors, bankers, are all mainly just bystanders. Right now, the heaviest chop to lift in China’s bureaucracy may be the one to stamp the resumption of IPOs. So, when exactly will IPOs resume? Sometime around Thanksgiving (November 24, 2013) would be my guess.

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China SOEs — How They Think and Why

Leave a Comment / December 15, 2013

– China First Capital blog There are many flavors of State-Owned Enterprise (“SOE”)  in China, from polluting monster chemical factories to quaint dumpling houses that date from before the revolution.  Since coming to China, I’ve seen up-close quite a number SOEs, probably more than most other non-Chinese. No two are quite alike. But, equally, SOEs in China, from the largest centrally-administered “national champions” (known as 央企, or “yangqi”, in Chinese and include such familiar names like Sinopec, China Mobile, ICBC) that earn billions in profits every year to smaller local loss-making industrial companies with a few hundred employees, share a similar genetic code. Or more precisely, provide the same iron rice bowl.

That phrase (铁饭碗 ) was widely used during Mao’s time, and I still heard it frequently when I first came to China 1981.  It’s since faded from common use. But, the concept remains embodied within all SOEs. Simply put, an “iron rice bowl” means a job for life, and so a life without the worry of going unfed. In today’s China, with the threat and the memory of famine now extinguished, it’s more a way of expressing the unique way an SOE functions, how it views its role in society and the benevolent — some might say paternalistic — way it cares for its employees.

An SOE is, above all,  a very Chinese institution, and in many ways, one of the few holdovers from the Maoist era.  Chinese then didn’t so much work for a company as they belonged to a “work unit“, a 单位 (“danwei”). A paying job was in some senses the least important thing provided by one’s work unit, since cash salaries used to be very low, under $10 a month for mid-level managers. Instead, one’s work unit provided housing, schools, communal heating, medical care, ration tickets, permission to marry, to travel or have a child, subsidized meals and fresh food.

In theory, the work unit was the Great Provider, anticipating and meeting all of one’s needs in life. In practice, of course, it offered not a lot more than a very rudimentary existence and a job for life. For most Chinese, especially all working for private sector companies, the danwei system was dismantled ten years ago. A job is just a job, not a lifetime meal ticket.

But, for those working at SOEs, many of the more desirable features of the danwei system have been preserved, starting with the fact you are very unlikely ever to be fired. What’s more, the company itself is also highly unlikely to ever go bankrupt or face a serious crisis that would lead to mass layoffs.  Today’s SOEs hold, in effect, a permanent right to operate, regardless of market conditions.

China’s current group of SOEs are a privileged rump, those spared from a massive cull over ten years ago. That put the worst, least efficient SOEs out of business, and forced tens of millions to take early retirement or go off in search of new jobs, mainly in the private sector.

SOEs, along with the military and the Party, are the third of China’s key pillars of state power. While each is subject to the control of the country’s leadership, each also operates, to some extent,  by rules of its own. Chinese leaders are known to complain, at times, about the power, wealth and influence of the country’s larger SOEs.

SOEs are ultimately kept in business by other SOEs — loans from the state-owned banks, and orders or supplies from fellow SOEs. In most cases, they have a marked preference for doing business with one another.  Partly, this is because SOEs tend to understand better the way other SOEs think and act. Partly, it’s also because SOEs function together as mutual assistance society. If one gets in trouble, others will either voluntarily help out, or be ordered to do so by SASAC （“国资委”）, the government organization that manages Chinese SOEs.

SOE jobs usually pay less than private sector competitors. But, for many, that’s more than compensated by the perks that come with the job. While Google is famous for its free food and recreation areas,  an SOE has its own attractions, tailored to the tastes of its Chinese employees. Workloads tend to be modest, and a long lunchtime siesta is built into every working day. During winter, the company will often provide extra cash to pay for heating.

There is, in my experience, an obvious camaraderie among SOE workers,  a shared identity and pride working for what are usually very large, well-known companies that tower over their private sector competitors and neighbors. If not always in practice, at least in theory, an SOE is meant to be in business for the benefit of all of China, not to accumulate profits or generate wealth purely for its shareholders.

It’s a noble mission, but one that can lead to its own rather systematic form of inefficiency. Urged on by SASAC, they set ambitious growth targets every year to increase output. They achieve this, in most cases, by pouring more borrowed money into new capital equipment, often to produce products the government says China needs or wants. The amounts invested, and the returns on those investments, tend to move in opposite directions.

SOEs can borrow at half the cost of private sector companies. Their hurdle rate is also often half that, or less, than private companies’.  As a result, projects with limited financial rationale often get built.

Take LEDs, solar and wind power. All three were heavily over-invested by SOEs because the Chinese government had made such “green energy” projects a national priority. More energy was probably consumed forging the steel and building factories and equipment to produce LED assemblies, solar panels and wind turbines than has been saved by lowering overall energy use in China. A lot of these LED, solar and wind projects are now mothballed, due to losses and falling demand.

Part of what SOEs exist to do is to take government economic policy and turn it into hard, if sometimes not very productive, assets. That outlook, of course, also impacts the way SOE staff work. Their pay isn’t linked to profits any more than company-wide strategy is.

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Why China PE will rise again — Interview in China Law & Practice Annual Review 2013

2 Comments / March 11, 2014

—CLP

 

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Peter Fuhrman, chairman of China First Capital, talks to David Tring about his company’s disciplined focus, what the IPO freeze means for PE investors and how a ruling from a court in China has removed a layer of safety for PE firms

What is China First Capital?

China First Capital is a China-focused international bank and advisory firm. I am its chairman and founder. Establishing, and now running, China First Capital is the fulfilment of a deeply-held ambition nurtured for over 30 years. I first came to China in 1981, as part of a first intake of American graduate students in China. I left China after school and then built a career in the US and Europe. But, throughout, I never lost sight of the goal to return to China and start a business that would contribute meaningfully and positively to the country’s revival and prosperity.

China First Capital is small by investment banking industry standards. Our transaction volume over the preceding twelve months was around $250 million. But, we aim to punch above our weight. China First Capital’s geographical reach and client mandates are across all regions of China, with exceptional proprietary deal flow. We have significant domain expertise in most major industries in China’s private and public sector, structuring transactions for a diversified group of companies and financial sponsors to help them grow and globalise. We seek to be a knowledge-driven company, committed to the long-term economic prosperity of Chinese business and society, backed by proprietary research (in both Chinese and English), that is generally unmatched by other boutique investment banks or advisory firms active in China.

What have been some of the legislative changes to the PE sector this year that are affecting you?

The recent policy and legislative changes are mainly no more than tweaks. There has been some sparring within China over which regulator would oversee private equity. But, overall, the PE industry in China is both lightly and effectively regulated. A key change, however, occurred through the legal system within China, when a court in Western China invalidated the put clause of a PE deal done within China, ruling that the PE firm involved had ignored China’s securities laws in crafting this escape mechanism for their investment.  While the court ruled on only a single example, the logic applied in this case seems to me, and many others, to be both persuasive and potentially broad-reaching. For PE firms that traditionally added this put clause to all contracts they signed to invest in Chinese companies, and came to rely on it as a way to compel the company to buy them out after a number of years if no IPO took place, there is now real doubt about whether a put clause is worth the paper it’s printed on. Simply put, for PE firms, it means their life-raft here in China has perhaps sprung a leak.

What are some of the hottest sectors in China that are attracting PE investors?

At the moment, with IPOs suspended within China and Chinese private companies decidedly unwelcome in the capital markets that once embraced them by the truckload – the US and Hong Kong – there are no hot sectors for PE investment in China now. The PE industry in China, once high-flying, is now decidedly grounded and covered in tarpaulin. What is perhaps most unfortunate about this is that what we are seeing mainly is a crisis within China’s PE industry, not within the ranks of China’s very dynamic private entrepreneurial economy. In other words, while financing has all but dried up, China’s private companies continue, in many cases, to excel and outperform those everywhere else in the world. The PE firms made a fundamental miscalculation by pouring money into too many deals where their only method of exit, of getting their money back with a profit, was through an IPO. By our count, there are now over 7,500 PE-invested deals in China all awaiting exit, at a time when few, if any exits are occurring. Since PE firms themselves have a finite life in almost all cases, this means over $100bn in capital is now stuck inside deals with no high-probability way to exit before the PE funds themselves reach their planned expiry. The PE industry has never seen anything quite like what is happening now in China.

What is a typical day like for you at China First Capital?

We are lucky to work for an outstanding group of companies, mainly all Chinese domestic. Indeed, I am the only non-Chinese thing about the business. I am in China doing absolutely what I love doing. There are no aspects of my working day that I find tedious or unpleasant. Even at my busiest, I am aware I am at most a few hours away from what the next in an endless series of totally delicious Chinese meals. That alone has a levitating effect on my spirit. But, the real source of pleasure and purpose is in befriending and working beside entrepreneurs who are infinitely more skilled, more driven and wiser to the ways of the world and more successful than I ever could hope to be.

We are quite busy now working for one of China’s largest SOEs. It’s something of a departure for us, since most of our work is with private sector companies. But, this is a fascinating transaction that provides me with a quite privileged insider’s view of the way a large state-owned business operates here in China, the additional layers of decision-making and the unique environment that places far greater onus on increasing revenues than profits.

What do you find are some of the major issues or concerns for foreign PE clients when doing deals in China?

All investors looking to make money in China, whether on the stock market or through private equity and venture capital,  must confront the same huge uncertainty – not that China itself will stop its remarkable economic transformation and stop growing at levels that leave the rest of the developed world behind in the dust. This growth I believe will continue for at least the next 20 years. The big unknown has to do with the actual situation inside the Chinese company you are buying into. Can the financial statements and Big Four audits be relied on? Are the actual profits what the company asserts them to be? How great is the risk that investors’ money will disappear down some unseen rat hole?

Some frightening stories have come to light in the last two years. How widespread is the problem of accounting fraud in China? Part of the problem really is just the law of big numbers. With a population almost triple that of the US and Western Europe combined, China has a lot of everything, including both remarkable businesses run by individuals who are the entrepreneurial equal of Henry Ford and Steve Jobs, and well as some shady operators.

What is your outlook for China’s PE sector in the coming 12 months?

I believe the current crisis will abate, and stock markets will once again welcome Chinese private sector companies to do IPOs. The IPOs will be far fewer in number than in 2010, but still the revival of IPO exits will also thaw the current deep-freeze that has shut down most PE activity across China. PE firms will again start to invest, and put a dent in the $30 billion or more in capital they have raised to invest in China but have left untouched. The PE industry in China, since its founding a little more than a decade ago, grew enormously large but never really matured. There are now too many PE firms. By some count, the number exceeds 1,000, including hundreds of Renminbi PE firms started and run by people with no real experience investing in private companies. Their future appears dire. At the same time, the global PE firms that bestride the industry, including Carlyle, Blackstone, TPG, KKR, have yet to fully establish they can operate as efficiently and profitably in China as they do in Europe and the US.

While the China PE industry struggles to recover from many self-inflicted wounds, China’s private sector companies will continue to find and exploit huge opportunities for growth and profit in China, as the nation’s one billion consumers grow ever-richer and ever more demanding.

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China SOE Accounting — BAAP Not GAAP Applies

Leave a Comment / December 15, 2013

China SOE accounting–

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If the last two years of crisis in investing in Chinese companies proves anything, it’s that any Chinese company that pays more tax than it should, documents every transaction and practices the most forensic accounting methods is the one with the calmest, happiest investors. Such companies are very rare among the thousands invested in by private equity, and not very common among publicly-traded ones,  if professional short-sellers like Muddy Waters, as well as securities regulators in the US and Hong Kong are to be believed.

Chinese companies, especially private ones,  live under a cloud of suspicion their books are cooked, while their auditors turn a complicit blind eye. While that cloud hovers, it will remain impossible for Chinese private companies in large numbers to successfully sell their shares to the public through an IPO. Chinese companies already listed are not much better off. For many, their share prices remain seriously depressed because of investor doubts about the accuracy of the financial accounts.

For PE firms, it represents a very painful dilemma. To have any chance to IPO, their portfolio companies will often need to pay more tax. But, doing so makes the companies less profitable and so much less attractive to the capital markets. Pay first and pray for an IPO later is pretty much the current PE exit strategy in China.

What a refreshing change, therefore, it is to encounter the financial accounts of a Chinese state-owned enterprise (“SOE”). By Chinese standards, their accounts are often clean enough to eat off. SOEs often seem to take pride in paying as much tax as possible. Rather than hiding income, they seem to want to exaggerate it.

Why do SOEs operate this way? It could be argued that tax-paying is their form of national service. Most SOEs pay no dividends to the state, even though the state is the majority, indeed often the 100% owner. Or perhaps SOEs are trying to set a righteous, though generally ignored, example of dutiful tax compliance?

In fact, the heavy and perhaps over-scrupulous tax-paying can also be seen as the result of a system of diligent, almost fanatical record-keeping practiced inside SOEs. Everything bought or sold, every Renminbi moving inside or outside,  is tabulated by the SOEs large team of in-house bookkeepers. Note, I say bookkeepers, not accountants. An SOE has many of the former and few, if any, of the latter.

That’s because SOEs also operate by their own set of accounting standards. I call it “Chinese BAAP“, or “bureaucratically accepted accounting principles“. This is, needless to say, as different from GAAP as any two financial tracking systems could possibly be.

Under Chinese BAAP, the purpose of the annual financial statement is to produce a record that bureaucratic layers above can use. This means especially the administrators at SASAC, the government agency that owns and manages most SOEs. SASAC’s job is to make sure that SOEs are (a) increasing output while operating profitably; and (b) not engaged in any kind of corrupt hanky-panky.

Of the two, SASAC is probably more concerned that government property is not being pilfered, misappropriated, wasted or diverted to pay for senior management’s weekend gambling junket to Macao. This isn’t to say that such things can’t occur. But, the accounting system used by an SOE is designed to be so meticulous, so focused on counting and double-counting, that bad acts are harder to do and harder to hide.

If I could bill out all the time I’ve personally spent during 2013 studying and complying with SOE payment procedures, I’d probably have at least 100 billable hours by now. I should bill the SOE for all this time, but figuring out how to do so would probably take me another 60 hours.

The main purpose of all the rules seems to be to keep a very solid tamper-proof paper trail of money leaving the SOE. This is a far cry, of course, from accounting, at least as its understood outside China. The way assets are valued, and depreciated, follows a logic all its own. One example: an SOE client of ours bought and owns a quite large plot of suburban real estate outside Chengdu. Its main factory buildings are set on top of it. The land is booked at its purchase price as an intangible asset on the company balance sheet. Under Chinese BAAP, this is apparently allowed.

To meet SASAC-imposed growth targets, SOEs are known to boost revenues through a kind of wash-trading. Profit isn’t impacted. Only top-line. BAAP turns a blind eye.

Every SOE is audited once-a-year. Few private companies are. The main purpose of the audit is not only, as under GAAP, to determine accurately a company’s expenses and revenues. It’s also to make sure all of last year’s assets, plus any new ones bought during the current audit year,  can be located and their value tabulated.

From the standpoint of a potential investor, while the logic of Chinese BAAP may take some getting used to,  an SOEs books can be understood and, for the most part, trusted. There should be little worry, as in private sector companies, that there are three sets of books, that sales are being made without receipts to escape tax, and that company cash flows through an ever-changing variety of personal bank accounts. SOE management, in my view, wouldn’t know how to perpetrate accounting fraud if they were being paid to do so. They’ve grown up in a system where everything is counted, entered into the ledger, and outputted in the annual SASAC audit.

An investor who takes majority control of an SOE, as in the two deals we are now working on,  would want to transition the company to using more standard accounting rules. It would also want the company to avail itself, as few seem now to do, on all legal methods to defer or lower taxes. In short, there is good money to be made in China going from BAAP to GAAP.

 

China SOE Buyouts — Case Study Part 2

Leave a Comment / December 15, 2013

Jin finial

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When you can find them, State-Owned Enterprise (“SEO”)  buyouts are among the better investments in China. The reasons: the companies are cheap, professionally-managed and free of accounting fraud. The not-trivial challenge: finding good SOEs that can be bought.

For such an important part of the world’s second-largest economy, Chinese SOEs are widely misunderstood. They account for at least 20% of China’s GPD. Some estimates put SOEs’ contribution to GPD at 60% or higher. But, SOEs are often characterized, to quote from a World Bank analysis, as “dying dinosaurs that continuously absorb resources from the economy but produce little economic value.”

To be sure, there are many SOEs that fit this description. But, equally, there are plenty of good businesses among China’s more than 150,000 SOEs. The good ones, quite often, can be made substantially better by bringing in outside capital and chopping away at the heavy bureaucratic crust.

Buyouts make money when a new owner buys an business for less than it’s worth, then reinvigorates it. Generally that’s done by buying lazily-run subsidiaries inside larger conglomerates.

No conglomerate anywhere, at any time,  has been more laid-back about managing its assets than SASAC, the huge government organization that is the legal owner of most Chinese SOEs.

SOEs operate in, but are not entirely of, the market economy. They benefit from cheap and plentiful capital via loans from state-owned banks. But, SASAC is generally far more concerned with increasing revenues and investment than profits. SASAC generally doesn’t demand SOEs pay it dividends. Instead, it asks for an audit every year that shows an SOE’s revenues and assets are growing, and no money is actually being lost or assets pilfered. SASAC doesn’t act like an owner so much as a custodian.

SASAC’s casual attitude to profit-making filters down to all levels within an SOE.  Given the choice to maximize or minimize profits, most SOEs will choose the latter.  The goal is to make a little more than last year, but not so much that SASAC, or more senior levels in government, begin to ask questions. With few exceptions (mainly larger centrally-administered SOEs quoted in the US like China Mobile and PetroChina) the corporate equivalent of a “gentleman’s C“, a net margin of around 2.5%, is considered satisfactory.

You don’t need to be a Buffett, Bonderman, Kravis, or Rubenstein to make money buying the right Chinese SOE. You generally don’t need to get your hands too dirty, launch a hostile takeover, borrow a ton of money, or make yourself unpopular by firing surplus workers. It’s going to be enough in most cases just to retain and incentivize current managers, and inform them that their goal now is to deliver net margins as good as, if not better, than private sector competitors.

Not in all cases but many, the current management of an SOE is quite good, professional, dedicated. The managers operate within a system that downplays the importance of maximizing profit. So, they behave correspondingly. But, that doesn’t mean they don’t know how to do so, especially when they have their salary or share options tied to profitability.

In a previous post I mentioned our two new SOE clients. We are working now to privatize them by selling majority ownership to a private sector investor. Both are 100%-owned by one state-owned holding company which, in turn, is fully-owned by another, even larger SOE holding group. Above them, is the local SASAC in the city where the holding companies are both headquartered. No sooner did we start asking the managers how to improve profits, then they began to share information on how much additional profit was being left unclaimed — unnecessary commission payments, tax rebates not filed for, revenues booked through unrelated group companies.

In the case of these two companies, the current CEOs have been running the businesses since they were started more than five years ago. They are about as far from a stereotyped paper-pushing “SOE Manager” as one could imagine. They are in their mid-40s, and take evident pride in running their businesses as efficiently as any Western manager would. The difference is, a lot of the profit they earn is siphoned off through lots of internal layers within the holding group. At the moment, that’s of little concern to them. They are ordinary salaried workers giving SASAC precisely what it wants. Giving more would do nothing to advance their careers, or fatten their pay packets.

These two CEOs are excited and ambitious to run independent private sector companies that will be free to make and keep as much money as the market and tax laws allow. I have confidence that in both cases, net income would more than double within two years, and triple within five.

What’s needed isn’t restructuring. It’s gardening. You weed out all the unnecessary fees, commissions and chop back the overheads. This reveals the companies’ genuine – and impressive – bottom line.

We are still doing our internal work with the companies, but will soon start the search for new majority owners for each company. All the layers above, up to and including the local SASAC, seem to support these transactions. Why? The holding company already has one very successful publicly-traded company. Once spun off, these two subsidiaries should follow a similar path and one day go public. That is the surest way to assure the companies have sufficient access to low-cost capital and so finance continued growth. Both companies, with revenues of over $100mn, are growing quickly.

Everyone is currently in agreement that the best way for these two subsidiaries to become not just the largest but the most profitable companies in their industry in China is by bringing in majority private shareholders, both to invest in the business and provide more focused, profit-oriented ownership. They sought our investment banking and advisory help to do so.

This isn’t to say these deals, or any SOE takeover, is as effortless as body-surfing. The privatization process in China is still evolving. Any transaction like this will likely generate some opposition. From whom? And from what level? Both are impossible to say.

A separate concern of mine: there are far too few capable and experience takeover firms active in China. Among those that are around, the level of experience and comfort with buying control of an SOE is not uniformly high. Done right, the new owners would be able to profit from a large gap between the current asset value as calculated using SASAC rules and each company’s level of underlying and future profitability. In other words, you buy using NAV but sell later on a p/e multiple.

Making money on that swap, from NAV-to-p/e, is the simple idea at the heart of many of the world’s most successful takeovers. Opportunities to do this are now quite rare in the US and Europe, which is one reason the returns for big buyout firms like KKR, Blackstone and Carlyle has generally been trending down over the last 25 years, and why it’s harder for Warren Buffett to find the kind of underpriced gems he treasures most.

The best days of takeovers have passed, right? Or should Buffett, Rubenstein, Bonderman and Kravis be booking flights to China?

 

 

China Investment Banking Case Study: An SOE Privatization

4 Comments / December 15, 2013


China First Capital Signing ceremony

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Anyone who’s dipped into this blog will know that I rarely, if ever, discuss directly what me and my company China First Capital do, our client work. Partly it’s because the work is usually by necessity confidential (clients, investors, deal terms) and partly because I don’t blog as a marketing tool.

But, I plan over coming months to share significant details about a “live deal” we are now working on, a buyout transaction involving a Chinese state-owned enterprise (SOE). The reasons: its size and structure make it an unusual transaction in China, and one that might also bust some myths about the way business in China, especially involving SOEs, actually works.

While I can’t reveal the name of the company, I can disclose why I think it’s such a compelling deal.  Our client is one of China’s largest, most well-known and most successful SOEs. The group’s overall annual profit of over Rmb12 bn (about USD$2bn) also make it one of the richest. Unlike a lot of SOEs, this one operates in highly-competitive markets, and has nothing like a monopoly in China.

The deal we’re working on is to restructure then “privatize” two profitable subsidiary companies of this SOE. Both of these subsidiaries are the largest businesses in China in their industry. Their combined revenues are about $220mn.

Privatization has two slightly different meanings in Chinese finance. First, is the type of deal, very common a decade ago, where big SOEs like China Mobile, Sinopec, PetroChina, ICBC, Air China, are converted into joint stock companies and then a minority share is listed through an IPO on stock markets in China, US or Hong Kong. The companies’ majority owner remains the Chinese state, with the shares usually held and managed by a powerful arm of the government known in Chinese as 国资委, in English known as the State-owned Assets Supervision and Administration Commission, or more commonly SASAC. In theory, SASAC probably holds the world’s largest and most valuable share portfolio, far bigger than Fidelity,  Vanguard, or the world’s sovereign wealth funds.

The other, rarer,  type of privatization is where a company’s majority ownership changes hands, from state to private ownership. This is the type of control deal we are working on. The plan is to spin out the two subsidiaries by selling a majority stake to either a strategic or financial acquirer. In all likelihood, each company will one day go public either in China or Hong Kong, at which time, I’d expect their market caps to each be well over US$1bn.

In essence, the deals are structured as a recapitalization, where a new private-sector majority owner will contribute capital in excess of the company’s current assessed value. That valuation is determined by an independent accounting firm,  based on current asset value.

The privatization process is heavily regulated and tightly controlled by SASAC. It involves multiple levels of review, outside valuation, and then an open-market auction process. The system has changed out of all recognition from the first generation of government asset sales done in the 1990s. These deals involved little to no public disclosure or transparency and generated quite a lot of criticism and resentment that Chinese state assets were being sold to insiders, or the well-connected, for a fraction of their true value.

For an investment bank, working with an SOE, especially a large and famous one, has a process, logic and rhythm all its own. There are many more layers of management than at a typical Chinese private company, and many more voices involved in decision-making. In this case, we’re rather fortunate that the chairman of the holding company is also the founder of the two subsidiaries we’re now seeking to spin out. He started the companies from zero less than ten years ago, and has built them into proud, successful, fast-growing businesses.

This chairman has far more sway over the strategy and direction of the SOE than is usual in China. I first met him over a year ago. I was called to visit the company to explain the process through which an SOE like his could raise outside capital. Though curious, the chairman said at the time it seemed like more trouble than it would be worth. He had a comfortable life, and was nearing mandatory retirement age.

In fact, as I now understand, that first meeting was really just a way to kickstart a long, complicated and confidential discussion process involving the chairman, his senior management team, as well as even more senior officials at the SOE.  Over the course of a year, the chairman was able to persuade himself, as well as the many others with a potential veto, that a spin-out of the two companies was worth considering in greater detail.

The privatization offers the promise of long-term access to capital and also, most likely, a greater degree of management autonomy.  Though the two subsidiaries do not sell to, rely on or otherwise have related party transactions with the parent, they are ultimately subject to some rather heavy and often-stifling bureaucratic controls. Contrary to the reputation of many Chinese SOE, the two companies sell high-end products to large fastidious global customers. They operate in highly kinetic markets but with a corporate structure above them that is as slow, ponderous and impenetrable as a five-hour Peking Opera performance.

The chairman invited me to return for another visit in June. What followed was a rather intensive process of me and my team submitting several different financing plans and options, including the privatization of either the whole holding company or various subsidiaries, either as standalones, or grouped into mini-conglomerates. These different plans got discussed very actively inside the SOE. In under a month, the company had decided how it wanted to proceed: that its two strongest and most successful subsidiaries should be separately spun off and majority control in each offered to a new investor.

It may not sound like it, but one month is a remarkably fast time for an SOE to consider, decide and then get necessary approvals to do just about anything. We also work with another even larger Beijing-headquartered SOE and it took them almost four months to get the eleven different people needed to approve, and apply the chop to, our template Non-Disclosure Agreement.

I was summoned with one day’s advance notice to return to the company in late July to sign a cooperation agreement to advise them on the proposed privatization/recapitalization of the two subsidiaries. Again, that’s rather typical of SOEs:  meetings are called suddenly, and one needs to drop whatever one’s doing and attend. For me, that meant a hastily-booked two hour flight, then a three-and-a-half hour drive to the company’s headquarters. A photo from the signing ceremony is at the top of this page. (I have to cover over the name of the company.)

The contract signing was followed by another in a series of very elaborate and extremely tasty meals. The chairman has converted a 13-acre plot of the company’s land into an organic farm, where he grows fruits and vegetables and raises free-range pigs, ducks, chickens. Everything I’ve eaten while visiting the company has come from this farm. Everything is remarkably good. And, yes, along with the food, a rather large amount of Chinese alcohol is poured.

In future posts, I’ll talk about different aspects of the transaction, including how to parse the balance sheet and P&L of an SOE, as well as the industrial and investment logic of doing a takeover of an SOE. In the current market environment in China, where so many PE minority investments are stranded with no means to exit, there has probably never been a better time to do buyout transactions, particularly of mature and successful industrial companies with scale, good profit margins and clean accounting. Good businesses like this are few. We are now working for two of them.

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

1 Comment / July 23, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

2 Comments / June 29, 2013

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

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

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

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

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

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

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

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

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

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

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

 

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

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New capital drought threatens growth in China — China Daily

Leave a Comment / June 24, 2016

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

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By Peter Fuhrman

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

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

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

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

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

New capital drought threatens growth

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

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

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

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

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

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

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

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

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

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

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

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

 

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Jiuding Capital: China’s “PE Factory” Breaks Down

Leave a Comment / June 12, 2013

Less than 18 months ago, Harvard Business School published one of its famed “cases” on Kunwu Jiuding Capital (昆吾九鼎投资管理有限公), praising the Chinese domestic private equity firm for its ” outstanding performance ” and “dazzling investment results”. (Click here to read abridged copy.) Today,  the situation has changed utterly. Jiuding’s “dazzling results”, along with that HBS case, look more like relics from a bygone era.

Jiuding developed a style of PE investing that was, for awhile, as perfectly adapted to Chinese conditions as the panda is to predator-free bamboo jungles in Sichuan. Jiuding kept it simple. Don’t worry too much about the company’s industry, its strategic advantage, R&D or management skills. Instead,  look only for deals where you could make a quick killing. In China, that meant looking for companies that best met the requirements for an immediate domestic IPO. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations.

Jiuding’s pre-investment work consisted mainly of simulating the IPO approval process of China’s securities regulator, the CSRC. If these simulations suggested a high likelihood of speedy CSRC IPO approval, a company got Jiuding’s money. The objective was to invest and then get out in as short a period as possible, preferably less than two years. A more typical PE deal in China might wait four years or more for an opportunity to IPO.

Jiuding did dozens of deals based on this investment method. When things worked according to plan, meaning one of Jiuding’s deals got quickly through its IPO, the firm made returns of 600% or more. After a few such successes, Jiuding’s fundraising went into overdrive. Once a small domestic Renminbi PE firm, Jiuding pretty soon became one of the most famous and largest, with the RMB equivalent of over $1 billion in capital.

Then, last year, a capital markets asteroid wiped out Jiuding’s habitat.  The CSRC abruptly, and without providing any clear explanation, first slowed dramatically the number of IPO approvals, then in October 2012, halted IPOs altogether. This has precipitated a crisis in China’s private equity industry. Few other PE firms are as badly impacted as Jiuding. The CSRC’s sudden block on IPOs revealed the fact that Jiuding’s system for simulating the IPO approval process had a fatal flaw. It could not predict, anticipate or hedge against the fact that IPOs in China remain not a function of market dynamics, but political and institutional policies that can change both completely and suddenly.

If Jiuding made one key mistake, it was assuming that the IPO approval system that prevailed from 2009 through mid-2012 was both replicable and likely to last well into the future. In other words, it was driving ahead at full speed while looking back over its shoulder.

Jiuding’s deals are now stranded, with no high probability way for many to achieve IPO exit before the expiry of fund life. That was another critical weakness in the Jiuding approach: it raised money in many cases by promising its RMB investors to return all capital within four to six years, about half the life cycle of a typical global PE firm like Carlyle or Blackstone.

Jiuding’s deals, like thousands of others in China PE,  are part of a backlog that could take a decade or more to clear. The numbers are stupefying: at its height the CSRC never approved more than 125 IPOs a year for PE-backed companies in China. There are already 100 companies approved and waiting to IPO, 400 more with applications submitted and in the middle of CSRC investigation, and at least another 2,000-3,000 waiting for a time when the CSRC again allows companies to freely submit applications.

Jiuding’s assets and liabilities are fundamentally mismatched. That’s as big a mistake in private equity as it is in the banking and insurance industries. Jiuding’s assets –  its shareholdings in well over a hundred domestic companies — are and will likely remain illiquid for years into the future. Meantime, the people whose capital it invests,  mainly rich Chinese businesspeople, will likely demand their money back as originally promised, sometime in the next few years. There’s a word for a situation where a company’s near-term liabilities are larger than the liquidatable value of its assets.

In the Harvard Business School case, Jiuding’s leadership is credited with perfecting a “PE factory”,  which according to the HBS document “subverted the traditional private equity business model.”  They might as well have claimed Jiuding also subverted the law of gravity. There are no real shortcuts, no assembly line procedure, for making and exiting successfully from PE investments in China.

In an earlier analysis, written as things turned out just as the CSRC’s unannounced block on IPOs was coming into effect, I suggested Jiuding would need to adjust its investment methods, and more closely follow the same process used by bigger, more famous global PE firms. In other words, they would need to get their hands dirty, and invest for a longer time horizon, based more on a company’s medium term business prospects, not its likelihood of achieving an instant IPO.

Jiuding, in short, will need to focus its investing more on adding value and less on extracting it. Can it? Will it? Or has its time, like the boom years of CSRC IPO approval and +80X p/e IPO valuations in China,  come and gone?