Amid flow of money, hopeful entrepreneurs warned that innovation is crucial to success
Every country is touchy about some topics, especially when raised by foreigner. Living in China for almost seven years now, and having been a student of the place for the last forty, I thought I knew the hot buttons not to press. Apparently not.
The topic at hand: high-tech innovation in the PRC and why it seems to lag so far behind that of neighboring Taiwan. A recent issue of one of Chinaâ€™s leading business publications, Caijing Magazine, published a Chinese-language article I wrote together with China First Capitalâ€™s COO, Dr. Yansong Wang, about Taiwanâ€™s high-flying optical lens company Largan Precision.
Soon after the magazine was published, it began circulating rather widely. Howls of national outrage began to reach me almost immediately. Mainly we were accused of not understanding the topic and having ignored Chinaâ€™s many tech companies that are at least the equal, if not superior, to Largan.
I didnâ€™t think the article would be all that contentious, at least not the facts. Largan last year had revenues in excess of $1 billion and net profit margins above 40%, more than double those of its main customer, Apple, no slouch at making money. China has many companies which supply components to Apple, either directly or as a subcontractor. None of these PRC companies can approach the scale and profitability of Largan. In fact, there are few whose net margins are higher than 10%, or one-quarter Larganâ€™s. Case in point: Huawei, widely praised within China as the country’s most successful technology company, has net margins of 9.5%.
Taiwan inaugurated its new president last month, Tsai Ing-wen, who represents the pro-Taiwan independence party. Few in the PRC seem to be in a mood to hear anything good about Taiwan. In one Wechat forum for senior executives, the language turned sharp. â€œChina has many such companies, you as a foreigner just donâ€™t know about them.â€ Or, â€œLargan is only successful because like Taiwan itself, it is protected by the American governmentâ€ and â€œApple buys from Largan because it wants to hold back Chinaâ€™s developmentâ€.
Not a single comment Iâ€™ve seen focused on perhaps more obvious reasons Chinaâ€™s tech ambitions are proving so hard to realize: a weak system of patent protection, widespread online censoring and restrictions on free flow of information, a venture capital industry which, though now large, has an aversion to backing new directions in R&D.Â In Taiwan, none of this is true.
Largan is doing so well because the optical-quality plastic lenses it makes for mobile phone cameras are unrivalled in their price and performance. Any higher-end mobile phone, be it an iPhone or an Android phone selling for above $400, relies on Largan lenses.
Many companies in the PRC have tried to get into this business. So far none have succeeded. Largan, of course, wants to keep it that way. It has factories in China, but key parts of Larganâ€™s valuable, confidential manufacturing processes take place in Taiwan. High precision, high megapixel plastic camera lenses are basically impossible to reverse-engineer. You canâ€™t simply buy a machine, feed in some plastic pellets and out comes a perfect, spherical, lightweight 16-megapixel lens. Largan has been in the plastic lens business for almost twenty years. Todayâ€™s success is the product of many long years of fruitless experimentation and struggle. Largan had to wait a long time for the market demand to arrive. Great companies, ones with high margins and unique products, generally emerge in this way.
We wrote the article in part because Largan is not widely-known in China. It should be. The PRC is, as most people know, engaged in a massive, well-publicized multi-pronged effort to stimulate high-tech innovation and upgrade the countryâ€™s manufacturing base. A huge rhetorical push from Chinaâ€™s central government leadership is backed up with tens of billions of dollars in annual state subsidies. Largan is a good example close to home of what China stands to gain if it is able to succeed in this effort. Itâ€™s not only about fat profits and high-paying jobs. Largan is also helping to create a lager network of suppliers,Â customers and business opportunities outside mobile phones. High precision low-cost and lightweight lenses are also finding their way into more and more IOT devices. There are also, of course, potential military applications.
So why is it, the article asks but doesnâ€™t answer, the PRC does not have companies like Largan? Is it perhaps too early? From the comments Iâ€™ve seen, that is one main explanation. Give China another few years, some argued, and it will certainly have dozens of companies every bit as dominant globally and profitable as Largan. After all, both are populated by Chinese, but the PRC has 1.35 billion of them compared to 23 million on Taiwan.
A related strand, linked even more directly to notions of national destiny and pride: China has 5,000 years of glorious history during which it created such technology breakthroughs as paper, gunpowder, porcelain and the pump. New products now being developed in China that will achieve breakthroughs of similar world-altering amplitude.
Absent from all the comments is any mention of fundamental factors that almost certainly inhibit innovation in China. Start with the most basic of all: intellectual property protection, and the serious lack thereof in China. While things have improved a bit of late, it is still far too easy to copycat ideas and products and get away with it. There are specialist patent courts now to enforce Chinaâ€™s domestic patent regime. But, the whole system is still weakly administered. Chinese courts are not fully independent of political influence. And anyway, even if one does win a patent case and get a judgment against a Chinese infringer, itâ€™s usually all but impossible to collect on any monetary compensation or prevent the loser from starting up again under another name in a different province.
Another troubling component of Chinaâ€™s patent system: it awards so-called â€œuse patentsâ€ along with â€œinvention patentsâ€. This allows for a high degree of mischief. A company can seek patent protection for putting someone elseâ€™s technology to a different use, or making it in a different way.
Itâ€™s axiomatic that countries without a reliable way to protect valuable inventions and proprietary technology will always end up with less of both. Compounding the problem in China, non-compete and non-disclosure agreements are usually unenforceable. Employees and subcontractors pilfer confidential information and start up in business with impunity.
Why else is China, at least for now, starved of domestic companies with globally-important technology? Information of all kinds does not flow freely, thanks to state control over the internet. A lot of the coolest new ideas in business these days are first showcased on Youtube, Twitter, Instagram, Snapchat. All of these, of course, are blocked by the Great Firewall of China, along with all kinds of traditional business media. Closed societies have never been good at developing cutting edge technologies.
Thereâ€™s certainly a lot of brilliant software and data-packaging engineering involved in maintaining the Great Firewall. Problem is, thereâ€™s no real paying market for online state surveillance tools outside China. All this indigenous R&D and manpower, if viewed purely on commercial terms, is wasted.
The venture capital industry in China, though statistically the second-largest in the world, has shunned investments in early-stage and experimental R&D. Instead, VCs pour money into so-called â€œC2Câ€ businesses. These â€œCopied To Chinaâ€ companies look for an established or emerging business model elsewhere, usually in the US, then create a local Chinese version, safe in the knowledge the foreign innovator will probably never be able to shut-down this â€œChina onlyâ€ version. Itâ€™s how Chinaâ€™s three most successful tech companies â€“ Alibaba, Tencent and Baidu â€“ got their start. Theyâ€™ve moved on since then, but â€œC2Câ€ remains the most common strategy for getting into business and getting funded as a tech company in China.
Another factor unbroached in any of the comments and criticisms I read about the Largan article: universities in China, especially the best ones, are extremely difficult to get into. But, their professors do little important breakthrough research. Professorial rank is determined by seniority and connections, less so by academic caliber. Also, Chinese universities donâ€™t offer, as American ones do, an attractive fee-sharing system for professors who do come up with something new that could be licensed.
Tech companies outside China finance innovation and growth by going public. Largan did so in Taiwan, very early on in 2002, when the company was a fraction of its current size. Tech IPOs of this kind are all but impossible in China. IPOs are tightly managed by government regulators. Companies without three years of past profits will never even be admitted to the now years-long queue of companies waiting to go public.
Taiwan is, at its closest point, only a little more than a mile from the Chinese mainland. But, the two are planets apart in nurturing and rewarding high-margin innovation. Taiwan is strong in the fundamental areas where the PRC is weak. While Largan may now be the best performing Taiwanese high-tech company, there are many others that similarly can run circles around PRC competitors. For all the recent non-stop talk in the PRC about building an innovation-led economy, one hears infrequently about Taiwanâ€™s technological successes, and even less about ways the PRC might learn from Taiwan.
That said, I did get a lot of queries about how PRC nationals could buy Largan shares. Since the article appeared, Largan’s shares shot up 10%, while the overall Taiwan market barely budged.
Our Largan article clearly touched a raw nerve, at least for some. If it is to succeed in transforming itself into a technology powerhouse, one innovation required in China may be a willingness to look more closely and assess more honestly why high-tech does so much better in Taiwan.
(An English-language version of the Largan article can be read by clicking here. )
(è´¢ç»æ‚å¿— Caijing Magazine’s Chinese-language article can be read by clicking here.)
Mainland Chinaâ€™s securities regulator will fine-tune policies related to back-door listing (reverse merger)attempts by US-listed Chinese companies, industry insiders say, but it is unlikely to ban them or impose other rigid restrictions.
â€œIt is clear that the regulator does not like the recent speculation on the A-share markets triggered by the relisting trend and will do something to curb such conduct, but it seems impossible they would shut good-quality companies out of the domestic market,â€ Wang Yansong, a senior investment banker based in Shenzhen, said.
The China Securities Regulatory Commission (CSRC) was considering capping valuation multiples for companies seeking relisting on the A-share market after delisting from the US market, Bloomberg reported on Tuesday. Another option being discussed was introducing a quota to limit the number of reverse mergers each year from companies formerly listed on a foreign bourse.
However, Wang said the CSRC was more likely to strengthen verification of back-door listing deals on a case-by-case basis.
â€œTo curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals, and wonâ€™t allow poor-quality companies to seek premiums through this process,â€ she said.
US-listed mainland companies have been flocking to relist on the A-share market since early last year, when the domestic market started a bull run, in order to shed depressed valuations in American markets.
The valuations of relisted companies have boomed, and that has triggered a surge in speculation on possible shell companies â€“ poorly performing firms listed on the Shanghai or Shenzhen bourses. In a process called a reverse takeover or back-door listing, a shell can buy a bigger, privately held company through a share exchange that gives the private companyâ€™s shareholders control of the merged entity.
The biggest such deal was done by digital advertising company Focus Media. Its valuation jumped more than eightfold to US$7.2 billion after it delisted from Americaâ€™s Nasdaq in 2013 and relisted in Shenzhen in December last year, with private equity funds involved in the deal reaping lucrative returns.
Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm, said the trend of delisting and relisting was â€œone of the biggest wealth transfers ever from China to the USâ€.
â€œThe money spent by Chinese investors to privatise Chinese companies in New York ended up lining the pockets of rich institutional investors and arbitrageurs in the US,â€ he said.
However, a tightening or freeze on approval of such deals would threaten not only US-listed Chinese companies in the process of buyouts and shell companies, but also the buyout capital sunk into delistings and relistings.
â€œThe more than US$80 billion of capital spent in the â€˜delist-relistâ€™ deals is perhaps the biggest unhedged bet made in recent private equity history … if, as seems true, the route to exit via back-door listing may be bolted shut, this investment strategy could turn into one of the bigger losers of recent times,â€ he said.
On Friday, CSRC spokesman Zhang Xiaojun sidestepped a question about a rumoured ban on reverse takeover deals by US-listed Chinese companies in the A-share market, saying it had noticed the great price difference in the domestic and the US markets, and the speculation on shell companies, and was studying their influences.
Chinese firms looking to jump a massive queue of companies seeking to do initial public offerings (IPOs) and start trading their shares on the Shanghai or Shenzhen markets are increasingly going through the backdoor by taking control of companies that already have coveted listing status.
The fashion for so-called reverse takeovers is seeing some unlikely combinations, such as a mobile game developer getting listed through a shoe company and a pharmaceutical distributor tying up with a brewer. In such deals, a listed company buys a bigger privately-held company through a share exchange that gives the private companyâ€™s shareholders control of the merged entity.
Companies in the IPO queue, and those advising them, had hoped China would shift to a faster registration-based system for stock market flotations from the current approval regime this March. But the new securities regulator said it would take time to draft the new rules, leaving 762 companies lined up seeking to do IPOs and many of them concerned that the process could take years.
This is prompting companies to consider acquiring listed entities whose businesses are often very modest or deteriorating in a bid to gain quick market access.
“It’s a sign of companies’ complete lack of confidence in their ability to calculate how long they would have to wait to get a primary IPO listing in China. It’s absolutely unknowable at this stage,” said Peter Fuhrman, CEO of China-focused investment bank China First Capital.
These deals are proving lucrative for investors in the companies being acquired – often at sizable premiums to their stock market value – but they also raise governance concerns as those getting backdoor listings do not get the same scrutiny they would face in a formal IPO.
Reverse takeovers also bring back memories of a series of accounting scandals in 2011-2012 involving Chinese firms that gained access to U.S. markets through those transactions. The U.S. Securities and Exchange Commission suspended trading and revoked the registration of some companies, with more than 100 of them delisted or suspended from trading at the New York Stock Exchange over the two-year period because of fraud and accounting issues, according to a McKinsey & Co report.
In a public bulletin in June 2011, the SEC warned investors that â€œmany companies either fail or struggle to remain viable following a reverse merger,â€ and noted there had been â€œinstances of fraud and other abuses involving reverse merger companies.â€
The regulator later approved tougher standards for reverse mergers at both the NYSE and Nasdaq exchanges.
Some other markets, including Hong Kong and Australia, also tightened and clarified rules on backdoor listings to prevent similar problems.
“The main concern with backdoor listings is…that they are often easier than IPOs and companies do not have to go through the IPO application process and accompanying scrutiny,” said Jamie Allen, secretary general of the Asian Corporate Governance Association.
An average of 10 companies a month were granted approval to list on the two Chinese exchanges this year and at that rate the backlog will take nearly six-and-a-half years to clear.
The China Securities Regulatory Commission (CSRC), the marketsâ€™ regulator, did not respond to a request for comment. Chinese companies have carried out $20.6 billion worth of reverse mergers so far this year, including a $2.7 billion deal by Alibaba-backed logistics company YTO Express in late March to merge with a Shanghai-listed clothing maker.
That’s higher than the $19 billion of deals over the same period last year and comes after a record $66.9 billion of backdoor listing activity in all of 2015, which was also spurred by a temporary shutdown of the IPO market in China, Thomson Reuters data showed. By comparison, volumes were $46.5 billion in 2014 and $27.4 billion in 2013.
Digital advertising company Focus Media, which delisted from the Nasdaq in 2013, relisted in Shenzhen in a $7.2 billion backdoor listing in December, the biggest ever such deal.
Chinese tycoon Wang Jianlin’s Dalian Wanda Commercial Properties may also seek a backdoor listing on the Shanghai stock exchange if it does not get regulatory approval to launch a planned IPO there soon, according to two people with knowledge of the matter.
Most of the deals have happened with concurrent secondary offerings to raise new funds for the merged companies.
WILLING TO WAIT
A China listing can come with a big bump in valuation. Companies listed on Shenzhenâ€™s ChiNext board for high-tech and fast growing companies trade at an average price-to-earnings ratio of 70 times, compared with 13.4 times in Shanghai, where Chinaâ€™s largest state-owned firms are listed, 9.3 times in Hong Kong and 20.3 at the Nasdaq.
The price in shares of Focus Media’s ‘shell’ target Hedy Holdings have nearly doubled in value since the companies announced in August the reverse merger that allowed Focus Media to list in Shenzhen. Shares in Kingnet Network Co Ltd have soared 154 percent since April 2015, when Taiya Shoes made a bid for the mobile game developer.
Still, some companies that only recently entered the China IPO queue are willing to wait.
“We are not sure how long (until) we can get listed, but we understand that a lot of companies are applying for IPO and may need to wait for a long time,” said an investor relations officer at Jiangsu Heshili New Material, which produces materials used for fiber optic cables and filed to go public in Shenzhen in March.
MAY NOT BE CHEAPER
Reverse takeovers can sometimes be more expensive than IPOs. An IPO can cost a lot in advisory fees and work with lawyers and auditors to get a companyâ€™s accounts and controls in shape to pass muster with regulators and exchanges. But with a takeover, there are also advisory fees and a lot of those same auditor and legal fees once the deal is completed â€“ plus there is the cost of taking control of the listed company at a premium to its share price.
Indeed, the flurry of deals is pushing the price of shell companies in China through the roof, making reverse mergers only practical for sizeable companies. There were 33 reverse mergers involving Chinese companies in 2015, putting the average deal size at about $2 billion, with the average price more than doubling to $4.1 billion so far in 2016, according to Thomson Reuters data.
“If you’re the nervous investors that took Focus Media private for a couple of billion in the U.S., if you’re a delivery company and you need money to buy airplanes, you can’t wait for two, three or five years,” Fuhrman said, in reference to the way in which being listed allows companies to raise funds more easily â€“ whether for investments or to let shareholders cash out.
“You gotta suck it up and pay the money.”
(Additional reporting by Tris Pan; Editing by Martin Howell)
Part two of a series. Read part one.
Greshamâ€™s Law, as many of us were taught a while back, stipulates that bad money drives out good. Thereâ€™s something analogous at work in Chinaâ€™s private equity and venture capital industry. Only here itâ€™s not a debased currency thatâ€™s dominating transactions. Instead, itâ€™s Renminbi private equity (PE) firms. Flush with cash and often insensitive to valuation and without any clear imperative to make money for their investors, they are changing the PE industry in China beyond recognition and making life miserable for many dollar-based PE and venture capital (VC) firms.
From a tiny speck on the PE horizon five years ago, Reminbi (RMB) funds have quickly grown into a hulking presence in China. In many ways, they now run the show, eclipsing global dollar funds in every meaningful category â€“ number of active funds, deals closed and capital raised. RMB funds have proliferated irrespective of the fact there have so far been few successful exits with cash distributions.
The RMB fund industry works by a logic all its own. Valuations are often double, triple or even higher than those offered by dollar funds. Term sheets come in faster, with fewer of the investor preferences dollar funds insist on. Due diligence can often seem perfunctory.Â Post-deal monitoring? Often lax, by global standards. From the perspective of many Chinese company owners, dollar PE firms look stingy, slow and troublesome.
The RMB fund industryâ€™s greatest success so far was not the IPO of a portfolio company, but of one of the larger RMB general partners, Jiuding Capital. It listed its shares in 2015 on a largely-unregulated over-the-counter market called The New Third Board. For a time earlier this year, Jiuding had a market cap on par with Blackstone, although its assets under management, profits, and successful deal record are a fraction of the American firmâ€™s.
The main investment thesis of RMB funds has shifted in recent years. Originally, it was to invest in traditional manufacturing companies just ahead of their China IPO. The emphasis has now shifted towards investing in earlier-stage Chinese technology companies. This is in line with Chinaâ€™s central government policy to foster more domestic innovation as a way to sustain long-term GDP growth.
The Shanghai government, which through different agencies and localities has become a major sponsor of new funds, has recently announced a policy to rebate a percentage of failed investments made by RMB funds in Shanghai-based tech companies. Moral hazard isnâ€™t, evidently, as high on their list of priorities as taking some of the risk out of risk-capital investing in start-ups.
Dollar funds, in the main, have mainly been observing all this with sullen expressions. Making matters worse, they are often sitting on portfolios of unexited deals dating back five years or more. The US and Hong Kong stock markets have mainly lost their taste for PE-backed Chinese companies. While RMB funds seem to draw from a bottomless well of available capital, for most dollar funds, raising new money for China investing has never been more difficult.
RMB funds seldom explain themselves, seldom appear at industry forums like SuperReturn. One reason: few of the senior people speak English. Another: they have no interest or need to raise money from global limited partners. They have no real pretensions to expand outside China. They are adapted only and perhaps ideally to their native environment. Dollar funds have come to look a bit like dinosaurs after the asteroid strike.
Can dollar funds find a way to regain their central role in Chinese alternative investing? It wonâ€™t be easy. Start with the fact the dollar funds are all generally the slow movers in a big pack chasing the same sort of deals as their RMB brethren. At the moment, that means companies engaged in online shopping, games, healthcare and mobile services.
A wiser and differentiated approach would probably be to look for opportunities elsewhere. There are plenty of possibilities, not only in traditional manufacturing industry, but in control deals and roll-ups. So far, with few exceptions, thereâ€™s little sign of differentiation taking place. Read the fund-raising pitch for dollar and RMB funds and, apart from the difference in language, the two are eerily similar. They sport the same statistics on internet, mobile, online shopping penetration: the same plan to pluck future winners from a crop of look-alike money-losing start-ups.
There is one investment thesis the dollar PE funds have pretty much all to themselves. Itâ€™s so-called â€œdelist-relistâ€ deals, where US-quoted Chinese companies are acquired by a PE fund together with the companyâ€™s own management, delisted from the US market with the plan to one day IPO on Chinaâ€™s domestic stock exchange. There have been a few successes, such as the relisting last year of Focus Media, a deal partly financed by Carlyle. But, there are at least another forty such deals with over $20bn in equity and debt sunk into them waiting for their chance to relist. These plans suffered a rather sizeable setback recently when the Chinese central government abruptly shelved plans to open a new â€œstrategic stock marketâ€ that was meant to be specially suited to these returnee companies. The choice is now between prolonged limbo, or buying a Chinese-listed shell to reverse into, a highly expensive endeavor that sucks out a lot of the profit PE firms hoped to make.
Outspent, outbid and outhustled by the RMB funds, dollar PE funds are on the defensive, struggling just to stay relevant in a market they once dominated. Some are trying to go with the flow and raise RMB funds of their own. Most others are simply waiting and hoping for RMB funds to implode.
So much has lately gone so wrong for many dollar PE and VC in China. Complicating things still further, Chinaâ€™s economy has turned sour of late. But, thereâ€™s still a game worth playing. Globally, most institutional investors are under-allocated to China.Â A new approach and some new strategies at dollar funds are overdue.
Peter Fuhrman moderates our SuperReturn China 2016 Big Debate: â€˜How Do You Best Manage Your Exposure To China?â€™. Discussants include:
Renminbi-denominated private equity funds basically didnâ€™t exist until about five years ago. Up until that point, for ten golden years, Chinaâ€™s PE and VC industry was the exclusive province of a hundred or so dollar-based funds: a mix of global heavyweights like Blackstone, KKR, Carlyle and Sequoia, together with pan-Asian firms based in Hong Kong and Singapore and some â€œChina onlyâ€ dollar general partners like CDH, New Horizon and CITIC Capital. These firms all raised money from much the same group of larger global limited partners (LPs), with a similar sales pitch, to make minority pre-IPO investments in high-growth Chinese private sector companies then take them public in New York or Hong Kong.
All played by pretty much the same set of rules used by PE firms in the US and Europe: valuations would be set at a reasonable price-to-earnings multiple, often single digits, with the usual toolkit of downside protections. Due diligence was to be done according to accepted professional standards, usually by retaining the same Big Four accounting firms and consulting shops doing the same well-paid helper work they perform for PE firms working in the US and Europe. Deals got underwritten to a minimum IRR of about 25%, with an expected hold period of anything up to ten years.
There were some home-run deals done during this time, including investments in companies that grew into some of Chinaâ€™s largest and most profitable: now-familiar names like Baidu, Alibaba, Pingan, Tencent. It was a very good time to be in the China PE and VC game â€“ perhaps a little too good. Chinese government and financial institutions began taking notice of all the money being made in China by these offshore dollar-investing entities. They decided to get in on the action. Rather than relying on raising dollars from LPs outside China, the domestic PE and VC firms chose to raise money in Renminbi (RMB) from investors, often with government connections, in China. Off the bat, this gave these new Renminbi funds one huge advantage. Unlike the dollar funds, the RMB upstarts didnâ€™t need to go through the laborious process of getting official Chinese government approval to convert currency. This meant they could close deals far more quickly.
Helpfully, too, the domestic Chinese stock market was liberalized to allow more private sector companies to go public. Even after last yearâ€™s stock market tumble, IPO valuations of 70X previous yearâ€™s net income are not unheard of. Yes,Â RMB firms generally had to wait out a three-year mandated lock-up after IPO. But, the mark-to-market profits from their deals made the earlier gains of the dollar PE and VC firms look like chump change. RMB funds were off to the races.
Almost overnight, China developed a huge, deep pool of institutional money these new RMB funds could tap. The distinction between LP and GP is often blurry. Many of the RMB funds are affiliates of the organizations they raise capital from. Chinese government departments at all levels â€“ local, provincial and national â€“ now play a particularly active role, both committing money and establishing PE and VC funds under their general control.
For these government-backed PE firms, earning money from investing is, at best, only part of their purpose. They are also meant to support the growth of private sector companies by filling a serious financing gap. Bank lending in China is reserved, overwhelmingly, for state-owned companies.
A global LP has fiduciary commitments to honor, and needs to earn a risk-adjusted return. A Chinese government LP, on the other hand, often has no such demand placed on it. PE investing is generally an end-unto-itself, yet another government-funded way to nurture Chinaâ€™s economic development, like building airports and train lines.
Chinese publicly-traded companies also soon got in the act, establishing and funding VC and PE firms of their own using balance sheet cash. They can use these nominally-independent funds to finance M&A deals that would otherwise be either impossible or extremely time-consuming for the listed company to do itself. A Chinese publicly-traded company needs regulatory approval, in most cases, to acquire a company. An RMB fund does not.
The fund buys the company on behalf of the listed company, holding it while the regulatory approvals are sought, including permission to sell new shares to raise cash. When all thatâ€™s completed, the fund sells the acquired company at a nice mark-up to its listed company cousin. The listco is happy to pay, since valuations rise like clockwork when M&A deals are announced. Itâ€™s called â€œmarket cap managementâ€ in Chinese. If youâ€™re wondering how the fund and the listco resolve the obvious conflicts of interest, you are raising a question that doesnâ€™t seem to come up often, if at all.
Peter continues his discussion of the growth of Renminbi funds next week. Stay tuned! He also moderates our SuperReturn China 2016 Big Debate: â€˜How Do You Best Manage Your Exposure To China?â€™.
Intralinks: The meltdown of Chinaâ€™s equity markets that began in the summer, despite measures by officials in Beijing aimed at calming investorsâ€™ nerves, has left many global investors jittery. Is this just a correction of an overheated market or the start of something more serious, and how would you describe the mood in China at the moment?
Peter Fuhrman: Never once have I heard of a stock market correction that was greeted with glee by the mass of investors, brokers, regulators or government officials. So too most recently in China. The dive in Chinese domestic share prices, while both overdue and in line with the sour fundamentals of most domestically quoted companies, has caused much unhappiness at home and anxiety abroad. The dour outlook persists, as more evidence surfaces that Chinaâ€™s real economy is indeed in some trouble. I first came to China 34 years ago, and have lived full-time here for the last six years. This is unquestionably the worst economic and financial environment Iâ€™ve encountered in China. Unlike in 2008, the Chinese government canâ€™t and wonâ€™t light a fiscal bonfire to keep the economy percolating. The enormous state-owned sector is overall on life support, barely eking out enough cash flow to pay interest on its massive debts. Salvation this time around, if itâ€™s to be found, will come from the countryâ€™s effervescent private sector. Itâ€™s already the source of most job creation and non-pump-primed growth in China. The energy, resourcefulness, pluck and risk-tolerance of Chinaâ€™s entrepreneurs knows no equal anywhere in the world. The private sector has been fully legal in China for less than two decades. It is only beginning to work its economic magic.
Intralinks: Much has been made of slowing economic growth in China. What are you seeing on the ground and how reliable do you view the Chinese official growth statistics?
Peter Fuhrman: If thereâ€™s a less productive pastime than quibbling with Chinaâ€™s official statistics, I donâ€™t know of it. Look, itâ€™s beyond peradventure, beyond guesstimation that Chinaâ€™s economic transformation is without parallel in human history. The transformation of this country over the 34 years since I first set foot here as a graduate student is so rapid, so total, so overwhelmingly positive that it defies numerical capture. That said, weâ€™re at a unique juncture in China. There are more signs of economic worry down at the grassroots consumer level than I can recall ever seeing. China is in an unfamiliar state where nothing whatsoever is booming. Real estate prices? Flat or dropping. Manufacturing? Skidding. Exports? Crawling along. Stock market prices? Hammered down and staying down. The Renminbi? No longer a one-way bet.
Intralinks: What impact do you see a slowing Chinese economy having on other economies in the APAC region and elsewhere?
Peter Fuhrman: Of course there will be an impact, both regionally and globally. Thereâ€™s only one certain cure for any country feeling ill effects from slowing exports to China: allow the Chinese to travel visa-free to your country. The one trade flow that is now robust and without doubt will become even more so is the Chinese flocking abroad to travel and spend. Only partly in jest do I suggest that the U.S. trade deficit with China, now running at a record high of about $1.5 billion a day, could be eliminated simply by letting the Chinese travel to the U.S. with the same ease as Taiwanese and Hong Kong residents. Manhattan store shelves would be swept clean.
Intralinks: With prolonged record low interest rates and low inflation in most of the advanced economies, many multinational companies have looked to China as a source of growth, including through M&A. Which sectors in China have tended to attract the majority of foreign interest? Do you see that continuing or will the focus and opportunities shift elsewhere? Is China a friendly environment for inbound M&A?
Peter Fuhrman: The challenges, risks and headaches remain, of course, but M&A fruit has never been riper in China. This is especially so for U.S. and European companies looking to seize a larger slice of Chinaâ€™s domestic consumer market. The M&A strategy that does work in China is to acquire a thriving Chinese private sector business with revenues in China of at least $25m a year, with its own-brand products, distribution, and a degree of market acceptance. The goal for a foreign acquirer is to use M&A to build out most efficiently a sales, brand and product strategy that is optimized for China, in both today’s market conditions, as well as those likely to pertain in the medium- to long-term.
The botched deals tend to get all the headlines, but almost surreptitiously, some larger Fortune 500 companies have made some stellar acquisitions in China. Among them are Nestle, General Mills, ITW, FedEx and Valspar. They bought solid, successful, entrepreneur-founded and run companies. Those acquired companies are now larger, often by orders of magnitude. The acquirer has also dramatically expanded sales of its own global products in China by utilizing the localized distribution channels it acquired. In Nestleâ€™s case, China is now its second-largest market in revenue-terms after the U.S. Four years ago, it ranked number seven.
Chinese government policy towards M&A is broadly positive to neutral. More consequential but perhaps less well-understood are the negative IPO environment for domestic private sector companies, as well as the enormous overhang of un-exited PE invested deals in China. These have transferred pricing leverage from sellers to buyers in China. Increasingly, the most sought-after exit route for domestic Chinese entrepreneurs is through a trade sale to a large global corporation.
Intralinks: After years of being seen mainly as â€œan interested partyâ€, rather than an actual dealmaker, Chinese players are increasingly frequently the successful bidder in international M&A transactions. What has changed in their approach to dealmaking to ensure such success?
Peter Fuhrman: Yes, Chinese buyers are increasingly more willing and able to close international M&A deals. But, the commonly-heard refrain that Chinese buyers will devour everything laid in front of them stands miles apart from reality. It seems like every asset for sale in every locale is seeking a Chinese buyer. The limiting factor isn’t money. Chinese acquirers’ cost of capital is lower than anywhere else, often fractionally above zero. The issue instead is too few Chinese companies have the managerial depth and experience to close global M&A deals. There are some world-class exceptions and world-class Chinese buyers. In the last year, for example, a Chinese PE fund called Hua Capital has led two milestone transactions, the proposed acquisition for a total consideration north of $2.5bn, of two U.S.-quoted semiconductor companies, Omnivision and ISSI. Hua Capital has powerful backers in China’s government, as well as outstanding senior executives. These guys are the real deal.
Intralinks: When it comes to doing deals, what are the differences between private/public companies and SOEs?
Peter Fuhrman: With rare exceptions, the SOE sector is now paralyzed. No M&A deals can be closed. Every week brings new reports of the arrest of senior SOE management for corruption. In some cases, the charges relate directly to M&A malfeasance, bribes, kickbacks and the like. SOE M&A teams will still go on international tire-kicking junkets, but getting any kind of transaction approved by the higher tiers within the SOE itself and by the government control apparatus is all but impossible for now. That leaves Chinaâ€™s private sector companies, especially quoted ones, as the most likely club of buyers. We work with the chairmen of quite a few of these private companies. The appetite is there, the dexterity often less so.
Intralinks: China has long been a fertile dealmaking environment for PE funds â€“ both home-grown and international. In what ways does the Chinese PE model differ from what we see in other markets?
Peter Fuhrman: Perhaps too fertile. For all the thousands of deals done, Chinese PEâ€™s great Achilles heel is an anemic rate of return to their limited partner investors, especially when measured by actual cash distributions. Over the last three, five, seven years, Chinese PE as a whole has underperformed U.S. PE by a gaping margin. Itâ€™s a fundamental truth too often overlooked. High GDP growth rates do not correlate, and never have, with high investment returns, especially from alternative investment classes like PE. If there is one striking disparity between PE as practiced in China as compared to the U.S. and Europe, itâ€™s the fact that that Chinese general partners, whether theyâ€™re from the worldâ€™s largest global PE firms or pan-Asian or China-focused funds, too often think and act more like asset managers than investors. The 2 takes precedence over the 20.
Intralinks: What opportunities and challenges are private equity investors facing?
Peter Fuhrman: The levels of PE and venture capital (VC) investing activity in China have dropped sharply. What money is being invested is mainly chasing after a bunch of loss-making online shopping and mobile services apps. The hope here is one will emerge as Chinaâ€™s next Alibaba or Tencent, the two giants astride Chinaâ€™s private sector. PE investment in Chinaâ€™s â€œreal economy,â€ that is manufacturing businesses that create most of the jobs and wealth in China, has all but dried up. Though out of favor, this is where the best deals are likely to be found now. Contrarianism is an investing worldview not often encountered at China-focused PE and VC firms.
Intralinks: As in many other markets, PE investors are having to deal with a backlog of portfolio companies ready to be exited. Do you feel that PEâ€™s focus on minority investments in China could prove a challenge when it comes to exiting those investments? What do you see as the primary exit route?
Peter Fuhrman: Exits remain both few in number and overwhelmingly concentrated on a single pathway, that of IPO. M&A exits, the main source of profit for U.S. and European PE firms, remain exceedingly rare in China. In part, itâ€™s because PE firms usually hold a minority stake in their Chinese investments. In part, though, the desire for an IPO exit is baked into the PE investment process in China. Price/Earnings (P/E) multiple arbitrage, trying to capture alpha through the observed delta in valuation multiples between private and public markets, remains a much-beloved tactic.
Intralinks: Finally, what is your overall outlook on China and advice for foreign companies and investors seeking opportunities to engage in M&A or invest there?
Peter Fuhrman: Yes, Chinaâ€™s economy is slowing. But the salient discussion point within boardrooms should be that even at 5% growth, Chinaâ€™s economy this year is getting richer faster in dollar terms than it did in 2007 when GDP growth was 14%. Thatâ€™s because the economy is now so much larger. This added increment of wealth and purchasing power in China in 2015 is larger than the entire economies of Taiwan, Malaysia, Thailand, and Hong Kong. Much of the annual gain in China, likely to remain impressively large for many long years to come, filters down into increased middle class spending power. This is why China must matter to global businesses with a product or service to sell. M&A in China has a cadence and quirks all its own. But, the business case can often be compelling. The terrain can be mastered.
Does [China’s] shift from a manufacturing-driven economy to a service-driven one make macroeconomic shocks like those seen this summer inevitable?
Peter Fuhrman: China has enjoyed something of a worldwide monopoly on hair-raising economic news of late: a stock market collapse followed by a klutzy bail-out, then a devaluation followed by a catastrophic explosion and finally near-hourly reports of sinking economic indicators. As someone who first set foot in China 34 years ago, my view is weâ€™re in an unprecedented time of economic and financial uncertainty . Consumers and corporates are noticeably wobbling. For a Chinese government long used to ordering â€œJump!â€ and the economy shouting back â€œHow high?â€ this is not the China they thought they were commanding.Â Everyone is looking for a bannister to grab.
And yet, China still has some powerful fundamentals working in its favour. Urbanization is a big one. It alone should add at least 3-4% to annual GDP a year for many years to come. The shift towards services and domestic growth as opposed to exports are two others. For now, these forces are strong enough to keep China propelling forward even as it tows heavy anchors like an ageing population, and a cohort of monopolistic state-owned enterprises (SOEs) that suck up too much of China’s capital and often achieve appalling results with it.
Look, the Chinese stock market had no business in the first place almost tripling from June last year to June of this. The correction was long, long overdue. It’s often overlooked that China’s domestic stock market has a pronounced negative selection bias. Heavily represented among the 3,000 listed companies are quite a number of China’s very worst companies, with the balance made up of lethargic, low-growth, often loss-making SOEs. The good companies, like Tencent or Baidu, predominantly expatriate themselves when it comes time to IPO. To my way of thinking, China’s domestic market still seems overpriced. The dead cats are, for now, still bouncing.
Given this overall picture, do you expect to see greater or fewer opportunities [in China] for alternative investments and why?Â
Peter Fuhrman: The environment in China has been challenging, to say the least, for alternative investment firms not just in the last year, but for the better part of the last decade. A lot hasn’t gone to plan. China’s growth and opportunities proved alluring to both GPs and LPs. And yet too often, almost systematically, the big money has slipped between their fingers. Partly it’s because of too much competition, and with it ballooning valuations, from over 500 newly-launched domestic Chinese PE and VC firms. The fault also sits with home-grown mistakes, with errors by private equity firms in investment approach. This includes an excessive reliance on a single source of deal exit, the IPO, all but unheard-of in other major alternative investment environments.
Overall PE returns have been lacklustre in China, especially distributions, before the economy began to slip off the rails. In the current environment, challenges multiply. A certain rare set of investing skills should prove well-adapted: firms that can do control deals, including industry consolidating roll-ups. In other words, a whole different set of prey than China PE investors have up to now mainly stalked. These are not pre-IPO deals, not ones predicated on valuation arbitrage or the predilections of Chinese young online shoppers. There’s money to be made in China’s own Rust Belt, backing solid well-managed manufacturers, a la Berkshire Hathaway. There’s too much fragmentation across the industrial board. China will remain the manufacturing locus for the world, as well as for its own gigantic domestic market.
Another anomaly that needs correcting: Global alternative investing has been overwhelmingly skewed in China towards equity not debt. The ratio could be as high as 99:1. This imbalance looks even more freakish when you consider real lending rates to credit-worthy corporates in China are probably the highest anywhere in the advanced world, even a lot higher than in less developed places like India and Indonesia. Regulation is one reason why global capital hasn’t poured in in search of these fat yields. Another is the fact PE firms on the ground in China have few if any team members with the requisite background and experience to source, qualify, diligence and execute China securitized debt deals. There’s a bit of action in the China NPL and distress world. But, straight up direct collateralized lending to China’s AA-and-up corporates and municipalities remains an opportunity global capital has yet to seize. Meanwhile, China’s shadow banking sector has exploded in size, with over $2.5 trillion in credit outstanding, almost all of which is current. There’s big money being made in China’s securitized high-yield debt, just not by dollar investors.
What’s the overall story of alternative investors engaging with central planning? How would you characterise the regulatory environment?
Peter Fuhrman: China has had a state regulatory and administrative apparatus since Europeans were running around in pelts and throwing spears at one another. So, yes, there is a large regulatory system in China overseen by a powerful government that is very deeply involved in economic and financial planning and rule-making. One must tread carefully here. Rules are numerous, occasionally contradictory, oft-time opaque and liable to sudden change.
Less observed, however, and less harrowing for foreign investors is the core fact that the planning and regulatory system in China has a strong inbuilt bias towards the goal of lifting GDP growth and employment. Other governments talk this talk. But it’s actually China that walks the walk. The days of anything-goes, rip-roaring, pollute-as-you-go development are about done with. But, still the compass needle remains fixed in the direction of encouraging strong rates of growth.
The Chinese government has also gotten more and more comfortable with the fact that most of the growth is now coming from the highly-competitive, generally lightly-regulated private sector. Along with a fair degree of deregulation lately in industries like banking and transport, China also often pursues a policy of benign neglect, of letting entrepreneurs duke it out, and only imposing rules-of-the-game where it looks like a lot of innocents’ money may be lost or conned. To be sure, foreign investors in most cases cannot and should not operate in these more free-form areas of China’s economy. They often seem to be the first as well as the fattest targets when the clamps come down. Just ask some larger Western pharmaceutical companies about this.
In the long view, how long can the parallel USD-RMB system run? Do you expect to see the experiments in Shanghaiâ€™s Pilot Free Trade Zone (FTZ) replicated and extended?Â
Peter Fuhrman: Unravelling China’s rigged exchange rate system will not happen quickly. Every baby step — and the steps are coming more fast of late — is one in the direction of a more open capital account, of greater liberalization. But, big change will all unfold with a kind of stately sluggishness in my view. Not because policy-makers are particularly wed to the notion of an unconvertible currency. There’s the deadweight problem of nearly $4 trillion in foreign exchange reserves. What’s the market equilibrium rate of the Dollar-Renminbi? Ask someone facing competition from a Chinese exporter and they’re likely to say three-to-one, or an almost 100% appreciation. Ask 1.4 billion Chinese consumers and they will, with eminent good reason, say it should be more like 12-to-one. Prices of just about everything sold to consumers in China is higher, often markedly higher, than in the US where I’m from. This runs from fruit, to supermarket staples, to housing, brand-name clothing up to ladder to cars and the fuel that powers them.
I think the irrational exuberance about Shanghai’s FTZ has slammed into the wall of actual central government policy of late.Â It will not, cannot, act like a free market pathogen.
Reform of China’s state-owned enterprises has been piecemeal, and private equity has had patchy success with SOEs. Do you expect this to change, and why?
Peter Fuhrman: For those keeping score, reform of SOEs has yet to really put any points on the board. The SOE economy-within-an-economy remains substantially the same today as it was three years ago. Senior managers continue to be appointed not by competence, vision and experience, but by rotation. The major shareholder of all these SOEs, both at centrally-administered level as for well as those at provincial and local level, act like indifferent absentee proprietors, demanding little by way of dividends and showing scant concern as margins and return-on-investment droop year-by-year at the companies they own.
There are good deals to be done for PE firms in the SOE patch. The dirty little secret is that the government uses a net asset value system for state-owned assets that is often out-of-kilter with market valuations. Choose right and there’s scope to make money from this. But, if you’re a junior partner behind a state owner who cares more about jobs-for-the-boys than maximizing (or even earning) profits then no asset however cheaply bought will ever really be in the money.
TPP has been described as ‘a club with China left out’. If it comes to pass, how do you expect China to respond?
Peter Fuhrman: China has responded. Along with its rather clumsy-sounding “One Belt, One Road” initiative it also has its Asia Infrastructure Investment Bank. The logic isn’t alien to me. When American Jews were barred from joining WASP country clubs, they tried to build better clubs of their own. When Chase Manhattan, JP Morgan and America’s largest commercial banks wouldn’t hire Jews, they went instead into investment banking, where there was more money to be made anyway.
But, China may not so easily and successfully shrug off their exclusion from TPP. It increases their aggrieved sense of being ganged-up upon. The US understands this and now frets more about Chinaâ€™s military power. The partners China are turning to instead â€“ especially the countries transected by the â€œOne Belt, One Roadâ€ â€“ look more like a cast of economic misfits, not dynamic free traders like the TPP nations and China itself. I donâ€™t think anyone in Beijing seriously believes that increased trading with the Central Asian -stans is a credible substitute. Even so, China will not soon be invited to join the TPP. China has hardly acted like a cozy neighbour of late to the countries with the markets and with the money. Being feared may have its strategic dividends. But the neighbourhood bully rarely if ever gets invited to the block party.
Peter Fuhrman will be speaking atÂ SuperReturn Asia 2015, 21-24 September 2015, JW Marriott, Hong Kong.
BYÂ Fraser Tennant
The deeper trends reshaping the business and investment environment in China today are the focus of a new report â€“ â€˜China 2015: Chinaâ€™s shifting landscapeâ€™ â€“ by the boutique investment bank and advisory firm, China First Capital.
As well as highlighting slowing growth and a gyrating stock market as the two most obvious sources of turbulence in China at the midway point of 2015, the report also delves into the deeper trendsÂ radically reshaping the countryâ€™s overall business environment.
Chief among these trends is the steady erosion in margins and competitiveness amongÂ many, if not most, companies operating in Chinaâ€™s industrial and service economy. As the report makes abundantly clear, there are few sectors and few companiesÂ enjoying growth and profit expansion to match that seen in previous years.
The China First Capital report,Â quite simply,Â paints a none too rosy picture of Chinaâ€™s long-term development prospects.
â€œChinaâ€™s consumer market, while healthy overall, is also becoming a more difficult place for businesses to earn decent returns,” explains Peter Fuhrman, China First Capitalâ€™s chairman and chief executive. â€œRelentless competition is one part, as are problematic rising costs and inefficient poorly-evolved management systems.â€
To read complete article, click here.
Slowing growth and a gyrating stock market are the two most obvious sources of turbulence in China at the midway point of 2015. Less noticed, perhaps, but certainly no less important for Chinaâ€™s long-term development are deeper trends radically reshaping the overall business environment. Among these are a steady erosion in margins and competitiveness in many, if not most, of Chinaâ€™s industrial and service economy. There are few sectors and few companies that are enjoying growth and profit expansion to match last year and the years before.
Chinaâ€™s consumer market, while healthy overall, is also becoming a more difficult place for businesses to earn decent returns. Relentless competition is one part. As problematic are rising costs and inefficient poorly-evolved management systems.Â From a producer economy dominated by large SOEs, China is shifting fast to one where consumers enjoy vastly more choice, more pricing leverage and more opportunities to buy better and buy cheaper. Online shopping is one helpful factor, since it allows Chinese to escape from the poor service and high prices that characterize so much of the traditional bricks-and-mortar retail sector. Itâ€™s hard to find anything positive to say about either the current state or future prospects for Chinaâ€™s â€œoffline economyâ€.
Meanwhile, more Chinese are taking their spending money elsewhere, traveling and buying abroad in record numbers. They have the money to buy premium products, both at home and abroad. But, too much of whatâ€™s made and sold within China, belongs to an earlier age. Too many domestic Chinese companies are left manufacturing products no longer quite meet current demands. Adapting and changing is difficult because so many companies gorged themselves previously on bank loans. Declining margins mean that debt service every year swallows up more and more available cash flow. When the economy was still purring along, it was easier for companies and their banks to pretend debt levels were manageable. In 2015, across much of the industrial economy, the strained position of many corporate borrowers has become brutally obvious.
These are a few of the broad themes discussed in our latest research report, â€œChina 2015 — China’s Shifting Landscapeâ€. To download a copy click here.
Inside, you will not find much discussion of GDP growth or the stock market. Instead, we try here to illuminate some less-seen, but relevant, aspects of Chinaâ€™s changing business and investment environment.
For those interested in the stock marketâ€™s current woes, I can recommend this article (click here) published in The New York Times, with a good summary of how and why the Chinese stock market arrived at its current difficult state. Iâ€™m quoted about the preference among many of Chinaâ€™s better, bigger and more dynamic private sector companies to IPO outside China.
In our new report, I can point to a few articles that may be of special interest, for the signals they provide about future opportunities for growth and profit in China:
Weâ€™re at a fascinating moment in Chinaâ€™s story of 35 years of rapid and remarkable economic transformation. The report’s conclusion: for businesses and investors both global and China-based, it will take ever more insight, guts and focus to outsmart the competition and succeed.
A sizeable quotient of the techno-hip crowd in the US and Europe is counting down the days to the launch next week of the newest Android mobile phone by Chinaâ€™s OnePlus. Itâ€™s called the OnePlus Two and follows a little more than a year after the 18-month-old companyâ€™s first phone, the OnePlue One, went on sale in the US and Europe. With barely a nickel to spend on marketing and promotion, OnePlus insouciantly dubbed its OnePlus One a â€œflagship killerâ€ claiming it delivered similar or better performance than Samsung, LG and HTC Android phones costing twice as much.
The tech media swooned, and buyers formed long online queues to buy one from the OnePlus website, www.oneplus.net, the only place the phones are sold. In little more than six months last year, OnePlus sold over one million phones.
The new OnePlus model is rumored to be built around a new top-of-the-line Qualcomm processor, and features a larger screen, an upgraded in-house version of Android software, fingerprint recognition. Price? Around $300. It will be available, as was the OnePlus One for most of the last year, on an â€œinvitation-only cash-upfrontâ€ basis to prospective buyers. How to get a coveted invitation remains something of a dark art. New OnePlus owners are given a certain number of invitations to send to whoever they please.
The July 27th launch will be an online event broadcast in virtual reality. OnePlus manufactured and is giving away a cardboard virtual reality viewer said to be as good or better than the ones sold by Google for $20. The viewers have been flying out the door for the last month.
Peter Fuhrman, CEO of China First Capital, explains how the countryâ€™s private equity market has struggled with profit returns and the importance of diversified exit strategies. He also predicts the rise of new funds to execute high-yield deals
Date: 05 May 2015
What is China First Capital?
China First Capital is an investment bank and advisory firm with a focus on Greater China. Our business is helping larger Chinese companies, along with a select group of Fortune 500 companies, sustain and enlarge market leadership in the country, by raising capital and advising on strategic M&A. Like our clients, we operate in an opportunity-rich environment. Though realistic about the many challenges China faces as its economy and society evolve, we are as a firm fully convinced there is no better market than China to build businesses of enduring value. China still has so much going for it, with so much more growth and positive change ahead. As someone who first came to China in 1981 as a graduate student, my optimism is perhaps understandable. The positive changes this country has undergone during those years have surpassed by orders of magnitude anything I might have imagined possible.
After a rather long career in the US and Europe, including a stint as CEO of a California venture capital company as well as a venture-backed enterprise software company, I came back to China in 2008 and established China First Capital with a headquarters in Shenzhen, a place I like to think of as the California of China. It has the same mainly immigrant population and, like the Silicon Valley, is home to many leading private sector high-tech companies.
What is happening in Chinaâ€™s private equity (PE) market?
Back in 2008, China’s financial markets, the domestic PE industry, were far less developed. It was, we now can see, a honeymoon period. Hundreds of new PE firms were formed, while the big global players like Blackstone, Carlyle, TPG and KKR all built big new operations in China and raised tons of new money to invest there. From a standing start a decade ago, China PE grew into a colossus, the second-largest PE market in the world. But, it also, almost as quickly, became one of the more troubled. The plans to make quick money investing in Chinese companies right ahead of their planned IPO worked brilliantly for a brief time, then fell apart, as first the US, then Hong Kong and finally China’s own domestic stock exchanges shut the doors to Chinese companies. Things have since improved. IPOs for Chinese companies are back in all three markets. But PE firms are still sitting on thousands of unexited investments. The inevitable result, PE in China has had a disappointing record in the category that ultimately matters most: returning profits to limited partners (LPs).
May 2015Â | Â COVER STORY Â | Â PRIVATE EQUITY
Financier Worldwide Magazine
Like many other facets of the financial services industry, the private equity (PE) asset class has endured a turbulent and difficult period since the onset of the financial crisis. Critics of the industry were quick to colour the PE space as a den of iniquity, a place for vultures and destroyers of jobs. In recent years, the sector has been required to comply with an increasingly tight set of regulatory requirements.
Chinese PE activity, by contrast, was rather more subdued. â€œIn 2014, the gap between the performance of the private equity industry in China and the US opened wide,â€ says Peter Fuhrman, chairman and founder of China First Capital, a China-focused global investment bank. â€œThe US had a record-breaking year, with 10-year net annualised return hitting 14.6 percent. 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. While IPO exits for Chinese companies in the US, Hong Kong and China reached 221, compared to only 66 in 2013, the ultimate measure of success in PE investing is not the number of IPOs; itâ€™s the amount of capital and profits paid back to LP investors. This is China PEâ€™s greatest weakness.â€