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


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. 


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. 


China M&A: 2008 Is A Record Year, And The Strong Growth Will Continue



Even as IPO activity all but came to a standstill in 2008, China’s M&A market reached an all-time high in 2008, with almost USD$160 billion in deals completed, according to Thomson Reuters. This makes China the biggest M&A market in Asia, for the first time ever. 

This is an important development, and I expect China’s role as Asia’s largest M&A market will continue into the future, despite the current economic slowdown. The reasons: M&A deals in China will continue to make business and financial sense. China’s M&A activity in 2008 was almost equally split between purely domestic deals – where one Chinese company buys or merges with another – and the cross-border acquisitions where Chinese and foreign firms join together – either with the Chinese firm buying into the overseas business, or the foreign firm taking a stake in a Chinese one.  

I see huge scope for growth in both areas. China’s economy, though growing more slowly now than in recent years, is still expanding. Despite its vase size (China is now the world’s third-largest economy, trailing only Japan and the US) Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate. China’s private sector is filled with minnows, not whales. 

The result: there is ample room for consolidation in virtually every industry. Smaller firms will continue to merge, to gain both market share and scale economies. Strong regional companies will acquire competitors elsewhere in China to become national powerhouses. 

The M&A market, more than IPO activity, tends to holds up well even during sour economic times, or when stock markets fall. As share prices drop, the lower valuations make it cheaper for acquirers to act. We had evidence of this recently in the US, where one of the biggest M&A deals of all-time was recently announced: Pfizer’s planned acquisition of Wyeth Labs. 

In China, valuations for both quoted and private companies are lower than they were a year ago. That lowers the cost of acquiring a competitor. The cheapest way to build market share, at this point in China, will often be to buy it. 

All M&A transactions have risk. Very often, the planned-for gains in efficiency never materialize from combining two similar businesses. In China, the complexities go above and beyond this. There is due diligence risk – the difficulty of getting accurate financial information about an acquisition target – and management risk as well.  Good Chinese companies are  usually owned and run by a single strong Chairman, with scarce management talent around him. In a merger, the boss of the acquired company will often step aside, leaving a big hole in that company’s management, and so making it harder for the acquiring company to integrate its new acquisition. 

How to do M&A right in China? Good deal-structure and good advice are crucial. Structure can anticipate and resolve some of the larger post-acquisition headaches. Advice is important to make sure that the price and strategic fit are right. Just as China’s SMB’s need specialized merchant banks to serve their needs in raising capital, these SMBs, as they grow, will also need competent M&A advisors to identify target companies, manage the DD, do the valuation work, help negotiate the price, and assist with post-acquisition integration. 

Last year was a strong one for M&A in China. But, the future should be even brighter, once current economic uncertainty begins to abate.  Looking ahead, I see a real possibility that China’s M&A market will overtake America’s as the world’s largest. I’m planning for my company to play a part in this. 

Houlihan Lokey Founding Partner James Zukin Sets His Sights on China



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

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

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

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

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

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

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

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

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

A New Year of Challenges and Opportunities in China’ Private Equity Industry


Looking purely at the economic news from China of late, this has not been the happiest of Chinese New Years. The Chinese government is estimating that 16% of the huge migrant labor force of 200 million will have no job to return to after the New Year.  Factories are continuing to close, or cut employment, across the country. Guangdong province, where China First Capital has its base in China, is particularly hard hit, because it’s still the primary production base for much of China’s better private factories. While factories are being moved out of Guangdong to less expensive, inland locations like Jiangxi, overall industrial employment in factories in Guangdong is still huge, and hugely reliant on migrant labor. There’s no solid date, but ten million or more workers may have lost their jobs in Guangdong over the last six months. 

The picture is no less bleak in terms of projections for corporate profits in China in 2009. Larger companies are reporting profit falls of over 50% in 2008, and forecasting even worse results this year. This matters crucially in China. Over 40% of total economic output is generated by business investment. This, in turn,  is intimately tied to corporate profits, since most of that business investment is financed out of retained profits. According to a recent report in the Wall Street Journal, “official statistics show that 63% of investment in China last year was financed by what are called “internally generated” funds, which include retained profits. That’s up from just below 50% a decade ago.” 

In other words, as corporate profits decline, they take Chinese GDP growth with them. This falling economic output, in turn, influences consumer sentiment, and so takes personal spending down with it. 

Good economic news is a scarce commodity this Chinese New Year. But, I see one bright glimmer of hope here. Chinese companies have been excessively reliant on retained earnings and expensive bank debt to finance their growth, rather than equity capital. The difficult economic environment, in China and indeed worldwide, provides a good opportunity for better Chinese companies to reorient their method of financing capital investment and growth. It’s the right time to take on equity capital, and use it as a platform to continue to invest and grow, even if corporate profits are in cyclical decline. 

The Chinese companies that can raise equity finance will enjoy a significant financial advantage over competitors, and so be able to gain market share. Adding equity finance lets a company both lower its overall cost of capital, and also increase the amount of capital it can put to work in its business. Both of these factors equate to a very real competitive advantage. 

Equity investors, principally PE firms, will need to change their orientation as well. The opportunities to do shorter-term “pre-IPO” financing are far fewer than they were, because stock market valuations are way down and IPO activity has slowed to a crawl. So, the simple arbitrage of a PE firm buying into a Chinese company at a valuation, say, of 10x and selling out 18 months later in an IPO at 20x are gone. 

Instead, PE investors in China need to think more like value investors, and less like arbitrageurs. This means looking for opportunities to deploy capital into good businesses offering high rates of return on that invested capital. Equity investment is then used to expand output, lower unit costs, gain market share, and so expand both profits and profit margins. Build profits and valuation will take care of itself. If a Chinese company can put equity capital to work well, and accelerate profits in 2009 and beyond, that business will be worth a lot more money when the IPO market revives than if it simply cut back on investing to ride out the bad times. 

This year is going to be difficult, challenging, but also potentially highly rewarding for all of us participating in the financing of private companies in China. It’s a year when good companies should be able to get even better. And smart-money PE firms will make far more, over the medium-term, than fast-money valuation arbitrageurs ever did. 


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



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. 

Distressing Times — China’s Weak PE Firms Look to Sell Out

Ming Dynasty Ivory Luohan


Look up. Those are vultures circling over China’s Private Equity market. The vultures, in this case, are distress investors, including AIG and GE Capital. They have quietly begun shopping for the investment portfolios of hard-up private equity and venture capital firms who spent the last three to five years investing in China. The price they are offering: as little as five to ten cents on the dollar. In other words, a PE fund that invested $100mn in Chinese private companies could liquidate those investments for as little as $10mn in cash.

Who would be crazy enough to sell at that price?

Good question. It’s hard to see why any PE or VC fund would want out at that sort of price. After all, their investors (aka LPs) are locked in for the long haul, about 7-10 years on average. This is the signal difference PE and VC firms enjoy compared to hedge funds, whose investors usually can redeem either quarterly or annually. A PE or VC fund has better balance of assets and liabilities: its illiquid investments are matched by liabilities to its investors that are similarly long-term. 

This means a PE or VC firm can ride out any market turbulence, even one as severe as what we’re experiencing now. China’s stock markets are off 60% over the last 12 months, and IPO activity (the usual exit route for PE and VC investments in China) has all but dried up.   

And yet, you can be sure there are PE and VC firms that will sell out in coming months to distress investors. Why? It’s not because these funds will be legally or contractually or even morally obliged to sell. It’s more a matter of confidence – or lack thereof. While LPs can’t withdraw their money, they can make life very tough for PE or VC partners whose investments are in deep trouble. 

Another reason, PE or VC partners don’t much like the prospect of nursing investments for many years, during a difficult period, with no strong likelihood of a successful exit. VC and PE partners like to say they’re long-term investors. But, the reality is, they like to get in and out within two to three years, collect their share of profits, use this success as a selling point to raise more money from which they can collect even higher management fees. And so the wheel spins. At least in good times. 

Well, the good times are over. 

I’ve run a VC firm through the last down-cycle following the crash of the internet bubble in 2000. It takes a different kind of mindset than that of many PE and VC investors, especially ones who had a relatively easy time during the boom years, when some very mediocre companies can achieve successful exits. 

China’s PE market today is quite reminiscent of Silicon Valley venture capital after the 2000 crash. A lot of Silicon Valley VC firms (generally those with the weakest ability to make winning investments) sold out to distress investors back then. A similar pattern is emerging in China – the weakest will perish.   

The good firms know how to keep the vultures at bay. They are the ones who know how to manage in lean times, and how to work harder, faster and smarter with their portfolio companies to improve operations and cash flow. 


Coming Soon — A Stock Market for High-Tech Companies in Shenzhen

Zhou Dynasty Horse Fittings

Despite delays and continuing uncertainty, 2009 should see the opening of China’s first stock market for smaller, high-growth technology companies. Modeled on the NASDAQ in the US and AIM in London, this new market will be headquartered in Shenzhen, as part of the Shenzhen Stock Exchange, the smaller of the two stock markets in China.

Overall, this is a positive development for China’s financial industry, and the private equity and venture capital communities. Since China’s Prime Minister, Wen Jiabao announced in March 2008 the planned establishment of this new stock market, after almost a decade of internal discussion, the date for the launch has steadily slid back, a casualty of the 60% fall in China’s main stock markets this year.  

The final details have not been announced, but what seems clear at this point is that this new market will have significantly lower qualifying thresholds for companies seeking a stock market listing, compared to the main boards in Shenzhen and Shanghai. The numbers talked about are net assets above RMB 20 million (US$2.8mn) and revenues above RMB 10mn (US$1.5mn). There seems to be no requirement, as of now, for companies to be profitable at the time of listing. It’s possible, therefore, that companies listed on the new exchange will have market caps that barely exceed $10mn. 


Here’s my thinking. The largest quoted companies on the Shanghai market are trading at a price-earnings multiple of under 12. This is down, like the broader market, by almost 60% from recent highs. Put those kind of multiples on a small company with revenues under US$2mn and profits below $1mn, and you have the possibility of market caps in that very low range. True, high-tech companies tend to enjoy higher p/e multiples than more traditional large-caps. But, even so, this new stock market will be operating in some unchartered territory for China’s financial markets — companies with comparatively thin floats, low total market value, and so, most likely, higher price volatility. 


This could help explain why the Chinese government has repeatedly delayed plans to launch this stock market for high-growth companies. The regulators have probably seen this year all the volatility they care to see for a long time. 


Of course, the key factor won’t be earnings multiples or volatility, but the quality of the underlying high-tech businesses to be quoted on this exchange. Here’s where I see bigger problems. China, like its richer neighbors in Asia, as well as Western Europe, would very much like to rival the USA in nurturing successful high-tech companies in industries like software and chip technology. Across China, there are high-tech business parks where early-stage technology companies are concentrated. By one count, there are over 5,000 across the country. But, so far, there haven’t been many big break-out successes. 


The simple truth is that, as other countries have learned over the last decade, it’s hard to duplicate the particular success the US has in developing successful high-tech businesses. Having a stock market for high-tech companies is certainly not much of a factor. If so, Germany, which started its own high-tech company stock market, the NeuerMarkt ten years ago, would today be awash with leading technology firms. Instead, there are few, if any good tech companies in Germany and the Neuer Markt eventually was shut down. Britain’s AIM market has also failed to produce many successes in that country. 


In my mind, China does have a better shot than Germany, or Britain, or Japan. The main reason: Chinese are more entrepreneurial, and there’s more a culture of prudent risk-taking than elsewhere. If any country has a shot to achieve some of the same success the US has enjoyed building great technology companies, it’s got to be China. 


So, I hope this new stock market gets started early in 2009. It will provide more motivation – not that much is needed – to China’s budding technology leaders, and also provide another viable exit route for venture capital investors in China








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. 

The future of PE in China — Big PE vs. Small PE

I never much liked the term “Private Equity” since it serves two very different meanings and even more different business models. That difference has never been more stark than it is today. There is what I like to call “Big PE” and “Small PE”. One is hurting, and the other is still thriving. Luckily for China First Capital, we focus working with the part of the PE industry that’s still in good shape.  

In Big PE, large-scale, multi-billion-dollar deals are done by famous firms of the likes of Kohlberg Kravis Roberts, Blackstone and Carlyle. In Small PE , another group of PE firms thrive by finding great companies, at an earlier stage in their development, and backing them with growth capital. 

Big PE targets larger, often publicly-traded companies, or divisions of these larger firms. Using a slug of equity to support a large pile of bank debt, these private equity deals are based on acquiring a controlling interest in a company, and can deliver outstanding results by tossing out tired and underperforming management teams, tightening up on operating efficiencies, investing for growth. In 1-3 years, if things go well, the Big PE firm exits the now-improved business through either a trade sale or primary stock market listing. 

What matters most here essentially is finding a poorly-run business, with a bad capital structure and often worse management. (To take one recent example among many, think of Cerberus’s purchase of Chrysler’s from Daimler.) Ideally, a Big PE firm can turn things around quickly after buying control, and get an exit where the debt is paid off, and the underlying equity gets a very high rates of return. 

There are two big problems now in Big PE: the drying up of credit, and the shrinking valuations put on the businesses spiffed up for sale by the PE firms.  The recession compounds the problems, since the deals are built on leverage, and the bank debt will often have aggressive covenants attached to it. Those covenants (generally targeting  operating metrics like increasing EBITDA) are much harder to achieve in a down economy. Covenants get breached, deals need to be restructured with the Big PE firm pouring in more of its own capital, and the time and value of an exit go in the wrong directions: it takes longer to make less. 

Not a good business to be in at the moment. 

Then there’s Small PE, which has never looked sounder. The core skill-set here never goes out of fashion. It’s the ability to find a great company with the potential to grow far larger. Small PE firms invest their own money, for a minority stake in a business. They then provide what help they can to management, and if they’ve chosen their portfolio investments well, will wait confidently for the optimal moment to achieve a very solid return on each individual investment.  

In other words, Small PE is not built on complex financial engineering, but on good, old-fashioned “stock-picking”. 

Last month, David Rubenstein, the co-founder and managing director of Carlyle Group, one of the biggest of the Big PE,  gave a presentation in Tokyo titled “What Happened? What Will Happen? A Look At The Changing Investment And Private Equity Worlds” . Rubenstein, who has made over a billion dollars personally in the PE industry, tried to summarize all the tectonic forces destabilizing Big PE. There’s a lot of alarming stuff in his presentation. The key line: “The Credit Crisis Has Dislocated the Private Equity Industry “. (If anyone would like a copy of the Rubenstein presentation, email me at                                                                                                                                          

Rubenstein’s prediction, which I share: “Deals: Smaller, Less Frequent, More Overseas”. In particular, Rubenstein foresees more PE firms raising money to invest in Asia. The fact he cites: Asia private equity fundraising has increased but remains small at 9.2% of the $331 billion raised by U.S. PE funds in 2007 considering that the combined GDP of the above countries is 93% of the GDP of the U.S. 

No question, Big PE will now try to act more like Small PE. The problem they’ll face is that they’re not well structured to find, assess and invest in smaller-sized deals. My guess is that the good PE firms already operating in Asia – the ones we work with regularly at China First Capital – will  be able move quicker and smarter than their new Big PE rivals. Here I means firms like China Renaissance Capital, ( which has a great record of finding strong middle-market companies in China, investing wisely and at fair valuations, and then working alongside management to create the operating conditions for an ideal exit. 

Rubenstein’s talk included a table showing the 2008 year-to-date performance of a number of the most well-known Big PE.  All the following have lost money this year. What you see here is a cumulative loss of many tens of billions of dollars:

􀂃 Tosca Fund – 62%

􀂃 Templeton Emerging – 50%

􀂃 Kensington/Citadel  –37%

􀂃 Satellite Overseas  -30%

􀂃 Marathon Global Equity – 20%

􀂃 Canyon Value Realiz. –20%

􀂃 Goldman Sachs Investment Partners –16%

􀂃 Deephaven Global –15%

􀂃 Millenium Global HY –14%

􀂃 Cantillon Europe –13%

􀂃 Zweig-Dimenna Intl. –8%

􀂃 Harbinger Offshore -5%

􀂃 Cerberus Intl. –3%

􀂃 Viking Global Equities –2%

The good Small PE firms are having far better years. My own prediction is that this performance gap will only widen over the next two years, as the deal pipelines for Asian PE firms we work with remain very strong. Big PE has to re-learn their approach, and try to master a new set of skills. All the while, they’ll be losing out on many of the best opportunities in Asia to their smaller, more nimble and more experienced rivals. 

It’s hard to find a dancing elephant. The reason: it’s hard to teach the elephant the steps. 

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. 

Good article on improving the flow of bank lending to China’s strongest SMEs

This is the right approach to direct greater bank lending to China’s best and most credit-worthy small businesses. A more efficient loan market will improve the overall returns for private equity investors, as it will lower the cost of capital, during early phases of growth, for the best SMEs. 


  • Need a Real Sponsor here

China’s Monetary Paradox

China yesterday did what many economists expected it to, and cut both the lending rate and the reserve requirement on banks. The move is intended to serve as a classic monetary stimulus as China faces its biggest economic test since 1978. But a different, paradoxical, strategy might be better: a stimulative tightening.

On the face of it, China’s problems don’t look all that unusual in the region. Real export growth has slowed to around 10%, although the turmoil overseas suggests this is about to get much worse. The bigger problem is the domestic real estate market, the other main driver of Chinese growth, with sales contracting more than 50% in recent months. China is at risk of its first real simultaneous downturn in external and domestic demand growth since 1996.

The solution in a normal economy would be an interest rate cut. Indeed, Beijing yesterday cut the lending rate to 6.9% while also reducing bank reserve requirements by 0.5 percentage points (exact requirements vary by bank size), both moves intended to boost liquidity. The underlying structural cause of these economic problems is unique to China, however. Despite 30 years of economic reform, the most important price in the economy — the price of money — is still controlled.

The undervaluation of the yuan, which can be inferred from the tremendous build-up of foreign exchange reserves, has sparked overseas calls for revaluation. Beijing has responded, allowing the yuan to appreciate 8% or so this year. That rise has only encouraged further inflows, however, so Beijing has held interest rates low to avoid exacerbating the inflow problem. Combined, these policies are the classic recipe for a bubble. The liquidity inflow creates an excess supply of money, and low nominal interest rates — 7.2% at the moment, well below nominal GDP growth of 20% — create the excess demand.

Beijing’s response has been to cap loan growth through regulation. Banks have been ordered not to lend, instructions which in particular this year have been backed up with sterilization, the government’s soaking up of excess yuan. Bank lending growth is now around 15% a year. That’s a big number in absolute terms, but not in the context of China’s rapid growth. The stock of outstanding credit has fallen relative to the size of the economy, closing in on 100% of GDP now from 125% of GDP in 2003. In the same period credit in the U.S. has ballooned to almost 180% of GDP — not even including the liabilities of the super-leveraged financial sector.

At first blush it looks like China’s banking straightjacket has protected the banks from themselves and the economy from the banks, in contrast to events elsewhere. The problem is that these policies are preventing banks from developing the risk management and other skills needed to make them self-supporting commercial institutions.

It is the government that decides how much lending occurs. Within what are effectively credit quotas it would in theory make sense for the banks to lend to companies that have the best ability to repay. In practice, though, there is little value in being too choosy. Banks can fulfil their quota with profitable firms by lending to pretty much any company that walks into the bank on Jan. 1 each year. In this environment, it is likely that the banks lend almost exclusively to the customers they are most familiar with.

One consequence is that smaller start-ups in the private sector find it harder to get credit, despite relatively low interest rates. This is why it is so important for Beijing to raise rates to replace the banking straightjacket, the regime of administrative measures and sterilization that has controlled lending growth so far. Under this new policy, credit growth would be controlled via the price rather the quantity of money. Only then will China’s banks begin to learn how to judge risk, and thus wean themselves away from state-owned enterprises and start lending to the more dynamic private sector.

This transition would have huge economic consequences. Most evidence suggests the small private firms are the most productive in China, and are also the most employment-intensive. Their development is stunted because credit rationing denies them money from the banks. Instead, they are pushed to the informal credit market, where interest rates can be as high as 40%. Indeed, even a borrowing rate in the formal banking sector of 15%, more than double the current rate, would be low for the army of small and medium-sized enterprises.

Which is why a nominal tightening via an interest rate hike wouldn’t necessarily be a tightening in practice at all, if banks in the meantime are released from their straightjacket of administrative controls and sterilization. By encouraging banks to think for themselves and thus potentially giving smaller enterprises access to relatively more affordable bank credit, a policy of easing by tightening might end up being just what China needs.

Mr. Cavey is head of China economics at Macquarie Capital Securities.



Why Wall Street rules rule in China Private Equity Deals

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

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

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

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

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

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

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

Moving From Transaction-Based to Relationship-Based in China’s PE Business

The PE industry in China is growing up. Fast. There are two key factors are at work. The first is the onrush of cash. The second is the onrush of talent.


Billions of new money is flowing into the Chinese PE industry. This is in marked contrast with the situation elsewhere. There’s not a lot of appetite for committing capital for any purpose except to invest in China. Other, traditional large PE markets (US and European buyout funds) are in cyclical decline, owing largely to the problems in global credit markets. Then, too, there’s the announced intention of the China’s $75 billion social security  fund to begin investing more freely in private equity firms in China.   


The weight of all this new money entering the China PE market is having an interesting effect on valuations. While valuations have certainly come down over the last year, they arguably would have fallen faster and farther if not for all the new money looking for opportunities. It’s what financial markets like to call “the weight of money” argument – the more cash there is around, the higher prices will rise. 

That’s one side effect of the new money entering the market. The other is that the level of professionalism, across the board, is rising in the PE industry. There’s a good reason for this. As the pool of capital grows, so too does the demand for higher levels of fiduciary responsibility and accountability. This is evident not just in tightening DD procedures, of course, but also in the involvement in the PE investment process in China of some the world’s leading professional service firms. 

This past week, I met with a Hong Kong-based partner at one of America’s largest and best law firms. This firm has been very active in China’s IPO market the last five years, and served as lead counsel for many of the larger public offerings by Chinese companies in US exchanges. This is a great business, with very fat fees. But, it’s also a highly cyclical one. The IPO market has cooled this year. So,  this firm has now made the shrewd decision to work on some smaller PE deals, rather than just the +$100mn IPOs they’ve relied on in the past.  The upfront transaction fees are, of course, lower. But, by getting involved earlier in a company’s financing process, at the time of PE financing, this law firm believes that it will be building a very solid base for the future. 

The calculation is very sound. By working on a PE financing today, the law firm will be ideally-positioned to serve as IPO counsel several years down the line. In other words, the firm is moving from being “transaction-based” to “relationship-based” , from targeting only high-dollar one-off IPO transactions, to building a longer-term relationship with a select number of very promising pre-IPO Chinese companies. Over time, this should yield far more revenue for the law firms that follow this path. There’s money to be made advising on PE investment rounds, on Board matters, on M&A work, and litigation. 

In principle, it’s an obvious shift to make, and more closely reflects best practices in the legal profession. In fact,  a good law firm, like a good merchant bank, should choose its clients wisely, and then commit to serving and advising them over the long-term. 

For us, at China First Capital, this is very much at the heart of our operating ethos. For larger law firms, it can sometimes be a tougher shift to make. For one thing, their existing fee structures make it harder to work with smaller clients.  The law firms will often need to cut fees as a way of building these longer-term relationships. That’s not always easy to do in a large law firm, where all partners are expected to generate maximum revenues. 

But, this change in mindset is happening. I know from experience, since this big US firm has offered to work with several of our clients, on their PE financings, and to cap their fees at an appropriate level. This is a great thing for our clients, since it gives them access to the best legal counsel possible, at a time when it will make a significant positive difference. The PE firms stand to benefit as well, since it should raise standards overall. 

This shift from transactional focus to relationship-building is more proof that China’s PE market is coming of age, and building the infrastructure on which to prosper for many decades to come.