Chinese Law

“A lot hasn’t gone to plan”: SuperReturn Interview

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Does [China’s] shift from a manufacturing-driven economy to a service-driven one make macroeconomic shocks like those seen this summer inevitable?

Peter Fuhrman: China has enjoyed something of a worldwide monopoly on hair-raising economic news of late: a stock market collapse followed by a klutzy bail-out, then a devaluation followed by a catastrophic explosion and finally near-hourly reports of sinking economic indicators. As someone who first set foot in China 34 years ago, my view is we’re in an unprecedented time of economic and financial uncertainty . Consumers and corporates are noticeably wobbling. For a Chinese government long used to ordering “Jump!” and the economy shouting back “How high?” this is not the China they thought they were commanding.  Everyone is looking for a bannister to grab.

And yet, China still has some powerful fundamentals working in its favour. Urbanization is a big one. It alone should add at least 3-4% to annual GDP a year for many years to come. The shift towards services and domestic growth as opposed to exports are two others. For now, these forces are strong enough to keep China propelling forward even as it tows heavy anchors like an ageing population, and a cohort of monopolistic state-owned enterprises (SOEs) that suck up too much of China’s capital and often achieve appalling results with it.

Look, the Chinese stock market had no business in the first place almost tripling from June last year to June of this. The correction was long, long overdue. It’s often overlooked that China’s domestic stock market has a pronounced negative selection bias. Heavily represented among the 3,000 listed companies are quite a number of China’s very worst companies, with the balance made up of lethargic, low-growth, often loss-making SOEs. The good companies, like Tencent or Baidu, predominantly expatriate themselves when it comes time to IPO. To my way of thinking, China’s domestic market still seems overpriced. The dead cats are, for now, still bouncing.

 

Given this overall picture, do you expect to see greater or fewer opportunities [in China] for alternative investments and why? 

Peter Fuhrman: The environment in China has been challenging, to say the least, for alternative investment firms not just in the last year, but for the better part of the last decade. A lot hasn’t gone to plan. China’s growth and opportunities proved alluring to both GPs and LPs. And yet too often, almost systematically, the big money has slipped between their fingers. Partly it’s because of too much competition, and with it ballooning valuations, from over 500 newly-launched domestic Chinese PE and VC firms. The fault also sits with home-grown mistakes, with errors by private equity firms in investment approach. This includes an excessive reliance on a single source of deal exit, the IPO, all but unheard-of in other major alternative investment environments.

Overall PE returns have been lacklustre in China, especially distributions, before the economy began to slip off the rails. In the current environment, challenges multiply. A certain rare set of investing skills should prove well-adapted: firms that can do control deals, including industry consolidating roll-ups. In other words, a whole different set of prey than China PE investors have up to now mainly stalked. These are not pre-IPO deals, not ones predicated on valuation arbitrage or the predilections of Chinese young online shoppers. There’s money to be made in China’s own Rust Belt, backing solid well-managed manufacturers, a la Berkshire Hathaway. There’s too much fragmentation across the industrial board. China will remain the manufacturing locus for the world, as well as for its own gigantic domestic market.

Another anomaly that needs correcting: Global alternative investing has been overwhelmingly skewed in China towards equity not debt. The ratio could be as high as 99:1. This imbalance looks even more freakish when you consider real lending rates to credit-worthy corporates in China are probably the highest anywhere in the advanced world, even a lot higher than in less developed places like India and Indonesia. Regulation is one reason why global capital hasn’t poured in in search of these fat yields. Another is the fact PE firms on the ground in China have few if any team members with the requisite background and experience to source, qualify, diligence and execute China securitized debt deals. There’s a bit of action in the China NPL and distress world. But, straight up direct collateralized lending to China’s AA-and-up corporates and municipalities remains an opportunity global capital has yet to seize. Meanwhile, China’s shadow banking sector has exploded in size, with over $2.5 trillion in credit outstanding, almost all of which is current. There’s big money being made in China’s securitized high-yield debt, just not by dollar investors.

 

What’s the overall story of alternative investors engaging with central planning? How would you characterise the regulatory environment?

Peter Fuhrman: China has had a state regulatory and administrative apparatus since Europeans were running around in pelts and throwing spears at one another. So, yes, there is a large regulatory system in China overseen by a powerful government that is very deeply involved in economic and financial planning and rule-making. One must tread carefully here. Rules are numerous, occasionally contradictory, oft-time opaque and liable to sudden change.

Less observed, however, and less harrowing for foreign investors is the core fact that the planning and regulatory system in China has a strong inbuilt bias towards the goal of lifting GDP growth and employment. Other governments talk this talk. But it’s actually China that walks the walk. The days of anything-goes, rip-roaring, pollute-as-you-go development are about done with. But, still the compass needle remains fixed in the direction of encouraging strong rates of growth.

The Chinese government has also gotten more and more comfortable with the fact that most of the growth is now coming from the highly-competitive, generally lightly-regulated private sector. Along with a fair degree of deregulation lately in industries like banking and transport, China also often pursues a policy of benign neglect, of letting entrepreneurs duke it out, and only imposing rules-of-the-game where it looks like a lot of innocents’ money may be lost or conned. To be sure, foreign investors in most cases cannot and should not operate in these more free-form areas of China’s economy. They often seem to be the first as well as the fattest targets when the clamps come down. Just ask some larger Western pharmaceutical companies about this.

 

In the long view, how long can the parallel USD-RMB system run? Do you expect to see the experiments in Shanghai’s Pilot Free Trade Zone (FTZ) replicated and extended? 

Peter Fuhrman: Unravelling China’s rigged exchange rate system will not happen quickly. Every baby step — and the steps are coming more fast of late — is one in the direction of a more open capital account, of greater liberalization. But, big change will all unfold with a kind of stately sluggishness in my view. Not because policy-makers are particularly wed to the notion of an unconvertible currency. There’s the deadweight problem of nearly $4 trillion in foreign exchange reserves. What’s the market equilibrium rate of the Dollar-Renminbi? Ask someone facing competition from a Chinese exporter and they’re likely to say three-to-one, or an almost 100% appreciation. Ask 1.4 billion Chinese consumers and they will, with eminent good reason, say it should be more like 12-to-one. Prices of just about everything sold to consumers in China is higher, often markedly higher, than in the US where I’m from. This runs from fruit, to supermarket staples, to housing, brand-name clothing up to ladder to cars and the fuel that powers them.

I think the irrational exuberance about Shanghai’s FTZ has slammed into the wall of actual central government policy of late.  It will not, cannot, act like a free market pathogen.

 

Reform of China’s state-owned enterprises has been piecemeal, and private equity has had patchy success with SOEs. Do you expect this to change, and why?

Peter Fuhrman: For those keeping score, reform of SOEs has yet to really put any points on the board. The SOE economy-within-an-economy remains substantially the same today as it was three years ago. Senior managers continue to be appointed not by competence, vision and experience, but by rotation. The major shareholder of all these SOEs, both at centrally-administered level as for well as those at provincial and local level, act like indifferent absentee proprietors, demanding little by way of dividends and showing scant concern as margins and return-on-investment droop year-by-year at the companies they own.

There are good deals to be done for PE firms in the SOE patch. The dirty little secret is that the government uses a net asset value system for state-owned assets that is often out-of-kilter with market valuations. Choose right and there’s scope to make money from this. But, if you’re a junior partner behind a state owner who cares more about jobs-for-the-boys than maximizing (or even earning) profits then no asset however cheaply bought will ever really be in the money.

 

TPP has been described as ‘a club with China left out’. If it comes to pass, how do you expect China to respond?

Peter Fuhrman: China has responded. Along with its rather clumsy-sounding “One Belt, One Road” initiative it also has its Asia Infrastructure Investment Bank. The logic isn’t alien to me. When American Jews were barred from joining WASP country clubs, they tried to build better clubs of their own. When Chase Manhattan, JP Morgan and America’s largest commercial banks wouldn’t hire Jews, they went instead into investment banking, where there was more money to be made anyway.

But, China may not so easily and successfully shrug off their exclusion from TPP. It increases their aggrieved sense of being ganged-up upon. The US understands this and now frets more about China’s military power. The partners China are turning to instead – especially the countries transected by the “One Belt, One Road” – look more like a cast of economic misfits, not dynamic free traders like the TPP nations and China itself. I don’t think anyone in Beijing seriously believes that increased trading with the Central Asian -stans is a credible substitute. Even so, China will not soon be invited to join the TPP. China has hardly acted like a cozy neighbour of late to the countries with the markets and with the money. Being feared may have its strategic dividends. But the neighbourhood bully rarely if ever gets invited to the block party.

 

Peter Fuhrman will be speaking at SuperReturn Asia 2015, 21-24 September 2015, JW Marriott, Hong Kong.

 

http://www.superreturnasia.com/blog/super-return-private-equity-conference/post/id/7653_A-lot-hasnt-gone-to-plan-Peter-Fuhrman-China-First-Capital-on-alternative-investments-in-the-PRC?xtssot=0

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Free Trade Zones, The Next Phase of Economic Reform — China National News TV Interview

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CCTV

It is the world’s most watched nightly news report, China’s CCTV 7pm evening news program, “Xinwen Lianbo” (新闻联播). Simultaneously broadcast on most terrestrial tv stations in China, it has a nightly audience estimated at over 100 million.

This past week, the level of broadcast Chinese on this news program took a brief, steep dive. The reason: a short clip of me speaking Chinese led off a news report about recent economic reforms in Guangdong Province and the introduction of pilot free trade zones in Guangdong‘s three largest cities, Shenzhen, Guangzhou and Zhuhai.

You can watch the video by clicking here. (You may need to sit through a pre-roll advertisement.) My contribution is mentioning how comparatively easy it is to register a business in Shenzhen Qianhai,  the most ambitious of Guangdong’s free trade zones.

I was out of the country in Europe when the broadcast was aired, so didn’t get to watch it live. But, I knew instantly something was going on. As I sat in a lunch meeting in Switzerland at 1:15pm (7:15pm China time), calls and messages started flooding in from friends and acquaintances watching the report in China.

 

M&A the Chinese Way: Buying First and Paying Later — Financial Times

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FT article

For these two, as well as companies wishing to find a buyer in China, the game now is to learn the new rules of China M&A and then learn to use them to one’s advantage.

Chinese companies mainly pursue M&A for the same reasons others do – to improve margins, gain efficiencies and please investors. The main difference, and it’s a striking one, is that in most cases domestic Chinese corporate buyers, especially the publicly-quoted ones who are most active now trying to do deals, have no money to buy another business.

Outside of China, there are three known ways to pay for an acquisition – with cash, borrowed money, or shares. All three are generally between excruciatingly slow and impossible for publicly-listed Chinese companies. The reason: companies’ retained earnings are just about always insufficient.

Banking and securities rules in China severely restrict the way publicly-traded companies in China can finance acquisitions using debt or by issuing new shares. Deals financed with leverage are basically forbidden. So, Chinese companies have invented two convoluted ways to get M&A done. They display a certain genius. Both involve trying to buy first and pay later.

Method One is for the acquirer to first negotiate a purchase then ask the Chinese stock market to suspend trading in its own shares. The acquirer will announce the deal publicly and if all goes to plan its share price will surge, often by as much as 50 per cent to 75 per cent.

This predictable outcome is the result of the fact almost all shares quoted in China are owned by small retail investors, commonly called Chinese brokers “old grandpas and grandmas”. Most have never cared to look at a company’s financials or studied its competitive position. Instead, they trade in and out of stocks depending mainly on rumor and hype fed to them by brokers or online tip sheets.

In China, an announced M&A deal is now always a market-moving event. The movement tends to be all in one direction. Up.

Once trading in the acquirer’s shares resumes and the price duly jumps up, the acquirer then initiates the laborious process of applying to the Chinese securities regulator, the China Securities Regulatory Commission (CSRC), for permission to do a secondary share offering.

This will then, it’s hoped, yield the cash to complete the acquisition. The approval process will generally take six months or longer. Chinese securities rules are cumbersome and mandate that the new shares be issued at a discount to the share price at the time of application.

The result: the sequence of “announce first, then apply” means the acquirer can raise the cash needed to buy the target on more favorable terms for the acquiring company, lowering the amount of dilution.

Method Two, a close cousin, is to persuade a friendly domestic investment fund to buy the target company then hold onto it for as long as it takes the intended final owner to get the money in place through the secondary offering. In other jurisdictions, this might be deemed a “concert party” and so likely to land everyone in jail. In China, it’s becoming common practice.

In fact, a new form of investment fund has come into being especially to do deals like this. They call themselves “市值管理基金” which you can translate as “market cap management funds”. They exist to help publicly-traded companies do M&A deals that will lift the company’s share price, and not much else.

They make money buying and selling shares, as well as marking up for resale companies they buy on behalf of publicly-traded companies. They are not buyout funds as understood elsewhere, since these market cap management funds are buying on behalf of a specific company and have no particular industry expertise or experience managing an acquired company. They act purely as a temporary custodian.

Most often, the acquirer will contribute a small amount of limited partner capital to the “market cap management fund” as a way to bind the two organisations together. It can take a year or more from when the market cap management fund first buys the target company then sells to the publicly-traded acquirer, and from there, several more years before this acquisition starts to have an impact, if any, on the acquiring company’s earnings. In other words, a very long timetable.

That by itself is not a problem for the acquirer, since it is as eager to give a shot of adrenalin to its own share price and maintain it on this higher plane as it is to get control of the target company and integrate it into its business. Market cap management trumps industrial logic as a reason to pursue M&A.

I’ve yet to see evidence of much skepticism from Chinese stock market investors that an announced M&A deal may not benefit the acquirer. In the US and other more developed capital markets, it’s frequently the opposite. An acquiring company will as often as not see its shares fall when it announces plans for a takeover. That’s because in most cases, as far as hard empirical evidence can determine, the main beneficiaries of any M&A deal are the target company’s shareholders. Too often, for acquirers M&A deals prove to be too expensive and synergies elusive.

We’ve been invited by domestic listed companies in China to help consult on M&A deals where “market cap management” was an explicit purpose. Finding an attractive target is also a consideration, but a somewhat secondary one.

The discussions, in the main, are unlike anywhere else where M&A deals are being planned and executed. They revolve around how to get the money together, when and for how long to halt share trading, and by how much the listed company’s shares will likely go up, and stay up, once the M&A announcement is made.

Where the publicly-listed company has private sector, rather than State-owned enterprise background, the chairman will usually be the largest single shareholder. The chairman’s net worth stands to get the biggest boost if market cap management works as planned.

Opportunities for global buyout funds
The lengthy, roundabout nature of Chinese M&A is creating attractive opportunities for global corporations and buyout firms. They are the only participants in the M&A arena in China both with cash in hand or easily accessed to close deals and the experience to manage a company well once it’s bought.

From the perspective of potential Chinese sellers, both of these are extremely valuable, since they remove much of the uncertainty in agreeing to sell to a domestic acquirer. Global corporates and buyout firms will thus often be buyers of first choice for sellers.

For now, few global corporates and buyout firms are busy closing M&A deals in China. There are a host of reasons, including China’s slowing economic growth, the perception China is becoming more hostile towards foreign investment, the difficulty persuading owners of better Chinese companies to give up majority control. All valid concerns. But, there are larger forces now at work that make it attractive to expand through acquisition in the world’s largest fast-growing market.

First, in almost all industrial and service industries, China is beginning at last a process of rationalisation and consolidation. Costs are rising quickly, especially for labor, energy and debt service. These are applying vice-like pressure on margins. Markets for most products and services in China are no longer growing by +25 per cent a year and suffer from overcapacity.

Scale, efficiency, quality, modern management are the only ways to combat the punishing margin pressure. This plays directly to the strengths of larger global corporations and buyout firms. They know how to do this, how to transform a capable smaller business into a large market-share leader.

It’s something of a well-kept secret, but some of the world’s most successful M&A deals have seen large global corporations buying private sector businesses in China. The successful buyers generally prefer it this way, that few know how well they are doing after buying and upgrading a Chinese domestic company.

Why tip off competitors? For every well-publicized horror story there are at least three quiet successes. Indeed, one can find within a single Fortune 500 company three great examples of how to do domestic M&A well in China, and achieve a big payoff. The company is Swiss food giant Nestle.

They first opened an office in China in 1908. The big transformation began a hundred years later, in 1998, when they decided to buy an 80 per cent ownership in a Chinese powdered bullion company Taitaile. That company is now more than twelve times the size it was when Nestle bought in.

They followed that up with two other large acquisitions of domestic Chinese food and beverage brands, drinks company Yinlu and candy brand Hsu Fu Chi. In all cases, Nestle bought majority control, but not 100 per cent. They kept the founder in place, as CEO and a minority owner.

That has proved a brilliant model for successful M&A in China, and not only at Nestle. When discussing with Chinese business owners the advantages of selling control to a capable global company, we often share details of Nestle’s M&A activity in China, including the fact that the Chinese owner stays but gets to spend Nestle’s money, leverage its resources, to build a giant business. That’s a pretty attractive proposition.

All three acquisitions have thrived under Nestle’s ownership and now enjoy significant market shares. Thanks largely to these acquisitions, China is Nestle’s second-largest market overall. It was number seven just four years ago.

From my discussions with the China M&A team at Nestle, they are frank that it’s not always been smooth sailing. The M&A deals all involved trying to blend one of the world’s most fastidious, slow-moving and more bureaucratic cultures with the free-wheeling, “ready, fire, aim” style common to all Chinese domestic entrepreneurs. Corporate culture gaps could not get any wider. And yet, it’s worked out well, better in fact than Nestle hoped when going in.

Nestle tells us it is hungry to do more acquisitions in China. Chinese still spend half as much on food per capita as Mexicans. That’s where the growth will come from. Market dynamics in China are also moving strongly in Nestle’s favor, as food quality and safety become paramount concerns. Further acquisitions should help Nestle gather in billions more in revenue in China along with higher market shares.

Across multiple industries, the circumstances are similar in China, and so favor smart, bold acquirers. Choose good targets, buy them at a good price, convert great entrepreneurs to great managers and partners, don’t script everything from your far-off global headquarters. Do these right and M&A can work in China. No market cap management required.

(Originally published Financial Times BeyondBrics)

http://blogs.ft.com/beyond-brics/2015/05/08/ma-the-chinese-way-buying-first-and-paying-later/

http://www.chinafirstcapital.com/en/FT.pdf

 

China First Capital Interview: Cashing in and cashing out — China Law & Practice

 

China Law & Practice

Peter Fuhrman, CEO of China First Capital, explains how the country’s private equity market has struggled with profit returns and the importance of diversified exit strategies. He also predicts the rise of new funds to execute high-yield deals

Date: 05 May 2015

What is China First Capital?

China First Capital is an investment bank and advisory firm with a focus on Greater China. Our business is helping larger Chinese companies, along with a select group of Fortune 500 companies, sustain and enlarge market leadership in the country, by raising capital and advising on strategic M&A. Like our clients, we operate in an opportunity-rich environment. Though realistic about the many challenges China faces as its economy and society evolve, we are as a firm fully convinced there is no better market than China to build businesses of enduring value. China still has so much going for it, with so much more growth and positive change ahead. As someone who first came to China in 1981 as a graduate student, my optimism is perhaps understandable. The positive changes this country has undergone during those years have surpassed by orders of magnitude anything I might have imagined possible.

After a rather long career in the US and Europe, including a stint as CEO of a California venture capital company as well as a venture-backed enterprise software company, I came back to China in 2008 and established China First Capital with a headquarters in Shenzhen, a place I like to think of as the California of China. It has the same mainly immigrant population and, like the Silicon Valley, is home to many leading private sector high-tech companies.

What is happening in China’s private equity (PE) market?

Back in 2008, China’s financial markets, the domestic PE industry, were far less developed. It was, we now can see, a honeymoon period. Hundreds of new PE firms were formed, while the big global players like Blackstone, Carlyle, TPG and KKR all built big new operations in China and raised tons of new money to invest there. From a standing start a decade ago, China PE grew into a colossus, the second-largest PE market in the world. But, it also, almost as quickly, became one of the more troubled. The plans to make quick money investing in Chinese companies right ahead of their planned IPO worked brilliantly for a brief time, then fell apart, as first the US, then Hong Kong and finally China’s own domestic stock exchanges shut the doors to Chinese companies. Things have since improved. IPOs for Chinese companies are back in all three markets. But PE firms are still sitting on thousands of unexited investments. The inevitable result, PE in China has had a disappointing record in the category that ultimately matters most: returning profits to limited partners (LPs).

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China’s rise enters a more challenging phase, where bold ambitions confront stubborn, often centuries-old obstacles

China First Capital 2014 Survey cover

China’s economy and society have both reached levels of wealth and development that were unimaginable 30 years ago. What comes next? How can China continue to push forward, against some deep-seated problems, including how to generate globally-competitive innovation, how to sort out land ownership, how to attract and reward global investment flows? These issues are examined in detail in the new research study published by China First Capital.

The new report is titled ” China Survey 2014: The Rise Continues, New Directions & Challenges“. Copies may be downloaded by clicking here or from the research reports page of the company’s website.

China’s economy remains vibrant and fast-evolving. Many of the Fortune 500 successes stories of recent years – KFC, P&G, Coca-Cola – are finding it harder and harder to keep winning in the China market. As they lose share, other companies are gaining, both domestic and international. The report looks at this transformation through the vantage point of China First Capital’s rather long experience working in China,  alongside some talented CEOs in both domestic and global corporations, the incumbents and the disrupters both.

Investing successfully in China, either through the stock market or through M&A, also remains challenging. But, it’s worth the strain, the report asserts, since no other country can rival China today in terms of both the number and scale of money-making opportunities.

The new China First Capital report discusses these broad trends, and also examines the following in depth:

  •  is China’s investment community (PE and VC firms, stock market investors)  over-allocating now to mobile services and online shopping;
  •  an assessment of the serious challenge facing traditional shopping mall operators and retailers mainly because of competition from soon-to-IPO Alibaba’s online shopping giant;
  • a sober analysis of actual disappointing state of China’s high-tech industry;
  • how China triumphed over India, and won the battle as the world’s best and biggest Emerging Market,
  • why 3M may be the most successful American company in China, but flies so far beneath everyone’s radar

Some of the contents have already been published here on this blog and on Seeking Alpha.

The report’s core conclusion is that China has come a long way and in raw terms is certainly the most successful emerging economy of all time. But, it needs to become more innovative, generate more globally important technology breakthroughs, not just copycatting. There’s no absence of hype around about how China is poised to become a global technology powerhouse. The report, though,  cites China’s failure to serially produce an aircraft engine as a concrete, if not often talked-about, reminder of its technology frustrations and limitations.

 

 

The Misfortunes of the Big Four in China

China First Capital blog

Last week, an SEC judge in the US delivered a spanking to the Big Four accounting firms, barring their Chinese affiliates for six months from doing audit work for US-quoted Chinese companies. “To the extent [the Big Four] found themselves between a rock and a hard place,” the judge’s decision declares, “it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law that one wishes to follow.”

Overall, the judge’s 112-page ruling on the audit work of the Big Four in China makes for interesting, and at times damning, reading. You can click here to access it.The judge’s decision should probably be required reading for anyone working in Chinese private equity and capital markets transactions with Chinese companies. Investments in Chinese companies worth many tens of billions of dollars rely, at least to some extent, on the accuracy and reliability of Big Four audits. That audit bedrock looks shakier now than it did a week ago.

The Big Four are appealing the decision meaning that for now at least, they can continue to serve their US-listed Chinese clients, continue to audit their accounts, and continue to earn sizable fees for doing so. If they lose the appeal, they will need to suspend for six months their main activity in China. The Big Four have a near-monopoly on audit work for the over 160 Chinese companies listed in the US. Will their Chinese clients permanently go elsewhere? What about the 15,000 people working for the Big Four in China? How will the firms pay them during the half-year suspension? How will they spend their working days if not engaged in audit work?

This much is clear: whatever happens with the appeal, the reputation and trustworthiness of the Big Four’s work in China has taken a recent beating. The judge’s decision last week is particularly ill-timed. Chinese companies have only just regained some of the lost trust of US investors, allowing IPOs to resume. I have friends at all Big Four firms, and have worked with all of them over the last six years in China.

This dispute between the SEC and the Big Four has been bubbling away for over two years. It was triggered by a series of SEC investigations into serious misbehavior by some Chinese companies then-quoted in the US — fraudulent financial accounts, incomplete disclosure, faked revenues. The companies were punished, and their shares delisted from the US stock exchange. But, what about the Big Four auditors? Why hadn’t they uncovered and reported their clients’ misconduct to the SEC? Were the Big Four in China careless?  Negligent? Or even complicit in these Chinese companies’ attempts to mislead US investors?

This quickly became a focus of the SEC investigation. To determine if the Big Four audits were performed thoroughly and in compliance with US securities laws, the SEC asked the Big Four in China for their audit papers — that is, the complete written documentation showing what they did and with what level of diligence and accuracy. The Big Four refused the SEC requests to hand over the audit papers, saying that to do so would violate Chinese state secrecy laws.

They used the same argument with the judge. He rejected it outright. Instead, he says the Big Four demonstrated “gall” in “flouting” the SEC, were “oblivious” to some core legal issues, and took a “calculated risk” they wouldn’t get punished. Strong stuff. While the judge doesn’t say directly that greed was a major factor in the Big Four’s decision to disobey SEC orders, but it may be fair to make that inference. Their strategy seems basically having one’s cake and eating it too. They wanted to keep earning big fees for China audit work, while not fully complying with US securities laws. In specific cases cited by the judge, accounting fraud at US-listed Chinese companies was first brought to light by short-sellers, rather than by the Big Four audits.

The judge’s ruling notes the fact that over the last decade, the Big Four have built very large businesses in China. KPMG China and Ernst & Young China both tripled in size from 2004-2012. PWC grew fastest, increasing its staff four-fold to over 8,000 people. Such rapid growth is unprecedented as far as I know in the history of large accounting firms.

One large irony here is that the Big Four are accused by the judge of violating Sarbanes-Oxley. That law has overall been very good to the Big Four, since it gave accountants increased responsibility to police US-listed companies’ financial accounts. The scope of audits increased and with it the fees. But, when things go wrong, as they have with quite a number of Chinese quoted companies listed in the US, the auditors can potentially be held legally liable.

The Big Four all argued to the judge they should be treated leniently because if banned, no other accountants in China have the training and professionalism to do audit work that meets SEC standards for investor protection.  Any Chinese company that can’t find a new auditor would need to delist from the US stock exchanges. The judge dismissed this argument, and helpfully lists a group of five other accounting firms that have done audits in China and, unlike the Big Four, turned over audit papers to the SEC when asked.

Some big US multinationals including P&G, Amazon.com, Apple, The Coca-Cola Company and Nike, with large revenues and operations in China, would probably also need to find new Chinese auditors if the ban is upheld. Investing or operating a US-owned business in China, never easy, will become even trickier if the Big Four are forced to down pencils in China and serve the six-month SEC suspension.

 

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

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.

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Neue Zurcher Zeitung Interview

 

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

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.

 

China SOE Buyouts — Case Study Part 2

Jin finial

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


China First Capital Signing ceremony

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.

 

 

Private Equity Secondaries in China: Hold Periods, Exits and Profit Projections

How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital’s latest research note. An abridged version is available by clicking here. Titled, “Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity” the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.

This new report is, like the two preceding ones (click here and click here) the result of China First Capital’s path-breaking research  to measure the scale of the problem of unexited PE investments in China,  and to illuminate strategic alternatives for GPs investing in China.  China First Capital will publish additional research reports on this topic in coming months.

As this latest report explains, “these [hold period and investment return] models tend to support the thesis that “Quality Direct Secondaries“  currently offer the best risk-adjusted opportunities in China’s PE asset class.”  Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.

“Until recently,” the China First Capital report points out, “private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. 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. The planned hold period rarely extended more than three years, and in many cases, no more than a year.  Those assumptions on valuation differentials as well as hold period are no longer valid.”

There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China’s still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:

  1. IPO
  2. Trade sale / M&A
  3. Secondary sale
  4. Buyback / recapitalization

Our conclusion is the current exit crisis is likely to persist. “Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals.”

Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only,  option available for a PE firm with diminishing fund life. “Buyers of these direct secondaries will not avoid or outrun exit risk,” the report advises. “It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund’s hold period. ”

The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China “Quality Secondaries” offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.

Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.

Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure,  are not available in the abridged version.

 

 

China’s Soda Wars

(New Jia Duo Bao can on left, with the new SOE-owned Wang Lao Ji can on right)

Imagine this scenario. Coca-Cola is sued for bribery and trademark infringement. It loses in arbitration and beginning the next day it is banned from selling soda under its iconic brand across the US. It immediately switches to a new name, keeping the original packaging design and colors. Meantime, the victor in the lawsuit starts selling a soda under the name Coca-Cola using the same script lettering, same can design as the original, and tasting pretty much exactly like Coke.

Sounds far-fetched, doesn’t it? But, this is precisely what’s going on now in China.  After a arbitration hearing filled with lurid tales of bribery and corruption, the country’s most popular and most famous soft drink changed hands overnight. The brand is called Wang Lao Ji, (王老吉). Everyone in China is familiar with it. It’s a soft drink made from Chinese medical herbs. It outsells Coke by a significant margin in China. Like Coca-Cola, Wang Lao Ji’s recipe was first dreamed up by a pharmacist during the 19th century, and the exact formula remains a secret. In 1949, the Chinese government nationalized the private pharmacy that owned the Wang Lao Ji recipe.

Twelve years ago, a Hong Kong company called Hong Dao Group licensed the Wang Lao Ji brand name from a state-owned medical products company based in Guangzhou. Hong Dao is owned by the descendants of Wang Zebang, the original inventor of Wang Lao Ji back in 1828.  Hong Dao invested heavily to create China’s first home-grown soft drink megabrand, borrowing many of the same techniques that Coca-Cola pioneered, including saturation advertising and efficient nationwide distribution.

Last year, Hong Dao sold about three billion (yes, billion) cans of its Wang Lao Ji. The price, at around Rmb 4 (US 75 cents) per can,  is higher by about 40% than the price Coke charges in China. At that price, gross margins must be about the highest of any legal product sold in China, probably +80%.

Since May, when it lost the arbitration case, Hong Dao has been forbidden to sell Wang Lao Ji in China under that name. So, overnight, the company switched to a new name, Jia Duo Bao (加多宝)but kept the original colors and packaging intact. Just as quickly, the Guangzhou SOE, called Guangzhou Wanglaoji Pharmaceutical Co., Ltd. (广州王老吉药业有限公司), a subsidiary of the state-owned Guangzhou Pharmaceutical Holdings Limited (广州医药集团有限公司), began selling its own version of Wang Lao Ji in a can almost identical to the one used up to then by Hong Dao.

So now there are two drinks, with two different brand names, owned by two different companies, with similar if not identical taste, being sold in almost identical cans. The famed Coke-Pepsi rivalry in the US seems like a quaint antique by comparison.

Who benefits most? At the moment, it’s the ad agencies and television stations. Both companies are now pouring in tens of millions of dollars into tv advertising to influence Chinese customers. The ads ran during almost every prime-time commercial break during coverage of the Olympics. The ads are hard to tell apart, with lots of smiling and zesty young people partying and toasting one another with red cans. Hong Dao’s ads hint that the new drink is same as its old Wang Lao Ji, but without actually mentioning that name.

During the arbitration, detailed were revealed about the way Hong Dao originally secured the license in 2000 to the Wang Lao Ji name. It turns out a manager at Guangzhou Pharmaceutical Holdings agreed to take a bribe of about $500,000 in return for giving Hong Dao a sweetheart deal. Hong Dao paid less than $1 million a year for the rights to use the Wang Lao Ji brand name in China, even as annual sales of Hong Dao’s product reached Rmb 16 billion, ($2.5 billion.)

The manager who took the bribes was given a long prison term for misappropriating state property.Perhaps anticipating it might lose the arbitration case, Hong Dao began last year putting the name Jia Duo Bao, in small letters, on its Wang Lao Ji cans.  When the arbitration decision was announced, both companies reacted with breathtaking speed and efficiency. Hong Dao pulled all its Wang Lao Ji cans and almost immediately had its new Jia Duo Bao aluminum cans in stores. The SOE too clearly had everything geared up, awaiting the court decision. Its version of Wang Lao Ji was quickly on shelves across China. The SOE says the red can’s sales in July grew ten-fold compared to the previous month.

At this point, neither company is competing on price. Nor is there any sign that the overall market for this drink is growing much. So, the likely effect will be to split the 2011 Rmb16 billion of annual sales revenues by around 50-50. Guangzhou Pharmaceutical Holdings’ stock price has shot up, anticipating a flood of profits from selling its Wang Lao Ji in the familiar red cans.  Guangzhou Pharmaceutical Holdings surrendered the tiny annual licensing fee from Hong Dao, and now own outright what is arguably among China’s ten most famous brands.

Watching from the sidelines, I remain somewhat amazed that the two companies did not reach some kind of settlement rather than going through the arbitration process. I find Chinese generally to be very practical in business, and loathe to settle disputes in court. Given Hong Dao’s revenues and likely profits from selling Wang Lao Ji, it seems it could have put much more money on the table and persuaded Guangzhou Pharmaceutical Holdings to continue to license the brand. Switching to Jia Duo Bao has imposed heavy marketing and re-branding costs at a time when its previous monopoly market share is under serious attack.

Not that long ago, of course, China was mainly a market for all kinds of knockoff products — or to use the Chinese phrase, “shanzhai” 山寨. There was little interest in or defense of trademarks and copyright. Go back 30 years to when I first came to China, and there were few, if any, brands at all. That has all changed very markedly, particularly within the last two years.

China’s consumer market, within a decade, will likely overtake the US to become the world’s largest. With consumers shifting en masse to buying brand-name products, all brands active in China, both domestic and global, across just about every product category, are scrambling for every nano-unit of market share.

In the case of Wang Lao Ji and Jia Duo Bao, never in such a short time has such a large consumer market, the one for Chinese soft drinks, been so completely ruptured and so completely remade.

 

 

Intellectual Property Law in China — rule of law is replacing law of the jungle

Ming Dynasty lacquer box

Within a two-minute walk from my apartment in Shenzhen, there is ample evidence that intellectual property, particularly American, is not very well-protected in China. Nighttimes, three different vendors set up their folding tables on the main street with pirate DVDs by the carton-full, including many of the latest Hollywood releases. Cost: RMB5 each, or 73 cents each.

A little further west at the main intersection, a huge new superstore is under construction. The four-story-high signs proclaim it’s Shenzhen’s new “Official NBA Store”. But, when I emailed a friend who is one of the top executives at the NBA headquarters in New York, intending to congratulate them on their expansion in China, he emailed back to say that the NBA has no such project underway in Shenzhen. In other words, some other group is going to try to hijack the NBA logo (and most likely, when the store opens, NBA merchandise as well) and pass itself off as the genuine article, presumably making a killing along the way in basketball-crazy China. 

So far so ordinary, right? Everyone knows that China is a paradise for counterfeiters and IP thieves, right? 

Well, as is often the case in China, things are not quite as malign as they appear from the outside, in the minds of Western critics. Slowly but surely, China is taking the right steps to build a legal framework through which intellectual property – including foreign IP — can be protected in court. * 

This is very good news for all of us in the private equity and investment banking industries in China. Improved enforcement will help bring China into closer accord with the rest of the developed world in terms of IP protection. In many successful companies, intangible assets, including IP, are the most valuable item on the balance sheet. So, protecting IP is commensurate with protecting the value of a business, and so the financial interest of investors. 

There’s another key reason: some of the best private Chinese companies are developing their own successful brands in the Chinese domestic market. These Chinese brand-leaders are among the best opportunities for private equity investment, not just in China, but anywhere in the world. They face the same threats in China as foreign companies whose IP is being stolen. As the IP legal system develops, China’s own emerging brands will find it easier to defend their position in the domestic market, and shut down competitors who are ripping them off. 

One telling data point: perhaps the fastest-growing area of Chinese law – measured by billable hours among well-qualified lawyers – is in intellectual property. That’s because it’s getting much easier for companies to prevail in court against those who appropriate their logos, trademarks, designs, patents and other intellectual property. 

The court system is more and more responsive to such claims of IP theft. So, with increasing regularity, Western companies are taking action in Chinese courts. This is, without question, a positive development, and one that points the way toward a future where IP protection is more strenuously and uniformly enforced across China. 

The legal system is still evolving. At the moment, damage awards for the victor in an IP infringement case are not very high, often no more than RMB500,000 ($73,000), which is not going to be enough to discourage many of the larger-sized businesses in China that are producing and selling products that obviously rip off other companies’ IP. But, there’s often more at stake here than just the damage award. Litigation in China, as elsewhere, is costly. The victor in an IP case, in addition to the damages, will often also be awarded legal costs, meaning they can reclaim their entire legal fees from the company they’ve just defeated in cost. 

This is the real sting in the tail. Legal fees can easily reach amounts 10-20 times higher than the maximum damages. So, the victor can ultimately collect tens of millions of renminbi from the loser. In addition, of course, the losers have to swallow their own legal fees, which can be no less sizable. That sort of cumulative penalty (damages+own costs+victor’s costs) is enough to inflict a lot of pain on a company that is prospering by stealing someone else’s IP. Now, sure, collecting on a large monetary judgment in China can be a challenge. But, if the losing Chinese company is large enough, it’s hard for them to escape paying. They can’t just close up shop, and start again under another name. 

As China’s economy continues to grow robustly, more companies (including those whose success is predicated on stealing others’ IP) reach a size where they are too large and too well-established to escape the effects of such a punitive judgment. Result: some of the worst and largest IP offenders will be the first to suffer, made to bear heavy costs, or forced out of business. 

Now, of course, it’s likely going to be a very long time before the pirate DVD street vendors are put out of business. It’s not often discussed, but other countries, including the US, have similar sorts of opportunistic businessmen. I’ve been to areas of Los Angeles – usually not the nicest ones – and found guys on the street selling pirate DVDs of the latest Hollywood movies owned by studios that are headquartered less than 10 miles away. If the US can’t shut these operators down, it’s unrealistic to ask China to. 

But, the legal remedies now available – and I expect them to get even more extensive and water-tight over time –allow companies in China to act against the biggest IP thieves who do the most financial damage. This will benefit both foreign and the domestic Chinese companies now investing heavily to build their own brands and unique IP. A category of private equity investors in China will be winners also – those that back the companies now developing the brands that will one day dominate China.   

 

* I am once again indebted to Luo Ke, of Fangda Partners, and Elliott Chen of Junzejun, for sharing insights, perspective, legal knowledge. Every discussion I have with them is a joy. They always seem to provide the impetus for a blog post. 

 

 

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