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.
- How much of your equity are you selling?
- What will you use this equity investment for?
- When do you hope to complete this fund‐raising?
- When will you IPO?
- What are you looking for besides capital from an investor?
- How do you think you can double or triple your profits?
- How much is your valuation?
- Who are your competitors and what are your competitive edges?
- Can you please explain your strategy for growing faster than your competitors?
- Please give me brief summary of the jobs and the past experience of the most important members of your management team?
The world’s largest and soon-to-be second largest economies, the US and China, don’t seem at first glance to have very much in common. The USA is a new country with an old political system. It’s a little appreciated fact that the US political system, coupling a federal democracy with capitalism, is now arguably the world’s oldest, since it’s been going for 232 years without major changes. China, by contrast, is a very old country – indeed the oldest of all nation-states – but with very new, fast-evolving political and economic systems.
And yet, there are some powerful similarities, ones that appeal directly to me as a builder and financier of private companies. In terms of raw entrepreneurial talent and ambition, China and the US are all but identical. Now, granted, American and Chinese entrepreneurship can often take very different forms — the US is a mature economy that grows at a solid but hardly spectacular pace. Technology plays a key part in many of the best new entrepreneurial ideas. Think of Google or Facebook. China is booming, and every year, millions of move from subsistence farming to relative abundance, from have-nots to consumers. Opportunities abound, in the most basic industries like agriculture and mining, all the way to biotech and semiconductors.
Even so, the entrepreneurial foundation of both China and the US is plainly, and remarkably, visible. A reverence for hard work, vigorous personal ambition, a keen eye for spotting opportunity, these are qualities shared by the people of both countries. It’s why I am so optimistic about the prospects of both countries. And also why I think that China and the US are the two best markets for private equity and venture investment. Entrepreneurship, more than capital, is what drives the process of private equity finance.
Dig still deeper, and you find other important commonalities. In both China and the US, the government does not, thankfully, cripple what my favorite economist, Gary Becker of University of Chicago, calls “the dynamic energies of the competitive private sector”. My hope and belief are that this will continue to be the case for many years to come, and that China and the US will continue to offer great opportunities for building great private companies like those we work with at China First Capital.
There’s always a conflict, in every large economy, between those who want to regulate and tax the private sector, and those who want to maximize the room for businesses to operate free of burdensome regulations and high taxation. Seen in the broadest terms, the US and China are together following one path, and Europe and Japan are following another. China and the US are still open to high-levels of commercial competition with limited government intrusion. This makes both countries more friendly toward the new ideas of entrepreneurs. Europe and Japan, by contrast, are more regulated, more taxed, more anti-competitive, and so less hospitable to the entrepreneurship that drives China and the US.
Entrepreneurs create wealth. Governments don’t. It’s a fundamental reality best understood and practiced in the US and China – and best understood, as well, by those whose capital is placed at risk in private equity deals. Capital goes to where the risk-adjusted returns are greatest. Today, that’s China and the US.
It will be true tomorrow as well.
Today is a day of immense satisfaction and pride for the Chinese, and for those of us who aspire for China’s success and progress. The 2008 Beijing Olympics have begun, and quite literally, the eyes of the world are on China. A remarkable four billion people, or nearly 2/3 of the inhabitants of this planet, are expected to watch the Olympics over the next two weeks. The image many will form of China will be of a proud and ancient civilization restored to greatness.
I celebrate the day, and its wider significance. It was 37 years ago, in the spring of 1971, that I, along with most Americans of my generation and older, got their first live televised glimpses of China. Nine American ping-pong players, accompanied by a larger number of American journalists, became the first official delegation to China since the founding of the People’s Republic in 1949.
Less than a year later, Richard Nixon paid his historic visit. I was just a boy, but can still remember the excitement and awed wonder on seeing my first live images of the Great Wall, Tiananmen Square and the Summer Palace. It was also deeply inspiring. I was totally (and as it turns out, permanently) fascinated by China from the earliest age, and these images on the TV gave direction and purpose to my life even then. I had to learn Chinese and get to China!
It took a decade, but in 1981, I arrived in China for the first time, crossing the Lowu bridge on foot, arriving in a Shenzhen that was then a small border village of 30,000. Today, it is a city of over 13 million. It was one of the happiest days of my life. I’d fulfilled that childhood goal of going to China. My goal changed that day, to one I’m still pursuing – building a deeper personal understanding of China, and a commitment to its future.
I went straight to Beijing, and remember instructing the taxi driver at Beijing Station (in my very clumsy Chinese) to drive direct to Tiananmen. I spent the next few days, from my base at the Friendship Hotel out by Beida, riding trams and visiting the same places I’d seen on American TV 10 years earlier. I later took the train from Beijing to Nanjing, to do postgraduate work at Nanjing University.
It didn’t take long for me to realize that China’s greatest attraction wasn’t its historical sites, but its people.
Then, as now, I felt deeply at home in China. The lesson: home is not just the place one is from, but where one feels the strong sense of belonging, comfort and happiness. For me, that makes China home, even when I’m far away, as now, in California.
Over the next two weeks, hundreds of millions of people will see their first live televised images of China. Some surely will form a goal similar to mine long ago – to study the culture and language of the country, and plan a visit someday.
I’m American by birth. Yet, my own ambitions, personal and professional with China First Capital, are to contribute to the continued transformation of China into a nation of great progress and prosperity. There is no greater reward than working for something larger than oneself.
For me, 8-8-08 is primarily a day to celebrate China’s achievement. It’s also a day when I celebrate the opportunity to work alongside smart and talented people committed as well to building and financing the next generation of world-class Chinese businesses.
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.
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.
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.
I’m a very happy man today. After several weeks in the US, I’m back in China. Nowhere else on this planet more pleases, inspires, awes and enchants me. I have a very long – just about life-long, in fact – love affairs with China. As a boy growing up in the US during the height of the Cold War, China was remote, closed, secretive, hostile to US foreign policy – and deeply fascinating, to me. More fascinating, in fact, than anywhere or anything else. I can’t entirely explain why. Maybe it was Nixon’s visit in 1972. Or, more likely, my early, and abiding, love of my grandfather’s exquisite Ming and Ching dynasty jade collection, which I’m now very proud to own. (The photo on the left is one of the pieces from my grandfather’s collection, a vase from the Ching Dynasty.)
All I know is that as soon as I got to university in the US, I enrolled in Chinese class, and declared myself a Chinese history major. My first visit to China was 1981, when I arrived as a postgraduate student at Nanjing University.
My intent back then was to devote my life to China – working, living and learning. In fact, my career path took an unexpected course and I ended up in Europe for 15 very happy and rewarding years, many of them spent as a foreign correspondent, traveling to well over 60 countries. From there, I moved on to Los Angeles to run a venture capital firm, and then lead a finance business during its US IPO. I visited China during these years, but until last year, never had the opportunity to do what I’d long hoped and planned to do – work and live in China.
China First Capital is a culmination of my life’s dreams, hopes, and goals.
I divide my time now between LA and Shenzhen, maintaining an office and home in each place. I feel intensely fortunate now to be involved in my work in the most important and history-changing development of our time: China’s rapid rise to economic greatness. This work is deeply meaningful and fulfilling for me, because I have this long and unbreakable bond (in my heart as well as my mind) to this country. China is reassuming its role at the epicenter of world commerce, and everyone in the world, quite literally, benefits from this.
Right now, I have one specific, personal benefit in mind. Just as soon as I shower and unpack, I’m off for a delicious lunch of Sichuan food at a local place where I’ve gotten to know the owners, an extended family from Chongqing.
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.
That sound you just heard was the IPO window slamming shut for venture and PE-backed companies in the US. In the second quarter of this year, not a single US company went public. This is the first time this has happened since 1978, when the US VC and PE industry was 1% its current size. In other words, these are unusually tough times for the US venture and PE community.
Will China soon follow suit? Not likely, in my view. In private equity, as in so many other industries, China and the US are becoming more and more decoupled. Chinese companies will continue to go public, on the US market, as well domestically and in other Asian markets, including Hong Kong and Singapore. I remain very optimistic about the prospects of Chinese companies now getting PE and venture finance – and no less optimistic about how well many of these investments will do for the PE firms that are investing. For Chinese companies, IPOs and other exits, including trade acquisition, will continue, at exit values that will reward those investing at typical pre-IPO multiples in China of 6-9x last year’s earnings.
Why the different path for Chinese and US companies backed by PE and VC firms? Start with the economy. The US is going through a period of very slow growth, close to, but not yet in, a recession. This, plus the effect of high oil prices, have weighed heavily on the US stock market, which in turn, limits the appetite among investors for IPOs by US companies. IPOs are traditionally far more difficult to arrange during a time of falling stock prices.
China’s stock market – as well as those of Singapore and Hong Kong – have followed the US down. That correlation between stock markets still exists. But, even during a down market, Chinese companies can still succeed with a public offering. In Hong Kong, whose overall market has fallen by 18% so far this year, Chinese companies are still going public at a rate of about one a day.
What explains this? A big part of it, in my view, is that too much venture and equity capital in the US has gone into technology and biotech, and less to established and profitable businesses. Don’t get me wrong. The technology market in the US is great, and I’m still active in the US venture community. But, this heavy concentration on two sectors, technology and biotech, is itself a cause of the IPO drought of 2008. Those two industries tend to be both hyper-competitive and volatile. For every Google that goes public, there are dozens of tech companies that take VC funding and then disappear without a trace. A huge percentage of the venture funding goes to early-stage businesses, with zero or limited revenues, and perhaps only some untested IP.
So, while American VCs bet heavily on two high-risk/high-reward industries, the overall stock market is made up of many different sectors, with different rates of growth, maturity and different capabilities to respond to competition. In fact, the vast majority of companies listed on the US exchanges aren’t in the technology or biotech industries.
Let’s look now at Chinese companies getting PE and VC funding and going public. They are drawn from a far wider range of industries than their US counterparts. The Chinese PE market doesn’t focus on technology companies, or biotechs, or indeed on any single industry. This is a great strength. Chinese companies getting equity finance and then an IPO exit reflect, far more broadly, the overall composition of the stock market, and so the overall investor demand.
The other key differentiator – the Chinese economy continues to grow strongly. It’s increasingly powered by domestic consumption, and will be for decades to come. This, in itself, creates enormous opportunities for the creation of very valuable businesses serving the Chinese domestic market – example: consumer goods and the businesses that supply those producers. We are working with a client that manufactures a key component used in disposable diapers, a market that will likely grow by upwards of 50% a year. Fewer than 15% of China’s babies are being swaddled in disposable nappies, compared to over 90% in most middle income countries.
My conclusion – as long as private equity capital in China continues to flow into great companies in a wide variety of industries, particularly ones that service the domestic economy, the Exit Window will remain not only open, but ever-larger.
A very warm welcome to all readers of this blog. My goal is to communicate ideas and trends that will contribute to the success of China’s Private Equity industry.