Valuation

IPO Market in China — Down in 2008, But Not By As Much as in the USA

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Looking for confirmation of how much more vibrant China’s IPO market — and therefore private equity market — is than the US? Well, the numbers are in. China’s IPO market has stumbled. America’s is in a coma.  

As reported in the Shanghai Daily, the number of IPOs in 2008 on China’s domestic stock exchanges fell, both in number and amount of capital raised. The totals were 76 IPOs, compared to 118 in 2007. The total capital raised was US$15 billion (RMB 103.4 billion) on the Shanghai and Shenzhen stock exchanges, down 77% from a year earlier.

While hardly a banner year for IPOs in China, the situation in the IPO market in the US was nothing short of cataclysmic. IPO activity was basically at a standstill, touching lows not seen for a generation. The last two quarters of the year, there wasn’t a single IPO by a venture capital or private equity-backed business. The IPO window in China may have closed somewhat. In the US, it seems welded shut.

What does this mean? Well, for one thing, it’s not a predictor of future activity. The US markets are highly cyclical. IPO activity ceased, in large part, because of more general weakness in the stock market, which was down over 33% in 2008. As the stock market begins to recover, so will IPO activity. Meantime, however, many venture capital and private equity firms in the US are going to suffer. Badly. 

In China, stock markets fell more steeply than in the US, but that didn’t entirely undermine the public appetite for new issues. There are a lot of cultural factors at work here. But, one fact that’s often overlooked is that most shares in China are owned by individuals. In the US, over two-thirds (by valuation) are owned by institutions. Individuals tend to have a higher appetite for risk than institutions, whose managers are constrained by fiduciary responsibilities and a competitive need to outperform their peers.

So, when it comes to the IPO market, China enjoys a structural advantage over the US, at this point in history. Equally important, China’s continued high economic growth of over 8% underpins corporate profit growth that is among the fastest in the world. 

Each $1 of profit in China can still be sold for $15 or more at IPO. That’s why China looks even more attractive, comparatively, than it did before for many of the world’s private equity firms. 

In the global competition for capital, China now ranks as a genuine superpower. 

Valuations head down in Chinese Private Equity — but too low is as bad as too high

How much is an asset worth? When the asset is a Private Equity stake in a high-growth private Chinese company, it’s as much a question of timing and sentiment, as underlying value. 

It’s clear as 2008 ends that the steep falls in world stock markets this year are causing a general reappraisal of valuation multiples in PE deals in China. This is logical, and inevitable. 

It’s logical, because entry and exit multiples can’t be completely decoupled. When share markets fall, so do price-equity multiples for most public companies. Their unquoted peers should track downward also.

The element of inevitability is that in many instances, the multiples on some PE investments in China had reached unsustainably high levels. How high? That depends who you ask. To me, if the multiple exceeds ten times trailing earnings, for a company in anything but exceptional cases in the high-tech or healthcare sectors,  the price is too high. 

PE firms chased valuations up. Now, they are chasing them down.

As recently as this spring, there were still investments being made in China at multiples of 12 times or higher. It’s hard to imagine those same deals being done now at anything like that price. 

Usually, the high multiples were the outcome of a bidding war, where several PE firms were competing for the chance to invest in a Chinese company. I’m all in favor of this, that PE firms should compete for good opportunities. Like any competitive bidding process, it results in a fairer price to the seller. 

That’s a primary responsibility we have at China First Capital, to get our clients the highest valuation from the most suitable potential investor. Both are important: price and the firm doing the investing.                    

But, while a competitive market is a good thing, the high-altitude double-digit valuations are not. They create, at the very least, additional and unwanted pressure, post-investment, on companies to pursue growth at all costs. This is the only way a PE firm could hope to make a decent return. 

The more malign effect, in my view, is that they give false signals to the market: specifically, they can create valuation expectations among other laoban that are unrealistic and unattainable. This can then delay or even eliminate the possibility of these firms raising the PE funding they will need. That is in no one’s interest.

I met this past week with a couple of very smart, seasoned PE investors in Shanghai. All are expecting a more active period of investing ahead as the New Year begins, after several months of greatly reduced deal flow. They are also, of course, expecting lower valuations than were the case earlier this year.

As we all know, markets have a tendency to overshoot. I sense, perhaps, that the PEs are looking now for valuations that are as unrealistically low as they were unrealistically high just a few months back. 

This is a problem almost as severe as overly-high valuation expectations among companies. Low ball valuations (by which I mean low to mid- single digits) are only going to appeal to companies that have no other financing options, or who foresee problems ahead in their business – problems they will try to keep hidden from a potential PE investor. In other words, a company that would take money at three times last year’s earnings is probably one best left to its own devices. 

Home Is Where the Money Is: China Focuses on its Domestic Economy

It was President Richard Nixon who somewhat infamously remarked, “We’re all Keynesians now” in 1971, just about the time he launched a series of disastrous economic policies, including wage and price controls. This was right before Nixon’s fabled trip to China. 

Nixon is, of course, long gone, and a lot of Keynesianism theory has been discredited. But, China recently introduced its own brand of Keynesian-style economic stimulus package, totaling almost $600 billion. The purpose is to shore up the slowing Chinese economy, by increasing government spending by something like 15% of current annual gdp. That’s a very big chunk of change. 

Most of the money is meant to go towards infrastructure and poverty alleviation programs. It should help shield China’s economy from some of the ill effects likely to come from a recession in the US and Europe  – which for China, will mean slowing growth, if not an actual decline,  in exports and direct investment. 

The $600 billion stimulus package is an important sign of a larger change now underway in China’s economy. The huge domestic market, rather than exports, will be the main engine of growth from here on. This, in turn, bolsters the most compelling investment case for private equity investors in China.

The best investment opportunities will be those companies that have the products, services and potential to dominate in China’s domestic market. How to find these companies? The ideal businesses are those that already established themselves as high-quality producers for export markets, and are now turning their primary focus to the home market.  These companies already built manufacturing expertise and scale through exports. Ideally, they also continued to upgrade their OEM production to serve good global brands with higher-priced products, rather than as simply a low-cost, low-value producer.

An interesting comparison: this is the opposite of the strategy many of the best Japanese companies followed: they first achieved dominance in the very-competitive Japanese domestic market, then, battle-hardened, set out to conquer the world. Great examples of this are Toyota, Honda, Sony, Matsushita, Takeda Chemicals, Canon, Kao.

The Chinese approach is different, but no less powerful. Good Chinese companies have already mastered, through their OEM business, short product cycles and the importance of anticipating changing consumer taste.  Both are central to success in China’s domestic market as well.

At China First Capital, we’re fortunate to work with one client, Harson, that exhibits all the best characteristics of a Chinese business now building a dominant position in China’s domestic market. Harson began as an OEM manufacturer, and continually upgraded its manufacturing and product design to serve some of the best international brand names in its industry. Under its very able and far-sighted chairman, Harson then began, almost five years ago, to use that foundation to build its own domestic brand business in China.  That domestic business is now thriving, and moving forward, should account for over 60% of Harson’s projected $300mn in total revenues within two years.  

There will be no faster-growing large market in the world than China’s domestic market. The Chinese government will play a role, by spending on improving education and infrastructure. But, the great entrepreneurs, like Harson’s, will do even more to remake China over the next two decades and beyond by selling Chinese more of what they want and crave. 


Fraud in Private Equity Investing in China

A partnership at a successful Private Equity firm is one of the most rewarding, interesting, reputation-enhancing and lucrative jobs available anywhere. But, it’s not without its perils.

 

This was brought home rather dramatically recently. A partner I know at a China-based PE firm (one of the best, incidentally) recently found out that one of the companies he recently invested in may, in fact, be fraudulent. I didn’t ask for the details, and they weren’t volunteered. I offered my commiserations, and expressed my hope that everything would work out satisfactorily for him and his firm.  

 

This is not an isolated instance. Just recently, the four directors representing foreign investors’ interests in a Shenzhen-based credit company called Credit Orienwise Group, resigned from their directorships following the disappearance of its chairman, Zhang Kaiyong, in early September. Facts are still hard to come by, and may never become widely known. Credit Orienwise is a private company, and the investors are also under no obligation to disclose to the public just how much money has been lost in this fraud.  

 

On paper, Credit Orienwise looked to be a good company. It bills itself as one of the largest private credit guarantee companies and lenders to small and medium enterprises in Southern China.  

 

But, it now looks certain that some of the most experienced and well-managed PE investors in the world may have been defrauded.  

 

Credit Orienwise had received more than US$63 million from four of the largest and most experienced PE investors operating in Asia: the Asian Development Bank, GE Capital Equity Investments Ltd., Citigroup Venture Capital International and The Carlyle Group. It’s hard to find a business in China with a more gold-plated group of investors. Could it really be possible that all four failed in their DD to uncover any actionable evidence, or strong suspicions that would have steered them away from making the investment? And then, once having done so, where was the corporate governance?  

 

This looks to be a failure by investors of very dramatic proportions.  

 

Of course, investors – even the best – sometimes lose money. I recall someone once asking Warren Buffett for his worst investment decision. He smiled and said, “How much time do you have?”  

 

Markets change quickly.A management group can pursue a flawed strategy or fail to execute efficiently. All these “operational risks” are present, to some extent, in any investment. But, the risk of being defrauded is something else. It’s precisely the one risk that’s meant to be neutralized through effective DD and deal structure.  

 

It’s likely over 20 senior professionals – from PE firm partners to accountants and lawyers – were directly involved in the Credit Orienwise DD. Could all of them been swindled by Credit Orienwise’s Mr. Zhang? Perhaps. But, one thing is sure: those closely involved with this deal will never–should never — recover from this stain on their careers.  

 

Is investment fraud more widespread in China?  Circumstantial evidence might suggest so. It’s probably the biggest career threat to a PE and VC investor working in China. 

 

In my own experience as a VC, I’ve not had personal experience with an investment that turned out to involve fraud. I suspect this is true of most VCs and PEs. Fraud is rare, just because it is usually fairly easy to detect ahead of time – if not in the DD materials, than in the comments and character of the company’s leadership. 

 

 

Greed and prudence are the two core principles that guide the actions of a VC or PE investor. Which of these is the most important? As stories like this one involving Credit Orienwise suggest, it’s better for the PE or VC investor, especially in China, to let prudence be the final arbiter. 

Infinite Opportunities ÷ Finite Capital

To a hammer, every problem is a nail. Equally, to many fine entrepreneurs, seeing abundant opportunities for profit, the only problem is capital. Not markets. Or competition. Or industry cycles. 

In other words, good entrepreneurs usually plan big, to build big new businesses that will generate huge returns. That’s great. The only limiting factor they perceive is access to adequate capital to build big enough and fast enough to earn the largest potential return. The problem here, as we say in America, is that such an approach can be “assbackward”. Companies usually need to adjust their plans to the capital they can raise — not decouple the two entirely. 

We had a series of meetings this week with Chinese companies interested in working together with China First Capital to secure private equity funding. These meetings are usually long, detailed, and for the most part, highly enjoyable. We’re lucky to have so many outstanding companies approach China First Capital. They come from a very wide range of industries. For example, this past week, we met with one business in the high-tech synthetic fiber industry, and another that owns a large-scale sugar refinery. 

I’ve learned, over many years, first as a Forbes Magazine reporter and then as a venture capitalist, how to form a quick (and one hopes, accurate) assessment of a business’s potential. With both of these companies, the assessment is very positive. In both cases, though, the laoban clearly hadn’t thought very deeply about how much capital they both should and could raise. There was, at least at the start, this disconnect between the size of their plans, and their ability to finance them with equity capital. 

So, we needed quite a bit of time to explain things. Opportunities in business are infinite, but capital is finite resource. Investors want to achieve the highest risk-adjusted return possible. But, equally, they will determine how much capital to invest not purely, or even primarily, based on the potential return. They will also give strong consideration to issues of corporate control, valuation, ROI, even asset coverage. 

So, while investors will applaud a company with a solid plan to build a new division with annual profits of over $25mn within three years, they won’t be rushing to invest the $50mn that’s required to get there, if the current business is worth $70mn. That would require the investor, in most circumstances, to take a controlling stake in the overall business. The $50mn investment represents over 70% of the current company value. Few investors want to own that much of a portfolio company, even if they foresee great returns. 

There are all kinds of proven and effective ways to raise larger sums, two of the most common are using a mix of debt and equity, or staging the investment in tranches. The starting place for any business seeking equity finance is to ask “how much money can we best raise now?” rather than “how much money do we want to achieve most quickly our business goals?” The answer to the first determines not only which businesses opportunities a company can pursue, but at what scale. 

Capital – its cost and availability — is often among the last considerations for an entrepreneur. Part of our role as merchant bankers is to bring the entrepreneur’s plans down to earth, to keep those plans and the ability to finance them in harmony. The appropriate-sized tool for the appropriate-sized task. This idea is beautifully expressed by this ancient carved image of Chinese rice threshing machinery. 

The Ten Questions Every Laoban Should Answer Before Seeking PE Funding

One of the supreme satisfactions of my work – and I’m fortunate that my job offers quite a few – is the time spent advising laoban (“business owner” in Chinese) on the value of private equity investment. These owners are entrepreneurs, not financial engineers. So, the world of private equity deal-making and finance is often entirely unfamiliar. As I tell these laoban, in my less-than-fluent Chinese, “you have already done the hardest thing possible in business, by taking an idea, adding little or no capital, and created in China, the most competitive market in the world, a successful business of significant size and fantastic prospects.” Compared to this, anything will appear easy, including closing a round of equity capital from one of the leading private equity or venture capital firms. 

Now, of course, closing a PE investment round is anything but easy. It involves, at a minimum,  a sizable amount of time, stamina, senior-level attention, perseverance, transparency, thoroughness and commitment to building a fully-aligned partnership with an outside investor.  I’ve seen it from both sides, both as a CEO and as a venture capitalist. The process can seem like breaking rocks with a spoon. 

But, it’s always rewarding and inspiring for me to see how quickly our laoban start mastering the intricacies of raising capital. They climb the steep learning curve fast. But, it is still a learning curve, and I’ve often made the process harder by doing an inadequate job preparing them for their first meetings. In fact, there ought to be a typically wise four-character Chinese proverb, or chengyu, to describe it: “Good students. Poor instructor.” 

I’ll admit to being a poor instructor. But, an improvable one? I’d like to think so. 

Together with my colleagues at China First Capital, I’ve put together a list of ten questions laoban should expect to hear in a first meeting with a PE firm. The purpose: to give the laoban a quick sense of the scope and rigor of the PE investment process.   

Of course, in any first meeting with a professional PE firm, there will be many more than ten questions. It’s unlikely any PE would ask all – or even the majority – of the ten on the list. 

But, these owner-entrepreneurs are all outstanding problem-solvers. If they weren’t, they wouldn’t be running and owning the sort of businesses of interest to good PE investors. 

So, the questions are really just a catalyst, to get the laoban to think about how a sophisticated investor will evaluate his business. In other words, to see his business from the outside looking in. This is like refraction, where shifting the angle changes the quality of the light. 

Here are the ten questions.  There are no right answers, of course. Only a right mindset.      

 

  1.  How much of your equity are you selling?
  2. What will you use this equity investment for?
  3. When do you hope to complete this fund‐raising?
  4. When will you IPO?
  5. What are you looking for besides capital from an investor?
  6. How do you think you can double or triple your profits?
  7. How much is your valuation?
  8. Who are your competitors and what are your competitive edges?
  9. Can you please explain your strategy for growing faster than your competitors?
  10. Please give me brief summary of the jobs and the past experience of the most important members of your management team?

DD Done Right

Due diligence is rarely anyone’s idea of fun and games. Nor should it be. And yet, several days into the process now I’m struck just how positive the process can be, when it’s done right, done well, done in an atmosphere of shared goals and shared respect. At its best, DD sets the tone for a long period of successful partnership and value-creation between a company and an investor. 

This week, DD kicked off between one of our China First Capital clients and the Private Equity firm intending to invest in the company’s first round of equity finance. The PE firm is among the best, and it operates with the precision of a Geneva watchmaker. The DD checklists sent in advance were exhaustive, prepared both in Chinese and English, encompassing legal, financial and managerial topics. 

Our client – after recovering from the initial shock on seeing the sheer volume of information to be collected and presented – dug in and worked until late each night over the weekend to get the material ready.  The laoban struck exactly the right note from the beginning, explaining to his sometimes-beleaguered staff, that the volume of DD material was conclusive proof that this PE firm would make a professional, highly-competent and valuable partner if the deal closes. 

In other words, it’s a step in a process of increased transparency, meticulousness and accuracy. This will benefit the company immediately, in its operations and planning, and ultimately put it in a far stronger position as it moves toward a successful public listing down the road.   

We insist to our clients that they embrace this approach:  “even as a private company, you should adopt the standards of a public one.” This makes the transition to a publicly-traded company, accountable to both to regulators and shareholders, infinitely smoother.  It’s also just good business. 

On Monday, the PE firm’s DD team arrived at our client’s office, and set right to work. The highest standards clearly pervade all aspects of the PE firm’s operation, from the team — led by a woman of uncommon intelligence, poise and grace —  to the lawyers and Big Four accountants chosen to assist. 

They set the right mood from the outset: one of professional collaboration and partnership, rather than of abrasive investigation. In two days of highly-focused scrutiny, with lawyers, accountants and the PE firm’s team working on parallel tracks, the investor got an enormous amount of its preliminary due diligence completed. On Day Three, they headed out to visit the client’s factory in a neighboring province. 

It’s an old truism of PE and VC investing that the one certainty of the DD process is that there will be surprises, generally of an unwelcome variety. The real question is how large are the surprises and how well they are addressed, by both PE firm and the target company. 

I have confidence that in this case, the DD process will continue in a spirit of shared purpose and reciprocal transparency. As a result, I foresee a great outcome for both our client and this PE investor. 

PEs as Agents of Change

It’s been a turbo-charged week in China and Hong Kong. My time was evenly divided between our China First Capital clients and several of the PE and VC firms that we’re privileged to work with. I resist the use of the word “work”, because I feel so deeply fortunate to be involved in such important and valuable pursuits with such outstanding businesspeople. 

We’re all part of something far larger than just allocating capital. Capital, in the hands of a talented entrepreneur, is perhaps the greatest “change agent” of all, with the potential to achieve phenomenal rewards for the principals, as well as society as a whole.   

It’s easy to lose sight of this, of course, in the crush of negotiating or closing a deal. But, there is no more important work than creating conditions for an entrepreneur to thrive. I’ve seen this so many times over my career, the remarkable, transformational power of a great idea, in the hands of the right person with the capital resources to achieve his goals. This past week, I saw it at ground-level, as one of China First Capital’s clients signed a term sheet and began due diligence process with one of the largest Hong Kong-based PE firms. 

This is how wealth is created.   

As some of you will know, I worked for many years as a journalist with Forbes Magazine, and so had the good fortune to spend a lot of time with some of the world’s most successful business leaders, listening to and observing at close hand their approaches to earning a profit and rewarding their shareholders. 

It was about as good an education as one could have into what constitutes “best practices” in business. I’ve used those lessons over and over since I left journalism and started working in venture capital, and IPO markets. I use the same lessons just about every day here in China. Among our clients are entrepreneurs of a class that one finds at the top of some of the best global businesses. 

Among the PE investors we work with are individuals with a special 20-20 foresight that identifies and seizes on opportunities for profitable investment.  

Together, they are remaking China, and remaking the world. 

Are Chinese Private Equity valuations too low?

Not long ago, just to ask the question would invite ridicule. But now, after the almost-halving of Chinese share prices so far in 2008, it’s more than appropriate to ask, “Are Chinese company valuations too low?”

My answer? Yes, they are too low.

According to the MSCI index, the current average PE ratio of all quoted Chinese companies is 16X, equal to Japan’s, and lower than the 18X average for US-quoted companies. In other words, investors are willing to pay more, on average, for a company’s earnings stream in the US than in China. And yet, of course, profit growth in China is, on average much higher.

It’s not at all remarkable to find Chinese companies whose profits are growing by over 40% a year. In fact, among our clients at China First Capital, that’s the norm, rather than the exception. Some clients’ profits double year after year. Not very many, if any,  US companies can match that rate of growth, for the simple reason that the overall US economy is stagnant, while China’s continues to roar along at a +10% growth rate. Corporate profits form a part of the calculation of gdp growth, and it’s historically true that corporate profits just about everywhere grow faster than the underlying economy.

That’s what makes the current PE valuation for China something of a conundrum. PE ratios are an expression, after all, of collective sentiment on the future rate of corporate profit growth. Clearly, China’s is now, and will likely remain for quite some time, higher than not only the US’s, but the rest of the world’s.  

It’s not hard to find good reasons for this steep drop in Chinese valuations this year. Bad news has come not as single spies, but as entire regiments in 2008. Natural disasters (the worst winter weather in 50 years, and then the horrific earthquake in Sichuan), the steady appreciation of the renminbi effecting China’s export competitiveness, the slowdown of the US economy, the end of pump-priming government spending in the run-up to the Olympics, the global rise in oil prices, and a near-doubling in inflation to +7% all contributed to investors loss of confidence, and with it, a decline in China’s share values.

But, this look like a classic case of a market overcorrecting. The decline in share prices, and with it China’s average PE ratio, certainly seem excessive.  The fundamentals are still very solid for very many Chinese businesses. Corporate profits, though under pressure in China as elsewhere, can sustain themselves at very high rates of growth. China’s best companies are improving margins, improving efficiency, quality and productivity, and focusing on the fast-growing Chinese domestic market.  In other words, good companies in China do exactly what the good ones in the US do – get stronger and leaner when times get tougher.

It seems to me that valuations will rise again soon, maybe not to the dizzy heights of a year ago, but to a level reflecting this one fundamental truth – nowhere else on the planet will corporate profits on a whole grow as fast, for as long into the future, as they will in China. 

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.