Entrepreneurship

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

Leave a Comment / January 19, 2014

China First Capital 2014 research report cover

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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.

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Private Equity in China 2014: A Dialogue

1 Comment / January 19, 2014

pendant

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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.

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Hong Kong IPO Today for China First Capital Client Hydoo

Leave a Comment / October 31, 2013

Hydoo Prospectus

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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.

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Better and Worse Investment Ideas For China’s Future

Leave a Comment / October 16, 2013

–tablescreen Where is China headed and how to make money by getting there first? If you were to ask professional China investors, almost without exception you’ll be offered an identical vision of the China of 2020 and beyond:  retired Chinese in their tens of millions living in assisted-living housing spending their days on their smartphones buying clothes, playing games and booking European vacations.

It follows, the pros will tell you, that the best places to put your money today are with Chinese companies building retirement and assisted living housing, mobile apps and online shopping websites. Indeed, these are the sectors getting by far the most attention and seeing the most substantial flows of new investment capital these days.

I happen to think the “smart money” is wrong and here’s why. First, in my experience across 30 years of business life, whenever you get so much agreement about where the future is headed and where money should be staked, the predictions usually prove wrong and the money usually lost.

In this case, the basic analysis is fine. Yes, China is getting older and yes it needs more places to house and care for the elderly. And, yes, Chinese will buy more stuff online since prices are often much lower than in shops. But, only a fraction of the projects now receiving funding will be successes.

The assisted living, online shopping and mobile services businesses already seem over-invested. And yet the money keeps pouring in. It reminds me very much of the last “can’t miss” investment idea in China: group shopping. Two years ago, PE and VC firms poured billions into at least a dozen different group shopping sites in China Most, if not all of that, will be lost.

There are formidable hurdles in the way of all three of the currently-favored business models. For assisted living and retirement housing, it’s not clear Chinese retirees in significant numbers will want to move into these kinds of places, even if their kids are paying. Nor is it clear how these projects will make equity investors money, since Chinese banks remain loathe to lend money to any kind of real estate project.

Online shopping? Great business, but all the companies getting investment have to compete with a few powerhouses with huge market shares. The list includes Alibaba’s Taobao business, Yihaodian (part-owned by Wal-Mart), Amazon China, 360buy.com. I see little reason to believe these newer PE-backed entrants will make any serious dent against these competitors.

As for mobile services, yes Chinese have all switched en masse to smartphones. And, yes, they use the mobiles to do lots of stuff online, including shopping, chat, games. Problem is, in the overwhelming number of cases, Chinese don’t pay for any of it. In my view, they never will. Any investment predicated on the theory that eventually Chinese will start paying fees to mobile service-providers is usually based on not much more than a hope and a prayer. Nothing solid.

So, where else to put money now to be best-positioned for the China of 2020? I can think of two places. One is organic foods and the other is health supplements and what are called “functional foods” in the US.

As of now, both are tiny industries in China, a fraction of their size in the US and Europe. My guess is that the market in China will eventually dwarf those two other places. I’ve read about a few PE investments in these industries. But, in general, the so-called “smart money”  has stayed out.

So, why do I think organic, “functional foods” and supplements will become huge businesses in China? In general, the same forces will prevail in China that have propelled the growth of these industries in the US and Europe: a wealthier population, more interested in their health, more distrustful of traditional commercially-prepared foods, and also more interested to improve their health, fitness and life expectancy by exercising, eating well (including vitamins and supplements) while keeping away from doctors.

In China, this distrust of commercial foods and commitment to a more healthful lifestyle, though still in a comparatively early stage,  is already strong, deep and widespread. So is the lack of trust in the quality of medical care received from doctors.

As anyone who lives in China can attest, there are very good reasons for all of this. Food scandals are common. There seems to be a lot of unhealthy and unhygienic food circulating.  Doctors don’t enjoy a very high standing any longer. They are often seen as fee-grubbing predators, ever willing to make phony diagnoses as a way to put more money in their pockets from their share of fees paid for tests, medicines, surgery, hospital care.

In short, the conditions couldn’t be riper for the development of organic foods, and health supplements of all kinds. Chinese traditional medicine shares quite a few principles in common with the OTC health supplements sold in the US. Chinese, in a way Westerners generally do not, have always accepted that Western pharmaceuticals should often be taken as a last resort. They worry greatly about side effects. If there’s a more “holistic” way to treat a condition, Chinese will often prefer it.

China, as of today, has no vitamin and supplement shops like GNC in the US, nor do mainstream pharmacies give such products any shelf space. When you can find them, vitamins are sold at very high prices in China, usually at least double the US level. There are no good domestic brands, no winning products or packaging formulated specifically for Chinese consumers.

One data point: it’s more and more widely known in China that fish oil is beneficial for digestion and circulation. And yet, it’s hard to find the product anywhere in China. When you do, it is usually stuff imported from the US, in old-looking packaging, with English-language  labels, and prices three to four times higher than in America.

Whether the world has enough cod livers to meet future Chinese demand for fish oil is another story. But, I’m confident the China market should eventually rival the US’s in size.

As for organic and healthy foods, China has lots of conventional supermarkets. But, so far no one has tried to follow the path blazed by Whole Foods Market in the US. Nor are there large, established organic food brands like Organic Valley, Applegate.

It will all happen. When, and which investors will make the big money is hard to say. Even now, the demand for genuine organic fruits, vegetables and dairy outstrips the available supply. There’s yet no real standard in China for what can be called organic, and so Chinese consumers often view products labeled that way with suspicion. That too represents a business opportunity in China — providing standards and credentials for the organic farming industry.

The lesson here: in China, the best business opportunities are often hiding in plain sight, often unseen by professional investors. Nowhere is contrarian investing more warranted and more potentially profitable.

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The China IPO Embargo: How and When IPOs May Resume

Leave a Comment / September 26, 2013

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China IPO

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1 Comment / July 23, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

2 Comments / June 29, 2013

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

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

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

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

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

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

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

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

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

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

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

 

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

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New capital drought threatens growth in China — China Daily

Leave a Comment / June 24, 2016

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

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By Peter Fuhrman

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

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

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

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

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

New capital drought threatens growth

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

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

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

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

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

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

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

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

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

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

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

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

 

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Anti-Dumping or Blatant US Protectionism? How the US Tried and Failed to Destroy a Great Chinese Entrepreneur

Leave a Comment / May 6, 2013

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Reckless or evil? You decide. In July 2009, the US Department of Commerce started an anti-dumping investigation of the “narrow woven ribbon with woven selvedge” industry. Never heard of it?  It’s the colored ribbon Americans use primarily in gift-wrapping. It’s not a particularly big industry, probably less than $500 million a year in retail sales in the US. But, adding ribbon to gift-wrapped packages is a staple of American culture. The major store chains like Target, Wal-Mart, Michael’s and Costco all stock a wide variety of ribbon in different colors and widths, and sell it for a few dollars per pack.

Back when I was a kid, the ribbon was made by American manufacturers. Gradually, of course, much of the production shifted to Asia, first Taiwan, then China. Lowering manufacturing costs also kept retail prices down, which has likely allowed more Americans to use more ribbon to decorate their gifts.  Who could complain about that?

There remains one large American manufacturer called Berwick Offray, based in Pennsylvania. They’ve been in the woven ribbon business for over 100 years. They launched the complaint that led to the US government action, claiming they were suffering “material harm” because of Chinese ribbon being dumped in the US. According to the official document issued by the Department of Commerce in July 2009, the US government’s preliminary investigations seemed to confirm Berwick Offray’s contention that Chinese manufacturers were receiving state subsidies as a way to flood the US market and steal market share, harming Berwick’s business. The US government signaled its intention to levy punitive tariffs on the Chinese imports.

In its 142-page 2009 preliminary report, (click here to download) the Department of Commerce offers a feedlot of industry data, manufacturing techniques and product descriptions, all of which are aimed to substantiate the claim that Chinese manufacturers, who now hold the largest share of the US market, are selling the ribbon in the US below cost, with the loss being covered through a variety of unspecified subsidies from the Chinese government. Keep in mind that the total amount of US imports of woven ribbon from China seemed then to be below $100mn. A lot of market share data in the report was blacked out, presumably for commercial secrecy reasons. A lot of other information was absent because the Commerce investigators said they couldn’t find people willing or able to answer its questions.

So, the entire US federal government investigation, and preliminary finding of Chinese ribbon dumping was based both on incomplete data, and the dubious premise that the Chinese government would actively intervene with subsidies in such a small market. Total Chinese exports to the US in 2011 exceeded $400 billion. So, if the data is right, Chinese woven ribbon represents about 0.025% of total Chinese exports. The manufacturers are mainly privately-owned Chinese companies, not big SOEs with political clout in Beijing.

Among those Chinese manufacturers, one stands out for its scale, its variety of products and leading market share in the US. The company is called Yama Ribbon. They are based in Xiamen and dominate the industry in China. Yama is named in the Commerce Department report as one of the major exporters to the US. Since Yama is the biggest Chinese exporter, and the US government is suggesting Chinese government subsidies allow Chinese manufacturers to sell their ribbon below cost, it stands to reason that Yama should be fingered in the report as the main beneficiary of these subsidies. Right? The US government couldn’t possibly allege the Chinese government is subsidizing a product unless they’ve already confirmed the main Chinese producer is receiving such subsidies. Right?

Wrong. Trade policy, anti-dumping actions, punitive tariffs are very often a political toy in the US. Too often, US companies can use lobbyists or friendly politicians to pressure the Commerce Department to initiate an investigation. That alone can often cause exporters, whether they are dumping or not, to increase their prices, just to try to avoid any unilateral action by Washington. This, then, boosts the competitive position, and so the profits, of the US company that started the anti-dumping ball rolling. It isn’t called corruption, but often it should be understood as such.

Is this the case with Berwick Offray and woven ribbon? Did it use the US political process to help its foundering business in the US? That seems the case to me. Here’s why. After its initial report in 2009, the Commerce Department launched a more detailed analysis to identify all the subsidies Yama Ribbon and other Chinese manufacturers were receiving from the Chinese government.

In July 2010, the US officials announced they could find no evidence of Yama receiving any subsidies whatsoever. Yama Ribbon products were assigned an “anti-dumping” duty of 0%. It was a complete victory for Yama and a repudiation of misguided US protectionist trade policies. It received about zero press coverage, in China and the US, which is a shame.  Next time you hear someone spouting off about “unfair China trade practicies” or “predatory pricing”, think about Yama.

Several other Chinese manufacturers were found to be receiving subsidies, and their products were slapped with punitive duty rates of 125% to 249%. But, Yama is the main producer and exporter. If it’s receiving no subsidies, then it is impossible to claim the Chinese government is rigging the market to the detriment of Berwick Offray and the few other remaining US producers of woven ribbon.

How, you might ask, could the US government have even issued the preliminary 2009 report before establishing beyond doubt that Yama was getting favors from the Chinese government? The same question occurred to Yama’s founder and CEO, Yao Ming. (Yes, same name, but no relation to — physically or by bloodline –  to the Chinese basketball star.)  When he heard about the 2009 investigation and preliminary finding, Yao understood immediately it had the potential to damage, if not ruin his entire business, with 2011 revenues of over USD$50mn and over 1,000 employees. The US is his key market, over 70% of total turnover.

I’m fortunate enough to know Yao Ming. He’s a modest, hard-working entrepreneur, among the best I’ve ever met. My guess is as a businessman he could run circles around the people who manage Berwick Offray.  He’s not a political creature, speaks very little English, and until then, was unschooled in the ways of US trade policy. The US government was asserting Chinese ribbon exporters were getting subsidies and yet Yao knew he was receiving nothing. Knowing, and proving it to Washington, of course, are very different stories. He tried getting help from the Chinese Ministry of Commerce. But, they told him, effectively, he would have to fight this one on his own. They have bigger trade battles to wage with the US than this tiny one over gift ribbon.

So Yao hired lawyers, both in China and the US, and fought back. He’s the only Chinese entrepreneur I’ve heard about with this kind of character and self-confidence to spend a not-small amount of money to fight back against the US government. Even more remarkably, he won a resounding and speedy victory.

He more or less dared the US government to prove he was getting subsidies, including indirect ones like loan subsidies, special deals to buy factory land or tax holidays. When the US government couldn’t find a thing, it gave up pursuing Yama. Justice, in this case, was served. But, Yao was also lucky. His business is unusual in China. At that time, he has no bank loans, and his factories are rented. Both are rare among manufacturers in China. For any other manufacturer in China, it would be far harder to prove as quickly an absence of subsidies, direct or indirect. Yao needed to act, before the threat of an anti-dumping action permanently damaged his business in the US.

As an American citizen, I’m more than a little disgusted by what the US government did in this case: it made that 2009 announcement, declaring a preliminary finding, without really checking its facts. Had Yao not acted quickly, hired lawyers and proved his case, his business would have been sunk, and Americans would end up paying much more to decorate their gifts.

Had Commerce wanted to, it would have taken almost no time or effort to establish that Yama, as the largest Chinese ribbon exporter, was likely getting nothing from the Chinese government. But, they didn’t bother. That’s the worst of it. People at the Department of Commerce know how damaging an investigation and preliminary finding like this can be to any businesses implicated in wrongdoing.

In the end, from what I can tell, Commerce cared more about placating Berwick Offray than in making sure it didn’t unjustly harm a company faraway in China. Everything, in the end, has turned out well for Yao Ming and Yama. His business, including exports to the US, continue to thrive. He has some of the highest net margins I’ve seen in a Chinese manufacturing company. His revenues this year will approach USD$100mn. He has opened an office now in New Jersey to help handle all the orders. His Chinese competitors are now largely shut out of the US market because of the punitive duties. None seems to have had the scale or cash to hire lawyers and go to court in the US, as Yao Ming did. So whether these punitive duties are justified is, to me, an open question.

Yama’s business is number one in the US not because it sells product at the lowest price. It doesn’t. It has a better business model, thanks to the business smarts of its founder Yao Ming. He keeps a large stock of ribbon in a huge array of sizes and colors in inventory in the US, to meet spot orders. While it increases his costs, because of the extra working capital needed to finance the inventory, distributors and retailers can get orders filled more quickly. So, they buy from Yama. The company’s scale and service allow it now to earn margins that would be the envy of just about every other manufacturer operating in China.

Yao Ming is Chinese. But, he is the kind of Horatio Alger entrepreneur many in the US most admire. He makes a good product, sells it at a fair price, is good to his workers, and fought back against knuckle-headed Washington bureaucrats and won.

 

 

Chinese Market Loses Its Bite — Private Equity News Magazine

Leave a Comment / December 6, 2014

–PEnews

 

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A stagnant exit market is likely to cause problems for firms that ventured into China in the boom years

Statistics rarely tell the whole story. However, as China celebrates the Year of the Snake, the most recent figures for private equity exits in the country make sobering reading for those who were convinced that the surge in private equity in the world’s most populated nation was the ticket to easy returns. In the final quarter of 2012, there was no capital raised by sponsors through primary initial public offerings of companies they backed, no capital raised through sales to strategic buyers and just $30 million from secondary buyouts, according to data from Dealogic.
That collapse in the exit market is creating a huge backlog of businesses in private equity hands that could force many companies to the wall and drive a shakeout in the industry, losing investors billions in the process. Global private equity firms, from large buyout specialists TPG Capital and Carlyle Group to mid-market players like 3i Group, all flooded
into the Chinese market raising capital from international investors for deals on the expectation of outsized returns as the economy opened and boomed. They were joined by thousands of domestic players that raised capital in local currency from the growing band of China’s wealthy individuals eager to get a slice of the market.

Incredible Success

Peter Fuhrman, chairman and CEO of investment bank China First Capital, said: “In the course of the last five years China has grown into the largest market by far for the raising and deploying of growth capital in the world. It has been an incredible success story when it comes to talking investors into opening up their wallets and allocating much-needed capital to thousands of outstanding Chinese entrepreneurs.” More…

 

 

Five Minutes with Peter Fuhrman — Private Equity International Magazine

Leave a Comment / May 1, 2014

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The chairman of research firm China First Capital discusses China’s growing exit problem, and its possible impact on private equity in 2013.

A growing concern for private equity in China is the lack of IPO exits. How do you see that playing out in 2013?

“I don’t expect any substantial improvement or change in the problems that are blocking IPO exits domestically and internationally. And because the China private equity industry is significantly over-allocated to IPO exits, along with diminishing fund life, [this] will be a time of increasing difficulty for GPs. At the same time, the inability to exit will also continue to prevent [GPs] from doing new deals, and that is where the greatest economic harm will be done. Of course I don’t trivialise the importance of the $100 billion that’s locked away in unexited PE investments, but the real victims of this are going to be the private entrepreneurs of China. At this point, over half of all [China’s] GDP activity is generated from the private sector. The private equity money and the IPO money is what [businesses] need to grow, because private companies in China basically can’t borrow. They need private equity money and IPO proceeds to continue to thrive. “  More…

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China private equity specialist says IPO drought means investors must rethink — Week in China

Leave a Comment / May 1, 2014

 

week in china

 

 

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With China’s IPO gusher now reduced to a trickle, prospects for some of the privately-owned companies which have traditionally boosted much of China’s economic growth could be at risk.

So says Peter Fuhrman, founder and chief executive at China First Capital, a boutique investment bank and advisory firm. His firm has just released a new report warning that new private equity investment has basically come to a halt in China since the middle of last year.

Fuhrman talked to WiC this week about the reasons for the slowdown, and why he would like to see more investors considering alternative exits, including sales in the secondary market. More…

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Paid to Gamble But Reluctant To Do So

Leave a Comment / January 24, 2013

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Venture Capital Financing in the US

(Source; The Wall Street Journal)

 

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They are the best-paid gamblers in the world, the General Partners at private equity and venture capital firms. They are paid to take risks, to make bets, with other people’s money. And for this, they usually get a guaranteed high annual retainer, a salary that generally puts them in the top 1% of all wage-earners in their country, and also a share of profits earned from putting others’ money at risk. In other words, their life is on the order of “heads I win, tails I win” compensation. They make a handsome salary, have all their expenses covered, are unlikely ever to get fired, and also usually get to claim 20%-25% of the profits from successful deals.

Given those incentives, and the fact the guys with the money (your fund’s LPs) are paying you to find great opportunities and bet on them rather than sit on your hands, you would assume that GPs would want to keep the flow of new deals moving along at a reasonable pace. In fact, inactivity is, next to losing all the LPs money on bad investments, the surest way for a PE fund to put itself out of business. And yet this do-nothing strategy is now common across China’s private equity industry. For the better part of a year, deal-making has all but dried up.

From a recent high of around 1,200 PE deals closed in a single year in China,  in 2012 the total tumbled. My surmise is that the number of new PE deals closed in China last year was down at least 75% from 2011. The activity that took place did so almost entirely during the first half of the year. An industry now holding over $100 billion in capital and employing well over 10,000 people, including some of the most well-educated and well-paid in China, ground to a halt during 2012.

Let me offer up one example. I won’t name them, since I know and like the people running this shop: a fund that is among the biggest of all China-focused PEs, with over $4 billion in capital, made a total of three investments in all of 2012. Two of them were in “club deals” where they threw money into a pot along with a bunch of other funds. Though they keep a full-time staff of 100, funded by the management fee drawn from LPs money, this firm closed only one deal that they actually initiated. At a guess, these guys have an annual management fee in excess of $50mn, and during 2012, their headcount more than doubled.

In any other line of work, a company that decreased its output to about zero, while significantly increasing its expenses, would be on the fast-track to insolvency. But, not in the PE industry in China. It’s currently the norm. Now, of course, those same PE firms will say they are keeping themselves busy monitoring their previous investments, rather than closing new ones. Yes, that’s necessary work. But, still, the radical slow-down in PE activity in PE is without precedent elsewhere in the PE and VC world.

Look, for example, to the VC industry in the US. In good years and bad, with IPOs plentiful and nonexistent, VC firms keep up their dealmaking.  These two charts at the top of the page show this quite clearly. Across a six-year cycle of capital markets boom and bust, the number of new VC investments closed stayed relatively constant at between 600-800 per quarter. In other words, VC workloads in the US stayed relatively stable. They kept channeling LP money into new opportunities. The dollar amounts fluctuated, peaking recently during the run-up to the highly-anticipated IPOs of Linkedin, Facebook, Groupon and Zynga.  Valuations rose and so did check size. But, deal flow stayed steady, even after Linkedin, Facebook, Groupon and Zynga’s share prices nosedived following IPOs.

This is the picture of a mature industry, managed by experienced professionals who’ve seen their share of stock market up and down cycles, heard thousands of pitches for “sure things” that raised some money only to later crash and burn. Some VC firms crashed and burned with them. But, overall, the industry has kept its wits, its focus and its discipline to invest through bad times as well as stellar ones.

The contrast with China’s PE industry is rather stark. There are perhaps as many as 5,000 PE and VC firms in China. No one knows for sure. New ones keep getting formed every week. The more seasoned of the China PE and VC firms have a history of about 10 years. But, the overwhelming majority have been in this game for less than five years. In other words, today there is a large industry, well-financed and with control over a significant amount of the growth capital available in the world’s second largest economy, that was basically created out of nothing, over just the last few years.

Obviously, these thousands of new PE firms couldn’t point to their long history of identifying and investing in private companies. But, LPs poured money in all the same. They were investing more in China — in the remarkable talents of its entrepreneurs and the continued dynamism of its economy — than in the track record of those doing the investing. That seems a wise idea to me. As I’ve mentioned more than once, putting money into China’s better entrepreneur-led companies is certainly among the better risk-adjusted investment opportunities in the world.

If anything, the opportunities are riper and cheaper than a year ago, as valuations have come down and good companies with significant scale (revenues above $25mn) have kept up a rate of profit growth above 30%. In the US VC industry, this would be a strong buy signal. Not so in China. Not now.

PE firms are collecting tens of millions of dollars from LPs in management fees, but not putting much new LP money to productive use by investing in companies that can generate a return. Nor are they actively exiting from previously-made investments and returning capital to LPs. This situation can’t last indefinitely.  For people handed chips and paid to gamble, it’s unwise to spend too much of the time away from the casino snoozing in your high roller suite.

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Buyout Firms Lack Exit Ramp in China — Wall Street Journal

Leave a Comment / June 25, 2016

 

WSJ

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With the door to initial public offerings in China largely shut, private-equity firms invested there are having a tough time cashing out. The alternative—selling to another buyout firm or a company looking to expand via acquisition—remains rare in a market where buyers are relatively few.

Private-equity firms are sitting on more than $130 billion of investments in China and are under pressure from investors to find an exit, Shenzhen-based advisory firm China First Capital said in a report last week.

Gary Rieschel, founder of Shanghai-based Qiming Venture Partners, said, “There needs to be a broader number of choices in buyers” in China.

Private-equity firms have generally exited their China investments through IPOs, but the number of private-equity-backed IPOs approved by mainland regulators has plummeted. Meanwhile, the Hong Kong IPO market has softened and sentiment toward Chinese companies in the U.S. has soured because of accounting scandals.

In October, the China Securities Regulatory Commission shut the IPO door completely on the mainland, halting the approval of new listings over worries that a glut of offerings would further weigh on sagging share prices. The Shanghai Composite Index was one of the world’s worst performers in 2012, sinking to a near four-year low in early December before a rally pulled the index up slightly for the year.

Analysts say they don’t expect the CSRC to approve any IPOs until at least March, when Beijing’s top lawmakers usually hold important annual planning meetings.

The regulator approved 220 IPOs of companies backed by private-equity or venture-capital firms in 2010, but that fell to 165 the following year and 97 last year, research firm China Venture said. There are now nearly 900 companies waiting to list in China, the CSRC said on its website.

Hong Kong’s market, meanwhile, has seen fewer IPOs over the past year as investors soured on new listings after several underperformed the broader market. U.S. private-equity firm Blackstone Group, which owns 20% of chemical company China National Blue Star, scrapped a planned Hong Kong listing of a unit called Bluestar Adisseo Nutrition Group in 2010 due to weak markets. It has yet to list that firm.

Carlyle Group has struggled to exit some of its deals, including two deals it made in 2007, a $20 million investment in Shanghai-based language-training firm NeWorld Education Group and a $100 million investment in Zhejiang Kaiyuan Hotel Management Co. A company spokesman said the holding periods for those investments are normal because private-equity firms usually stay invested for four to seven years. The spokesman also said Carlyle has successfully exited many deals, including the recent sale of its stake in China Pacific Insurance, which generated a profit of more than $4 billion.

In more-developed markets, private-equity firms can count on exiting their investments through sales to rival buyout firms or to companies looking to grow through strategic acquisitions. But in China, private-equity firms have sold stakes to rival firms or other companies only an average of 15 times a year over the past three years, according to data provider Dealogic.

China’s secondary buyout market—where private-equity firms sell to each other—remains immature. Among the handful of such deals, Actis Capital sold a majority stake last month in Beijing hot-pot chain Xiabu Xiabu, for which it had paid $50 million in 2008, to U.S. firm General Atlantic for an undisclosed amount.

Domestic consolidation is rare compared with the activity in developed countries. Chinese companies that are still growing quickly may prefer to hold off selling, and there are fewer big corporate domestic buyers.

“China is still a relatively fragmented economy with a disproportionately small number of large businesses relative to the size of its economy and very few national businesses,” said Vinit Bhatia, head of China private equity for Bain & Co.

When a private-equity firm does sell a Chinese portfolio company, the size of the deal tends to be small. Last year’s biggest sale was MBK Partners’ $320 million sale of a majority stake in Luye Pharma Group, which it bought in 2008. The buyer was AsiaPharm Holdings Ltd.

Usually, though, foreign private-equity firms hold only minority stakes in Chinese companies because full control is tough to get, in part for regulatory reasons. Domestic private-equity firms, meanwhile, are often content to hold minority stakes in fast-growing companies, which can offer healthy returns.

Management may not be on board when a minority investor wants to put the whole company up for sale. Chinese chairmen, who are often the founders of their businesses, prefer to remain at the helm, said Lei Fu, co-founder of Shanghai-based private-equity firm Ivy Capital.

Still, private-equity investors say they are hopeful that more buyers will emerge in China this year, even if the IPO markets stay shut.

The number of strategic Chinese buyers should increase as the government encourages consolidation across industries and as medium-size companies begin growing more rapidly with a rebound in the economy, they say.

“Five years ago we would think of multinationals…Now we think more local companies” when looking for buyers, says Huaming Gu, Shanghai-based partner at private-equity firm Baird Capital.

 

http://blogs.wsj.com/deals/2013/01/15/buyout-firms-lack-exit-ramp-in-china/

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China Private Equity Secondaries — the new China First Capital research report

Leave a Comment / April 7, 2013

 

In the current difficult market environment for private equity in China, secondary transactions provide a valuable way forward.  Staging successful IPOs or M&A will remain severely challenging. This is the conclusion of a proprietary research report recently completed and published by China First Capital. An abridged version is available by clicking here.  You can also visit the Research Reports section of the China First Capital website.

Secondaries potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments. And yet these secondary deals still remain rare. As a result, General Partners, Limited Partners and investee companies, as well as China’s now-large private equity industry,  are all at risk from serious adverse outcomes.

This new CFC research report is a data-driven examination of the potential market for secondary transactions in China, the significant scope for profit on all sides of the transaction, as well as the no less significant obstacles to the development of an efficient, liquid, stable long-term market in these secondary positions in China.

The report’s conclusion is that secondaries have the potential to benefit all three core constituencies in the China PE industry — GPs, LPs and investee companies. The universe of deals potentially available for secondary exit is large, over 7,500 unexited investments made in China by PE firms since 2000.

However, the greatest potential for both PE sellers and buyers across the short to medium term is in a group of select companies CFC terms “Quality Secondaries“. These are PE investments that fulfill four criteria:

  1. unexited and not in IPO approval process, domestically or internationally
  2. investee companies have grown well (+25% a year) since the original round of PE investment, and have continuing scope to expand enterprise value and achieve eventual capital markets or trade sale exit in 3-6 year time frame
  3. businesses are sound from legal and regulatory perspective, have effective corporate governance, and a majority owner  that will support secondary sale to another PE institution
  4. current PE investor seeks secondary exit because of fund life or portfolio management reasons

CFC’s  analysis reveals that the potential universe of “Quality Secondaries” is at least 200 companies. This number will likely grow by approx. 15%-25% a year, as funds reach latter stage of their lives and if other exit options remain limited.

At the current juncture, in this market environment, and assuming “Quality Secondary” deals are done at market valuations, these investment represent some of the better values to be found in growth capital investing in China.  DD risk is significantly lower than in primary deals, and contingent risks (opportunity costs, and legal risks of pursuing other non-IPO exits) are lower.

Despite the current lack of significant deal-making activity in this area, secondaries will likely go from current low levels to gain a meaningful share of all PE exits in China.

The secondaries market in China will have unique factors compared to the US, Europe and elsewhere. There will likely be limited investor interest in any secondary deal involving a Chinese company or a portfolio that has underperformed since PE investment, or could otherwise be characterized as a  “distress” situation.

Quality Secondaries transactions in China will involve PE investors “cherry-picking” good companies at fair valuations.  The primary motivation for selling PEs is misalignment between its remaining fund life and the time required and risk inherent in achieving  domestic or offshore IPO or trade sale exit during that shortened time frame.

In contrast with secondary deals done outside China, we do not expect to see much activity involving the sale of all or most of a PE firm’s portfolio of investments. Specialist secondary firms operating elsewhere (e.g. Coller Capital, Harbourvest) do not currently have the experience or manpower in China to take on the complexities of managing and liquidating all or most of an existing portfolio of minority investments.

Rather, we expect those PEs with strong operating performance in growth capital investing in China to exploit favorable market conditions by becoming active buyers of Quality Secondaries.   GPs that prefer larger deals, (+USD25mn/Rmb200mn), should be particularly interested in Quality Secondaries, since company scale and investment amount will likely be larger, on average, than primary deals in China.

Selling PEs can pursue exit strategies based on option of selling either part or all of a successful unexited deal. A part liquidation in Quality Secondary transaction can mitigate risk and return capital to LPs while still retaining future upside. A full exit through secondary can increase fund’s realized IRR and so assist future fundraising. Importantly, a selling PE needs to act before pricing leverage is transferred mainly to buyers — generally this means secondary deals should be evaluated and priced in market when fund still has minimum of two years left of active period.

While clearly the most acute need for exit will be investments made before 2008, more recent investments need also to be assessed based on current market conditions. Many GPs are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve.

In particular, much of this “wait and see” approach is based on the hope that Hong Kong’s once-vibrant, now-moribund IPO market for Chinese companies returns to its earlier state. The US stock market will certainly remain off limits to most Chinese companies for a long time to come. Exit through China’s domestic stock market is now seriously blocked by bureaucratic slowdowns and an approval backlog that even under optimistic scenarios could take three to five years to clear.

The need for diversification is no less paramount for exits than entries. Many of the same PEs that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on  a single path to exit: the Hong Kong IPO.  By itself, such dependence on a single exit path is risky. In the current environment, it looks even more so.

The flood of Chinese IPOs in Hong Kong basically came to a halt a year ago.  When they do resume, it may prove challenging for all but the best and biggest Chinese companies to successfully issue shares there. What will become of the other deals? How will GPs and LPs profit from investments already made? That’s the focus on this new report, titled, “China Secondaries:  The Necessary & Attractive Exit For Private Equity Deals in China“.