Private Equity

Private Equity Firms in China in the Firing Line – Ratcheting Up the Criticism of Performance Ratchets

Ming Dynasty Cloisonne

In an interesting discussion this week in Shenzhen with a very smart and capable lawyer (Ke Luo of Fangda Partners), I learned about a small, but growing backlash against the Top Tier private equity firms working China. Evidently there have been some articles in the Chinese press voicing criticisms of their approach and methods, and comparing them unfavorably with Chinese domestic investment companies. 

Upfront disclosure: we choose to work only with the 70 or so Top Tier private equity firms active in China, as we believe they are the best investors for companies with the greatest potential, adding more value, beyond just capital, than any other source of investment. 

A main point of contention: the ratchet and performance provisions of most of the top private equity investment deals in China (and everywhere else in the world). These are the provisions, incorporated into the final closing share purchase agreement, through which the PE firm gains greater ownership in a company they’ve invested in if the company fails to meet previously agreed revenue, profit or margin targets.   

It’s a penalty for underperformance. And a very effective and focusing one. It’s not uncommon for these ratchets provisions to specify that the PE firm can gain an additional 10-15% ownership, at no additional cost,  in a company that fails to meet the annual targets. 

In good economic times and in solidly-run companies, ratchet provisions are very rarely put into effect. So, they are a generally just a ghoulish contingent presence in every PE investment contract, the stick that compliments the carrot of a PE firm investing in your business. I know from personal experience that the concept can seem very off-putting – even frightening – to some Chinese bosses: that the PE firm will, for example, go from owning 25% of his company to 40% of his company if the owner has one year that falls below the projected levels of profit and revenue. 

We’re not in good economic times at the moment, so it’s a certainty that more ratchet provisions will be triggered this year. This is what is behind some of the complaining in the Chinese press about international PE firms. Chinese investment firms apparently don’t often include ratchet provisions. The implication of the articles is that a Chinese company is better off taking money from a Chinese investment company, and so free itself from the possibility of a sort of “takeover by stealth”, as the PE firm’s ownership ratchets upward with each year of under-target performance. 

On the surface, ratchet provisions are a very fat, very easy target. So, no surprise some in the Chinese press are attacking them. But, it’s a very incomplete, unfair – and even financially illiterate – criticism to say that because of performance ratchet provisions, a Chinese company is better off taking money from a Chinese investment company. 

Chinese investment firms may not use performance ratchets, but they have a variety of other serious weaknesses. Believe me, I’m no fan of ratchets of any kind, and work hard in negotiations with PE firms to eliminate their potential for causing harm to our clients’ businesses.  But, I still think, in almost all cases, a good Chinese private company is far better off taking money from a reputable PE firm than from a more loosely-run Chinese investment business. 

The reasons are many. But, the most deep-seated are based on an appreciation of what an outside investor can and should provide a strong Chinese SME company besides just capital. Money, famously, all spends the same. So, taking $10mn from a rich uncle or from a leading private equity firm is no different, in terms of what the money can buy – a new factory perhaps, or expanded marketing and sales, or an acquisition. 

The key difference is that the best PE firms are going to do a lot more than just write a check and then wait for the riches to flow three years later at IPO. They are going to get deeply involved assisting the company to improve all areas of its operations, implementing best practices in areas like financial accounting and corporate governance, as well as providing real expertise on hard core sales and operational issues. They also know, from past successful experience, how best to guide a private company towards a successful IPO, whether on China’s domestic stock market, or abroad.

A Chinese investment company, from what I can gather, does not have the experience, the management talent – or even the inclination – to be involved in such a detailed fashion with the companies it invests in. 

I believe, based on my own practical experience,  that the good PE firms often really do make a significant difference inside a company, enabling it to get further faster than it otherwise would. Of course, PE firms can be a pain to work with. This goes way beyond the potential for a ratchet provision to be triggered. The good PE firms act as fiduciaries for their Limited Partners, and so require a massive amount of due diligence before investing, and no less enormous information flows (generally on financial performance) after an investment is made. They want quarterly board meetings, and often hold veto rights on any spending above $500,000 or so. 

But, in return, the PE firm will go to the furthest limits of its collective abilities to make sure the Chinese company succeeds above and beyond even what the boss of that company could expect. A domestic Chinese investment company? Most likely, they have had little experience with leading good companies toward successful IPOs, little operational knowledge, little desire to commit so thoroughly to adding value inside a company. 

So, yes, performance ratchet provisions are nasty. However, they should never come into effect – if the company and the PE firm are doing everything in their power to keep the business growing. The PE firms, contrary to the way it may appear, do not  want performance ratchets triggered any more than the company’s owner does. It’s also going to reflect badly on the PE firm’s judgment and abilities, and so make it harder for them to continue to raise money for future investment.

In other words, every time a performance ratchet is triggered, it gets harder for that PE firm to continue to thrive. They would rather own a smaller share of a solid company that’s meeting its targets, than a bigger share of one that isn’t.

 

Chinese Language Report on Private Equity in China 2009: 中国的私募股权投资与战略并购

Following on from the publication of the China First Capital report, 2009 Private Equity and Strategic M&A Transactions in China — A Preview , the Chinese version is now completed. It’s more than just a change in language.

It incorporates a different but complimentary perspective to the English report, one enriched by the deep knowledge, insights and experience of my China First Capital colleague, Amy Bai. 谢谢白海鹰。

Here’s the first section. 

China First Capital Chinese language report on Private Equity, Venture Capital in China 2009

 

 

  chinese-balance

 

危机创造机遇

2008 年对于中国是不平凡的一年。2008年带给我们骄傲和欢乐,也带给我们挫折和悲伤。北京奥运会使我们感到前所未有的骄傲和自豪。刚刚战胜了冰冻灾害的我们又遭遇了汶川大地震。

从经济领域来看,2008年同样也是不平凡的一年。在年初,上海、深圳和香港的股市都出现了长势良好的喜人景象。IPO形势大好。然而,在2008年夏,股市开始暴跌 ,IPO也开始枯竭。到年底,上海、深圳和香港的股市均下跌了60%左右。 

中国的私募股权投资和风险投资出现了与股市涨跌相应的波动变化。在年初,投资活动非常活跃。上半年,私募股权投资和风险投资在中国的投资总额超过了100多亿美元。随着金融风暴的影响,私募股权投资和风险投资也放缓了在中国的投资步伐。到去年底的时候,基本上已经停止了所有投资活动。 

中国,美国和全球其他国家均以前所未有的方式采取了一系列干预措施,以期稳定经济。然而, 

当我们跨入2009年时,全球经济进入衰退期已成为不争的事实。 

大家所关心的问题是,经济复苏期何时来临?何时开始新一轮的投资比较合适?我公司愿与您们分享就上述问题的一些观点和想法。 

作为中国首创投资的董事长,凭借在资本市场,私募股权投资和商业领域20余年的经验,我经历过数次商业周期,并且成功地带领我的企业幸存了下来。例如,我曾经担任美国加州一家风险投资公司的首席执行官,目睹了网络泡沫的破灭, 当时的情形和现在类似,所有的私募股权投资活动几乎都停止了。 但是,仅仅两年以后,交易活动和企业估值又呈现回升趋势。 

所以,我们认为,就整体投资环境而言,2008年的金融风暴将会继续影响中国经济的发展,中国目前仍旧会经受各种考验。但是,对于私募股权投资、风险投资和兼并收购而言,2009年是个充满着无限机会的一年。机会与风险并存。只要你抓住了机会,成功就近在咫尺。 

2009年,企业所有人和私募股权投资公司可以期待商业主题中的下列几点。 

行业整合与质的飞跃

2009年新年伊始,我们就感受到了中国经济所面临的严峻局面。经济增长速度减慢,成千的工厂倒闭和数以万计的人失业。中国许多经济领域已经出现了一种所谓超饱和状态,也就是很多企业在一个经济领域竞争,但是每个企业的市场份额都很小。这种情况下,中国企业进行合并的时机已经成熟。

在市场经济的自由竞争规律下,缺乏竞争力的企业会逐渐被淘汰。然而,具有竞争力的企业会不断赢取市场份额。并且,在良性循环下会不断发展壮大。产量不断提高,成本继续降低,从而,提高利润。企业将所赚取的盈余再度投到生产中以降低成本,进而形成一个良性循环。 

从消费者的角度来说,一个优秀的企业,由于其管理完善、生产效率高和销售策略适当,吸引着无数消费者。除此之外,强有力的主导品牌将会适时并购其他品牌。在这种状况下,企业间的合并已经成为不可避免的趋势。 

在中国,这种合并的势头刚刚开始。中国拥有仅次于美国的巨大的国内市场。在中国的许多纵向市场(包括金融服务,消费品,分销和物流,零售,时尚等),只要多争取一分的市场份额,销售收入就能增加上千万美元。 

通常,相对于企业所处行业,中国企业的规模都相对较小。在一些国营企业和半国营企业不占主导地位的区域,优秀民营企业抢先出击,兼并和收购其他区域内的竞争者,进而成为国内行业的领军企业。

对于投资者来说,这种帮助企业进行并购活动的机会将是空前的。企业在并购后的兴盛是投资者和企业共同期待的。即使在经济衰退期,并购案中 的优胜企业也会呈现销售收入和利润长期持续增长的现象。 

利润增长为IPO

重现提供了平台

 

在过去的五年里,对于投资中国市场的私募股权投资者和风险投资者来说,IPO无疑是最可靠的退出途径。 

下面的图显示,IPO交易量在2007年达到了高峰。在2008年初,IPO交易量继续呈现高增长趋势。然而,到2008年的下半年,IPO交易量急转直下,直到2009 年年初

 chart-1

 

 

众所周知, IPO市场与股票市场紧密相连。当股票市场整体表现不好时,企业发行新股票的欲望也会相应减弱。所以,只要中国股票市场和香港股票市场继续呈现薄弱趋势,IPO活动就不会呈现上升趋势。 

对于私募股权投资者和风险投资者来说,这意味着他们需要做出巨大的改变。 

为适应当前形势,私募股权投资公司和风险投资公司需要改变他们的投资方向。较之前而言,企业IPO前的短期投资机会已大大减少。换言之,私募股权投资公司或风险投资公司以18倍的估值投资于中国企业, 18个月后,再以20倍的价值发行上市的简单套利的机会已经一去不复返了。 

取而代之的是,在中国进行投资活动的私募股权投资公司应该从价值投资者的角度考虑他们在中国的投资,而不是从套利的角度去衡量他们在中国的投资。这说明了,私募股权投资公司在中国寻找目标企业时,应以企业的长远高回报为目标注入投资基金。 

企业的利润增长为中国市场的IPO重现提供了平台。具体而言,私募股权投资的重点应该集中在帮助企业提高运作效率和利润率上。 

这是一个值得强调的财务理念,尤其是在现今中国。企业估值归根结底是一个与公司盈利能力相关的函数,而不是一个投资者愿意为公司盈利能力而支付的价格函数。在市盈率倍数的公式中,“收益”部分是关键,而不是“价格”部分。在过去的五年时间里,IPO股票价格市盈率可谓差距巨大。IPO股票价格市盈率高至超过100, 低至少于5。 

对于中国市场来讲,情况可以瞬息万变。IPO股票价格市盈率很有可能出现回升趋势。什么时候会发生?我们无法给您一个准确的答案。但是我们可以确定的是,一个优秀的私募股权投资者想要投资于有明确目标和有能力实现目标的中国优秀企业。

 换言之,企业有计划和具体步骤去提升利润和利润率。那么,选择正确的中国企业进行投资,选择适当的额度进行投资和帮助企业提升整体价值,是私募股权投资公司和风险投资公司在未来几年内成功的关键所在。

 私募股权投资公司和风险投资公司提升企业价值的方式有很多。可以通过向企业提供市场营销,业务发展,金融工程,运营效率,企业治理,审计,战略兼并和收购等方面专业人才,来帮助企业迅速提高企业价值。

无论通过上述哪种方式,企业的收益都有可能被大大提高。关键点是,帮助企业保持强劲的利润增长态势。这样,在股市复苏的时候,IPO的时机再一次到来时,我们的客户企业会从中脱颖而出,赢得最高收益。 

2009年,一个有着投资重点和帮助企业成长的私募股权投资公司会脱颖而出。

 

 


AltAssets writes on China First Capital’s Report on Private Equity in China 2009

AltAssets is among the world’s leading sources for news and analysis on the global private equity industry. They just published a summary of my firms report, 2009 Private Equity and Strategic M&A Transactions in China — A Preview“. 

AltAssets is based in London, and provides news and research to more than 1,000 institutional investors and 2,000 private equity and venture capital firms worldwide.

Here is what they wrote about the China First Capital report:

 

altassets_logo

CHINA THE MOST ROBUST EMERGING MARKET FOR PRIVATE EQUITY AND VENTURE CAPITAL SAYS REPORT”


China continues to be the world’s most robust emerging market for private equity and venture capital finance, even in a difficult global economic environment, according to the Private Equity and Strategic M&A Transactions in China 2009 report just released by China First Capital, a boutique investment bank with offices in China, Hong Kong and the USA.

Peter Fuhrman, China First Capital’s chairman and the report’s author, said, “While the overall investment environment remains challenging and the effects of 2008’s turbulence are still being felt, 2009 will be a year of unique opportunity for private equity, venture capital and M&As in China.” 

China’s economy continues to grow, powered largely by successful small and medium private businesses, many of which are among the fastest-growing companies in the world. Private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1bn in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market. 

“In 2009, China should rightly be among the most attractive and active private equity investment markets in the world,” the China First Capital report predicts. “Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.” 

The report identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are: the drive for industrial consolidation; profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA; increased importance of convertible debt and other hybrid financings; opportunities for strategic M&As; well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market. 

“The pathways to success in China are fewer and narrower than in recent years. But, for the entrepreneurs and private equity investors that can navigate their way in 2009, this will be a year of abundant opportunity,” Fuhrman added. 

Copyright © 2009 AltAssets

Houlihan Lokey Founding Partner James Zukin Sets His Sights on China

scholars-rock

 

I had the good fortune, while in LA, to have lunch recently with James Zukin. Jim is one of the name partners of the premier middle-market investment bank in the US, Houlihan Lokey Howard & Zukin. Jim and his partners were so far ahead of the curve, in spotting market opportunities, that they had to wait years for the curve even to appear behind them.

Over lunch, Jim explained how the firm stayed clear of Wall Street, both literally and figuratively, locating its headquarters in Los Angeles, and making the astute strategic decision to build a highly-focused and well-differentiated fee-based investment banking franchise, rather than an “all-purpose financial supermarket” that mixes advisory work with proprietary trading, market-making and IPO underwriting. We all know now how that supermarket model holds up over a full cycle: it doesn’t. The biggest of that breed, Merrill Lynch, sold out to Bank of America, and two other titans, Bear Sterns and Lehman Brothers, are both kaput.

Meantime, Houlihan Lokey (“HL”) has built and sustained a very successful business based first on providing fairness opinions and other valuation work, and then built up its lucrative practice advising on restructuring and M&A, and doing private placements. Even in dire financial times like now, HL continues to perform, doing solid, high-quality work a range of middle-market and SMB clients. HL again ranked as the number one firm in M&A advisory work in 2008 in deals of $2 billion or less, beating out Credit Suisse, Goldman Sachs, and others.

The race is won by the smart and focused, not the “supermarketized”.

Jim Zukin, no surprise, is the embodiment of the strategic qualities that have made his firm a consistent, anomalous success. A self-described “outsider”, he is by turns smart, charming, witty and modest. (Like me, he also likes a good burger.)

We met to talk about China, where Jim has personally spearheaded HL’s activities over the last few years, traveling back and forth frequently from LA, and opening offices in Beijing and Hong Kong. He speaks with palpable joy when discussing his visits to China. His workload at home in the US means fewer trips to China now, but he still refers to China, with heartfelt passion, as his “mistress.” It’s a description I’ve now shamelessly lifted from him, to describe my own long-term, requited love affair with China.

Jim Zukin is the one remaining “name partner” of Houlihan Lokey Howard & Zukin. He remains the chairman of Houlihan Lokey Asia. That’s a concrete sign of the company’s commitment to build a dynamic and durable business there.

HL has built a solid platform for growth in China. Its areas of expertise – and entrepreneurial outlook – position it well there. I know from my own experience that there is a sizable opportunity, to cite one example, to provide financial opinion, M&A and restructuring advisory work to the leading international PE firms active in China.

I have every reason to expect HL to succeed in China, with the same sort of approach that has worked so well for the firm in the US. How do they do it? Simple: Don’t run with the herd. Run with a better map.

Why Wall Street rules rule in China Private Equity Deals

Quite possibly, these have been the two toughest weeks in the history of Wall Street. Two of the largest, most well-established investment banks (Merrill and Lehman Brothers) have been shattered by losses in mortgage and derivatives markets. Two others, Goldman Sachs and Morgan Stanley, are now converting to traditional bank holding companies. Other banks are teetering, and the stock market itself has experienced some of its largest one-day losses ever. 

Amid all the change and turmoil, it’s worth remembering just what makes Wall Street so central to the world’s financial industry. The US capital markets are both the largest, and the most liquid in the world. This is no less true today than it was a month or a year ago. As important is the fact that Wall Street has developed, over the last 70 years, a set of rules, procedures and best practices for raising capital.   These have become the de facto global standard. Put another way: Wall Street rules rule. 

I’m reminded of this fact quite frequently these days. We’re in the process now, at China First Capital, of closing an investment round for one of our Chinese SME clients, from one of Asia’s most successful PE firms. The closing legal documents are weighty, running to over 300 pages in total. The governing law is Hong Kong’s. But, the actual text of many of the documents comes direct from US private equity and IPO closings, including numerous references to the “Securities Act of 1933”, the basic foundational law for share offerings done in the US since then. 

So, here we have a Chinese company obtaining equity capital from a Hong Kong-based investor, while the securities law cited is from the USA. It seems a puzzle at first, even allowing for the possibility our client may one day choose to list its shares in the USA. So, why the reliance on US law and practice? 

Quite simply, because it comes closest to striking an ideal balance between the often competing interests of management and outside shareholders. In economics terminology, this is known as the “principal-agent problem”. (For anyone who wants to read more, Wikipedia has a decent summary: http://en.wikipedia.org/wiki/Principal-agent_problem).  This describes the frequent, and often inevitable tensions that can arise between outside investors and the inside management that makes the day-to-day decisions. The management has access to far more information about a company than the providers of capital.   It’s important to keep these divergent interests aligned. That’s what a lot of US securities law assures. It does so by mandating, for example, how often board and shareholders’ meetings must be called, with what kind of notice period, and what rights an investor has to inspect the books and records of the company they’ve put money into. 

For private equity deals, the US has also evolved a series of specific protections for investors. These rules make sure, for example, that an investor has the right to sell its shares in a public offering, and to be kept fully informed during the IPO process. These are essential for the proper functioning of the global private equity industry. As you’d expect, the investor rights figure prominently in the closing documents for our client. I recognize the terms and conditions, since I’ve seen them, more or less verbatim, in PE and VC deals I’ve worked on in the US. 

So, while Wall Street may be undergoing the most far-reaching changes in several generations, it’s leadership position is unchallenged in resolving these principal-agent problems, and making the flow of capital more ample and more secure than it would be under any other legal structure. 

The Term Sheet Goes Global

Time zones, languages, continents and business models may change as you cross the Pacific, but the Private Equity Term Sheet remains the same.

This is my conclusion after seeing the first Term Sheets arrive for our China First Capital clients recently. This is a happy moment – not so much for ourselves, of course, but for the entrepreneurs and PE firms we are fortunate to work with. For me, seeing these first Term Sheets is cause for reflection and, I hope,  some insight, on the constant truths of the equity investment process. 

I’ve been involved in quite a few Term Sheets for US venture deals over the years. I was surprised to find the Term Sheets this week very familiar, even though the investor and the target company are both based in China. In every other respect except the Term Sheet, the circumstances couldn’t be more different than a typical US venture deal — the governing law,  the industry, the company’s ownership, the likely timing and nature of the exit. 

So, why, despite all these vast differences, are there such deep similarities in Term Sheets? Start with the fact that there’s commonality in the approach of all good institutional investors: they all must exercise fiduciary responsibility on behalf of those whose money they are investing. This, in turn,  means the due diligence process needs to be thorough and professional, and the terms under which investments are made be sufficiently protective of the source of the invested capital. 

This fiduciary duty is made concrete in many of the standard provisions of a Term Sheet, whether that Term Sheet originates in Palo Alto or Shanghai. Indeed, the majority of the text in a Term Sheet is there to protect the fund’s Limited Partners from bad outcomes: share structure (preferred), board seats, liquidation preferences, anti-dilution provisions, preemptive rights, matters requiring special approval, performance guarantees. 

So far so familiar. 

The other big element of any Term Sheet, of course, is where the PE or VC firm is asserting primarily its own interests. The two most obvious areas: expiration dates and “no shop clauses”.  I was mildly surprised to see these in the Term Sheets recently submitted to clients of China First Capital. I’d mistakenly thought the “no shop clause”, in particular,  expressed a very local, American legalistic reality. In business negotiations, Americans need to specify as much as possible in writing, to protect against the ultimate evil of American business life: business litigation. 

Chinese, though, seem to have a far less obsessive need to document everything in writing, and certainly don’t have the same persistent, gnawing fear of litigation. It’s a “guanxi” society, where trust between individuals forms a more insoluble bond than any contractual term. 

A part of me, therefore, wishes the “no shop” clause hadn’t crossed the Pacific. I view them as the Pre Nuptial Agreement of the PE and VC investing world. They can create an air of mutual distrust, at a time when both sides are trying very hard to build a lasting partnership. 

A Term Sheet should serve the same fundamental goal: to allow great PE investors to put capital to work in truly outstanding investment opportunities, while limiting risk for the owners of that capital. I’m excited that the Term Sheets I’ve reviewed this week, once finalized,  will achieve this goal, and achieve phenomenal outcomes for everyone involved.