Valuation

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

Leave a Comment / April 11, 2013

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

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

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

“Until recently,” the China First Capital report points out, “private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year.  Those assumptions on valuation differentials as well as hold period are no longer valid.”

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

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

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

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

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

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

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

 

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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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Private Equity Valuation: Terminal Multiple Is All That Matters

2 Comments / September 10, 2012

A lot gets written, and even more gets discussed, about how to value private companies for the purposes of PE or VC investment. There is an awful lot of “Mongolian talk” going around, a translation of the Chinese term, 胡说 , meaning senseless drivel. PEs often use irrelevant or misleading comps to justify a lowball valuation. Companies are no less guilty, setting their valuation expectations unrealistically high, based on hear-say about other deals being done or a misreading of current stock market p/e multiples.

So, how do you work out a fair valuation? The only way I know is if both sides agree on the same set of facts to advance from. That is already challenge enough. How big a challenge?

Below, I share part of an email memo I sent to a large Chinese industrial equipment manufacturer. Their controlling shareholder hopes to sell down some of its shares, while also raising some new capital for the business. They are a sophisticated group, with strong management. They approached several investment banks, including ours, to represent them in the capital raising. We made the final cut, and they then insisted that the advisor they choose must achieve a valuation for them of at least 10X this year’s net income.

In more than just the two words “that’s unreasonable”,  I set out why they need to be more accommodating with reality.

“Your goal, which I thoroughly share, is to bring in a first-rate PE and get the best price for a valuable asset. I would work with all my diligence to achieve that.  But, let’s look frankly and factually at current market conditions. At the moment, domestically-listed Chinese companies in [your]  industry are trading at a trailing p/e of 28X and forward (this year’s) p/e of 22x. Both have fallen by approx. one-third in the last year. (The 22X is the basis we should use, to compare like-with-like. You have set your valuation target of +10X based on this year’s net income.) 

Your valuation target of +10X is a discount to quoted comps of 50% or narrower. That is a smaller discount, and so higher entry valuation for PE firms, than deals being done now. 

As you know, all PE deals, since they involve illiquid companies often years away from IPO exit, are always done at discount to quoted comps. The discount is not fixed, but the only time PE deals were closed routinely at prices over 10X (rarely if ever above 15X) was two years ago or more when comparable stock market p/e valuations (generally on the CHINEXT)  were 70X-100X previous year’s net.   A rich price indeed, and for a while, it had a levitating effect on PE valuations.

Current market conditions are that there are no investments from first-line PEs with terminal multiples at +10X. I emphasize the word “terminal multiple” because quite often — too often in our experience — a PE will offer a higher multiple at term sheet stage, to win the competitive right to pursue exclusive due diligence. These deals are almost always “repriced” at closing to a level below 10X, when PE firm has most of the leverage. PE will claim they turned up “new facts” in DD, as they always do, that justify the repricing.  They promise you +10x in a term sheet knowing they will only close the deal at a lower price, when all other interested investors have vanished from the scene. Unfair? Duplicitous? Get used to it. It’s the way the game is played.

The other common occurrence in China PE is that there is a headline multiple of +10X but it is linked to an aggressive next year + this year (sometime even three year) profit guarantee. The level is set by PE firm in full expectation that company will not meet the profit targets, so triggering the ratchet, often quite punitive. This process will bring the terminal multiple down significantly. We’ve seen and heard of deals where this terminal multiple is half the headline number at signing of term sheet or Share Purchase Agreement. In other words, the SPA has a headline multiple of 12X, but terminal multiple, after ratchet is triggered,  works out to 6X-7X.

From my experience, the ratchet is triggered in over half PE deals done in China. In the case of some leading China PEs, [names omitted to shield the guilty], the ratchet is triggered in over 80% of the deals they do. The ratchet trigger is very unfortunate for the company, and reflects the fact they are badly advised, by advisory firms paid a fee based on “headline valuation at closing” not terminal valuation.  

The other condition attached to deals with headline p/e of +10X is a high IRR (usually +20% p.a. simple interest) for buybacks triggered by “no qualifying IPO”. The buyback is a feature of almost all PE deals done in China. As you would be financially liable for such a payment, if I work as your investment banker, I’d want to negotiate this mechanism very carefully with PE, to assure your best interests are fully protected. It’ll mean a fight with the PE firms, but it will be gentlemanly. You want an IRR of no more than 10%. Why? One way to think of it is that for every 100 basis points the buyout IRR is fixed above LIBOR, you can argue the terminal multiple falls by 0.3X to 0.5X, because of the contingent liability.  

Yours is a highly cyclical industry. We are now in the downward loop, heading for the bottom of cycle. This negatively impacts valuation. Your cap table, particularly the fact the company is controlled by a CEO who has no capital directly invested in the business, also negatively impacts valuation. For last three years (2009, 2010, 2011) your net income has been flat, and net margins have fallen by almost half. This too negatively impacts valuation.  That’s three strikes already. You’re not “out”, as in baseball. But, it’s a three-ton weight pushing down your terminal multiple. 

I can promise you that if we work together, you will get the best outcome available in current marketplace, and be working with a firm that shares your commitment to integrity, professionalism and accountability.  

But, if you do decide to move forward with the other advisor, I’d urge you to ask them to address the specific points raised here, and structure their compensation on an “all or nothing” basis: they only earn a fee if the terminal multiple is above 10X, as they are now promising.  

A seller’s focus on valuation is understandable. But, too often in our experience, it can play into the hands of both the PE investor and your investment banker. Both will encourage your expectations knowing that the final bill on valuation will only be presented to you in two to three year’s time.  More often than not, only they will be feeling victorious at that point.

Cordially,
Peter”

This company decided to retain the other investment bank.

 

 

The “OTCBB-ization” of the Hong Kong Stock Exchange

Leave a Comment / March 6, 2012

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From the world’s leading IPO stock market to a grubby financial backwater with the sordid practices of America’s notorious OTCBB. Is this what’s to become of the Hong Kong Stock Exchange ?

I see some rather disturbing signs of this happening. Underwriters, with the pipeline of viable IPO deals drying up, are fanning out across China searching for mandates and making promises every bit as mendacious and self-serving as the rogues who steered so many Chinese companies to their doom on the US OTCBB.

The Hong Kong Stock Exchange (“HKSE”) may be going wrong because so much, until recently, was going right.  Thanks largely to a flood of IPO offerings by large Chinese companies, the HKSE overtook New York in 2009 to become the top capital market for new flotations. While the IPO markets turned sharply downward last year, and the amount of IPO capital raised in Hong Kong fell by half, the HKSE held onto the top spot in 2011. US IPO activity remains subdued, in part due to regulatory burdens and compliance costs heaped onto the IPO process in the US over the last decade.

During the boom years beginning around 2007, all underwriting firms bulked up by adding expensive staff in expensive Hong Kong. This includes global giants like Goldman Sachs, Citibank and Morgan Stanley, smaller Asian and European firms like DBS, Nomura, BNP Paribas and Deutsche Bank and the broking arms of giant Chinese financial firms CITIC, ICBC, CIIC, and Bank of China. The assumption among many market players was that the HKSE’s growth would continue to surge, thanks largely to Chinese listings, for years to come. With the US, Europe and Japan all in the economic and capital market doldrums, the investment banking flotilla came sailing into Hong Kong. Champagne corks popped. High-end Hong Kong property prices, already crazily out of synch with local buying power,  climbed still higher.

The underwriting business relies rather heavily on hype and boundless optimism to sell new securities. It’s little surprise, then, that IPO investment bankers should be prone to some irrational exuberance when it comes to evaluating their own career prospects. The grimmer reality was always starkly clear. For fundamental reasons visible to all but ignored by many, the flood of quality Chinese IPOs in Hong Kong was always certain to dry up. It has already begun to do so.

In 2006, the Chinese government closed the legal loophole that allowed many PRC companies to redomicile in Hong Kong, BVI or Cayman Islands. This, in turn, let them pursue IPOs outside China, principally in the US and Hong Kong. Every year, the number of PRC companies with this “offshore structure” and the scale and growth to qualify for an IPO in Hong Kong continues to decline. A domestic Chinese company cannot, in broad terms, have an IPO outside China.

Some clever lawyers came up with some legal fixes, including a legally-dubious structure called “Variable Interest Entity”, or VIE, to allow domestic Chinese companies to list abroad. But, last year, the Chinese Ministry of Commerce began moving to shut these down. The efficient, high-priced IPO machine for listing Chinese companies in Hong Kong is slowly, but surely, being starved of its fuel: good Chinese private companies, attractive to investors.

Yes, there still are non-Chinese companies like Italy’s Prada, Russia’s Rusal or Mongolia’s Erdenes Tavan Tolgoi still eager to list in Hong Kong. There is still a lot of capital, while listing and compliance costs are well below those in the US. But, the Hong Kong underwriting industry is staffed-up mainly to do Chinese IPOs. These guys don’t speak Russian or Mongolian.

So, the sorry situation today is that Hong Kong underwriters are overstuffed with overhead for a “coming boom” of Chinese IPOs that will almost certainly never arrive. China-focused Hong Kong investment bankers are beginning to show signs of growing desperation. Their jobs depend on winning mandates, as well as closing IPOs. To get business, the underwriters are resorting, at least in some cases, to behaviors that seem not that different from the corrupt world of OTCBB listing. This means making some patently false promises to Chinese companies about valuation levels they could achieve in an Hong Kong IPO.

The reality now is that valuation levels for most of the Chinese companies legally structured for IPO in Hong Kong are pathetically low. Valuations keep getting slashed to attract investors who still aren’t showing much interest. Underwriters are finding it hard to solicit buy offers for good Chinese companies at prices of six to eight times this year’s earnings. Some other deals now in the market and nowhere near close are being priced below four times this year’s net income. At those kind of prices, a HK IPO becomes some of the most expensive equity capital around.

In their pursuit of new mandates, however, these Hong Kong underwriters will rarely share this information with Chinese bosses. Instead, they bring with them handsomely-bound bilingual IPO prospectuses for past deals and suggest that valuation levels will go back into double digits in the second half of this year. In other words, the pitch is, “don’t look at today’s reality, focus instead at yesterday’s outcomes and my rosy forecast about tomorrow’s”.

This is the same script used by the advisors who peddled the OTCBB listings that damaged or destroyed so many Chinese companies over the last five years. Another similar tactic used both by OTCBB rogues and HK underwriters is to pray on fear. They suggest to Chinese bosses that they should protect their fortune by listing their company offshore, at whatever price possible and using whatever legally dubious method is available. They also play up the fact a Chinese company theoretically can go public in Hong Kong whenever it likes, rather than wait in an IPO queue of uncertain length and duration, as is true in China.

In other words, the discussion concerns just about everything of importance except the fact that valuation levels in Hong Kong are awful, and there is a decent probability a Chinese company’s HK IPO will fail. This is particularly the case for Chinese companies with less than USD$25 million in net income. The cost to a Chinese company of a failed IPO is a lot of wasted time, at least a million dollars in legal and accounting bills as well as a stained reputation.

There is, increasingly, a negative selection bias. Investors rightly wonder about the quality of Chinese companies, particularly smaller ones, being brought to market by underwriters in Hong Kong.

“No one has a crystal ball”, is how one Hong Kong underwriter, a managing director who spends most of his time in China scouring for mandates, explains the big gap between promises made to Chinese bosses, and the sad reality that many then encounter. In a real sense, this is on par with him saying “I’ve got to do whatever I’ve got to do to earn a living”. He can hold onto his job for now by bringing in new mandates, then hope markets will turn around at some point, the valuation tide will rise, and these boats will lift. This too is a business strategy used for many years by the OTCBB advisor crowd.

The OTCBB racket is now basically shut down. Those who profited from it are now looking for work or looking elsewhere for victims, er mandates. Tiny cleantech deals are apparently now hot.

My prediction is a similar retrenchment is on the way in Hong Kong, only this time those being retrenched won’t be fast-buck types from law firms and tiny OTCBB investment banks no one has heard of. Instead, it’ll be bankers with big salaries working at well-known brokerage companies. The pool of IPO fees isn’t big enough to feed them all now. And, that pool is likely going to evaporate further, as fewer Chinese companies sign on for Hong Kong listings and successfully close deals.

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CFC’s New Research Report on Capital Allocation and Private Equity Trends in China

Leave a Comment / February 28, 2012

 

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Capital allocation, not the amount of capital,  is the largest financial challenge confronting the private equity industry in China. Capital continues to flood into the PE sector in China. 2011 was a record year, with over $30billion in new capital raised by PE firms, including both funds investing in dollars and those investing in Renminbi. China’s private equity industry seems destined now to outstrip in size that of every other country, with exception of the US. Ten years ago, the industry hardly existed in China.

Yes, it is a time of plenty. Yet, plenty of problems remain. Many of the best private companies remain starved of capital, as China’s domestic banks continue to choke back on their lending. As a result, PE firms will play an increasingly vital role in providing growth capital to these companies. 

These are some of the key themes addressed in CFC’s latest research report, titled “2012-2013: 中国私募股权融资与市场趋势”. It can be downloaded from the CFC website or by clicking here.

The report is available in Chinese only.

Like many of CFC’s research reports, this latest one is intended primarily for reference by China’s entrepreneurs and company bosses. Private equity, particularly funds able to invest Renminbi into domestic companies,  is still a comparatively new phenomenon in China. Entrepreneurs remain, for the most part, unfamiliar with all but the basics of growth capital investment. The report assesses both costs and benefits of raising PE.

This calculus has some unique components in China. Private equity is often not just the only source for growth capital, it is also, in many cases, a pre-condition to gaining approval from the CSRC for a domestic IPO. It’s a somewhat odd concept for someone with a background only in US or European private equity. But, from an entrepreneur’s perspective, raising private equity in China is a kind of toll booth on the road to IPO. The entrepreneurs sells the PE firm a chunk of his company (usually 15%-20%) for a price significantly below comparable quoted companies’ valuation. The PE firm then manages the IPO approval process.

Most Chinese companies that apply for domestic IPO are turned down by the CSRC. Bringing in a PE firm can often greatly improve the odds of success. If a company is approved for domestic IPO, its valuation will likely be at least three to four times higher (on price/earnings basis) than the level at which the PE firm invested. Thus, both PE firm and entrepreneur stand to benefit.

The CSRC relies on PE firms’ pre-investment due diligence when assessing the quality and reliability of a company’s accounting and growth strategy. If a PE firm (particularly one of the leading firms, with significant experience and successful IPO exits in China) is willing to commit its own money, it provides that extra level of confidence the CSRC is looking for before it allows a Chinese company to take money from Chinese retail investors.

From a Chinese entrepreneur’s perspective, the stark reality is “No PE, No IPO”.

CFC’s Jessie Wu did most of the heavy lifting in preparing this latest report, which also digests some material previously published in columns I write for “21 Century Business Herald” (“21世纪经济报道) and “Forbes China”  (“福布斯中文”). The cover photo is a Ming Dynasty Xuande vase.

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China PE Firms Do PF (Perfectly Foolhardy) “Delist-Relist” Deals

Leave a Comment / June 22, 2011

Hands down, it is the worst investment idea in the private equity industry today: to buy all shares of a Chinese company trading in the US stock market, take it private, and then try to re-list the company in China. Several such deals have already been hatched, including one by Bain Capital that’s now in the early stages, the planned buyout of NASDAQ-quoted Harbin Electric (with PE financing provided by Abax Capital) and a takeover completed by Chinese conglomerate Fosun.

From what I can gather, quite a few other PE firms are now actively looking at similar transactions. While the superficial appeal of such deals is clear, the risks are enormous, unmanageable and have the potential to mortally would any PE firm reckless enough to try.

A bad investment idea often starts from some simple math. In this case, it’s the fact there are several hundred Chinese companies quoted in the US on the OTCBB or AMEX with stunningly low valuations, often just three to four times their earnings.  That means an investor can buy all the traded shares at a low overall price, and then, in partnership with the controlling shareholders,  move the company to a more friendly stock market, where valuations of companies of a similar size trade at 20-30 times profits.

Sounds easy, doesn’t it? It’s anything but. Start with the fact that those low valuations in the US may not only be the result of unappreciative or uncomprehending American investors. Any Chinese company foolish enough to list on the OTCBB, or do any other sort of reverse merger, is probably suffering other less obvious afflictions. One certainty:  that the boss had little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing which, among its other curses, likely cost the Chinese company at least one million dollars to complete, including subsequent listing and compliance costs.

Why would any PE firm, investing as a fiduciary, want to go in business with a boss like this? An “undervalued asset” in the control of a guy misguided enough to go public on the OTCBB may not be in any way undervalued.

Next, the complexities of taking a company private in the US. There’s no fixed price. But, it’s not a simple matter of tendering for the shares at a price high enough to induce shareholders to sell. The legal burden, and so legal costs, are fearsome. Worse, lots can – and often will – go wrong, in ways that no PE firm can predict or control. The most obvious one here is that the PE firm, along with the Chinese company, get targeted by a class action lawsuit.

These are common enough in any kind of M&A deal in the US. When the deal involves a cash-rich PE firm and a Chinese company with questionable management abilities, it becomes a high likelihood event. Contingency law-firms will be salivating. They know the PE firm has the cash to pay a rich settlement, even if the Chinese company is a total dog. Legal fees to defend a class action lawsuit can run into tens of millions of dollars. Settling costs less, but targets you for other opportunistic lawsuits that keep the legal bills piling up.

The PE firm itself ends up spending more time in court in the US than investing in China. I doubt this is the preferred career path for the partners of these PE firms. Bain Capital may be able to scare off or fight off the tort lawyers. But, other PE firms, without Bain’s experience, capital and in-house lawyers in the US, will not be so fortunate. Instead, think lambs to slaughter.

Also waiting to explode, the possibility of an SEC investigation，or maybe jail time. Will the PE firm really be able to control the Chinese company’s boss from tipping off friends, who then begin insider trading? The whole process of “bringing private” requires the PE firm to conspire together, in secret, with the boss of the US-quoted Chinese company to tender for shares later at a premium to current price. That boss, almost certainly a Chinese citizen, can work out pretty quickly that even if he breaks SEC insider trading rules, by talking up the deal before it’s publicly disclosed, there’s no risk of him being extradited to the US. In other words, lucrative crime without punishment.

The PE firm’s partners, on the other hand, are not likely immune. Some will likely be US passport or Green Card holders. Or, as likely, they have raised money from US institutions. In either case, they will have a much harder time evading the long arm of US justice. Even if they do, the publicity will likely render them  “persona non grata” in the US, and so unable to raise additional funds there.

Such LP risk – that the PE firm will be so disgraced by the transaction with the US-quoted Chinese company that they’ll be unable in the future to raise funds in the US – is both large and uncontrollable. The potential returns for doing these “delist-relist” deals  aren’t anywhere close to commensurate with that risk. Leaving aside the likelihood of expensive lawsuits or SEC action, there is a fundamental flaw in these plans.

It is far from certain that these Chinese companies, once taken private, will be able to relist in China. Without this “exit”, the economics of the deal are, at best, weak. Yes, the Chinese company can promise the PE firm to buy back their shares if there is no successful IPO. But, that will hardly compensate them for the risks and likely costs.

Any proposed domestic IPO in China must gain the approval  of China’s CSRC. Even for strong companies, without the legacy of a failed US listing, have a low percentage chance of getting approval. No one knows the exact numbers, but it’s likely last year and this, over 2,000 companies applied for a domestic IPO in China. About 10%-15% of these will succeed. The slightest taint is usually enough to convince the CSRC to reject an application. The taint on these “taken private” Chinese companies will be more than slight. If there’s no certain China IPO, then the whole economic rationale of these “take private” deals is very suspect.  The Chinese company will be then be delisted in the US, and un-listable in China. This will give new meaning to the term “financial purgatory”, privatized Chinese companies without a prayer of ever having tradeable shares again.

Plus, even if they did manage to get CSRC approval, will Chinese retail investors really stampede to buy, at a huge markup, shares of a company that US investors disparaged? I doubt it. How about Hong Kong? It’s not likely their investors will be much more keen on this shopworn US merchandise. Plus, these days, most Chinese company looking for a Hong Kong IPO needs net profits of $50mn and up. These OTCBB and reverse merger victims will rarely, if ever, be that large, even after a few years of spending PE money to expand.

Against all these very real risks, the PE firms can point to what? That valuations are much lower for these OTCBB and reverse merger companies in the US than comparables in China. True. For good reason. The China-quoted comps don’t have bosses foolish or reckless enough to waste a million bucks to do a backdoor listing in the US, and then end up with shares that barely trade, even at a pathetic valuation. Who would you rather trust your money to?

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CFC’s New Research Report, Assessing Some Key Differences in IPO Markets for Chinese Companies

Leave a Comment / December 7, 2010

China First Capital research report cover

For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

  1. Valuation, p/e multiples
  2. IPO approval process – cost and timing of planning an IPO
  3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.


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The Changing Formula of PE Investing in China: Too Much Capital ÷ Too Few PE Partners = Bigger Not Always Better Deals

Leave a Comment / February 16, 2010

Yuan tray


In the midst of one of the worst global recession in generations and the worst crisis in recent history in the global private equity industry, China looks like a nation blessed. Its economy in 2009 outperformed all others of any size, and the PE industry has continued, with barely a hitch,  on its path of blazingly fast growth.

In 2009, over $10 billion  of new capital was raised by PE firms for investing in Asia, with much of that targeting growth investments in China. For the first time, a significant chunk of new PE capital was raised in renminbi, a clear sign of the future direction of the industry. 

This year will almost certainly break all previous records. A good guess would be at least $20 billion in new capital is committed for PE investment in China. For the general partners of funds raising this money, the management fees alone (typically 2% of capital raised) will keep them in regal style for many years to come. 

In such cases, where money is flooding in, the universal impulse in the PE industry is to do larger and larger deals. But, in China especially, bigger deals are almost always worse deals on a risk-adjusted basis. Once you get above a $20 million investment round, the likelihood rises very steeply of a bad outcome. 

The reasons for this are mostly particular to China. The fact is that the best investment opportunities for PE in China are in fast-growing, successful private companies focused on China’s booming domestic market. There are thousands of companies like this. But, few of these great companies have the size (in terms of current revenues and profits) to absorb anything much above $10mn. 

It comes down to valuation. Even with all the capital coming in, PE firms still tend to invest at single-digit multiples on previous year’s earnings. PE firms also generally don’t wish to exceed an ownership level of 20-25% in a company. To be eligible for $20 million or more, a Chinese company must usually have last year’s profits of at least $15 million. Very few have reached that scale. Private companies have only been around in China for a relatively short time, and have only enjoyed the same legal protection of state-owned businesses since 2005. (see my earlier blog post)

Seeing this, a rational PE investor would adjust the size of its proposed investment. In most cases, that will mean an investment round of around $10 million – $15 million. But, rational isn’t exactly the guiding principle here. Instead of doing more deals in the $10 million – $15 million range, PE firms flush with cash most often look to up the ante.  Their reasoning is that they can’t increase the number of deals they do, because they all have a limited number of partners and limited time to review investment opportunities. 

This herd mentality is quite pervasive. The certain outcome: these same cash-rich PE firms will bid up the prices of any companies large enough to absorb investment rounds of $20 million or more. This process can be described as “paying more for less”, since again, there are very few great private Chinese companies with strong profit margins and growth rates, great management, bright prospects and  profits of $20 million and up. 

Some day there will be. But, it’s still too early, given the still limited time span during which private companies have been free to operate in China. There are, of course, quite a few state-owned enterprises (SOEs) with profits above $20 million. Most, however, are the antithesis of an outstanding, high-growth Chinese SME. They are usually tired, uncompetitive businesses with bloated workforces, low margins, clapped-out equipment and declining market shares. They would welcome PE investment, and are likely to get it because of this rush to do larger deals. Some SOEs might even get a new lease on life as a result of the PE capital. 

The certain losers in this process: the endowments, pension funds and other institutions who are shoveling the money into these PE firms as limited partners. They probably believe, as a result of their own credulity and some slick marketing by PE firms,  their money is going to invest in China’s best up and coming private businesses. Instead, some of their money is likely to go to where it’s most easily invested, not where it’s going to earn the highest returns. 

Bigger is clearly not better in Chinese PE. I say this even though we are fortunate enough now to have a client that is both very large and very successful. It is on track to raise as much as $100 million. It is every bit as good (if not better) than our smaller SME clients. Unlike PE firms, we don’t seek bigger deals. We just seek to work with the best entrepreneurs we can find. Most often for us, that means working for companies that are raising $10 million – $15 million, on the strength of profits last year of at least $5 million. 

Our business works by different rules than the PE firms. We aren’t using anyone else’s capital. There’s no imperative to do ever-larger deals. We have the freedom to work with companies without much considering their scale, and can instead choose those whose founders we like and respect, and whose performance is generally off-the-charts. 

The ongoing boom in PE investment in China is likely to continue for many, many years. This is due largely to the strength of the Chinese economy and of the private entrepreneurs who account for a large and growing share of all output. 

But, the push to do larger deals will cause problems down the line for the PE industry in China. It will result in capital being less efficiently allocated and returns being lower than they otherwise would be. PE firms will collect their 2% annual management fee, regardless of how well or poorly their investments perform. 

Raising private capital for PE investment in China is a good business. And, at the moment, it’s also an easier business than finding great places to invest bigger chunks of capital. 

Navigating China’s Treacherous IPO Markets

Leave a Comment / January 11, 2010

Song plate from China First Capital blog post

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC). 

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  


The End of the Line for Old-Style PE Investing in China

2 Comments / January 4, 2010

Ming Dynasty flask, from China Private Equity blog post

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

chart1









If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.


How PE Firms Use Tax Arbitrage To Turbocharge Their Profits

1 Comment / October 31, 2009

Lacquer scholar's tools, from China First Capital blog post

Private companies the world over share one common trait: a preference for paying as little tax as possible. In Italy, for example, under-reporting of taxable income by privately-owned companies is an accepted national pastime. Italy even created a special national police force, the Guardia di Finanza,  just to go after this rampant tax-cheating. They haven’t had much luck, as far as anyone can tell. 

China is no different, of course. Private companies here will try to organize their affairs in such a way that taxable income is kept as low as is plausibly possible. Business taxes are large in number and relatively high considering China is still a developing country. Corporate income taxes, for example, can reach 33% depending where you are. This is on top of a national VAT of 13%-17%, and all kinds of other assessments on wages, assets, real property. 

The usual practice is to maintain three sets of books, one for tax authorities, one for banks that show a better picture to keep the loans flowing, and the third lets the owner see the real picture. Again, this is pretty much standard practice the world over.

Public companies, of course, have far less latitude to under-report taxable income, since they undergo a properly intensive audit every year. They also have a very different incentive than private companies. A public company’s share price is usually determined by its profitability. The higher the profit, the higher the share price. Many public companies have gotten into trouble by reporting too much profit, sometimes by fabricating sales, as a way to bolster their share price. 

This opposing approach in reporting taxable income creates a very nice arbitrage opportunity investing in private Chinese companies on the road to a public listing. This tax arbitrage often turbocharges the already high risk-adjusted returns for PE investors in China. 

Here’s how it works: PE investors generally use a Price-Earnings multiple to value a company on the way in. The multiple will usually be between six and nine times last year’s profits. That’s already a little low, given how large and fast-growing these companies often are. But, the 6-9X  valuation multiple becomes more akin to highway robbery when you look at it more closely. Everyone knows, of course, that the profit number used to make this valuation calculation is understated. It’s generally based on the only set of audited returns that are available, and those are the books prepared for China’s tax authorities. 

So, if the company’s tax records show a profit last year, for example, of $5mn, it’s a reasonable assumption the real figure is anywhere from 40% to more than 100% higher. But, the the purposes of calculating valuation, only the under-reported number is used. The effect is to lower the PE multiple from 6-9x. to perhaps 3-5x.  That makes these PE investments China in a screaming bargain, assuming everything goes well, of course, after the investment. 

But, from the PE firm’s standpoint, it gets even better than being able to buy in at very low valuations. They know that a big part of the plan, after investment, will be the get the company ready for an IPO. This is usually a two to three year process that involves reporting a larger and larger percentage of the actual profit as taxable profit, since this will also be the profit number used for IPO valuation. 

For every dollar of “found” profits inside a company, the PE investor stands to make at least five extra dollars in return, based on a typical-sized investment where the PE firms buys 25% of the shares. This gain occurs even if the company does nothing after investment to increase its profits. All that’s happening is an accounting change that puts money in PE firm’s pocket. 

It’s a reasonable assumption that a Chinese company going public will get a PE multiple of 20x. (Currently, in China, the PE multiples are often twice that level.) The PE firm buys the same dollar of profits for $4, and then sells it for $20 a few years later. 

Of course, the plan will be to do even better, by putting the PE capital to work in ways that will earn a good return over the same two to three year period. So, let’s assume that profits at least double, but perhaps even triple, from the taxable- reported income the PE investor used to make this original valuation.  The IPO valuation captures not just the profit from the accounting arbitrage, but the company’s own high-octane performance after the investment. 

Add it up, and it’s not unreasonable for the PE firm to make a +300% return in only two to three years. Of course, it’ll never be seen quite this way. Instead, the PE firm will get a lot of credit for improving a company’s financial reporting and controls, and so enhancing profits. The PE firms do play a role in this. But, a lot of the profit was there to begin with. All the PE firm did was ask the company’s owner to report more of it, pay more tax, and so bring his books into alignment with public company standards. 

Now, my friends in PE firms will probably view things differently, stressing the part about the work they do after investment to improve accounting controls, and that they will never know precisely how much buried profit there is a company until after they’ve invested. It’s a basic principle of finance that there’s an information asymmetry between the owner-manager and outside shareholders.

Sometimes, not only profits are hidden, but all kinds of other unpleasantness. Both are true, and yet on balance, PE firms are getting by far the better of the deal. Their due diligence, which is both extensive and expensive, should uncover anything serious before money is committed. Once the money is invested, however, the PE firm can start benefitting from profits that remained hidden from the taxman..

Shenzhen’s New Growth Enterprise Market: Getting it Right, Right From the Start

1 Comment / October 31, 2009

 

China First Capital blog post -- Ming Dynasty jade bowl

 

“Manage people’s expectations. Then, exceed them.” That’s not a bad rule to live by, or management principle to apply in regulating China’s fast-moving capital markets. This past week, China Regulatory Securities Commission, the nation’s stock market regulator, moved one step closer to opening trading in the new, Shenzhen-based, Growth Enterprise Market. It’s been ten years in the planning. The names were finally announced of the first companies that will list on the new market when trading begins later in October. All are private SME, and several had pre-IPO private equity funding.

The total amount of capital this first crop of IPOs will raise is well above most earlier estimates. The original stated plan was for smaller companies to list on the GEM, which, in turn, suggested the GEM market would be only a marginal contributor of growth capital for private SME. The minimum requirement was set at just $1.5mn in aggregate profits over the last two years. Even at high Chinese multiples, firms of that size would struggle to raise more than $10mn in an IPO.

But, in something of a surprise, CSRC chose larger companies to be in the first group to list. It now looks like that the ten companies will raise a total of over $400mn when their IPOs close, or an average of $40mn each. This, in turn, points to a cumulative market capitalization for this first group of around $2 billion. That bodes well for the market’s long-term future. A larger market capitalization means more liquidity and so less volatility in the share price. This will help attract more capital to the new Shenzhen market, and to subsequent future IPOs there.

Bravo, I say! The CSRC may well get the formula right, and so prove that these smaller-capitalization “growth stock markets” can work, both for companies and investors.

Elsewhere, these growth stock markets have mainly failed in their stated purpose to create an efficient platform for smaller companies to attract investors and raise capital. Germany’s Neuer Markt shut down soon after it was created. The small-cap markets in Singapore and Hong Kong have been disappointments. Small-cap companies stayed small-cap companies, which is entirely contrary to the purpose of a “growth board” like this. The granddaddy of them all, America’s OTC Bulletin Board, has become an all-purpose dumping ground for shady American firms, stock manipulators, and, sadly, several hundred once-strong Chinese SME who listed there after taking very bad advice from self-interested advisors and brokers looking to make a quick buck.

It’s anybody’s guess how many companies will list on Shenzhen’s GEM this year, or next. There is a backlog of at least 100 that have applied, and been provisionally accepted by CSRC. One thing we know: each IPO in China will get its final approval as part of an orderly process that takes into account the performance of companies already listed on GEM, and stock prices trends overall.

The Shenzhen GEM shows every sign of beginning to fill a very large, very important funding gap in China. Assuming, as I hope, that CSRC continues its preference for companies able to raise at least $30mn-$40mn in a public listing, these IPOs will channel capital to companies who would otherwise find it very hard to come by. Most of the private equity and venture firms that we work with don’t write checks that large. They generally invest around $10mn-$25mn in pre-IPO equity capital to own 20%-30% of a private Chinese SME. These investments are done at valuations of around eight times last year’s profits. So, a GEM listing could become the best source of growth capital for an SME that already has achieved some success, has profits of over $10mn-$20mn a year, but is still too small for a main board listing, in China or outside.

The public markets have two big advantages over private equity financing: they offer much higher price-earnings valuations, and give shareholders a liquid market to trade their shares. On the other hand, for Chinese SME, staging an IPO in China always has a level of deep unpredictability. The CSRC makes all the decisions about which companies can IPO and when. So, SME can wait two years or more to apply, get approval, and then put the IPO proceeds in the bank. If that SME is now growing quickly, has outsized opportunities near-to-hand with a high rate of return, but can’t finance its growth internally or with bank debt, a round of private equity will almost certainly be the best route to follow.

Done right (see my earlier blog post, on Foshan Saturday ‘s IPO) a company’s market capitalization, when it eventually completes its IPO, can be at least three times larger than it is at present. That means the laoban gets richer (nothing wrong with that), and investors are happier, too, because of the increased liquidity and stability from the higher market cap at IPO.

I’m extremely positive about the role the GEM will play in helping to build even stronger private Chinese SME. The CSRC and Chinese government have taken over ten years to plan this new stock market, and learn from the mistakes of others. All signs now are that they have done so, and the GEM will gradually create a group of publicly-traded private companies that will go on to achieve far more impressive results in the future.

Size Matters – Why It’s Important to Build Profits Before an IPO

Leave a Comment / June 9, 2009

Qing Dynasty plate -- in blog post of China First Capital

Market capitalization plays a very important part in the success and stability of a Chinese SME’s shares after IPO. In general, the higher the market capitalization, the less volatility, the more liquidity. All are important if the shares are to perform well for investors after IPO.

There is no simple rule for all companies. But, broadly speaking, especially for a successful IPO in the US or Hong Kong, market capitalization at IPO should be at least $250 million. That will require profits, in the previous year, of around $15mn or more, based on the sort of multiples that usually prevail at IPO.

Companies with smaller market capitalizations at IPO often have a number of problems. Many of the larger institutional investors (like banks, insurance companies, asset management companies) are prohibited to buy shares in companies with smaller market capitalizations. This means there are fewer buyers for the shares, and in any market, whether it’s stock market or the market for apples, the more potential buyers you have, the higher the price will likely climb.

Another problem: many stock markets have minimum market capitalizations in order to stay listed on the exchange. So, for example, if a company IPOs on AMEX market in the US with $5mn in last year’s profits, it will probably qualify for AMEX’s minimum market capitalization of $75 million. But, if the shares begin to fall after IPO, the market capitalization will go below the minimum and AMEX will “de-list” the company, and shares will stop trading, or end up on the OTCBB or Pink Sheets. Once this happens, it can be very hard for a company’s share price to ever recover.

In general, the stock markets that accept companies with lower profits and lower market capitalizations, are either stock markets that specialize in small-cap companies (like Hong Kong’s GEM market, or the new second market in Shenzhen), or stock markets with lower liquidity, like OTCBB or London AIM.

Occasionally, there are companies that IPO with relatively low market capitalization of around RMB300,000,000 and then after IPO grow fast enough to qualify to move to a larger stock market, like NASDAQ or NYSE. But, this doesn’t happen often. Most low market capitalization companies stay low market capitalization companies forever.

Another consideration in choosing where to IPO is “lock up” rules. These are the regulations that determine how long company “insiders”, including the SME ownerand his family, must wait before they can sell their shares after IPO. Often, the lock up can be one year or more.

This can lead to a particularly damaging situation. At the IPO, many investment advisors sell their shares on the first day, because they are often not controlled by a lock up and aren’t concerned with the long-term, post-IPO success of the SME client.  They head for the exit at the first opportunity.

These sales send a bad signal to other investors: “if the company’s own investment advisors don’t want to own the shares, why should we?” The closer it gets to this time when the lock up ends, the further the share price falls. This is because other investors anticipate the insiders will sell their shares as soon as it becomes possible to do so.

There are examples of SME bosses who on day of IPO owned shares in their company worth on paper over $50 million, at the IPO price. But, by the time the lock up ends, a year later, those same shares are worth less than $5mn. If it’s a company with a lot market capitalization, there is probably very little liquidity. So, even when the SME bosshas the chance to sell, there are no buyers except for small quantities.

The smaller the market capitalization at IPO, the more risky the lock-in is for the SME boss. It’s one more reason why it’s so important to IPO at the right time. The higher an SME’s profits, the higher the price it gets for its shares at IPO. The more money it raises from the IPO, the easier it is to increase profits after IPO and keep the share price above the IPO level.   This way, even when the lock up ends, the SME boss can personally benefit when he sells his shares.

Of all the reasons to IPO, this one is often overlooked: the SME boss should earn enough from the sale of his shares to diversify his wealth. Usually, an SME boss has all his wealth tied up in his company. That’s not healthy for either the boss or his shareholders. Done right, the SME boss can sell a moderate portion of his shares after lock in, without impacting the share price, and so often for the first time, put a  decent chunk of change in his own bank account.

We give this aspect lot of thought in planning the right time and place for an SME’s IPO. We want our clients’ owners and managers to do well, and have some liquid wealth. Too often up to now, the entrepreneurs who build successful Chinese SMEs do not benefit financially to anything like the extent of the cabal of advisors who push them towards IPO. 

 

 

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How to Time an IPO – the Right Path to the Stock Market for a Strong Chinese SME

Leave a Comment / June 4, 2009

Ching Dynasty snuff bottle in China First Capital blog post

 

The timing of IPO is the most important question for all Chinese SME preparing for a public listing. Unfortunately, the correct answer is often the one most rarely heard. Instead, many investment bankers and advisors in China tell the SME boss that an IPO should be scheduled “as soon as possible”.

This is often music to the bosses untrained ears, since they’re wrongly assuming that the proceeds of an IPO will go directly into their pockets – a misconception these same investment bankers and advisors can literally cash in on. They’ll tell the SME boss the “bad” news — that the IPO proceeds must go to the company not to his personal bank account, and that the boss won’t be able to sell any of his own shares for a year or more after the IPO – towards the end of the expensive pre-IPO planning process, when it’s usually too late to pull out, without losing a huge amount of money.

This is if they bother to mention it at all. I’ve heard of instances where the Chinese boss is never told directly by his investment bankers, lawyers and advisors, but only finds out if his staff prepares a Chinese translation of the SB-2 prospectus used in OTCBB listings.

So, if not “right away”, what is the correct answer to the question: “when should a Chinese SME IPO”? Of course, circumstances will differ for each company. But, as a general principle, an IPO should come at the apex of an SME’s growth curve, when the company is achieving its historical highest return on equity and return on investment. This way, the SME will get a fuller value for its shares when it does list them publicly.

This also explains why pre-IPO private equity can have such a key role to play in the process. The purpose: put more capital to work than the company can generate internally, or can borrow from banks. This equity capital is then invested where it will earn the highest return over a two to three year period – for example, increasing production and improving economies of scale, or accelerating the pace of opening new distribution outlets.

The PE firm will also help improve efficiencies – in their role as risk-sharing partner with the SME boss – that can lead to significant improvement in net margins. In most cases, the pre-IPO PE capital can result in a doubling of profits. Done right, the pre-IPO capital will result in only modest level of dilution for existing owners – usually no more than 25%. It’s like switching on the after-burners: the SME can speed up its growth, improve its margins, seize large available market opportunities, and so position itself for a far more successful IPO in two to three years’ time.

An IPO has one great value above everything else: it will be the cheapest and most efficient way for an SME to raise the capital it needs to expand its business. The shares will likely be valued at multiples two times higher than a pre-IPO PE investor will pay. Since the amount of capital raised will be a multiple of profits, the higher the profits at IPO the better.

To illustrate this, let’s imagine a company with profits last year of RMB75 million. It has its IPO now, at a PE of 15 and its market capitalization at IPO is RMB 1,125,000,000. The company sells 25% of its shares in the IPO, and so it raises RMB 281,250,000. If instead the company waits another year, it raises a RMB50 million of pre-IPO private equity to help push its profit growth. A year later, profits have reached RMB120 million. If the company now has its IPO, at the same PE of 15, and sells 25% of the shares, it will raise RMB450,000,000 or 60% more.

Let’s  assume  the company continues to maintain a high return-on-investment, after IPO. If so, the more money raised at IPO, the higher profits should be able grow in the future. This is perhaps the most important predictor of overall share performance after IPO. By waiting to IPO, so that its size and profits would be larger, this company will be able to raise much more at IPO and so continue generate higher profits for many years into the future.

A company can IPO only once. So, it is important to raise the optimal amount during this one IPO. If a company IPOs too early, it will sacrifice its ability to finance its growth in the future. Many of the most successful IPOs in China were for private SME companies that had pre-IPO investment from private equity companies: Baidu, Alibaba, Suntech, Belle. That isn’t a coincidence. It’s the result of the sort of smart IPO-planning that is too rare in China.

 

 

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Stairway to Hell? IPO Activity in China Falls Off a Cliff

Leave a Comment / March 9, 2009

 

Not quite “a staircase to hell”, but the graphic below shows the steep fall in IPO activity in China in 2008. It looks pretty scary, doesn’t it? Chinese IPO activity in 2008 was at its lowest level since 2004. IPO activity basically came to a halt towards the end of last year. 

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No one looking at the table will see much room for optimism. But, it’s worth remembering that though down by almost 80% from the year earlier, IPOs of Chinese companies in 2008 still did manage to raise $20 billion of new capital. The key thing now is that this money is used well and wisely, to build profits and market share at these now-publicly-traded Chinese companies. By doing so, these companies will provide an impetus for companies and investors to get back into the IPO market. 

In other words, the IPO market in China is most attractive vibrant not when a company sees a big price jump in its first days of trading. This does little for company, and benefits mainly those who claimed an allocation of shares ahead of the IPO. The key driver for the IPO market should be that the capital raised in an IPO is used wisely, to put companies on a higher growth path. 

Higher profits will boost company valuation, and also allow newly-listed companies to more easily raise additional equity capital in the future. As I sometimes remind the Chinese laoban we work with, “an IPO should not be just a goal in itself, but also the cheapest way to raise additional capital to build your business even faster.” 

Take the money from a public listing to make more money: that’s the quickest way in which Chinese companies can do their part for reviving the IPO market and start building again the “staircase to heaven”, with annual gains every year in the amount of money raised through IPOs. 

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