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Buyout Firms Lack Exit Ramp in China — Wall Street Journal

Leave a Comment / June 25, 2016

 

WSJ

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With the door to initial public offerings in China largely shut, private-equity firms invested there are having a tough time cashing out. The alternative—selling to another buyout firm or a company looking to expand via acquisition—remains rare in a market where buyers are relatively few.

Private-equity firms are sitting on more than $130 billion of investments in China and are under pressure from investors to find an exit, Shenzhen-based advisory firm China First Capital said in a report last week.

Gary Rieschel, founder of Shanghai-based Qiming Venture Partners, said, “There needs to be a broader number of choices in buyers” in China.

Private-equity firms have generally exited their China investments through IPOs, but the number of private-equity-backed IPOs approved by mainland regulators has plummeted. Meanwhile, the Hong Kong IPO market has softened and sentiment toward Chinese companies in the U.S. has soured because of accounting scandals.

In October, the China Securities Regulatory Commission shut the IPO door completely on the mainland, halting the approval of new listings over worries that a glut of offerings would further weigh on sagging share prices. The Shanghai Composite Index was one of the world’s worst performers in 2012, sinking to a near four-year low in early December before a rally pulled the index up slightly for the year.

Analysts say they don’t expect the CSRC to approve any IPOs until at least March, when Beijing’s top lawmakers usually hold important annual planning meetings.

The regulator approved 220 IPOs of companies backed by private-equity or venture-capital firms in 2010, but that fell to 165 the following year and 97 last year, research firm China Venture said. There are now nearly 900 companies waiting to list in China, the CSRC said on its website.

Hong Kong’s market, meanwhile, has seen fewer IPOs over the past year as investors soured on new listings after several underperformed the broader market. U.S. private-equity firm Blackstone Group, which owns 20% of chemical company China National Blue Star, scrapped a planned Hong Kong listing of a unit called Bluestar Adisseo Nutrition Group in 2010 due to weak markets. It has yet to list that firm.

Carlyle Group has struggled to exit some of its deals, including two deals it made in 2007, a $20 million investment in Shanghai-based language-training firm NeWorld Education Group and a $100 million investment in Zhejiang Kaiyuan Hotel Management Co. A company spokesman said the holding periods for those investments are normal because private-equity firms usually stay invested for four to seven years. The spokesman also said Carlyle has successfully exited many deals, including the recent sale of its stake in China Pacific Insurance, which generated a profit of more than $4 billion.

In more-developed markets, private-equity firms can count on exiting their investments through sales to rival buyout firms or to companies looking to grow through strategic acquisitions. But in China, private-equity firms have sold stakes to rival firms or other companies only an average of 15 times a year over the past three years, according to data provider Dealogic.

China’s secondary buyout market—where private-equity firms sell to each other—remains immature. Among the handful of such deals, Actis Capital sold a majority stake last month in Beijing hot-pot chain Xiabu Xiabu, for which it had paid $50 million in 2008, to U.S. firm General Atlantic for an undisclosed amount.

Domestic consolidation is rare compared with the activity in developed countries. Chinese companies that are still growing quickly may prefer to hold off selling, and there are fewer big corporate domestic buyers.

“China is still a relatively fragmented economy with a disproportionately small number of large businesses relative to the size of its economy and very few national businesses,” said Vinit Bhatia, head of China private equity for Bain & Co.

When a private-equity firm does sell a Chinese portfolio company, the size of the deal tends to be small. Last year’s biggest sale was MBK Partners’ $320 million sale of a majority stake in Luye Pharma Group, which it bought in 2008. The buyer was AsiaPharm Holdings Ltd.

Usually, though, foreign private-equity firms hold only minority stakes in Chinese companies because full control is tough to get, in part for regulatory reasons. Domestic private-equity firms, meanwhile, are often content to hold minority stakes in fast-growing companies, which can offer healthy returns.

Management may not be on board when a minority investor wants to put the whole company up for sale. Chinese chairmen, who are often the founders of their businesses, prefer to remain at the helm, said Lei Fu, co-founder of Shanghai-based private-equity firm Ivy Capital.

Still, private-equity investors say they are hopeful that more buyers will emerge in China this year, even if the IPO markets stay shut.

The number of strategic Chinese buyers should increase as the government encourages consolidation across industries and as medium-size companies begin growing more rapidly with a rebound in the economy, they say.

“Five years ago we would think of multinationals…Now we think more local companies” when looking for buyers, says Huaming Gu, Shanghai-based partner at private-equity firm Baird Capital.

 

http://blogs.wsj.com/deals/2013/01/15/buyout-firms-lack-exit-ramp-in-china/

Download PDF version.

 

China Private Equity Secondaries — New York Times, Bloomberg, CNNMoney

Leave a Comment / March 12, 2014

–Dual

It is imperative for the private equity industry in China to develop an efficient, liquid market for secondaries. Our goal is both to facilitate an active dialogue, as well as help bring this about. Only by breaking the current logjam of no exits in China PE can money again start to flow in significant amounts to capital-hungry private companies. No less than the future fitness of China’s entrepreneurial private sector is at stake.

In the last several days, along with the Wall Street Journal article posted yesterday, five other financial media (New York Times, Bloomberg, AVCJ, PEI, CNN Money) published stories on this topic, referencing research results from China First Capital. I’m pleased to share them.

Private Equity in China: Which Way Out?

HONG KONG — Welcome to the private equity game in China: you can buy in anytime you like, but you can never leave. At least, that is how it is starting to seem for many of the firms that bought in big during the boom of last decade.

Starting from a base of almost nothing in 2000, global private equity funds and their start-up local counterparts rushed into the Chinese market – completing nearly 10,000 deals worth a combined $230 billion from 2001 to 2012, according to a report released this week by China First Capital, a boutique investment bank based in the southern city of Shenzhen.More…

 

Private-equity funds in China are still holding 82 percent of the companies they’ve invested in since 2007, as the frozen market for initial public offerings keeps them from exiting, a study showed.

Funds hold 6,584 companies after disposing of 1,445 and seeing 20 go bankrupt, according to a report from China First Capital, a Shenzhen-based firm that advises on private equity and mergers. Investors still hold companies valued at $94.3 billion, compared with a total of $194.7 billion, according to public data compiled by the firm and its own research. More...

 

 

At least 200 private equity portfolio companies in China are attractive targets for potential secondary buyers and the number is likely to grow 15-25% per year as funds come to the end of their lives and find that exit options are still limited.

These companies represent the cream of a much larger pool of investments that are as yet un-exited by Chinese PE investors, according to a proprietary study by specialist investment bank China First Capital. It estimates that more than 7,500 portfolio companies remain in private equity firms’ portfolios from investments made since 2000.  More…

 

As other exit avenues for private equity dry up in China, GP-to-GP secondaries could be the only option for the 7,500 unexited portfolio
companies, according to a recent study from China First Capital.

China has 7,550 unexited private equity investments totaling $100 billion that will soon have to be realised through routes other than the traditional IPO, according to a recent study from China First Capital.
As fund lives begin to expire, Peter Fuhrman, chairman and chief executive of CFC, believes the standout option will be GP-to-GP secondary transactions. This is especially true for RMB funds, which have a three-to-five year life rather than the ten years typical with US dollar funds. More…

China’s stalled market for new share listings is severely limiting the ability of private equity funds to cash out their
investments in the country, according to a new research report from China First Capital.
The Shenzhen-based investment bank analyzed more than 9,000 private equity and venture capital deals completed in
China since 2001, and found that more than $100 billion — much from the U.S. — remains invested. More…

 

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Cornerstone Investing: Brilliant New Idea or Mistaken Strategy for China Private Equity Firms?

Leave a Comment / December 19, 2012

Cornerstone investing is among the latest new investment strategies favored by some in the private equity industry in China. It is still early. But, cornerstone deals may prove to be among the least successful risk-adjusted ways to make money investing in Chinese companies.  Cornerstone investing involves putting big money up to buy shares in a company at the time of its IPO. In essence, it’s no different than buying any other publicly-traded share through your stockbroker, except a little worse in one respect. The cornerstone investors usually accept restrictive covenants that prevent them from exiting until months after the IPO. The investment strategy, such as it is, amounts to hoping the stock price will go up.

This is obviously quite a departure from the way PE firms typically operate in China: discovering a great private company, putting money in while the company is still illiquid, then nurturing their growth for several years up to and beyond a public offering. Done well, this process will earn a PE investor returns of 500% or more. Generally, PE firms also can indemnify themselves against losing money by exercising a put to sell their shares back to a company that fails to IPO successfully. It’s hard to imagine any scenario where cornerstone investing can do as well, and many where it will be significantly worse. One example: the possibility that the overall stock market performs poorly,  as it has in Hong Kong for the last year or so.

Cornerstone investing is a well-established practice in Hong Kong IPOs. Previously, it was only rich Hong Kong plutocrats who did these deals, at a time when most IPOs were heavily oversubscribed and likely to record a big first day jump in price. Now, the plutocrats are gone, new IPOs have fallen steeply,  valuations are way down, and PE firms have taken their place. What is it they say about fools going where wise men dare not tread?

How popular are these cornerstone deals now in Hong Kong? Hundreds of millions of dollars of PE capital have already been deployed. According to data from Bank of America Merrill Lynch cited by the Wall Street Journal, “private-equity funds… [make] up 41% of cornerstone investors in Hong Kong IPOs in 2012, compared with just 5% last year.” The only limiting factor seems to be the big falloff in the number of Chinese companies going public in Hong Kong this year. PE firms appetite to do these deals seems, if anything, to be getting stronger.

Finding a cornerstone investor is usually a great deal for the company staging an IPO, since it means there are fewer shares that need to be sold to the general public, and the lock-in provisions provide comfort to other investors that the company should be worth more later than it is at time of IPO. So, price volatility is reduced.

And the corresponding benefits for the PE firm are? Good question. The PE firms will claim they are buying into a good company at a comparatively good price, that they’ve done extensive DD and are confident of long-term stock price appreciation, with moderate to low risk. In other words, it’s a good place to invest their LPs money. That might be more plausible if cornerstone investing was producing large returns of late. It hasn’t. The Hong Kong stock market remains at a very low level. Yes, maybe the Hong Kong stock market will rally, and so lift these shares, conveniently after the lock-in has expired, allowing the PE firms a nice trading profit.

As an investment strategy, this basically amounts to market timing. And as most financial theory teaches us, all market timing is as likely to lose money as earn it. The PE firms will argue otherwise, that they are acting like good “value investors”, buying the shares at what they deem to be a low IPO price. As the company grows, its stock price will as well. Could be. But, there is an argument that this is what hedge funds and mutual funds are designed to do. They bet on the earnings momentum and so share price direction of publicly-traded equities. Is PE investing in China so difficult, so profit-constrained that PE firms now need to appropriate someone else’s business model? And do so without having much, if any, of a track record in this sort of investing?

That’s really the challenge here. Why should PE firms do these deals if there are still many outstanding pre-IPO equity investment opportunities available in China? PE firms can acquire a meaningful ownership stake in a dynamic private Chinese company, at low valuation, enjoy all kinds of special investor rights and privileges, including that guaranteed buy-back, that aren’t available to cornerstone investors.

With cornerstone investing, a PE firm is mainly at the mercy of the stock market. Will overall share prices go up or down or stay the same? It’s passive. With typical PE investing, the potential rewards, as well as downside protections, are obviously much better. But, so is the work you need to do.

That may explain a lot of the appeal of cornerstone investing. Cornerstone investing is simple. You get the IPO prospectus from a well-known underwriter, parse the audited financials, study other quoted comps, maybe talk to management about their growth prospects and how the IPO proceeds will be spent. You then make a determination about whether the company looks to be a good medium-to-long term bet. You never need to leave the office.

Compare that to PE deals in China. Due diligence is messy, slow, expensive and hazardous. Many deals never close because the PE firm discovers, during DD, that a Chinese firm’s financials are not compliant with tax laws, or the founder’s main supplier is his cousin’s husband or the company has failed to acquire the appropriate licenses. In these cases, the PE firm has to swallow the cost of the DD, which can run to $250,000 or more per deal. Too many examples of this kind of loss-making and a PE firm will start to find its LPs are less willing to commit money in the future.

This kind of “DD risk” is largely absent from cornerstone deals. A company staging an IPO has gone through multiple rounds of vetting, approval and audits. All paid for by parties other than the PE firm. So, cornerstone investing can look, from a certain crooked perspective, like typical PE investing minus all the costs and hassle of “DIY DD”. After all, the companies going public are usually similar in scale, business model and growth to purely-private deals the PE firm will look at in China.

Cornerstone investing is suddenly popular with some PE firms because stock market valuations have fallen so far in Hong Kong. Valuations, in p/e terms, are usually lower now in a Hong Kong IPO than for a comparable company raising money in a private placement in China: 4-8X this year’s net income for the HK IPOs, and 8-10X for the private placements.

PE firms are given money by investors, and usually paid an annual management fee, to take on this risk and trouble of finding good companies, screening them, negotiating a good deal, and then remaining actively engaged, after investment, on the board, to help the company achieve its targets and an eventual exit. This is where the big money has been made in China PE, not in betting on the direction of publicly-traded share prices.

As a stock picking strategy, it’s not unreasonable to suppose that Hong Kong stock prices are now at a cyclical low, and will start to move closer to the valuations on China’s domestic stock markets. If so, then some cornerstone deals may end up making decent money.

But, PE firms are not, or should not be, stock-pickers, market-timers, valuation arbitrageurs. This is truest of all for those PE firms that raised money to invest – actively and passionately — in China’s outstanding private entrepreneurial companies.

 

 

Two New CFC Research Reports

Leave a Comment / April 7, 2013

China First Capital (中国首创）published two new research reports, one in English and one Chinese. Both are now available for download here. The contents are different, as is the focus.

To download the English report, titled “Private Equity in China 2012: The Pace of Change Quickens“, Click here

For the Chinese report, “2012-2013 中国私募股权融资与市场趋势” Click here

In fact, “No Exit” would be the more appropriate title for a report about private equity in China this year. Jean-Paul Sartre‘s famous play of that name is a conversation between three dead people stuck in hell. They are eternally damned. PE funds currently stuck inside Chinese investments with no way to exit are not in such a hopelessly miserable situation. But, some may be feeling that way.

Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all pretty much slammed the door shut on IPOs for Chinese companies. In previous years, over 300 Chinese companies would IPO. This year, that number will fall by at least 80%, maybe more. Stock markets in the US, Hong Kong and China all have slightly different explanations for the sharp drop-off in IPOs of Chinese companies. But, a common thread runs throughout: a deep distrust among investors and regulators of the accuracy of Chinese companies’ financial accounts.  The view is that a Chinese company’s IPO prospectus may be as much a work of fiction as the Sartre play. Under such circumstances, companies can’t IPO, and PE firms can’t find buyers for their illiquid shares.

China’s domestic stock markets were the last to bar the door against Chinese IPOs. Until mid-year, China’s all-powerful securities regulator the CSRC was continuing to process and approve IPO applications, and companies were going public at a rate of about five a week. Then, in July, the whole complex system of approving and placing IPO shares basically stopped functioning. A Chinese company called Xindadi (新大地） exposed a serious defect at the heart of the regulatory system in China. The CSRC’s primarily function is to stop any bad company with dodgy accounts from accessing China’s domestic capital markets. Layer upon bureaucratic layer is piled up inside the CSRC to prevent officials from conspiring together to let a bad company’s application pass through. The underwriter, the lawyers and accountants are also held legally accountable to detect and expose bad companies. Yet Xindadi managed to slip through.

Xindadi’s IPO application was approved by the CSRC and the company was waiting its turn to go public when media reports surfaced that described a rather clumsy, though, nearly-successful fraud. Xindadi’s financial accounts  turned out to be fake from top to bottom. Xindadi’s business model is aptly summarized by comments made nearly a century ago by the US Federal Trade Commission about another rogue outfit, ” fraud, deceit, misrepresentation, dishonesty, breach of trust and oppression.”

The Xindadi IPO was pulled before the underwriters could sell any shares. The CSRC went into a kind of post-traumatic shock from which it’s yet to recover. It basically stopped approving new IPOs in most cases. Meanwhile the number of Chinese companies who’ve filed for IPO continues to lengthen, and now is over 800. If and when the CSRC goes back to its previous rate of approving IPOs, which isn’t likely anytime soon,  it would take four years to clear this backlog.

Predictably, for PE firms in China,  “No Exit” has now turned into “No Entrance”. Not knowing when IPO windows will reopen, PE firms have mainly stopped doing new deals.  Chinese private sector companies, for whom PE is the main source of growth capital, are feeling the pinch. Equity capital, even for good companies,  is difficult, if not impossible, to come by. The abrupt cut-off of PE financing will certainly lead to slower growth and fewer new jobs in China.

IPOs of Chinese companies in the US, Hong Kong and China have been an important, if little recognized, part of China’s growth story over the last decade. They fueled the boom in private equity  — both the creation over the last five years of hundreds of new PE firms and the raising of tens of billions of dollars in new capital –  and with it, a huge increase in total net new investment into China’s private sector companies. Chinese investment, particularly spending by state-owned companies, and government-backed infrastructure projects, is still largely financed by bank lending. But, the equity capital provided by PE firms has played a key part in financing the growth of larger private companies in China.  PE money has underpinned increased competition, choice and economic dynamism in China.

Now that gusher of PE money has turned to a trickle.  What next for private equity and corporate finance in China? The two new CFC reports summarize some of the main developments and trends in private equity and capital markets this year, and makes some predictions about the year to come. The Chinese-language report was written, as are other CFC Chinese reports, for the specific use and reference of domestic Chinese business-owners and senior management. The key message is that it’s getting far more difficult for companies to raise money, either through private placement or IPO.

The English report focuses more heavily on what’s going on in the private equity industry in China. Unlike many, I remain overall extremely positive about the fundamentals in China, that PE investment in China’s growing private sector companies represents the best risk-adjusted investment opportunity in the world. While exits through IPO are far fewer, China’s strongest investment asset remains firmly in place:  the compounded genius of its millions of private entrepreneurs to create wealth and push forward positive social and economic change.

 

Dollars No Longer Welcome

1 Comment / October 23, 2012

2012 is going to be a bad year for new dollar investment in Chinese financial assets. This reverses what was thought to be, only a few years ago, an irreversible trend as more of the world’s largest and most sophisticated investors sought to increase the asset allocation in China. It’s not that China has fallen out of favor with institutional investors. If anything, China’s comparative strengths — in terms of solid +7% economic growth, a vibrant domestic consumer market, reasonably healthy banks, prudent fiscal policy — stand in ever starker contrast with the insipid economies and improvident governments of Europe, the US, Japan.

So, how come fewer dollars are flowing into China? The main reason is that the stock markets in the US and Hong Kong have fallen out of love with Chinese IPOs. These two stock markets have been the primary source for more than a decade of new dollar funding for domestic Chinese companies. Just two years ago, Chinese companies accounted for one-third of all IPOs in the US. The IPO market for Chinese companies listing in Hong Kong was even hotter. Last year, almost $70 billion was raised by Chinese companies listing on the Hong Kong Stock Exchange.

Dollars raised in New York or Hong Kong IPOs were converted into Renminbi, then invested to fuel the growth of hundreds of Chinese private companies and SOEs. Stock markets in London, Frankfurt, Seoul, Singapore, Sydney also provided access for Chinese companies to list and raise capital there. Overall, the international capital markets have been a key source of growth capital for Chinese companies, and so an important part of China’s overall economic transformation.

This year, the US will probably host fewer than five Chinese IPOs, and the total amount raised by Chinese companies in Hong Kong will be down by at least 65% from last year. The two other sources of dollar investment in Chinese companies — private equity and institutional purchases of Chinese shares — are also trending downward. Of the two, PE money was by far the more important, particularly over the last decade. In a good year, over $5 billion of capital was invested into private Chinese companies by PE firms. But, rule changes in China began to make dollar PE investing more difficult starting five years ago. It’s harder now to get permission to convert dollars into Renminbi, and Chinese companies can no longer easily create offshore holding company structures to facilitate dollar investment and an eventual exit through offshore IPO.

Rule changes slowed, but didn’t stop, dollar PE investing in China. The bigger problem now is that stock market investors in the US, and to a slightly lesser extent those in Hong Kong, no longer want to buy Chinese shares at IPO. It’s mainly because retail and institutional investors outside China distrust the quality and truthfulness of Chinese corporate accounting. If offshore IPOs dry up, dollar PE investors have no way to cash out. M&A exit is still rare. The twin result this year: less dollar PE money entering China, and also a steep drop in offshore IPO fundraising for Chinese companies.

Consider what this means: the world’s largest pools of institutional capital are finding it more difficult to invest in the world’s fastest growing major economy. This makes no financial sense. Chinese companies have a huge appetite for growth capital, and have the potential to achieve high rates of return for investors. Investment in China’s private entrepreneurial companies remains perhaps the best risk-adjusted investment class in the world. But, all the same, this year will see a steep drop of new international investment in Chinese companies.

Perhaps partially to compensate, China this year has liberalized the rules somewhat to allow international institutions to buy shares quoted in China. But, since that money goes to buy shares held by other investors, rather than to the company itself, investing in Chinese-quoted shares has little, if any impact, in filling Chinese companies’ need for growth capital. The appeal of owning China-quoted shares is hardly overpowering, as the market has been a poor performer overall, and share prices are more propelled by rumor than fundamental value.

At any earlier time in recent history, a dramatic drop like this year’s in new dollar investment into China would be felt acutely by Chinese companies. But, as dollar investing has dried up, Renminbi investing has more than filled the gap. The Shenzhen and Shanghai stock markets are now far larger sources of fresh IPO capital for Chinese companies than New York or Hong Kong ever were. Also, Renminbi PE firms have proliferated.

For a mix of reasons, China is now, arguably, more financially self-reliant than it has been since Mao’s day. Autarky used to be state policy. Now, it is a consequence of China’s own rising affluence and capital accumulation, together with some nationalistic policy changes and the fall-off in interest among international investors to finance Chinese IPOs. Ironically, as China has been drawn more into the global trade and financial system, its need for external capital has lessened.

That is unfortunate. Dollar investment in China benefits both sides. It offers dollar investors higher potential rates of return than investing in mature developed economies. This means better-funded and more generous pensions for American and European retirees. For Chinese companies, dollar investors usually tend to be more hands-on, in a good way, than Renminbi funds. So, they help improve the overall competitiveness, professionalism, corporate governance and strategic planning of the Chinese firms they invest in. Many of China’s best entrepreneurial companies — including well-known firms like Baidu, Alibaba, Tencent, as well as hundreds of domestic Chinese brand-name companies few outside of China have heard of– were nurtured towards success by dollar investors.

Since just about everyone wins from new dollar investing in China, what can be done to reverse this year’s big slide? The answer is “not a lot”. I don’t see any strong likelihood that international investors will grow less allergic to Chinese IPOs. Renminbi PE and IPO funding for Chinese companies will continue to grow strongly. Only the removal of capital controls in China, and full Renminbi convertibility, would change the current situation, and lead, most likely, to large new flows of offshore capital into China.

But, full Renminbi convertibility is nowhere in sight. For the foreseeable future, China’s growth mainly will be financed at home.

 

 

 

Out of Focus: China’s First Big LBO Deal is a Headscratcher

1 Comment / September 6, 2012

The first rule of capitalism is the more buyers you attract, the higher the price you get. So, having just one potential buyer is generally a lousy idea when your goal is to make as much money as possible.

What then to make of the recently-announced plan by an all-star team of some of China’s largest PE firms, including CDH, Fountainvest, CITIC Capital, as well global giant Carlyle,  to participate in a $3.5 billion proposed leveraged buyout deal to take private the NASDAQ-listed Chinese advertising company Focus Media. Any profit from this “take private” deal, as far as I can tell,  hinges on later flipping Focus Media to a larger company. That’s because the chances seem slight a privatized Focus Media will be later approved for domestic Chinese IPO. But, what if Focus turns out to be flip-proof?

With so much money — as so many big name PE firms’ reputations –  on the line, you’d think there would a clear, persuasive investment case for this Focus Media deal. As far as I can tell, there isn’t. I have the highest respect for the PE firms involved in this deal, for their financial and investing acumen. They are the smartest and most experienced group of PE professionals ever assembled to do a single Chinese deal. And yet, for the life of me, I can’t figure out what they are thinking with this deal and why they all want a piece of this action.

If the goal is to try to arbitrage valuation differences between the US and Chinese stock markets, this deal isn’t likely to pan out. It’s not only that Focus Media will have a tough time convincing China’s securities regulator, the CSRC, to allow it to relist in China. Focus Media is now trading on the NASDAQ at a trailing p/e multiple of 18. That is on the high side for companies quoted in China.

Next problem, of course, is the impact on the P&L from all the borrowing needed to complete the deal. There’s been no clear statement yet about how much equity the PE firms will commit, and how much they intend to borrow. To complete the buyout, the investor group, including the PE firms along will need to buy about 65% of the Focus equity. The other 35% is owned by Focus Media’s chairman and China’s large private conglomerate Fosun Group. They both back the LBO deal.

So, the total check size to buy out all other public shareholders will be around $2.4 billion, assuming they investor group doesn’t need to up its offer. If half is borrowed money, the interest expense would swallow up around 50% Focus Media’s likely 2012 net income. In other words, the LBO itself is going to take a huge chunk out of Focus Media’s net income.  In other words, the PE group is actually paying about twice the current p/e to take Focus Media private, since its purchase mechanism will likely halve profits.

A typical LBO in the US relies on borrowed money to finance more than half the total acquisition cost. The more Focus Media borrows, the bigger the hit to its net income. Now, sure, the investors can argue Focus Media should later be valued not on net income, but on EBITDA. That’s the way LBO deals tend to get valued in the US. EBITDA, though,  is still something of an unknown classifier in China. There isn’t even a proper, simple Chinese translation for it. Separately, Focus Media is already carrying quite a bit of debt, equal to about 60% of revenues. Adding another big chunk to finance the buyout, at the very least,  will create a very wobbly balance sheet. At worst, it will put real pressure on Focus Media’s operating business to generate lots of additional cash to stay current on all that borrowing.

I have no particular insight into Focus Media’s business model, other than to note that the company is doing pretty well while already facing intensified competition. Focus Media doesn’t meet the usual criteria for a successful LBO deal, since it isn’t a business that seems to need any major restructuring, refocusing or realignment of interests between owners and management.

Focus Media gets much of its revenue and profit from installing and selling ads that appear on LCD flatscreens it hangs in places like elevators and retail stores. It’s a business tailor-made for Chinese conditions. You won’t find an advertising company quite like it in the US or Europe. In a crowded country, in crowded urban shops, housing blocks and office buildings, you can get an ad in front of a goodly number of people in China while they are riding up in a jammed elevator or waiting at a checkout counter.

The overall fundamentals with Focus Media’s business are sound. The advertising industry in China is growing. But, it’s hard to see anything on the horizon that will lift its current decent operating performance to another level. Without that, it gets much harder to justify this deal.

This is, it should be noted, the first big LBO ever attempted by a Chinese company. It could be that the PE firms involved want to get some knowledge and experience in this realm, assuming that there could be more Chinese LBOs coming down the pike. Maybe. But, it looks like it could be pretty expensive tuition.

Assuming they can pull off the “delist” part of the deal, the PE firms will need to find a way to exit from this investment sometime in the next three to five years. Focus Media’s chairman has been vocal in complaining about the low valuation US investors are giving his company. In other words, he believes the company’s shares can be sold to someone else, at some future date, at a far higher price. (He personally owns 17% of the equity.)

Who exactly, though, is this “someone else”? Relisting Focus Media in China is a real long shot, and anyway, the current multiples, on a trailing basis, are comparable with NASDAQ’s . This is before calculating the hit Focus Media’s earnings will take from leveraging up the company with lots of new debt. How about the Hong Kong Stock Exchange? Focus Media would likely be given a warm welcome to relist there. One problem: with Hong Kong p/e multiples limping along at some of the lowest levels in the world, the relisted Focus Media’s market value would almost certainly be lower than the current price in the US. Throw in, of course, millions of dollars in legal fees on both sides of the delist-relist, and this Hong Kong IPO plan looks like a very elaborate way to park then lose money.

That leaves M&A as the only viable option for the PE investor group to make some money. I’m guessing this is what they have on their minds, to flip Focus Media to a larger Chinese acquirer.  They may have already spoken to potential acquirers, maybe even talked price. The two most obvious acquirers, Tencent Holdings and Baidu, both may be interested. Baidu has done some M&A lately, including the purchase, at what looks to many to be a ridiculously high price, of a majority of Chinese online travel site Qunar.  So far so good.

The risk is that neither of these two giants will agree to pay a big price down the line for a company that could buy now for much less. The same logic applies to any other Chinese acquirer, though they are few and far between. I’d be surprised if Tencent or Baidu haven’t already run the numbers, maybe at Focus Media’s invitation. But, they didn’t make a move. Not up to now.

Could it be they don’t want to do the buyout directly, out of fear it could go wrong or hurt their PR? Maybe. But, I very much doubt they will be very eager to play the final owner in a very public “greater fool” deal.

I’m fully expecting to be proven wrong eventually by this powerhouse group of PEs, and that they will end up dividing a huge profit pile from this Focus Media LBO. If so, the last laugh is on me. But,  as of now, the Focus deal’s investment logic seems cockeyed.

 

 

The CSRC Disciplines the IPO Process in China

Leave a Comment / June 11, 2012

By turns mysterious, unpredictable, overextended yet under-experienced, byzantine in its complexity and frustrating for all who deal with it, the CSRC (“证监会”) comes in for a lot of criticism. The Chinese stock market regulator makes and enforces the rules for all 3,200 public companies traded on the Shanghai and Shenzhen stock exchanges. Though modeled after the US Securities and Exchange Commission, the CSRC’s remit is far broader. It alone decides which companies will be allowed to IPO. It plays gatekeeper, not just referee.

To win CSRC approval, it is by no means enough, as it usually is in the US, to have an underwriter and a few years of audited financials. All of the seven hundred IPO aspirants waiting in the queue for CSRC approval have these. Only a small minority will manage to jump through all the CSRC hoops and win approval for an IPO. The CSRC makes its own judgment about a company’s business model, future prospects, management caliber, shareholder structure, customer concentration, competitive position, planned use of IPO proceeds, the cleanliness of any outside investor’s money, related-party transactions, the appropriate IPO valuation, even the marital status of a company’s founder.

In effect, the CSRC is doing its utmost to take the “caveat” out of “caveat emptor”, by detecting ahead of time any taint that could damage a company’s post-IPO process. The CSRC can of its own volition forbid companies in an industry to IPO, as it did recently with real estate developers and private steel companies.

The purpose is to starve them of capital. It can also, just as suddenly, reverse its prior course and allow once-blacklisted industries to access public markets. It seems to be doing this now with Chinese companies in the restaurant industry. It can also play favorites. Companies from China’s restive Xinjiang region are currently given special priority, and shown more leniency, in approving IPOs.

The CSRC’s approach to IPO screening is not dissimilar to the way Goldman Sachs chooses companies to underwrite. Each is trying to select “sure bets”, companies that won’t prove an embarrassment a few year’s down the road. Goldman does it to make money and keep its high reputation, the CSRC to avoid social upheaval. Keeping China’s stock markets scandal free is a matter of paramount national importance. So far, the CSRC has succeeded at this.

Accounting and disclosure scandals have become commonplace for Chinese companies quoted in Hong Kong and the US. Not in China. Credit the CSRC’s thorough IPO filtering. The CSRC also keeps a tight lid on the supply of IPOs each year to prevent new issues from weighing down overall market valuation.

There is another overlooked benefit to the CSRC’s stringent IPO approval process.  It weeds out the flim-flammery, hype and exaggerated salesmanship from the IPO process. Any company approved by the CSRC for an IPO is all but guaranteed a successful closing. The underwriters have it easy. They barely need to break a sweat.

The same is most definitely not the case in the US and Hong Kong, for example. There, regulatory approval is the first and simplest step in an expensive, tightly-choreographed, quite often unsuccessful effort by underwriters to drum up investor interest and get them to bite. It involves a fair bit of hucksterism.  In the US,  IPO underwriters are salespeople. In China, they are order-takers.

Chinese underwriters have limited discretion over IPO pricing. For one thing, the CSRC is watching, and can deal severely with underwriters who seek what the CSRC decides are “overpriced” valuations. It seems like everyone in China knows where IPO valuation multiples are at any given time. At the moment, they are around 35 times last year’s net income for smaller companies listing on the Chinext, and around 25 times for larger companies.  The CSRC has grown increasingly vocal in criticizing big first day gains for newly-IPO’d companies.

The CSRC does not approve IPO applications of companies that don’t have at least two years of profits or ones that have huge numbers of users, but comparatively light profits. That is to say, no Facebook, Groupon or Linkedin types are allowed. This, too, removes a lot of the investment banking sales wizardry seen in the US during the IPO process.

One positive result of this is that underwriters in China are limited in what they can promise companies to win an IPO mandate. Good, bad or indifferent, an underwriter is likely to get just about the same price for shares it sells in an IPO. So, basically, winning mandates in China comes down to a lot of wining and dining, Karaoke and cartons of expensive cigarettes.

Since the CSRC’s approval process can drag on for up to two to three years, underwriters also have little, to no, say over IPO timing. The risk in the IPO process in China is, overwhelmingly, the risk of rejection by the CSRC. The CSRC rules mean underwriters and company are in it together. The underwriter needs to be active throughout the long process, and present at many meetings with the CSRC. The underwriters put their neck on the line by providing guarantees to the CSRC on the soundness of a company’s financials and pre-IPO disclosure.

Having seen the process from both angles, ten years ago as CEO of a US company during part of its IPO process, and now in China, working with clients seeking CSRC approval, my view is that the CSRC’s method has a lot to recommend itself. It puts far more focus on the company and less on its investment banker. An IPO in China is not so much a test of an underwriter’s marketing prowess and placement network, but more state-directed capital deployment to companies deemed by the CSRC to be most suitable and fit to receive a slice of  the public’s savings. Who the underwriter is and how they operate are basically afterthoughts.

This may offend against the market principles of a lot of financial professionals, that the only real IPO test a company should need to pass is if an investor will send a check to buy its shares. But, “safety first” seems a good principle for China at this stage. Private companies have only had access to China’s capital markets, in a substantial way, for two years, with the opening of the Chinext (创业板）board.

The stock market is now –and will remain — the lowest-cost way to finance the growth of private enterprise in China. Everyone stands to lose if confidence is badly shaken, or a scandal takes down one of these once-private now-public companies. For this reason, though many investment professionals are mystified by its decisions and sudden about-faces, the CSRC earns my support and respect.

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

Leave a Comment / March 6, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Too Few Exits: The PE Camel Can’t Pass Through the Eye of China’s IPO Needle

2 Comments / February 21, 2012

The amount of capital going into private equity in China continues to surge, with over $30 billion in new capital raised in 2011. The number of private equity deals in China is also growing quickly. More money in, however, does not necessarily mean more money will come out through IPOs or other exits. In fact, on the exit side of the ledger, there is no real growth, instead probably a slight decline, as the number of domestic IPOs in China stays constant, and offshore IPOs (most notably in Hong Kong and USA) is trending down. M&A activity, the other main source of exit for PE investors,  remains puny in China. 

This poses the most important challenge to the long-term prospects for the private equity industry in China. The more capital that floods in, the larger the backlog grows of deals waiting for exit. No one has yet focused on this issue. But, it is going to become a key fact of life, and ultimately a big impediment, to the continued expansion of capital raised for investing in China. 

Here’s a way to understand the problem: there is probably now over $50 billion in capital invested in Chinese private companies, with another $50 billion at least in capital raised but not yet committed. That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15mn. 

At the moment, only about 250 Chinese private companies go public each year domestically. The reason is that the Chinese securities regulator, the CSRC, keeps tight control on the supply of new issues. Their goal is to keep the supply at a level that will not impact overall stock market valuations. Getting CSRC approval for an IPO is becoming more and more like the camel passing through the eye of a needle. Thousands of companies are waiting for approval, and thousands more will likely join the queue each year by submitting IPO applications to the CSRC.

Is it possible the CSRC could increase the number of IPOs of private companies? In theory, yes. But, there is no sign of that happening, especially with the stock markets now trading significantly below their all-time highs. The CSRC’s primary role is to assure the stability of China’s capital markets, not to provide a transparent and efficient mechanism for qualified firms to raise money from the stock market. 

Coinciding now with the growing backlog of companies waiting for domestic IPOs, offshore stock markets are becoming less and less hospitable for Chinese companies. In Hong Kong, it’s generally only bigger Chinese companies, with offshore shareholder structure and annual net profits of at least USD$20 million, that are most welcome.

In the US, most Chinese companies now have no possibility to go public. There is little to no investor interest. As the Wall Street Journal aptly puts it, “Investors have lost billions of dollars over the last year on Chinese reverse mergers, after some of the companies were accused of accounting fraud and exaggerating the quality and size of their assets. Shares of other Chinese companies that went public in the United States through the conventional initial public stock offering process have also been punished out of fear that the problem could be more widespread.”

Other minor stock markets still actively beckon Chinese companies to list there, including Korea, Singapore, Australia. Their problem is very low IPO price-earnings valuations, often in single digits, as low as one-tenth the level in China. As a result, IPOs in these markets are the choice for Chinese companies that truly have no other option. That creates a negative selection bias.  Bad Chinese companies go where good companies dare not tread. 

For the time being, LPs still seem willing to pour money into funds investing in China, ignoring or downplaying the issue of how and when investments made with their money will become liquid. PE firms certainly are aware of this issue. They structure their investment deals in China with a put clause that lets them exit, in most cases, by selling their shares back to the company after a certain number of years, at a guaranteed annual IRR, usually 15%-25%. That’s fine, but if, as seems likely, more and more Chinese investments exit through this route, because the statistical likelihood of an IPO continues to decline, it will drag down PE firms’ overall investment performance.

Until recently, the best-performing PE firms active in China could achieve annual IRRs of over 50%. Such returns have made it easy for the top firms like CDH, SAIF, New Horizon, and Hony to raise money. But, it may prove impossible for these firms to do as well with new money as they did with the old. 

These good firms generally have the highest success rates in getting their deals approved for domestic IPO. That will likely continue. But, with so many more deals being done, both by these good firms as well as the hundreds of other newly-established Renminbi firms, the percentage of IPO exits for even the best PE firms seems certain to decline. 

When I discuss this with PE partners, the usual answer is they expect exits through M&A to increase significantly. After all, this is now the main exit route for PE and VC deals done in the US and Europe. I do agree that the percentage of Chinese PE deals achieving exit through M&A will increase from the current level. It could barely be any lower than it is now.

But, there are significant obstacles to taking the M&A exit route in China, from a shortage of domestic buyers with cash or shares to use as currency, to regulatory issues, and above all the fact many of the best private companies in China are founded, run and majority-owned by a single highly-talented entrepreneur. If he or she sells out in M&A deal,  the new owners will have a very hard time doing as well as the old owners did. So, even where there are willing sellers, the number of interested buyers in an M&A deal will always be few. 

Measured by new capital raised and investment results achieved, China’s private equity industry has grown a position of global leadership in less than a decade. There is still no shortage of great companies eager for capital, and willing to sell shares at prices highly appealing to PE investors. But, unless something is done to increase significantly the number of PE exits every year,  the PE industry in China must eventually contract. That will have very broad consequences not just for Chinese entrepreneurs eager for expansion capital and liquidity for their shares, but also for hundreds of millions of Chinese, Americans and Europeans whose pension funds have money now invested in Chinese PE. Their retirements will be a little less comfortable if, as seems likely,  a diminishing number of the investments made in Chinese companies have a big IPO payday.

 

 

 

ChiNext: One Year Later, Celebrating a Success

1 Comment / November 1, 2010

Zhou dynasty from China First Capital blog post

This past Saturday, October 30,  marked the one year anniversary of the founding of the ChiNext (创业板) stock market. In my view, the ChiNext has been a complete and unqualified success, and should be a source of pride and satisfaction to everyone involved in China’s financial industry. And yet, there’s quite a lot of complaining and grumbling going on, about high share prices, high p/e multiples,  “underperformance” by ChiNext companies, and the potentially destabilizing effect of insiders’ share sales when their 12-month lockup period ends.

Let’s look at the record. Over the last year, the board has grown from the original 28 companies to 134, and raised a total of 94.8 billion yuan ($14bn). For those 134 companies, as well as hundreds more now queuing up for their ChiNext IPO, this new stock market is the most important thing to ever happen in China’s capital markets.

Make no mistake, without the ChiNext, those 134 companies would be struggling to overcome a chronic shortage of growth capital. That Rmb 94.8 billion in funding has supported the creation of thousands of new jobs,  more indigenous R&D in China, and provided a new and powerful incentive system for entrepreneurs to improve their internal controls and accounting as a prelude to a planned ChiNext IPO.

China’s retail investors have responded with enthusiasm to the launch of ChiNext, and support those high p/e multiples of +50X at IPO. It is investors, after all, who bid up the price of ChiNext shares, and by doing so, allow private companies to raise more capital with less dilution. Again, that is a wholly positive development for entrepreneurship in China.

Will some investors lose money on their investments in ChiNext companies? Of course. That’s the way all stock markets work. The purpose of a stock market is not to give investors a “one way bet”. It is to allocate capital.

I was asked by a Bloomberg reporter this past week for my views on ChiNext. Here, according to his transcript,  is some of what I told him.

“For the first time ever, the flow of capital in China is beginning to more accurately mirror where the best growth opportunities are. ChiNext is an acknowledgement by the government of the vital importance of entrepreneurial business to China’s continued economic prosperity. ChiNext allocates growth capital to businesses that most need and deserve it, and helps address a long-standing problem in China’s economy: capital being mainly allocated to state-owned companies. The ChiNext is helping spur a huge increase of private equity capital now flowing to China’s private companies. Within a year my guess is the number of private equity firms and the capital they have to invest in China will both double.”

A market economy functions best when capital can flow to the companies that can earn the highest risk-adjusted return. This is what the ChiNext now makes possible.

Yes, financial theory would argue that ChiNext prices are “too high”, on a p/e basis. Sometimes share prices are “too high”, sometimes they are “too low”, as with many Chinese companies quoted on the Singapore stock market. A company’s share price does not always have a hard-wired correlation to the actual value and performance of the company. That’s why most good laoban seldom look at their share price. It has little, if anything, to do with the day-to-day issues of building a successful company.

Some of the large shareholders in ChiNext companies will likely begin selling their shares as soon as their lock-up period ends. For PE firms, the lock-up ends 12 months after an IPO. If a PE firm sells its shares, however, it doesn’t mean the company itself is going sour. PE firms exist to invest, wait for IPO, then sell and use that money to repay their investors, as well as invest in more companies. It’s the natural cycle of risk capital, and again, promotes overall capital efficiency.

There are people in China arguing that IPO rules should be tightened, to make sure all companies going public on ChiNext will continue to thrive after their IPO. That view is misplaced. For one thing, no one can predict the future performance of any business. But, in general, China’s capital market don’t need more regulations to govern the IPO process. China already has more onerous IPO regulations than any other major stock market in the world.

The objective of a stock market is to let  investors, not regulators, decide how much capital a company should be given.  If a company uses the capital well, its value will increase. If not, then its shares will certainly sink. This is a powerful incentive for ChiNext company management to work hard for their shareholders. The other reason: current rules prohibit the controlling shareholders of ChiNext companies from selling shares within the first three years of an IPO.

The ChiNext is not a path to quick riches for entrepreneurs in China. It is, instead, the most efficient way to raise the most capital at the lowest price to finance future growth. In the end, everyone in China benefits from this. The ChiNext is, quite simply,  a Chinese financial triumph.


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Meet China’s Newest — and Maybe Most Deserving — Billionaire

1 Comment / June 2, 2010

Aisidi

According to the most recent calculation by Forbes Magazine, there are about 800 dollar billionaires in the world. As of last week, there may be one more, Huang Shaowu.  And he’s a friend of mine.

On Friday, trading began on the Shenzhen Stock Exchange of mobile phone distributor and retailer Aisidi (爱施德) (Ticker: 002416) The IPO raised over RMB1.8 billion for the company, at a price-earnings multiple of 50. It leaves Shaowu’s holding company still in control of about 70% of the shares, now worth a little over $2 billion.

I was at the party to celebrate the IPO at the Hyatt in Shenzhen, along with about 300 others. The last time I saw Shaowu was about three weeks ago, after traveling around Shandong together for four days. Shaowu is a modest and sincerely warm man. He would never brag about his business. But make no mistake, he has a lot to brag about.

Aisidi is a leading distributor and retailer of mobile phones and Apple products in China. Its 2009 revenues were Rmb 8.75 billion (USD$1. 28bn), while net income reached Rmb875mn ($128mn). In the first quarter of 2010 net income rose by 70% over first quarter of 2009.

Aisidi got its start back in 1998, at a time when the mobile phone market in China was a fraction of its current size. That year, China Mobile had 25 million subscribers. As of now, they have over 700 million. In 1998, China was still then considered a poorer, developing nation. Shaowu took a big gamble back then, to begin distributing only brand-name mobile phones, and sell them at full market price. Shaowu saw more clearly than most the direction China’s mobile phone industry would take.

Aisidi’s business has grown enormously since 1998.  It acts as the trusted distributor for many of the top mobile phone brands, including Samsung, Sony Ericsson as well as Apple’s iPhone. It also has partnerships with China Mobile, China Telecom, China Unicom.

Aisidi doesn’t distribute, sell or otherwise transact in any way with shanzhai manufacturers. Only the genuine articles. Aisidi is also the key part of Apple’s retail strategy in China, with a market share of 45% of all Apple products sold in China.

The boss of Apple China was at Aisidi’s IPO party last week. I chatted with him, and for those who are wondering, there is still no timetable for when Apple’s new iPad will go on sale in China. When it does, it is certain to add significantly to Aisidi’s revenues and profits.

Way ahead of the pack, Shaowu saw that there was a market – and it turns out a truly enormous one – serving the Chinese who would pay top-dollar for phones they knew came straight from manufacturers, and would be repaired professionally and promptly if anything went wrong.

Shaowu built Aisidi to have the products and prices that allowed it to make money from the start and to become one of the larger private corporate tax-payers in China. Now as a public company, Aisidi has the resources to grow into one of China’s biggest entrepreneur-founded companies.

Shaowu  made his money doing something that took guts and insight. It was a real joy helping him celebrate Aisidi’s IPO. His success is deserved. He is both a nice guy and a helluva businessman.


Navigating China’s Treacherous IPO Markets

Leave a Comment / January 11, 2010

Song plate from China First Capital blog post

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

2 Comments / January 4, 2010

Ming Dynasty flask, from China Private Equity blog post

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

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

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

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

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

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

chart1









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

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

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

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

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

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

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

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

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