Chinese SME

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

FTlogo

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

 

US Private Equity Soars While China Stalls

cwPT_1800-05_M364_M22823697

In 2014, the gap between the performance of the private equity industry in China and the US opened wide.  The US had a record-breaking year, with ten-year net annualized return hitting 14.6%. Final data is still coming in, but it appears certain US PE raised more capital more quickly and returned more profits to LPs than any year previously.  China, on the other hand, had another so-so year. Exits picked up over 2013, but still remain significantly below highs reached in 2011. As a result profit distributions to LPs and closing of new China-focused funds are also well down on previous highs.

China’s economy, of course, also had an off year, with growth trending down. But, it’s hard to place the blame there. At 7.5%, China’s economy is still growing at around triple the rate of the US. China’s publicly-traded equities market, meanwhile, turned in a stellar performance, with the overall Chinese stock exchange average up 52% in 2014, compared to a 11.4% rise in the US S&P. When stock markets do well, PE firms should also, especially with exits.

While IPO exits for Chinese companies in US, HK and China reached 221, compared to only 66 in 2013, the ultimate measure of success in PE investing is not the number of IPOs. It’s the amount of capital and profits paid back to LP investors. This is China PE’s greatest weakness.

Over the last decade, China PE firms have returned only about 30% of the money invested with them to their LPs. This compares to the US, where PE firms over the same period returned twice the money invested by LPs. In other words, in China, as 2015 commences, PE firm investors are sitting on large cash losses.

China private equity distributions to LPs

 

China PE firms say they hope to return more money to their LPs in the future.  But, this poor pay-out performance is already having an adverse impact on the China PE industry. It is getting harder for most China PE firms to raise new capital. If this trend continues, there will be two negative consequences – first, the China PE industry, now the second largest in the world,  will shrink in size. Second, and more damaging for China’s overall economic competitiveness, the investment capital available for Chinese companies will decline. PE capital has provided over the past decade much-needed fuel for the growth of China’s private sector.

What accounts for this poor performance of China private equity compared to the US? One overlooked reason: China PE has lost the knack of investing and exiting profitably from Chinese industrial and manufacturing companies. Broadly speaking, this sector was the focus of about half the PE deals done up to 2011 when new deals peaked. That mirrors the fact manufacturing accounts for half of China’s GDP and traditionally has achieved high levels (over 30%) of value-added.

Manufacturing has now fallen very far from favor in China. Partly it’s the familiar China macro story of slowing export growth and margin pressures from rising labor costs and other inputs. But, another factor is at work: China’s own stock market, as well as those of the US and Hong Kong, have developed a finicky appetite when it comes to Chinese companies. In the US, only e-commerce and other internet-related companies need apply for an IPO. In Hong Kong, the door is open more widely and the bias against manufacturing companies isn’t quite so pronounced, especially if the company is state-owned. But, among private sector companies, the biggest China-company IPO have been concentrated in financial services, real estate, food production, retail.

For China-investing PE firms, this means in most cases their portfolios are mismatched with what capital markets want. They hold stakes in thousands of Chinese industrial and manufacturing companies representing a total investment of over $20 billion in LP money.  For now, the money is trapped and time is growing short. PE fund life, of course, is finite. Many of these investments were made five to eight years ago. China PE need rather urgently to find a way to turn these investments into cash and return money to LPs. Here too the comparison with US private equity is especially instructive.

The colossus that is today’s US private equity industry, with 3,300 firms invested in 11,000 US companies, was built in part by doing successful buyouts in the 1980s and 1990s of manufacturing and industrial companies, often troubled ones. Deals like Blackstone‘s most successful investment of all time, chemicals company Celanese, together with American Axle and TRW Automotive, KKR‘s Amphenol Corporation, Bain‘s takeover of  Sealy Corporation and many, many others led the way. Meanwhile, smart corporate investors like Warren Buffett’s Berkshire Hathaway, Honeywell, Johnson Controls, Emerson Electric and were also pouring billions into acquiring and shaping up industrial businesses. So successful has this strategy been over the last 30 years, it can seem like there are no decent industrial or manufacturing companies left for US PEs to target.

Along the way, US PEs became experts at selecting, acquiring, fixing up and then exiting from industrial companies. US PEs have shown again and again they are good at rationalizing, consolidating, modernizing and systematizing industrial companies and entire industrial sectors. These are all things China’s manufacturing industry is crying out for. Market shares are fragmented, management systems often non-existent, inventory control and other tools of “lean manufacturing” often nowhere to be found.

So here’s a pathway forward for China PE, to use in China the identical investing skills honed in the US. It should be rather easy, since among the US’s 100 biggest private equity firms, the majority have sizeable operations now in China, including giants like Carlyle, Blackstone, KKR, TPG, Bain Capital, Warburg Pincus. For these firms, it should be no more complicated than the left hand following what the right hand is doing.

It isn’t working out that way. This is a big reason why China PE is performing poorly compared to the US. PE partners in China in the main came into the industry after getting an MBA in the US or UK, then getting a job on Wall Street or a consulting shop. Few have experience working in,  managing or restructuring industrial companies. They often, in my experience, look a little out of place walking a factory floor. This is the other big mismatch in China PE — between the skill-sets of those running the PE firms what’s needed to turn their portfolio companies into winners.

Roll-up, about the most basic and time-tested of all US PE money-making strategies, has yet to take root in China. Inhospitable terrain? No, to the contrary. But, it requires a fair bit of sweat and grit from PE firms.

This may account for the fact that China PE firms are now mainly herding together to try to close deals in e-commerce, healthcare services, mobile games and other places where no metal gets bashed. PE firms formed such a crush to try to invest in Xiaomi, the mobile phone brand, that they drove the valuation up in the latest round of funding to $46 billion, so high none of them decided to invest. China PE is that paradoxical – fewer deals are getting done, fewer have profitable exits and yet valuations are often much higher than anywhere else.

Another worrying sign: of the big successful China company IPOs in 2014 – Alibaba, Dalian Wanda‘s commercial real estate arm, CGN, CITIC Securities, Shaanxi Coal, JD.com, WH Group  – only one had large global PE firms inside as large shareholders. That was WH Group, a troubled deal that had a hard time IPOing and has since sunk rather sharply. For the big global PE firms, 2014 had no big China IPO successes, which is probably a first.

The giant US PEs (Blackstone, Carlyle, KKR, Goldman Sachs Capital Partners, Bain Capital, TPG and the others) all voyaged to China a decade or more ago with high hopes. Some even dared predict China would become as important and profitable a market for them as the US. They were able to raise billions at the start, build big teams, but it’s been getting noticeably harder both to raise money and notch big successful deals. And so their focus is shifting back to the US.

China has so much going for it as an investment destination, such an abundance of what the US lacks. High overall growth, a government rolling in cash, a burgeoning and rapidly prospering middle class, rampant entrepreneurship, huge new markets ripe for taking. Why then are so many of the world’s most professional and successful investors finding it so tough to make a buck here?

 

Tencent Stalks Alibaba — China’s Number Two Internet Company Quietly Takes Lethal Aim at its Number One

China's two most successful internet entrepreneurs share a last name but have very different strategies for mobile e-commerce. The future belongs to which?
China’s two most successful internet entrepreneurs share a last name but have very different strategies for mobile e-commerce. The future belongs to which Ma?

China’s second-largest private sector company Tencent is aiming a cannon at China’s largest private sector company and new darling of the US stock markets Alibaba. Will Tencent fire? There’s a vast amount of money at stake: these two companies, cumulatively, have market cap of $400 billion, Tencent’s $140bn and Alibaba’s $260bn.

Alibaba, as most now know,  currently has China’s e-commerce market in a stranglehold, processing orders worth over $300 billion a year, or about 80% of all Chinese online sales by China’s 300 million online shoppers. Meanwhile, Tencent is no less dominant in online chat and messaging, with over 400mn users for its mobile chat application WeChat, aka “Weixin” (微信).

The two businesses appear worlds apart. And yet, they are now on a collision course. The reason is social selling, that is, using a mobile phone chat app to sell stuff to one’s friends and contacts. It’s based on the simple, indisputable notion it’s more reliable and trustworthy to buy from people you know. Facebook, Twitter, Linkedin are all quite keen on social selling in the US. But, nowhere is as fertile a market as China, because nowhere else is the trust level from buying through unknown online merchants as low.

Alibaba has accumulated most of its riches from this low-trust model at Taobao’s huge online bazaar. It is a collection of thirty million small-time individual peddlers that Alibaba can’t directly control. The result, especially in a country with no real enforceable consumer protection laws or litigation, Taobao can be a haven for people selling stuff of dubious quality and authenticity.

Chinese know this, and don’t much care for it. It’s one reason both US-listed JD.com and Amazon China both seem to be gaining some ground on Alibaba. Their strategies are similar:  to be the “anti-Taobao”, selling brand-name stuff directly, using their own buying power and inventory, their own delivery people, and a no-questions-asked return policy. Their range of merchandise, however, is far more limited than Taobao’s. Tencent in 2014 bought a significant minority stake in JD.com.

Thanks to Weixin, Tencent now has the capability directly to become Alibaba’s most potent competitor and steal away billions of dollars in transactions. Will it?

As of now, Tencent seems oddly reluctant. Even as millions of Weixin users have started using the app to buy and sell goods directly with their friends, Tencent has countered by making it more difficult. Tencent introduced limits on the number of contacts each Weixin user can add, has made sending money tricky, and has more or less banned users to include price quotes in their mobile messages. For now, Weixin users appear undaunted, and are using various ruses to get around Tencent’s unexplained efforts to limit their profit-making activities. One common one: using the character for “rice” (米) instead of the symbol for the Chinese Renminbi (元).

This social selling through Weixin is called “Weishang” (微商) in Chinese, literally “commerce on Weixin”. It is without doubt the hottest thing in online selling now in China.

It’s hard to understand why Tencent wouldn’t passionately embrace social selling on Weixin. For now, Weixin looks to be an enormous money sink for Tencent. The Weixin app is free to download and use. What money it earns from it comes mainly from promoting pay-to-play online games. That’s small change compared to the tens of millions of dollars Tencent spends on maintaining the server infrastructure to facilitate and store the hundreds of millions of text, voice, photo and video messages sent daily on the network.

Chinese of all ages are glued to Weixin at all hours of the day. It can be hard for anyone outside China to quite fathom how deeply-woven into daily life Weixin has become in the four years since its launch. Peak Weixin usage can exceed 10mn messages per minute. With only slight exaggeration, Tencent’s founder and chairman Pony Ma explains Weixin has become like a  “vital organ” to Chinese.

It’s not just young kids. I took part in a meeting recently with a partner from KKR and the chairman of a large Chinese publicly-traded company At the end of the discussion, they eagerly swapped Weixin accounts to continue their confidential M&A dialogue.

My office is in the building next to Tencent’s headquarters in Shenzhen. I know quite a few of the senior executives. But, no one can or will articulate why Tencent, at least for now, is unwilling to use Weishang take on Alibaba. Some who claim to know say it’s because the Chinese government is holding them back, not wanting to have Tencent steal Alibaba’s spotlight so soon after its most-successful-in-history Chinese IPO in the US.

The two have sparred before. Tencent years ago launched its own copycat version of Taobao, now called Paipai. But it failed to put a dent in Alibaba’s franchise. Alibaba, in turn,  launched its own online message system to compete with Weixin. But, it’s sunk from sight as quickly as a heavy stone dropped in a deep pond.

Seen from a seller’s perspective, Weishang is fundamentally more attractive than selling on Taobao. Margins are higher, not only because Tencent charges no fees, but it’s getting much harder and more expensive to get noticed on Taobao. That’s good for Alibaba’s all-important ad revenues, but bad for merchants.

How does Weishang work? A woman, for example, buys twenty sweaters at a wholesale price, then takes a selfie wearing one. She sends this out to her 300 contacts on Weixin. Though the message includes neither the price nor much of a sales pitch, since both may be monitored by Tencent, she will often get back replies asking how to buy and how much. The sales are closed either by phone call, or through voice messaging over Weixin, with payment sent direct to the seller’s bank account.

Tencent knows Weixin is being used more and more like this, but because it’s driven the commerce somewhat underground, Tencent has no idea on the exact scale of Weishang. My guess is aggregate Weishang sales are already in the tens, if not hundreds, of millions of dollars.

Alibaba has clearly noticed. But, social selling isn’t something its Taobao e-commerce marketplace can do. Its mobile e-commerce strategy amounts to making it easy to scroll through Taobao items on a small screen. Social selling in China is and will remain Tencent’s natural monopoly.

For anyone wondering, Alibaba’s IPO prospectus from a few months ago did not mention Weishang and Weixin, and Tencent gets a single nod as one of many possible competitors. Weishang really began to gain traction only during the second half of 2014, after the main draft of the Alibaba prospectus was completed.

To those outside China especially on Wall Street, Alibaba seems to be on the top of the world, as well as the top of its game. In the last four months, it’s collected $25 billion from the IPO and another $8 billion in a bond offering. Its share price price is up 50% since the IPO. For a lot of us living here in China, the boundless enthusiasm in the US for “Ali” (as the company is universally known here) can sometimes seem a bit unhinged.

When will Tencent make its move? Why is it now so reticent to promote Weishang, or discuss its plans with the investment community? Is it busy next door to me readying a dedicated secure payment system and warranty program for Weishang purchases?

I don’t have the answer, but this being China, I do know where to look for guidance. Sun Tzu’s “The Art of War”, written 2,500 years ago, remains the country’s main strategic handbook, used as often in business as in combat. The pertinent passage, in Chinese, goes “微乎微乎,至于无形;神乎神乎,至于无声;故能为敌之司命.” In English, you can translate it as “be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness. “

In other words, don’t let your competitor see or hear you coming until its already too late.

China’s Big Banks: learn how they overprice & misallocate loans while treating borrowers like conmen

Chinese banking loan approval process

Do you have the financial acumen to run the lending department of one of China’s giant state-owned banks? Let’s see if you qualify. Price the following loan to a private sector Chinese company.  Your bank is paying depositors 0.5% interest so that’s your cost of capital. The company has been a bank customer for six years and now needs a loan of Rmb 50mn (USD$8 mn).  The audit shows it’s earning Rmb 60mn a year in net profits, and has cash flow of Rmb 85mn.

You ask the company to provide you with a first lien on collateral appraised at Rmb 75mn and require them to keep 20% or more of the loan in an account at your bank as a compensating deposit. Next up, you ask the owner to pledge all his personal assets worth Rmb 25mn, and on top, you insist on a guarantee from a loan-assurance company your bank regularly does business. The guarantee covers any failure to repay principal or interest. What annual interest rate would you charge for this loan?

If you answered 5% or lower,  you are thinking like a foreigner. American, Japanese or German maybe. If you said 13% a year, then you are ready to start your new career pricing and allocating credit in China. At 10% and up, inflation-adjusted loan spreads to private sector borrowers in China are among the highest in the world, particularly when you factor in the over-collaterallization, that third-party guarantee and fact the loan is one-year term and can’t be rolled over. As a result, the company will actually only have use of the money for about nine months but will pay interest for twelve. Little wonder Chinese banks have some of the fattest operating margins in the industry.

Chinese private businessmen are paying too much to borrow. It’s a deadweight further slowing China’s economy. We are quite keen, by the way,  on private debt investing in China.

The high cost of borrowing negatively impacts corporate growth and so overall gdp growth. It is also among the more obvious manifestations of an even more significant, though often well-hidden, problem in China’s economy: the fact that nobody trusts anybody.  This lack of trust acts like an enormous tax on business and consumers in China, making everything, not just bank credit, far more expensive than it should be.

Online payment systems, business contracts, visits to the doctor, buying luxury products or electronics like mobile phones or computers: all are made more costly, inefficient and frustrating for all in China because one side of a transaction doesn’t trust the other. One example: Alibaba’s online shopping site, Taobao, will facilitate well over USD$200bn in transactions this year. Most are paid for through Alipay, an escrow system part-owned and administered by Alibaba. Chinese shoppers are loathe to buy anything directly from an online merchant. They generally take it as a given that the seller will cheat them.

Most of the world’s computers and mobile phones are made in China. But, Chinese walk a minefield when buying these products in their own country. It’s routine for sellers to swap out the original high-quality parts, including processors, and replace them with low-grade counterfeits, then sell products as new. Chinese, when possible, will travel outside China, particularly to Hong Kong, to buy these electronics, as well as luxury goods like Gucci shoes and Chanel perfume. This is the most certain way to guarantee you are getting the genuine article.

In the banking sector, loans need to have multiple, seemingly excessive layers of collateral, as well as guarantees. Banks simply do not believe the borrower, the auditors, their own in-house credit analysts, or the capacity of the guarantee firms to pay up in the event of a problem.

Disbelief gets priced in. This is the reason for the huge loan spreads in China. Banks regard their own loan documentation as a work of fiction. It stands to reason that if a company’s collateral were solid and the third-party guarantee enforceable, then the cost to borrow money should be at most a few points above the bank’s real cost of capital. Instead, Chinese companies get the worst of all worlds: they have to tie up all their collateral to secure overpriced loans, while also paying an additional 2%-3% a year of loan value to the third-party credit guarantee company for a guarantee the bank requires but treats as basically worthless.

In the event a loan does go sour, the bank will often choose to sell it to a third party at discount to face value, rather than go to court to seize the collateral or get the guarantee company to pay up. The buyer is usually one of the state-owned asset recovery companies formed to take bad debts off bank balance sheets. Why, you ask, does the bank require the guarantee then fail to enforce it? One reason is that Chinese private loan-assurance companies, which usually work hand-in-glove with the banks,  are usually too undercapitalized to actually pay up if the borrower defaults. Going after them will force them into bankruptcy. That would cause more systemic problems in China’s banking system.

Instead, the bank unloads the loan and the asset recovery companies seize and sell the only collateral they believe has any value, the borrower’s real estate. The business may be left to rot. The asset management companies usually come out ahead, as do the loan guarantee companies, which collect an annual fee equal to 2% to 3% of the loan value, but rarely, if ever, need to indemnify a lender.

Don’t feel too sorry for the bank that made the loan. Assuming the borrower stayed current for a while on the high interest payments, the bank should get its money back, or even turn a profit on the deal. Everyone wins, except private sector borrowers, of course. Good and bad like, they are stuck paying some of the highest risk-adjusted interest costs in the world.

When foreign analysts look at Chinese banks, they spend most of their time trying to divine the real, as opposed to reported, level of bad debts, devising ratios and totting up unrealized losses. They don’t seem to know how the credit game is really played in China.

Most of the so-called bad debts, it should be said, come from loans made to SOEs and other organs of the state. Trust is not much of an issue. SOEs and local governments generally don’t need to pledge as much collateral or get third-party guarantees to borrow. A call from a local Party bigwig is often enough. The government has shown it will find ways to keep banks from losing money on loans to SOEs. The system protects its own.

Chinese banks should be understood as engaged in two unrelated lines of business: one is as part of a revolving credit system that channels money to and through different, often cash-rich, arms of the state. The other is to take in deposits and make loans to private customers.  In one, trust is absolute. In the other, it is wholly absent.

Many Chinese private companies do still thrive despite a banking system that treats them like con artists, rather than legitimate businesses with a legitimate need for credit. The end result: the Chinese economy, though often the envy of the world,  grows slower and is more frail than it otherwise would be. Everyone here in China is paying a steep price for the lack of trust, and the mispricing of credit.

 

 

China’s central government gets serious about changing IPO rules and helping SMEs raise capital, Global Times article

globatimes

 

Govt calls for progress in IPO reform to help small firms

By Wang Xinyuan Source:Global Times Published: 2014-11-24

 

Amid a slowing economy, the Chinese government is considering strategies to help the country’s cash-starved micro and small companies. Upcoming IPO reform is expected to offer easier access to stock market funding, but investors are concerned it could divert funds from existing stocks.

 

While China’s economy has been affected by a weakening property sector, erratic foreign demand and sagging domestic investment growth, the authorities are hoping that the country’s millions of micro and small enterprises (MSEs) can offer a source of economic energy.

The State Council, the country’s cabinet, pledged on Wednesday to lower the cost of raising funds by giving banks more flexibility to lend and removing rigid profit requirements for a firm to get listed in stock markets, among other measures aimed at making it easier for small firms to grow.

At the meeting on Wednesday, Premier Li Keqiang urged the securities regulator to speed up plans to unveil simplified rules for new IPOs.

Two days after the cabinet’s meeting, the central bank cut interest rates for the first time in two years.

While the rate cut will be of particular benefit for large State-owned enterprises, simplified IPO access is expected to make it easier for cash-starved smaller firms to raise money directly in the markets.

Under the existing IPO scheme, applicants must meet certain conditions in order to get listed in Shanghai or Shenzhen, including having made a profit for at least two consecutive years and having net profit of at least 10 million yuan ($1.63 million).

Even if they meet these requirements, IPO applicants are also subject to the review and approval procedures of the China Securities Regulatory Commission (CSRC), the securities watchdog.

The CSRC suspended its IPO reviews in late 2012 in a bid to enhance information disclosure and crack down on rampant financial fraud and insider trading.

The CSRC also wanted to lay solid foundations for a new round of IPO reform intended to diminish government intervention and establish a more efficient, market-based IPO filing system.

The regulator restarted IPO approvals in December 2013 after a 13-month hiatus.

However, the suspension had resulted in a long queue of IPO applicants. As of mid-November this year, 570 firms were waiting for their applications to be reviewed, according to media reports.

A plan for an IPO filing system with a focus on information disclosure is likely to be released by the end of 2014, the 21st Century Business Herald reported on Thursday, citing a source close to the CSRC.

Equal access

Under the new IPO registration system, the CSRC will no longer intervene in the listing process and will focus on supervision rather than review and approval, analysts said.

The system will provide access to market financing for all firms, not just those at the front of the queue for IPO approval, and the investment value shall be judged by investors, not the government, Dong Dengxin, director of the Finance and Securities Institute at Wuhan University of Science and Technology, wrote on his Weibo on Saturday.

The CSRC was not available for comment on the schedule of IPO registration reform when reached by the Global Times on Thursday.

As China tries to move up the value chain and restructure its economy, small firms have become increasingly important. They also account for more than 70 percent of the country’s jobs.

“While the IPO reforms are absolutely correct in their direction and implementation, the capital markets in China are still unable to provide the financing needed for most MSEs to continue to grow,” Peter Fuhrman, chairman and CEO of Shenzhen-based investment bank China First Capital, told the Global Times in an e-mail on Saturday.

Relatively slow approval of IPOs and the exceptionally long waiting list are seen as the major reasons for the difficult funding.

There are “thousands of Chinese MSEs with good size and profits” that are waiting to go public, said Fuhrman.

Read full article.

China juices liquidity, and risk, at OTC exchange — Reuters

Reuters

China juices liquidity, and risk, at OTC exchange

SHANGHAI August 22 Thu Aug 21, 2014 5:10pm EDT

(Reuters) – Chinese brokerages will start making markets next week on China’s New Third Board, its leading over-the-counter (OTC) exchange but one long derided as a dead-end market populated by small little-known, opaquely managed firms.

The move has revitalized interest and trading volumes have exploded, but analysts warn of significant risk.

Most of the 66 Chinese brokerages so far approved to make markets – a business that requires deep cash reserves and sophisticated risk management skills – have little experience.

Market makers quote both a buy and sell price and guarantee share availability by holding shares themselves in inventory, which requires careful real-time management.

For brokerages it means extra profits, while China’s policymakers hope the liberalization will boost liquidity in an exchange that can provide capital for small innovative firms, needed for the next phase of economic expansion.

But, analysts fear that brokerages inexperience coupled with inadequate disclosure by listed companies could led to trouble for an exchange already saddled with image problems.

“Like all OTC markets – including… America’s Bulletin Board and Pink Sheets – China’s Third Board suffers from inherent fundamental flaws,” said Peter Fuhrman, chief executive at China First Capital.

“Liquidity and valuations are persistently low and disclosure is spotty. If it was designed to be a solution to the problem of erratic mainstream IPO policy and approvals on China’s main Shenzhen and Shanghai stock exchanges, the Third Board must be judged a major disappointment.”

Regardless of critics, trading volumes on the exchange soared almost 700 percent in May when Chinese media first reported the advent of market-makers, ChinaScope Financial data shows. Foreign investors are unable to trade on the exchange.

A Reuters analysis of daily data from the National Equities Exchange and Quotations (NEEQ), which runs the New Third Board, shows that August volumes are set to surpass May’s record. Transactions worth 1.16 billion yuan ($188.63 million), as of Aug. 19, were nearly double July’s total, while the volume of shares traded has more than tripled month-on-month.

SMALL CAP CELEBRATION

Smaller private companies in China are the country’s biggest aggregate employers and generators of GDP, but they have difficulty getting bank loans and even more difficulty getting regulatory approval to list on major markets or issue bonds.

However, while dozens of local governments have created OTC markets to help match companies with investors, the lack of market makers and lack of a clear upgrade path to major exchanges has caused most firms and investors to steer clear.

But that may be about to change.

“The expectation is that the Third Board can be an entree onto the growth enterprise board for select small companies,” said Brian Ingram, chief investment manager at Russell Ping An Investment Management.

“If the board does serve that purpose, it’s likely to see pretty rapid growth, and the catalyst for that growth is the fact that regulators are allowing brokerage houses to serve as market makers.”

Brokerages hope it will boost in profits, something they need badly having struggled since 2010 as investors steadily switched out of Chinese stocks, among the world’s worst performers, in favor of housing and high-yielding wealth management products.

SMALL-CAP FEEDING FRENZY

Chinese investors enthusiastically trade small, volatile tickers listed on Shenzhen’s ChiNext growth board, so some predict a revitalized OTC board will attract similar speculative interest, further supporting liquidity.

However, sustained interest from both investors and companies depends on whether regulators formally commit to allowing companies on the New Third Board upgrade to ChiNext.

“We’re now considering listing on the New Third Board, but we are waiting for policy confirmation that we can upgrade to ChiNext,” said Cui Lijun, deputy general manager at robotics firm LEN in Shenzhen.

Similar experiments have disappointed in the past, such as the hard-currency-denominated “B-share” board. Speculators bought B-shares hoping they would ultimately be upgraded to yuan-denominated A-shares, but in the end only a few companies were allowed to transfer, leaving the rest stranded.

CALLS FOR CAUTION

The chequered history of OTC markets in China and abroad, especially with regards to disclosure standards, also has many calling for caution.

In the late 2000s, small Chinese companies began listing on American OTC boards, and some managed to upgrade to major exchanges such as NASDAQ. But many were subsequently found to be riddled with accounting irregularities, causing a swathe of delistings.

Given this history, it is unclear whether regulators want to expand the aggregate OTC market or consolidate it.

Out of all of China’s 26 OTC markets, the New Third Board is the only one that companies from anywhere in China can list on, and it will now be the only one where making markets will be allowed.

Some analysts said that this means the government may be elevating the Third Board, so it can then kill off the rest.

But Zhang Yunfeng, the head of Shanghai’s rival OTC market, said in an interview published in China’s Securities Times on Wednesday that he doesn’t feel threatened.

“I’m not optimistic about the market making institution … if there’s not enough base liquidity, market making will have a hard time enabling market performance.”

www.reuters.com/article/2014/08/21/us-china-markets-otc-idUSKBN0GL26920140821

Download PDF version.

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.

 

 

Alibaba files for IPO in US — China Daily article

China Daily

 

 

Updated: 2014-05-07 06:56

By MICHAEL BARRIS in New York (chinadaily.com.cn)

Alibaba files for IPO in US

Alibaba Chairman and Non-executive Director Jack Ma participates in a teleconference in Hong Kong in this October 22, 2007 file photo, one day before its initial public offering in the territory. [Photo/Agencies]

Chinese e-commerce giant Alibaba Group Holding officially filed on Tuesday to go public in the US in what could be the largest initial public offering ever.

A regulatory filing gave a $1 billion placeholder value for the offering, but the actual amount is expected to be far higher, possibly exceeding $20 billion and topping not only Facebook’s $16 billion 2012 listing, but Agricultural Bank of China Ltd’s record $22.1 billion offering in Shanghai and Hong Kong in 2010.

Alibaba, founded by former English teacher Jack Ma in a Hangzhou apartment, and its bankers have been moving to throw their own shares behind the IPO, analysts have said.

In its filing Alibaba gave no date for the proposed IPO or whether it would be on the New York Stock Exchange or Nasdaq. It cited its advantageous placement in a nation in which e-commerce is fast becoming a way of life, as Chinese consumers turn to the Internet to buy innumerable items. But Alibaba’s prospectus cited statistics showing that the market hasn’t been fully tapped. Just 45.8 percent of China’s population used the Internet, while 49 percent of customers shopped online.

Often described as a combination of eBay and Amazon, Alibaba handled $240 billion of merchandise in 2013. With more than 7 million merchants, it has more than $2 billion in revenue and profit of more than $1 billion.

Alibaba’s sheer size could weigh on the stock price of US rival Amazon.com if the Chinese company’s shares are added to indexes and portfolios targeting e-commerce and related sectors, analysts said.

“Amazon simply doesn’t measure up to the size of Alibaba’s earnings and earnings growth rate,” analyst Robert Wagner wrote.

Shares aren’t expected to begin trading for several months, as the US Securities and Exchange Commission reviews Alibaba’s offering materials and the company promotes its prospects to institutional investors.

The offering managers are Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Morgan Stanley and Citigroup.

Ma, who has described the challenge of providing what he calls personal business as “my religion”, is Alibaba’s biggest individual shareholder, with an 8.9 percent stake.

Alibaba’s announcement continues a flurry of IPO filings by Chinese technology companies. Internet security application developer Cheetah Mobile is expected to go public on the New York Stock Exchange on Thursday and is expected to raise $153.75 million to $178.35 million. Three weeks ago, Weibo Corp, the Chinese micro blogging service owned by Sina Corp and Alibaba Group Holdings Ltd, raised $285.6 million in a Nasdaq IPO, while real-estate listings website Leju Holdings Ltd raised $100 million in an initial offering on the NYSE.

“The key question for China is how much new money, if any, Alibaba will raise in this US IPO,” Peter Fuhrman, chairman and CEO of China First Capital, told China Daily.

“If all the cash goes to Japan’s Softbank and US’s Yahoo, then it’s hard to see how Alibaba, its customers and the hundreds of millions of Taobao-addicted Chinese consumers will benefit from the IPO.” US web-portal company Yahoo is a 24-percent Alibaba shareholder, while Japan’s Softbank has a 37-percent stake.

http://usa.chinadaily.com.cn/business/2014-05/07/content_17490099.htm

WH Group Hong Kong IPO Goes Belly Up – Leaving Wall Street’s Most Famed Investment Banks and Some of Asia’s Biggest PE Firms at an Embarrassing Loss

WSJ Shuanghui WH Group failed IPO

There will be an awful lot of embarrassed financial professionals sulking around Hong Kong and Wall Street today. The reason: a crazy IPO deal financially-engineered by a group of 29 big name investment banks, led by Morgan Stanley, together with several large China and Asian-based PE firms including China’s CDH and Singapore’s Temasek Holdings failed to find investors. Their pig’s ear didn’t, as they promised, turn into the silk purse after all. The planned IPO of WH Group has been aborted.

WH Group was created by the banks and PE firms to hold the assets of American pork producer Smithfield Foods bought last year in a leveraged buyout. The other asset inside of WH Group is a majority shareholding in China’s largest pork company Henan Shuanghui Investment & Development.

I was one of the few who actually called into question almost a year ago the logic as well as the economics of the deal. You can read my original article here.

There weren’t a lot of other doubters at the time. The mainstream financial press, by and large, went along with things, accepting at face value the story provided to them by Morgan Stanley, CDH and others. Over the last few months, as the now-failed IPO got into gear in anticipation of closing the deal around now, the press kept up its steady reporting, not raising too many tough questions about what were obviously some glaring weak points – the high debt, the high valuation, the crazy corporate structure that made the deal appear to be what it wasn’t, a Chinese takeover of a big US pork company.

I have no special interest in this deal, since me and my firm never acted for any of the parties involved, nor do I own any shares in any of the companies involved. I just couldn’t get over, in reading the SEC documents filed at the time of the takeover, the brazenness of it, the chutzpah, that these big institutions seemed to be betting they could repackage a pound of sausage bought in New York for $1 as pork fillet and sell it for $5 to Hong Kong investors and institutions.

In other words, saying at the time it looked like the whole thing rested on a very shaky foundation was a reasonable conclusion for anyone who took the time to read the SEC filings. Instead, mainly what we heard about, over and over, was that this was (wrongly) China’s “biggest takeover of a US company,” a “merger between America’s largest pork producer and its counterpart in the world’s largest pork market.”

Morgan Stanley, CDH, Temasek and the others got a little too cocky. The original Smithfield “take private” deal last year went through smoothly. They moved quicker than originally planned to get the company re-listed in Hong Kong. Had they pulled it off, it would have meant huge fees for the investment bankers, and depending on the share price, a juicy return for the PE firms, most of whom had been stuck holding the shares in Henan Shuanghui Investment & Development for over seven years. First came word last week they wanted to cut back by 60% the size of the IPO due to the hostile reception from investors during the road show phase. Then the IPO was suddenly called off late on Tuesday, Hong Kong time.

One of the questions that never got properly answered is why these PE firms didn’t sell their Shuanghui shares on the Chinese stock market, but held them since IPO, without exiting. That’s unusual, especially since Shuanghui’s shares have traded well above the level CDH and others bought in at. I wasn’t in China at the time, but that original investment did not cover itself in praise and glory. Almost immediately after the PE firms went in, providing the capital to allow the state-owned Shuanghui to privatize itself in 2006, the rumors began to circulate that the deal was deeply corrupt, and for reasons never explained, was structured in a way where the PE firms did not have a way to exit through normal stock market channels.

The Smithfield acquisition never made much of any industrial sense. The PE firms that now own the majority (mainly CDH, Temasek, New Horizon, but also including Goldman Sachs’ Asia PE arm ) have no experience or knowledge how to run a pork business in the US. In fact, they don’t know how to run any business in the US. The Shuanghui China management, which is meant now to be serving two separate masters, simultaneously running the Chinese company and its troubled American cousin, similarly don’t know a hock from a snout when it comes to raising and selling pork in the US. This is, was and will remain the main business of Smithfield. Not exporting pork to China. How, when and why these US assets can be listed in Asia must certainly now count as a mystery to all of the big-name financial institutions involved, including Bank of China, which lent billions to finance the takeover last year, as did Morgan Stanley itself.

So, now we have this sorry spectacle of the PE firms, together with partners, having seemingly thrown more money away in a failed bid to rescue the original Shuanghui investment from its unexplained illiquidity. The WH Group IPO failure is also a stunning rebuke for the other PE-backed P2P take private deals now waiting to relist in Hong Kong. (Read here, here, here.) Smithfield, while no great shakes, is the jewel among the rather sorry group of mainly-Chinese companies taken private from the US stock exchange with the plan to sell them later to Hong Kong-based investors via an IPO.

This was among the most bloated IPOs ever, with 29 investment banks given underwriting mandates to sell shares. ( The IPO banks included not only Morgan Stanley, but also Citic Securities, Goldman Sachs, UBS, Barclays, Credit Suisse, JP Morgan, Nomura, Citigroup, Deutsche Bank.) All that expensive investment banking firepower. Result: among the most expensive IPO duds in history.

For the PE consortium that owns WH Group, they will have already likely lost over USD$15mn in LP money on legal, underwriting and accounting fees on this failed IPO. This is on top of a whopping $729mn fees paid by the PE firms for what are called “one-off fees and share-based payments” to acquire Smithfield. The subsequent restructuring ahead of IPO? Maybe another $100mn. If or when the WH Group IPO is tried again, the fees will likely be at least as high as the first time around. In short, the PE firms are already close to $1 billion in the red on this deal, not including interest payments on all the debt.  Smithfield itself remains lacklustre. Its net profit shrank 50% during the fiscal year leading up to the buyout.

With no IPO proceeds anywhere on the horizon, the issue looming largest now for the PE firms: is WH Group generating enough free cash to service the $7 billion in debt, including $4 billion borrowed to buy sputtering Smithfield? If not, next stop is Chapter 11.

By contrast, now feeling as delighted as pigs in muck are the mainly-US shareholders who last year sold their Smithfield shares at a 31% premium above the pre-bid price to the Chinese-led PE group. It doesn’t offset by much the US trade deficit with China, which reached a new record last year of $318 billion. But these US investors also get the satisfaction of knowing they have so far received the far better end of a deal against some of the bigger, richer financial institutions in Asia and Wall Street.

 

China’s SOEs attract PE interest — Private Equity International Magazine

Private Equity International Magazine

www.peimedia.com

China’s state-owned enterprise promise big returns for PE investors, as well as a big challenge.

By: Clare Burrows


In 2013, private equity investment in China dropped to just $4.5 billion – about 47 percent below the equivalent figure for 2012, according to data from Thomson Reuters. Since China’s dry powder level was estimated at $59 billion at the end of 2012, it’s clear that China’s GPs need to find new ways to deploy the vast amounts of capital raised during better times.

What seems to be catching the industry’s eye more than ever are the country’s state-owned enterprises:large, government-controlled organisations, many of which are in dire need of restructuring. While state-owned enterprises account directly or indirectly for 60 percent of China’s GDP, according to research by China First Capital, almost 100 percent of institutional capital, especially private equity, has
been invested into China’s privately-owned sector.

However, as the number of traditional opportunities falls, “this may leave investing in SOEs as the best, largest and most promising new area for private equity investment,” Peter Fuhrman, chairman and chief executive at China First Capital suggests.

And, some industry sources ask: what better target for private equity than these bloated, inefficient giants, which the newly-appointed Chinese government is apparently so keen to reform? SOEs are highly compliant when it comes to tax and accounting laws (a rare phenomenon among China’s privately-owned companies). Better still, they’re a bargain – because China’s State-owned Assets Supervision and Administration Commission (SASAC) regulates their price based on net asset value.

“If you have a highly profitable SOE that has very low net assets, you can potentially buy it at incredibly low P/E multiples,” Fuhrman says. With one deal China First is advising on, 51 percent of the business is being offered at 2x EBITDA, he adds. China First is currently acting as an investment banker for five of China’s largest SOEs, including China Aerospace, China State Construction, China Huadian, Wuliangye Group and Shandong Energy.

Click here to read full article

China’s Newest Billionaire, My Buddy Laowu — Bloomberg

Bloomberg

Bloomberg story

It took my friend and client Laowu 20 years to build his business, but less than four months from the IPO in Hong Kong to reach dollar billionaire status. While I hardly doubted he’d someday make it, it certainly happened quicker than I would have hoped or guessed. You can read my account of this remarkable businessman, his humble beginnings and his high-flying real estate development company, by clicking here.

Laowu’s company, Hydoo, has had a torrid run on the Hong Kong exchange. The share price is up over 70% since the listing on the last day of October 2013. That’s lifted the value of his family’s shares to north of $1 billion. I hadn’t kept track of the stock price, so didn’t know my friend had reached the milestone. Bloomberg’s China Billionaires reporter called today to ask if I would comment for the story he’s doing.

That article can be found here and can be downloaded in PDF here.

 

 

China’s Capital Markets Go From Feast to Famine and Now Back Again, China First Capital New Research Report

China First Capital 2014 research report cover

The long dark eclipse is over. The sun is shining again on China’s capital markets and private equity industry. That’s good news in itself, but is also especially important to the overall Chinese economy. For the last two years, investment flows into private sector companies have dropped precipitously, as IPOs disappeared and private equity firms went into hibernation. Rebalancing China’s economy away from exports and government investment will take cash. Lots of it. Expect significant progress this year as China’s private sector raises record capital and China’s state-owned enterprises (SOEs) gradually transform into more competitive, profit-maximizing businesses.

These are some of the conclusions of the most recent Chinese-language research report published by China First Capital. It is titled, “2014民企国企的转型与机遇“, which I’d translate as “2014: A Year of Transformation and Opportunities for China’s Public and Private Sectors”. You can download a copy by clicking here or visiting the Research Reports section of the China First Capital website, (http://www.chinafirstcapital.com/en/research-reports).

We’re not planning an English translation. One reason:  the report is tailored mainly to the 8,000 domestic company bosses as well as Chinese government policy-makers and officials we work with or have met. They have already received a copy. The report has also gotten a fair bit of media coverage over the last week here in China.

Our key message is we expect this year overall business conditions, as well as capital-raising environment,  to be significantly improved compared to the last two years.  We expect the IPO market to stage a significant recovery. Our prediction, over 500 Chinese companies will IPO worldwide during this year, with the majority of these IPOs here in China.

We also investigate the direction of economic and reform policy in China following the Third Plenum, and how it will open new opportunities for SOEs to finance their growth and improve their overall profitability, including through carve-out IPOs and strategic investment. SOEs will become an important new area of investment for PE firms and global strategics.

The SOEs we work with are all convinced of the need to diversify their ownership, and bring in profit-driven experienced institutional investors. For investors, SOE deals offer several clear advantages: scale is larger and valuations are usually lower than in SME deals; SOEs are fully compliant with China’s tax rules, with a single set of books; the time to IPO or other exit should be quicker than in many SME deals.

As financial markets mature in China, we think one unintended consequence will be a drop in activity on China’s recently-established over-the-counter exchange, known as the “New Third Board” (新三板).  The report offers our reasons why we think this OTC market is a poor, inefficient choice for Chinese businesses looking to raise capital. While the aims of the Third Board are commendable, to open a new fund-raising channel for private sector companies, the reality is that it offers too little liquidity, low valuations and an uncertain path to a full listing on China’s main stock exchanges.

Over the last three years, China has had the highest growth rate and the worst performing stock market among all major economies. In part, the long stock market slide is both necessary and desirable, to bring China’s stock market valuations more in line with those of the US and Hong Kong. But, it also points to a more uncomfortable reality, that China’s listed companies too often become listless ones. Once public, many companies’ profit growth and rates of return go into long-term decline. IPO proceeds are hoarded or misspent. Rarely do managers make it a priority to increase shareholder value.

A small tweak in the IPO listing rules offers some promise of improvement. Beginning this year, a company’s control shareholder, usually the owner or a PE firm, will be locked-in and prevented from selling shares for five years if the share price stays below the original IPO level.

Spare a moment to consider the life of a successful Chinese entrepreneur, both SOE and private sector. In two years, access to capital went from feast to famine. And now maybe back again. An IPO exit went from a reachable goal to an impossibility. And now maybe back again. Meanwhile, markets at home surged while those abroad sputtered. Government reform went from minimal to now ambitious.

2014 is going to be quite a year.

Private Equity in China 2014: A Dialogue

pendant

PE in China is changing. But, from what and into what?

Over the last week, I had an email discussion with a managing director in China of one of the world’s five largest private equity firms. He wrote to tell me about the fund’s recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China.

I’ll share an edited version here. I’ve taken out the firm’s name and any references that might make it identifiable.

Think it’s easy to be a private equity boss in China, to keep your job and keep your LPs happy? It’s anything but.

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn’t just reply, “sounds fine to me”.

Here’s my view of it, after a day’s thought. If I didn’t know it was from [your firm], or didn’t focus on the larger check size, I’d say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys — you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that’s your opportunity, to be the ” thoroughly professional, experienced, global, proper fiduciary” version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group,  can gain an IPO in next two years. The English idiom here is “making yourself a hostage to fortune”. In other words, the only way a PE could consistently achieve the goal of “IPO exits within 24 months” is based more on luck than planning and deal execution.

If you asked me, I’d think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It’s kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can “free ride”, to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn’t change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don’t cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can’t be faulted. In a nutshell, it’s “Get in, get out, get carry and get new capital allocations from one’s LPs.”

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don’t see them. I’m just one guy feeling the elephant’s tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically,  to raise outside PE money from a dollar fund at a discount to public markets.  Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That’s the part I’ll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you’re someone who looks at deals through a special, somewhat contrarian prism. Your firm’s new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We’re finishing up now a “What’s ahead in 2014″ Chinese-language report that we’ll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database.  I’ll send a copy when it’s done. You’ll see we’re basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors.  Your role: supply the fuel, supply the ammo.

 

China’s Logistical Nightmare

China First Capital blog logistics in China

China is modeling itself after the wrong part of the American economy. The money, the rhetoric and the policies are all focused on trying to replicate America’s lead in high-technology and innovation. Instead, China would be long-term much better off and its citizens enjoy immediate higher living standards if it copied something far more mundane from the US,  its distribution and logistics.  If China’s $9 trillion economy has an Achilles Heel, this is it. It simply costs too much to get things into consumers’ hands.

Wholesale layer is piled onto wholesale layer, with margin and fees extracted at every step. Fixers, expediters, overlookers all take a cut. Trucks are too small, tolls too high, warehouses too small, and road traffic too congested in major cities. Commercial and retail rents are high, relative to per capita income level. In China, there is enough “friction” in every retail transaction to start a bonfire.

Logistical costs and bottlenecks are the single biggest reason why so many goods made in China are sold at higher prices than in the US. This has more real-world consequences for average Chinese consumers than the level of the dollar-Renminbi exchange rate. It is logistics costs, all the stickiness and expense of getting products to market, that is most to blame for holding back the buying power, and so spending impulses, of Chinese consumers. Middlemen live well in China. Consumers less so.

It is cheaper, in many cases, to get a product made in China onto a container ship in Shanghai, offload it in Long Beach, truck it across the US, and then stock it on a shelf at a Wal-Mart in Georgia then it is to put the same product in front of Chinese consumers in a Wal-Mart in China. High taxes don’t help. China’s VAT, applied to most things sold at retail,  is set at a higher level than most sales taxes in the US. Another factor: retail competition as Americans know it is also largely absent in China. Stores don’t compete much on price in China. Wal-Mart won’t say, but it’s a fair assumption its margins in China are at least double those in the US.

But, high consumer prices in China are mainly the product of the high handling charges. A simple example. I eat a lot of fruit.  Most fresh fruit grown in China costs as much or more in supermarkets here than the same fruit grown and sold in the US.

Apples sell for around Rmb 6 (95 cents) per pound and up in China. The apple farmer gets around Rmb 1 per pound. The rest is liberally spread among all those standing between apple tree and my mouth.

Adjusted for purchasing power, Chinese average income levels are around 1/6th the US’s. So, that Chinese apple sells for equivalent, in US terms, of $6 a pound. That amounts to a lot of money per apple being shared by people other than the grower and the eater. How much? Chinese eat a lot of apples. In fact, almost half of all apples grown in the world are eaten in China, ten times more than total US consumption.

I met the boss of one of China’s largest apple shipping and packaging companies. Outside of China, this is a razor-thin margin business. But, the Chinese apple packer and shipper has profit margins well above 10%.

One of the most expensive links in the Chinese domestic supply chain are road tolls. China’s are among the most costly, per kilometer traveled, anywhere in the world. Trucks carrying agricultural products don’t pay tolls. Anything else moving along China’s highway system pays full freight. Depending where you are in the country, tolls run as high as 25 cents a mile for passenger cars. Trucks pay triple that. It all, of course, ends up being passed along to consumers.

To amortize the tolls, truckers overload their vehicles. This burns more fuel, degrades roadways (justifying still higher tolls), and makes loading and unloading more time-consuming and so more costly. According to the boss of a large long-distance shipping company I talked to, his trucks are routinely pulled over by traffic police and made to pay various on-the-spot fines. This can double the amount paid in tolls.

Everything about the logistics industry in China acts as a sponge soaking up consumers’ cash. The one exception: Shunfeng Express (顺丰快递).  Little known outside China, Shunfeng Express is China’s most successful private shipping and delivery companies. It alone proves that logistics in China doesn’t need to be wasteful, expensive and inefficient.

Shunfeng is modeled after Fedex, DHL and UPS, but operates on a scale, and at prices, that would be unimaginable to these global giants. Shunfeng is a secretive outfit. Not much is publicly disclosed. The founder lives in Hong Kong, but comes originally from the mainland.  It was started in 1993, and according to some media reports, its net income in 2010 of Rmb 13 billion ($2.1 billion). That may be a stretch, but Shunfeng is doing a lot right and deserves whatever profit it keeps.

Shunfeng picks up and delivers documents, packages and some bulk freight between cities in China. It charges a fraction of what Fedex or UPS do in the US. These US companies are mainly prohibited to operate in China’s domestic delivery market. I’m not sure they’d be so eager. For next-day document delivery within a city, Shunfeng charges under $2. Delivery to other cities: $3. If you want to move a few kilos of freight, Shunfeng not only ship it, but will come and package it for you. That part is free. The shipping usually works out to less than $5 a kilo.

One of the main reasons Alibaba’s Taobao has become so successful in China is that Shunfeng ships Taobao purchases cheaply and efficiently across China. Taobao, which operates like a cross between Amazon Marketplace and eBay, will likely facilitate transactions worth around USD$100 billion this year. A lot of that will get shipped and delivered by Shunfeng.

They have an army of delivery guys. Most larger office buildings in major cities have one permanently stationed inside. You call for a pickup and the Shunfeng guy arrives within minutes. Most letters and packages get moved around by either electric motorcycle or jet. It leases its own aircraft to fly stuff around within China.

Shunfeng doesn’t do cross-country trucking. This is one big reason Shunfeng are so efficient and so cheap. Anything that moves by truck in China is going to have multiple hands in the till, and so end up costing consumers too much.

Shunfeng has achieved its massive scale and now well-known brand in China without raising capital from the stock market, or bringing in outside professional investors until three months ago. There are few private companies in China I admire more, and who are doing more to benefit the average consumer in China. I wish I could invest. For the good of every consumer in China, Shunfeng should continue to grow, continue to expand the range of what it handles in China. That will do a lot to unstick China’s logistical logjam.

 

 

Hong Kong IPO Today for China First Capital Client Hydoo

Hydoo Prospectus

Welcome good news today from Hong Kong’s capital markets. The Chinese commercial real estate developer Hydoo (Chinese name 毅德) successfully IPOs on the Hong Kong Stock Exchange, raising over USD$200mn in new capital. With IPO channels for Chinese companies mainly blockaded, it’s especially welcome to see a Chinese private sector company raising so much from the stock market.  In this case, the delight is greater because Hydoo is a client of China First Capital. We acted as Hydoo’s investment bankers raising USD$80mn from Chinese private equity firm Hony Capital.  Hony’s 2011 investment, based on today’s IPO price, is now worth USD$150mn.

In addition to Hony, China’s giant financial services group Ping An also invested before IPO.  In total, Hydoo raised USD$140mn (Rmb 860mn) of institutional capital before IPO. Over 60% of the IPO shares (worth over $120mn) were sold by underwriters ahead of time to so-called “cornerstone investors“, including two large Chinese SOEs, Huarong and China Taiping Insurance, as well as retailer Suning (in which Hony owns a share).

I’m happy for Hony and the other investors, but happier still for Hydoo founders, particularly its chairman, Wang Zaixing, known to friends and family  as “Laowu”, literally “Venerable Fifth”. He is the fifth-born of ten children all of whom played a part in building Hydoo. The family is originally from Chaozhou in Guangdong, and speak the distinctive Chaozhou dialect. But, they ended up after 1949 in Ganzhou, Jiangxi Province.

The business Laowu started 18 years ago is now worth over $1 billion. The first time I met him, I told Laowu my goal as his investment banker, and my emphatic expectation,  was that his company would be worth at least that much at the time of its IPO. Another priority of mine was that he and his family members would still hold majority control after IPO.  That too has been achieved.  They hold almost 60% of the now publicly-traded business.

For me, Laowu personifies in many ways the large economic changes China has undergone in the last 30 years. He started life as a long-distance truck driver and from that humble start saw and grasped an opportunity to build wholesale trading centers for the emerging army of small businesspeople in China.

I first met Laowu and his company in 2009. The business was then called Haode (豪德). It was then still an old-school Chinese family business. There was no corporate structure in the traditional sense. Laowu and his brothers, sister and nephews would pair up, or act independently, to do individual large wholesale trading centers around China. When I met them, the family had already done 19 such projects. All had done very well. At the time, I’d never met a Chinese private company as profitable over as many years as Haode.

Over the last three years, the company has been transformed into a more professional enterprise. Hydoo provides a useful excellent template for how a Chinese family-owned business can make this transition to a publicly-traded company. Part of that process was splitting up the family’s existing business between a group that would follow Laowu and become shareholders of Hydoo, and five other siblings who chose not to participate, but remain active in some cases building their own wholesale trading centers.

As the IPO prospectus puts it,  this division was “a complex, delicate process involving the allocation of assets or interests in the existing businesses among a group of closely connected family members, who decided to split up into two independent groups with diverging goals going forward. Under the special circumstances, no written agreements were entered into in respect of the Family Allocation and no valuation appraised by independent valuers was undertaken when negotiating the Family Allocation. Instead, the Wang Family Group placed their focus on more subjective, personal factors.”

Me and my firm played a small part by advising Laowu and his siblings on the pros and cons of being part of a company planning for an IPO. But, as you’d expect, most of this was done within the private confines of a large, closely-knit family.  Along the way, though, I gained a deeper appreciation of the unique ways Chaozhou people do business.

Chaozhou natives are rightly famous both in China and throughout much of Southeast Asia for their business acumen. They are often described by other Chinese as “the Jews of China”.  As a Jew in China, I tend to think the description flatters my people. Chaozhou people seem to have an instinctive and unsurpassed talent for making money and entrepreneurship. Look around the world at the most successful Chinese business people, including the leading business families in Thailand, Indonesia, Singapore, Malaysia and Hong Kong, and a large percentage, including Asia’s richest magnate, Li Ka-shing, Thailand’s richest businessman Dhanin Chearavanont  and Indonesia’s top tycoon, Mochtar Riady, are either from Chaozhou or are descended from people who immigrated from there.

As this suggests, Chaozhou people are able and willing to uproot themselves and chase opportunities. Laowu didn’t leave China, but in building Hydoo, he did venture far afield from where he and his family were raised. He saw very early and profited richly from an economic shift within China that few others noticed 15 years ago. At the time, much of China’s economic growth was centered in southern China, and large coastal cities like Shanghai, Shenzhen, Xiamen. Laowu looked inland, especially in Shandong Province, one thousand miles north of Chaozhou.

As the economies of Shanghai and big southern coastal cities began to cool, inland areas, led by Shandong, began to boom. Shandong’s GDP growth, over the last ten years, has been among the highest of any part of China. Shandong is a huge market to itself (population 95mn) as well as a vital crossroads for commerce between north and south, east and west in China. Laowu built large wholesale parks to accommodate thousands of small traders, creating new clusters of small-scale commerce and entrepreneurship.

When you visit one of these centers, you get the impression that half of Shandong’s gdp is going in and out the doors. It’s crowded and vibrant. Even the smallest traders own their own small shop inside the Hydoo centers. That’s Hydoo’s model: they build the buildings, and as they do, sell off most of the units to thousands of individual small traders. Hydoo helps them get mortgages and often acts as guarantor on the loans. This lets thousands of small businesspeople become property-owners. As the Hydoo centers thrive (and they all do, as far as I know) the value of the real estate rises.

I know of no other businessman in China that has done as much as Laowu to build wealth and provide an entrepreneurial hub for such a large number of people in China. Hydoo is now spreading across more areas of China. It’s is building huge new wholesale parks in Sichuan, Hunan, Guangxi, Gansu.

I see Laowu infrequently these days. But, I’m as impressed now as I was when I first met him by his accomplishments. He and his family founded a business back when China was a different and less developed place. They stuck with it, kept reinvesting and now, through today’s IPO,  own shares worth more money than I can imagine. But, more important for me is that they still own the business, still own the majority and so answer to no one else. As an entrepreneur who helped create and sustain so many other entrepreneurs, Laowu deserves nothing less.