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Smithfield & Shuanghui: One little piggy comes to market — Week In China

Leave a Comment / June 24, 2016

week in china

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A record bid for America’s top pork producer isn’t quite as it first appears

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“What I do is kill pigs and sell meat,” Wan Long, chairman at Henan Shuanghui Development, told Century Weekly last year.

It’s an admirably succinct job description for a man who has been lauded by China National Radio as the “Steve Jobs of Chinese butchery” (Jobs, a vegan, probably wouldn’t have approved).

Starting out with a single processing factory in Luohe in Henan province, Shuanghui is now the largest meat producer in China, having benefitted in recent years from a shift in the Chinese diet away from rice and vegetables towards more protein.

So the announcement that it is now making a bid for the world’s largest hog producer, Smithfield Foods from Virginia in the US, prompted a flurry of headlines about the significance of the deal; its chances of getting security clearance from the Committee on Foreign Investment in the United States (CFIUS); and the broader implications for the meat trade in both countries if the takeover goes through.

Yet although Wan makes his profession sound like a simple one, Shuanghui’s bid for Smithfield turns out to be rather more complicated than many first assumed. Far from a case of a Chinese firm swooping in on an American target, the takeover reflects more complex trends too, including some of the peculiarities of the Chinese capital markets.

What first made headlines on the deal?

Privately-owned Shuanghui International has bid $7.1 billion for Smithfield Foods (including taking on its debt) in what the media is widely presenting as the biggest acquisition yet by a Chinese company of a US firm.

Shuanghui has processing plants in 13 provinces in China and produces more than 2.7 million tonnes of meat each year. But the plan is now to add Smithfield’s resources to the mix. “The acquisition provides Smithfield the opportunity to expand its offering of products to China through Shuanghui’s distribution network,” Wan announced. “Shuanghui will gain access to high-quality, competitively-priced and safe US products, as well as Smithfield’s best practices and operational expertise.”

What’s behind the move?

Most analysts have chosen to focus on Shuanghui’s desire to secure a more consistent supply of meat. Currently, it raises 400,000 of its own hogs a year, only a small share of the 11 million that it needs. That makes it reliant on other breeders in a country where the latest scare about contaminated meat is never far from the headlines. In the most recent case in March, the carcasses of thousands of pigs suddenly started floating down the Huangpu river upstream of Shanghai, after an outbreak of disease in nearby farms and a clampdown on the illicit sale of infected meat (see WiC186).

Now Shuanghui is said to be looking further afield to secure meat, and from a source that would allow it to differentiate its product range from that of its competitors.

“They’re a major processor who wants to source consistent, large volumes of raw material. You want to look at the cheapest sources and in the US, we’re very competitive,” Joel Haggard from the US Meat Export Federation told Bloomberg. Average hog prices in China are currently about $2.08 per kilo or a third higher than in the United States, Haggard also suggested.

How about changes in the industry in China?

A second theory is that Shuanghui is developing a more integrated supply chain in China and wants Smithfield’s help to complete the process.

This was something that C Larry Pope, chief executive at Smithfield, cited as a key factor in its willingness to pay a 31% premium for Smithfield stock. If so, that’s something of an irony: Continental Grain, Smithfield’s largest investor, has been pushing for a break up of the business to unlock more value for investors.

Still, an argument can be made that industry conditions are different in China, where the supply chain is shifting away from its reliance on more traditional household farming (the Mandarin character for “home” depicts a pig under a roof, for instance) to one in which large-scale, industrialised production begins to dominate.

Food safety concerns and the need to improve quality standards are also driving change across the industry. Yet despite signs of consolidation in hog breeding and slaughtering, integration across the full supply chain is a challenge. Shuanghui has already been trying to develop more of its own cold chain rather than rely on third parties (it operates seven private railways to transport its goods to 15 logistics centres, for instance, and has also invested in hundreds of its own retail outlets). But the Smithfield acquisition could help further with the integration effort, especially in areas such as adopting technology that tracks meat from farm to fork.

Paul Mariani, a director at agribusiness firm Variant Capital Advisors, told the Wall Street Journal last week that these systems have huge food safety benefits, allowing producers to track meat back to “where it was grown”. By contrast, Chinese suppliers struggle to achieve the same level of control, especially for meat sourced from the large number of smaller, family-owned firms.

How about in the US? Are Americans pleased with the deal?

The bid has already been referred to CFIUS, the committee that reviews the national security implications of foreign investments in US firms. But Smithfield’s Pope sounds confident, saying that he doesn’t expect “any concern” from the regulatory committee.

“We’re not exporting tanks and guns and cyber security,” he told reporters. “These are pork chops.”

All the same, the regulators will look at Smithfield’s supply contracts with the military, as well as whether any of its farms and factories are close to sensitive locations, an issue that has led to transactions being blocked or amended in the past.

For instance, the Obama administration intervened in the purchase of four Oregon wind farms by a Chinese acquirer this year because they were too close to a naval base.

“There’s a difference between a foreign company buying Boeing and one buying a hot dog stand,” Jonathan Gafni, president of Compass Point Analytics, which specialises in security reviews of this type, told the New York Times. “But it depends on which corner the stand is on.”

The committee will also look at whether Shuanghui could be in a position to disrupt the distribution of pork to American consumers. Indeed, Charles Grassley, the Republican Senator of Iowa, has already urged regulators to look closely at whether the Chinese government has any influence on Shuanghui’s management.

More ominously on Wednesday the chairwoman of the Senate’s Agriculture Committee expressed her concerns. Debbie Stabenow said those federal agencies considering the merger must take into account “China’s and Shuanghui’s troubling track record in food safety”. She further added that those agencies must “do everything in their power to ensure our national security and the health of our families is not jeopardised”.

Despite such concerns, the food security argument looks limited in scope, although some of the Chinese newspapers don’t expect the review to pass without issue. “Even the conspicuous absence of national security factors can hardly guarantee that US protectionists will not poke their noses into it,” the China Daily suggested pointedly.

Back in Washington, Elizabeth Holmes, a lawyer working for the Center for Food Safety, has also called for regulators to consider the bid from the wider perspective of food safety. “They’re supposed to identify and address any national security concerns that would arise,” she warned. “I can’t imagine how something like public health or environmental pollution couldn’t be potentially construed as a national security concern.”

The implication is that the takeover might damage Smithfield’s operations in the United States in some way, even leading to contamination among its locally sold products. Hence the fact that Shuanghui was forced to recall meat tainted by the additive clenbuterol two years ago has been seized upon by the deal’s critics.

Again, the Chinese media response has tended to be indignant, with widespread reference to Smithfield’s own use of ractopamine, an additive similar to clenbuterol that’s banned in hog rearing in China but not by authorities in the US.

According to Reuters, Smithfield has been trying to phase out its usage of the drug, presumably to clear the way for an increase in sales to China. And in response to American anxiety about food safety post-takeover at Smithfield, both parties have gone out of their way to reiterate that the goal is to export more American pork to the Chinese, and not vice versa. Smithfield’s chief executive Pope has argued the case directly, citing the superiority of American meat. “People have this belief…that everything in America is made in China,” he told reporters. “Open your refrigerator door, look inside. Nothing in there is made in China because American agriculture is the most competitive and efficient in the world.”

Similarly, Shuanghui executives are insisting that nothing will change in how Smithfield serves up its sausages to American customers. The company will continue to be run on a standalone basis under its current management team, no facilities will be closed, no staff will be made redundant and no contracts will be renegotiated. Food safety standards will remain as today. “We want the business to stay the same, but better,” Wan said.

So it sounds like the Smithfield deal could turn out to be a major coup for the Chinese buyer?

Not really, says Peter Fuhrman, chairman of China First Capital, a boutique investment bank and advisory firm based in Shenzhen. He thinks that much of the analysis of the bid for Smithfield has completely missed the point. That’s because Shuanghui International – the entity making the offer – is a shell company based in the Cayman Islands. It isn’t a Chinese firm at all, he says.

Shuanghui International also has majority control of Shuanghui Development, the Shenzhen-listed firm that runs the domestic meat business in China. But it is controlled itself by a group of investors led by the private equity firm CDH (based in China but heavily backed by Western money) and also featuring Goldman Sachs, Temasek Holdings from Singapore and Kerry Group.

The management at Shuanghui, led by Wan, holds a small stake in the new, offshore entity. But as far as Fuhrman is concerned, Shuanghui International has no legal or operational connection to Shuanghui’s domestic operations.

“If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.”

Of course, this raises questions about how the bid for Smithfield is being debated, especially its portrayal as the biggest takeover of a US firm by a Chinese one to date. It prompts queries too about the national security review underway in Washington, particularly any focus on the supposedly Chinese identity of the bidder. As it turns out, the Shuanghui bidding vehicle simply isn’t constituted in the way that people like Senators Grassley and Stabenow seem to believe.

So what is going on? Fuhrman says the bid for Smithfield is actually a leveraged buyout, made during a period in which private equity firms have been prevented from exiting their investments in China by blockages in the IPO pipeline (see WiC176 for a fuller discussion on this).

Instead, the investors that own Shuanghui are borrowing billions of dollars from the Bank of China and others to fund their purchase, with Fuhrman noting speculation that the plan is to relist Smithfield at a premium in Hong Kong in two or three years time.

How Shuanghui International is going to meet the interest payments on its borrowings in the meantime is less clear. But one possibility is that it will lean on Shuanghui Development, the operator in the Chinese market, to share some of the financial load. That could be problematic, raising hackles at the China Securities Regulatory Commission. It also prompts questions about the potential conflicts of interest (“among the most fiendish I’ve ever seen,” says Fuhrman) in the relationship between the investors that own Smithfield and the fuller group of shareholders at Shuanghai in China.

Ma Guangyuan, an economics blogger with more than half a million readers, takes a similar view. “If Shuanghui International acquires Smithfield Foods and sells the meat at high prices to Shuanghui Development, this will increase profits for the privatised Smithfield, but may not do much to help Shuanghui Development,” he predicts.

A further possibility is that having to service the LBO debt could curtail much of the investment envisaged by those who see the Smithfield purchase as a game-changing move for the industry. Of course, if it all goes to plan, the bid for Smithfield might turn out to be a game-changer for a small group of highly leveraged investors.But the jury must still be out on whether it will be quite so transformational for China’s domestic meat industry at large.

 

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China M&A: Three Recent Deals

Leave a Comment / June 4, 2013

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In the last month, three large takeovers were announced involving Chinese companies. In two of these, PE buyout firms (CITIC Capital and Blackstone)  are offering to take private Chinese companies (AsiaInfo-Linkage and Pactera) quoted on the US stock exchange. In the third, a Chinese acquirer (Shuanghui International) has offered to purchase all shares of US pork producer Smithfield Foods.

I’ve done a quick comparison of these deals across a range of financial variables — premium offered to current shareholders, p/e ratio, profit growth, last two years’ share price performance. I’ve also offered my own judgment on the risks and the industrial logic of the deal, on a scale of 1-10.

The results: the troubled deals, the ones with the highest risks and deepest uncertainties about future performance, with the most anemic share prices up to the date of the offer, with claims or investigations of accounting fraud, with the least industrial logic, are commanding the higher price.

Ah, the Mysterious Orient.

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Correction: I wrote this article based on the first day’s English-language media coverage of the Smithfield-Shuanghui International takeover. Big mistake. I took at face value the media’s account that this was a merger between China’s largest pork producer and America’s. Turns out the coverage was wrong, and so my conclusion was also. In the software business, it’s called GIGO, “Garbage in, garbage out.” The Smithfield-Shuanghui deal is every bit as precarious an LBO as the other two. The only improvement is that the target company, Smithfield, is a better and more transparent business than AsianInfo-Linkage or Pactera. For the real situation on this Smithfield deal, see this blog post.

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M&A Policy & Policy-making in China — A Visit to China’s Ministry of Commerce

Leave a Comment / May 28, 2013

(Me in borrowed suit* alongside Deputy Director General of the Policy Research Department, China Ministry of Commerce)

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China’s Ministry of Commerce invited me last week to give a private talk at their Beijing headquarters. The subject was the changing landscape for M&A in China. It was a great honor to be asked, and a thoroughly enjoyable experience to share my views with a team from the Policy Research Department at the Ministry.

For those whose Chinese is up to it, you can have a look at the PPT by clicking here.  The title translates as “China’s M&A Market: A New Strategy Targeting Unexited PE Deals”.

My China First Capital colleague, and our company’s COO, Dr. Yansong Wang offered our firm’s view that the current crisis of unexited private equity deals is creating an important opportunity for M&A in China to help strengthen, consolidate and restructure the private sector. Buyout firms and strategic acquirers, both China domestic and offshore, will all likely step up their acquisition activity in coming years, targeting China’s stronger private sector companies.

Potentially, this represents a highly significant shift for M&A in China, and so a shift in the workload and travel schedule of the Ministry of Commerce officials. M&A within China, measured both in number and size of deals,  has historically been a fraction of cross-border transactions like the acquisition of Volvo or Nexen. 

The Ministry of Commerce occupies the most prominent location of any government department in China, with the exception of the Public Security Ministry. Both are on Chang’an Avenue (aka “Eternal Peace Street” on 长安街）a short distance from Tiananmen Square. 

The Ministry of Commerce plays an active and central role in economic policy-making. Many of the key reforms and policy changes that have guided China’s remarkable economic progress over the last thirty years got their start there. The Ministry of Commerce is also the primary regulator for most M&A deals in China, both domestic and cross-border.

The key sources of growth for China’s economy have shifted from SOEs to private sector companies, from exports to satisfying the demands of China’s huge and fast-growing domestic market. In the future, M&A in China will follow a similar path. That was the main theme of our talk. More M&A deals will involve Chinese private sector companies combining either with each other, or being acquired by larger international companies eager to expand in China.

Ministry officials were quick to grasp the importance of this shift. They asked if policy changes were required or new administrative practices. We shared some ideas. China’s FDI has slowed recently. That is an issue of substantial concern to the Ministry of Commerce. M&A targeting China’s private sector companies represents a potentially useful new channel for productive foreign capital to enter China.

M&A, as the Ministry officials quickly understood, also can help ease some of the pain caused to private companies by the block in IPOs and steep decline in new private equity funding. In particular, they focused their questions on the impact on Chinese larger-scale private sector manufacturing industries.

I found the officials and staff I met with to be practical, knowledgeable and inquisitive. Market forces, and the exit crisis in China’s private equity industry, are driving this change in the direction of M&A in China. But, policies and regulatory guidance issued from the Ministry of Commerce headquarters can – and I believe will — also play a constructive role.

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* Three days before my visit,  the Ministry of Commerce suggested I should probably wear a suit, as senior officials there do.  By that time, I’d already arrived in Beijing, so needed to borrow one from a friend. The suit was tailored for someone 40 pounds heavier. As a result, as the above photo displays, I managed to be overdressed and poorly-dressed at the same time.

 

 

China PE value-added: Empty promises? AVCJ

Leave a Comment / December 5, 2014

Fin

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Author: Tim Burroughs

Asian Venture Capital Journal | 22 May 2013 | 15:47 secure

Tags: Gps | China | Operating partners | Buyout | Growth capital |Lunar capital management | Cdh investments management | Citic capital partners | Kohlberg kravis roberts & co. (kkr) | Jiuding Capital | Hony capital

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       –China value-add: Empty promises?

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Pulled by a desire to buy and build or pushed by a need to address restricted exit options, PE firms in China are placing greater emphasis on operational value-add. LPs must decide who’s all talk and who is action

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By the time Harvard Business School published its case study of Kunwu Jiuding Capital in December 2011, the investment model being celebrated was already fading.

Within four years of its launch, the private equity firm had amassed $1 billion in funds and 260 employees, having turned itself into a PE factory “where investment activities were carried out in a way similar to large-scale industrial production.” Jiuding’s approach focused on getting a company to IPO quickly and leveraging exit multiples available on domestic bourses; and then repeating the process several dozen times over. With IRRs running to 500% or more, an army of copycats emerged as renminbi fundraising jumped 60% year-on-year to $30.1 billion in 2012.

But the average price-to-earnings ratio for ChiNext-listed companies had slipped below 40 by the end of 2011, compared to 129 two years earlier; SME board ratios were also sliding. Already denied the multiples to which they were accustomed, nearly a year later these pre-IPO investors were denied any listings at all as China’s securities regulator froze approvals.

The Harvard Business School case study noted that concerns had been raised about the sustainability of the quick-fire approach, given that some of these GPs appeared to lack the skills and experience to operate in normalized conditions. “The short-term mentality creates volatility,” Vincent Huang, a partner at Pantheon, told AVCJ in October 2011. “A lot of these GPs don’t have real value to add and so they won’t be in the market for the long run.”

Subsequent events have elevated the debate into one of existential proportions for pre-IPO growth capital firms. Listings will return but it is unclear whether they will reach their previous heights: the markets may be more selective and the valuations more muted.

There is also a sense that GPs have been found out lacking a Plan B; renminbi fundraising dropped to $5.1 billion in the second half of 2012. The trend is reflected on the US dollar side as the slowdown in Hong Kong listings over the course of the year left funds with ever decreasing certainty over portfolio exits. If GPs – big or small – face holding a company for longer than expected, what are they going to do with it?

“We value control and we can take advantage of the M&A markets if we have it. We also like the IPO markets here but any investment where we aren’t a controlling shareholder, we can’t set down the timetable for exit,” says H. Chin Chou, CEO of Morgan Stanley Private Equity Asia. “We ask ourselves, ‘Do we like holding this investment for five years because there is no IPO? At some point the IPO market will come back but until then you have to be very comfortable holding it.”

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Blackstone Leads Latest Chinese Privatization Bid — New York Times

Leave a Comment / December 14, 2014

NYT

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MAY 21, 2013, 7:07 AM

Blackstone Leads Latest Chinese Privatization Bid

By NEIL GOUGH

A fund run by the Blackstone Group is leading a $662.3 million bid for a technology outsourcing firm based in China, the latest example of a modest boom among buyout shops backing the privatization of Chinese companies listed in the United States.

A consortium backed by a private equity fund of Blackstone that includes the Chinese company’s management said on Monday that it would offer $7.50 a share to acquire Pactera Technology International, which is based in Beijing and listed on Nasdaq.

The offer, described as preliminary, represents a hefty 43 percent premium to Pactera’s most recent share price before the deal was announced. The news sent the company’s stock up 30.6 percent on Monday, to $6.87 — still more than 8 percent below the offer price, in a sign that some investors remain wary that a deal will be completed.

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CITIC Capital’s Take Private Deal for AsiaInfo-Linkage: Is This The Chinese Way to Do an LBO?

Leave a Comment / May 21, 2013

Are we seeing the birth of “Leveraged Buyouts With Chinese Characteristics”? Or just some of the craziest, riskiest and unlikeliest buyout deals in worldwide history? That’s the question posed by the announcement this week that China buyout PE firm CITIC Capital Partners is leading the “take private” deal of NASDAQ-listed AsiaInfo-Linkage Inc., a Chinese software and telecommunications services that company whose shares have halved in value from over $20 during the last two years.

CITIC Capital first disclosed in January 2012 its intention to buy out the AsiaInfo-Linkage public shareholders. At the time, the share price was around $7. The board set up a committee to search for alternative buyers. It seems to have found none, and accepted this week CITIC’s offer to pay $12 a share, or 50% above the price on the day in January 2012 when it first notified the company of its interest. That seemed a rich premium 17 months ago. It seems no less so now.

Rule Number One in LBOs: do not pay any more than you absolutely need to acquire a majority of the shares. Few are the M&A deals where a premium of +50% is offered. Fewer still when the target company is one where the stock has been seriously battered for many years now. The share price went into something like a free fall in early 2010, from a high of $30 to reach that level of $7 when CITIC Capital first announced its move.

CITIC Capital is buying AsiaInfo-Linkage at a price that equates to well over 20 times its 2012 earnings. That sort of p/e multiple is rarely seen in buyout deals. Dell’s buyout is priced at half that level, or a p/e of 10X, and a premium of 25% above the share price the day before rumors about the “take private” deal started to spread.

It’s one of the exquisite oddities of this current craze to take Chinese companies private that PE firms are willing to pay p/e multiples to buy distressed quoted companies from US investors that are at least twice what the same PE firms generally say they will pay for a perfectly-healthy private Chinese company located in China. If anything, the reverse should be true.

Rule Number Two in LBOs: have a clear, credible plan to turn around the company to improve its performance and then look to sell out in a few years time. In this case, again, it seems far from obvious what can be done to improve things at AsiaInfo-Linkage and even more so, how and when CITIC Capital will exit. To complete the $900mn buyout, CITIC Capital will borrow $300mn. The interest payments on that debt are likely to chew up most of the company’s free cash, leaving nothing much to pay back principal. Sell off the fixed assets? Hard to see that working. Meantime, if you fail to pay back the principal within a reasonable period of time (say three to four years), the chances of exiting at a significant profit either through an IPO or a trade sale are substantially lower.

Leverage is a wonderful thing. In theory, it lets a buyout shop take control of a company while putting only a sliver of its own money at risk. You then want to use the company’s current free cash flow to pay off the debt and when you do, voila, you end up owning the whole thing for a fraction of its total purchase price.

In CITIC Capital’s case, I know they are especially enamored of leverage. They were formed specifically for the purpose of doing buyout deals in China. Problem is, you can’t use bank money for any part of a takeover of a domestic Chinese company. (AsiaInfo-Linkage is a rarity, a Chinese company that got started in the US over twenty years ago, and eventually shifted its headquarters to China. It is legally a Delaware corporation. This means CITIC Capital can borrow money to take it over.)

I met earlier this year with a now ex-partner at CITIC Capital who explained that the company’s attempts to do buyout deals in China have frequently run into a significant roadblock. Because CITIC Capital can’t borrow money for domestic takeovers, the only way it can make money, after taking control, is to make sure the company keeps growing at a high rate, and then hope to sell out at a high enough p/e multiple to earn a reasonable profit. In other words, a buyout without the leverage.

CITIC Capital is run mainly, as far as I can tell, by a bunch of MBAs and financial types, not operations guys who actually know how to run a business and improve it from the ground up. Sure, they can hire an outside team of managers to run a company once they take it over. But, in China, that’s never easy. Also, without the benefits of being able to leverage up the balance sheet, the risks and potential returns begin to look less than intoxicating.

We understand from insiders CITIC Capital’s plan is to relist AsiaInfo in Hong Kong or Shanghai within three years. Let’s see how that plays out. But, I’d rate the probability at around 0.5%. The backlog for IPOs in both markets is huge, and populated by Chinese companies with far cleaner history and none of the manifest problems of AsiaInfo.

AsiaInfo’s balance sheet claims there’s a lot of cash inside the company. But, we also understand it took many long months and a lot of “No’s” to find any banks willing to lend against the company’s assets and cash flow. In the end, the main lenders turned out to be a group of rather unknown Asian banks, along with a chunk from China’s ICBC. The equity piece is around 60% of total financing, high by typical LBO standards.

AsiaInfo-Linkage is in most ways quite similar to  “take private Chinese company” Ptp deals of the kind I’ve written about recently, here and here. It has the same manifold risks as the other 20 deals now underway — most notably, you walk a legal minefield, can only perform limited due diligence, spend huge sums to buy out existing shareholders rather than fixing what’s wrong in the company, and so end up paying a big price to buy a company that US investors have decided is a dog.

One good thing is that AsiaInfo-Linkage hasn’t been specifically targeted either by the SEC or short-sellers for alleged accounting irregularities. This isn’t the case with the other take private deal CITIC Capital is now involved with. It’s part of the consortium taking private the Chinese advertising company Focus Media, where a lot of questions have been raised about the quality and accuracy of the company’s SEC financial statements.

AsiaInfo-Linkage seems to be a decent enough company. It is growing. Its main problem is that it relies on three mammoth Chinese SOEs — China Mobile, China Telecom, China Unicom — for over 95% of its revenues. The company’s founder and chairman, Edward Tian, is backing the CITIC Capital deal. Along with CITIC Capital, two other PE firms, Singapore government’s Temasek Holdings and China Broadband Capital Partners (where Tian serves as chairman) are contributing the approximately $400mn in cash to buyout the public shareholders and take control.

Interestingly, Edward Tian has for seven years been a “senior advisor” to Kohlberg Kravis Roberts, aka KKR, perhaps the world’s leading buyout firm. In theory, that should have put KKR in a prime position to do a deal like this — they have far more capital and experience doing buyouts than CITIC Capital, and they are already very familiar with the boss. But, they kept their wallet closed.

Disclosure: I’m a big believer in the value of doing control deals for Chinese companies. We’re just completing a research and strategy report on this area and we expect to share it soon. But, the deals we like are for the best private Chinese companies where the current PE firm investor needs to find a way to sell out before the expiry of its fund life. Such deals have their complexity, and using leverage will not be an option in most.

But, these good assets could most likely be bought at half the price (on a p/e basis) that CITIC Capital is paying to a company that shows little prospect of being able quickly to pay off in full the money CITIC is borrowing to buy it. If that happens, CITIC Capital may be lucky to get its LPs’ money back. Is CITIC Capital perhaps trying a little too hard to prove LBOs in China have their own inscrutable Chinese logic that it alone fully understands?

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China private equity bitten again by Fang — Financial Times

Leave a Comment / May 1, 2014

FT

 

 

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By Simon Rabinovitch in Beijing

Financier Fang Fenglei is betting on private equity recovery

China’s unruly markets have vanquished many a savvy investor, but if one man knows how to play them it is Fang Fenglei.

From the establishment of the country’s first investment bank in 1995 to the complex partnership that brought Goldman Sachs into China in 2004 and the launch from scratch of a $2.5bn private equity fund in 2007, Mr Fang has been at the nexus of some of the biggest Chinese deals of the past two decades.

Even his abrupt decision in 2010 to start winding down Hopu, his private equity fund, was impeccably well timed. Since he left the scene, the Chinese stock market has been among the worst performers in the world and the private equity industry, once booming alongside the country’s turbocharged economy, has gone cold.

So the news that Mr Fang, the son of a peasant farmer, will return with a new $2bn-$2.5bn investment fund is more than a passing curiosity. The financier is betting that China’s beleaguered private equity industry will recover – a wager that at the moment has long odds.

The most immediate obstacle for the private equity industry in China is a bottleneck on exits from investments. Regulators have halted approvals for all initial public offerings since October, a tried and tested method for putting a floor under the stock market by limiting the availability of shares. But a side effect has been eliminating the preferred exit route of private equity companies.

Even before the IPO freeze, the backlog was already building up. China First Capital, an advisory firm, estimates that there are more than 7,500 unexited private equity investments in China from deals done since 2000. Valuations may have appreciated greatly but private equity groups are struggling to sell their assets.

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China’s IPO Drought Spurring Interest In M&A — FinanceAsia

Leave a Comment / December 5, 2014

FinanceAsia

 

With slim hope of exiting through a lucrative public listing, Chinese entrepreneurs and their investors are considering sales.

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China’s huge backlog of initial public offerings is creating an exit crisis for maturing private equity funds — and an opportunity for international investors interested in buying something other than a bit of a state-owned enterprise.

For China’s entrepreneurs, the dream of earning a rich valuation through an IPO is over, but the result could be a healthy increase in acquisitions as owners slowly come round to reality: that selling to a foreign buyer is probably the best way of cashing out.

There is no shortage of candidates, thanks to the unsustainable euphoria at the height of China’s IPO boom. The number of firms listing in China, Hong Kong and New York was only around 350 at its height, yet private equity funds were investing at triple that rate. As a result, there are now more than 7,500 unexited private equity deals in China.

“IPOs may start again, but it will never be like it was,” says Peter Fuhrman, chief executive of China First Capital, an investment bank that specialises in advising on private equity deals. “The Golden Age is likely over. There are 10,000 deals all hoping to be one of the few hundred to reach IPO.”

As long as the window to a listing was open, China’s entrepreneurs were willing to hold out in the hope of selling their business at a valuation of 80 or 100 times earnings. Even last year, when the window to IPO was firmly closed, few bosses chose to sell.

“Private equity activity was fairly muted in 2012 — you could count the meaningful exits on one hand,” says Lindsay Chu, Asia-Pacific head of financial sponsors and sovereign wealth funds at HSBC. But sponsors still have a meaningful number of investments that they will need to exit to return capital to LPs [limited partners].”

However, both Fuhrman and HSBC note signs of growing interest in M&A — or at least weakening resistance to the idea.

“I’m conservatively optimistic about leveraged buyouts,” says Aaron Chow, Asia Pacific head of event-driven syndicate within the leveraged and acquisition finance team at HSBC. “The market is wide open to do these deals right now, as financing conditions are supportive and IPO valuations may not provide attractive exits.”

Indeed, the ability to use leverage may be decisive in helping foreign buyers emerge as the preferred exit route for China’s entrepreneurs. Leverage is not an option for domestic buyers, which are also burdened with the need to wait for approvals, without any guarantee that they will get them.

This means foreign acquirers can move quicker and earn bigger returns, which may prove enticing to bosses who want to maximise their payday and get their hands on a quick cheque.

If this meeting of the minds happens, foreign buyers will get their first opportunity to buy control positions within China’s private economy, which is responsible for most of the country’s growth and job creation.

“The beauty here is these are good companies, rather than a troubled and bloated SoE that’s just going to give you a headache,” says Fuhrman. “It’s still a bitch to do Chinese acquisitions — it’s always going to be a bitch — but private deals are doable.”

Some of those deals may involve trade sales to other financial sponsors, as a number of private equity funds have recently raised capital to deploy in Asia and are well placed to take advantage of the opportunity, despite the challenges.

“There’s a lot of talk in Europe about funds having difficulty in their fund-raising efforts, but for the most part we’ve not seen that in Asia,” says Chu. Mainland companies will attract most of the flows, he says, but there are also opportunities across the region. “China is always going to be top of the list, but Asean is becoming an even bigger focus thanks to good macro stories and stable governments. Singapore, Indonesia and Malaysia are all attractive to private equity investors.”

© Haymarket Media Limited. All rights reserved.

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Anti-Dumping or Blatant US Protectionism? How the US Tried and Failed to Destroy a Great Chinese Entrepreneur

Leave a Comment / May 6, 2013

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Reckless or evil? You decide. In July 2009, the US Department of Commerce started an anti-dumping investigation of the “narrow woven ribbon with woven selvedge” industry. Never heard of it?  It’s the colored ribbon Americans use primarily in gift-wrapping. It’s not a particularly big industry, probably less than $500 million a year in retail sales in the US. But, adding ribbon to gift-wrapped packages is a staple of American culture. The major store chains like Target, Wal-Mart, Michael’s and Costco all stock a wide variety of ribbon in different colors and widths, and sell it for a few dollars per pack.

Back when I was a kid, the ribbon was made by American manufacturers. Gradually, of course, much of the production shifted to Asia, first Taiwan, then China. Lowering manufacturing costs also kept retail prices down, which has likely allowed more Americans to use more ribbon to decorate their gifts.  Who could complain about that?

There remains one large American manufacturer called Berwick Offray, based in Pennsylvania. They’ve been in the woven ribbon business for over 100 years. They launched the complaint that led to the US government action, claiming they were suffering “material harm” because of Chinese ribbon being dumped in the US. According to the official document issued by the Department of Commerce in July 2009, the US government’s preliminary investigations seemed to confirm Berwick Offray’s contention that Chinese manufacturers were receiving state subsidies as a way to flood the US market and steal market share, harming Berwick’s business. The US government signaled its intention to levy punitive tariffs on the Chinese imports.

In its 142-page 2009 preliminary report, (click here to download) the Department of Commerce offers a feedlot of industry data, manufacturing techniques and product descriptions, all of which are aimed to substantiate the claim that Chinese manufacturers, who now hold the largest share of the US market, are selling the ribbon in the US below cost, with the loss being covered through a variety of unspecified subsidies from the Chinese government. Keep in mind that the total amount of US imports of woven ribbon from China seemed then to be below $100mn. A lot of market share data in the report was blacked out, presumably for commercial secrecy reasons. A lot of other information was absent because the Commerce investigators said they couldn’t find people willing or able to answer its questions.

So, the entire US federal government investigation, and preliminary finding of Chinese ribbon dumping was based both on incomplete data, and the dubious premise that the Chinese government would actively intervene with subsidies in such a small market. Total Chinese exports to the US in 2011 exceeded $400 billion. So, if the data is right, Chinese woven ribbon represents about 0.025% of total Chinese exports. The manufacturers are mainly privately-owned Chinese companies, not big SOEs with political clout in Beijing.

Among those Chinese manufacturers, one stands out for its scale, its variety of products and leading market share in the US. The company is called Yama Ribbon. They are based in Xiamen and dominate the industry in China. Yama is named in the Commerce Department report as one of the major exporters to the US. Since Yama is the biggest Chinese exporter, and the US government is suggesting Chinese government subsidies allow Chinese manufacturers to sell their ribbon below cost, it stands to reason that Yama should be fingered in the report as the main beneficiary of these subsidies. Right? The US government couldn’t possibly allege the Chinese government is subsidizing a product unless they’ve already confirmed the main Chinese producer is receiving such subsidies. Right?

Wrong. Trade policy, anti-dumping actions, punitive tariffs are very often a political toy in the US. Too often, US companies can use lobbyists or friendly politicians to pressure the Commerce Department to initiate an investigation. That alone can often cause exporters, whether they are dumping or not, to increase their prices, just to try to avoid any unilateral action by Washington. This, then, boosts the competitive position, and so the profits, of the US company that started the anti-dumping ball rolling. It isn’t called corruption, but often it should be understood as such.

Is this the case with Berwick Offray and woven ribbon? Did it use the US political process to help its foundering business in the US? That seems the case to me. Here’s why. After its initial report in 2009, the Commerce Department launched a more detailed analysis to identify all the subsidies Yama Ribbon and other Chinese manufacturers were receiving from the Chinese government.

In July 2010, the US officials announced they could find no evidence of Yama receiving any subsidies whatsoever. Yama Ribbon products were assigned an “anti-dumping” duty of 0%. It was a complete victory for Yama and a repudiation of misguided US protectionist trade policies. It received about zero press coverage, in China and the US, which is a shame.  Next time you hear someone spouting off about “unfair China trade practicies” or “predatory pricing”, think about Yama.

Several other Chinese manufacturers were found to be receiving subsidies, and their products were slapped with punitive duty rates of 125% to 249%. But, Yama is the main producer and exporter. If it’s receiving no subsidies, then it is impossible to claim the Chinese government is rigging the market to the detriment of Berwick Offray and the few other remaining US producers of woven ribbon.

How, you might ask, could the US government have even issued the preliminary 2009 report before establishing beyond doubt that Yama was getting favors from the Chinese government? The same question occurred to Yama’s founder and CEO, Yao Ming. (Yes, same name, but no relation to — physically or by bloodline –  to the Chinese basketball star.)  When he heard about the 2009 investigation and preliminary finding, Yao understood immediately it had the potential to damage, if not ruin his entire business, with 2011 revenues of over USD$50mn and over 1,000 employees. The US is his key market, over 70% of total turnover.

I’m fortunate enough to know Yao Ming. He’s a modest, hard-working entrepreneur, among the best I’ve ever met. My guess is as a businessman he could run circles around the people who manage Berwick Offray.  He’s not a political creature, speaks very little English, and until then, was unschooled in the ways of US trade policy. The US government was asserting Chinese ribbon exporters were getting subsidies and yet Yao knew he was receiving nothing. Knowing, and proving it to Washington, of course, are very different stories. He tried getting help from the Chinese Ministry of Commerce. But, they told him, effectively, he would have to fight this one on his own. They have bigger trade battles to wage with the US than this tiny one over gift ribbon.

So Yao hired lawyers, both in China and the US, and fought back. He’s the only Chinese entrepreneur I’ve heard about with this kind of character and self-confidence to spend a not-small amount of money to fight back against the US government. Even more remarkably, he won a resounding and speedy victory.

He more or less dared the US government to prove he was getting subsidies, including indirect ones like loan subsidies, special deals to buy factory land or tax holidays. When the US government couldn’t find a thing, it gave up pursuing Yama. Justice, in this case, was served. But, Yao was also lucky. His business is unusual in China. At that time, he has no bank loans, and his factories are rented. Both are rare among manufacturers in China. For any other manufacturer in China, it would be far harder to prove as quickly an absence of subsidies, direct or indirect. Yao needed to act, before the threat of an anti-dumping action permanently damaged his business in the US.

As an American citizen, I’m more than a little disgusted by what the US government did in this case: it made that 2009 announcement, declaring a preliminary finding, without really checking its facts. Had Yao not acted quickly, hired lawyers and proved his case, his business would have been sunk, and Americans would end up paying much more to decorate their gifts.

Had Commerce wanted to, it would have taken almost no time or effort to establish that Yama, as the largest Chinese ribbon exporter, was likely getting nothing from the Chinese government. But, they didn’t bother. That’s the worst of it. People at the Department of Commerce know how damaging an investigation and preliminary finding like this can be to any businesses implicated in wrongdoing.

In the end, from what I can tell, Commerce cared more about placating Berwick Offray than in making sure it didn’t unjustly harm a company faraway in China. Everything, in the end, has turned out well for Yao Ming and Yama. His business, including exports to the US, continue to thrive. He has some of the highest net margins I’ve seen in a Chinese manufacturing company. His revenues this year will approach USD$100mn. He has opened an office now in New Jersey to help handle all the orders. His Chinese competitors are now largely shut out of the US market because of the punitive duties. None seems to have had the scale or cash to hire lawyers and go to court in the US, as Yao Ming did. So whether these punitive duties are justified is, to me, an open question.

Yama’s business is number one in the US not because it sells product at the lowest price. It doesn’t. It has a better business model, thanks to the business smarts of its founder Yao Ming. He keeps a large stock of ribbon in a huge array of sizes and colors in inventory in the US, to meet spot orders. While it increases his costs, because of the extra working capital needed to finance the inventory, distributors and retailers can get orders filled more quickly. So, they buy from Yama. The company’s scale and service allow it now to earn margins that would be the envy of just about every other manufacturer operating in China.

Yao Ming is Chinese. But, he is the kind of Horatio Alger entrepreneur many in the US most admire. He makes a good product, sells it at a fair price, is good to his workers, and fought back against knuckle-headed Washington bureaucrats and won.

 

 

Shenzhen: A beacon for private enterprises — China Daily

Leave a Comment / June 24, 2016


 

–A beacon for private enterprises

2013-04-20

By Hu Haiyan and Chen Hong ( China Daily)

Shenzhen bears a superficial resemblance to Shanghai. There are dozens of multinationals and gleaming skyscrapers casting their shadows over narrow lanes. Their respective economic performances last year were also similar: Shenzhen’s GDP hit 1.3 trillion yuan ($210 billion), gaining by 10 percent from 2012. Shanghai GDP reached 2 trillion yuan, increasing by 7.5 percent from 2011.

Both are testing grounds for China’s economic reform policies. Still, for Peter Fuhrman, 54, Shenzhen is a private-sector city, a city that has its face pointed toward the future.

In 2009, Fuhrman moved to Shenzhen from California. The chairman and CEO of China First Capital, an international investment bank and advisory firm focused on China, he is always struck by how similar Shenzhen and California are.

“Both are places where new technologies, and valuable new technology companies, are born and nurtured. I treasure the role Shenzhen has played over these last 30 years in helping architect a new China of renewed purpose and importance in the world,” Fuhrman says. “It is impossible to imagine a US without California. It is so much the source of what makes America great. Shenzhen, too, is a major source of what makes China great, what makes this country such a joy for me to live in. “

More…

Download PDF version.

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China’s GPs search for exits — Private Equity International Magazine

Leave a Comment / May 24, 2013

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Chinese GPs are running low on exit options, but the barriers to unconventional routes – like secondary sales to other GPs – remain high.

By Michelle Phillips

China’s exit woes are no secret. With accounting scandals freezing the IPO route both abroad and domestically, the waiting list for IPO approval on China’s stock exchanges has come close to 900 companies.  Fund managers have at least 7,550 unexited investments worth a combined $100 billion, according to a recent study by China First Capital. However, including undisclosed deals, the number of companies could be as high as 10,000, says CFC’s founder and chairman Peter Fuhrman.
CITIC Capital chief executive Yichen Zhang told the Hong Kong Venture Capital Association Asia Private Equity Forum in January that because many GPs promised high returns in an unrealistic timeframe (usually three to five years), LPs were already starting to get impatient. He also predicted that around 80 percent of China’s smaller GPs would collapse in the coming years. “The worst is yet to come,” he said.
What ought to become an attractive option for these funds, according to the CFC study, are secondary buyouts. Even if it lowers the exit multiple, secondaries would provide liquidity for LPs, as well as potentially giving the companies an influx of cash, Fuhrman says.

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

Leave a Comment / April 11, 2013

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

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

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

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

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

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

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

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

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

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

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

 

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More Trouble for the Big Four Accountants in China: Pushing Prudent Analysis or Propaganda?

Leave a Comment / March 18, 2013

This is not a good time for the Big Four accounting firms in China. The SEC has charged them with breaking securities law, while one of the group, Deloitte, is now in serious hot water in the US, facing a shareholder class action in Delaware for aiding a US-listed Chinese company in defrauding US investors. If Deloitte loses, or opts to settle, it could uncork a tidal wave of copycat claims that would do serious, perhaps irreparable damage to the China business of Deloitte, and then also possibly to Ernst & Yong, Price WaterhouseCoopers and KPMG.

The charges against the Big Four all boil down to allegations they were either negligent in fulfilling their statutory duties, or in cahoots with bad guys scheming to defraud US investors. The implication of the SEC charges seems to be the accountants’ willy-nilly pursuit of fees led the Big Four to cut corners, surrender objectivity, and allow their judgment to become corrupted.

Similar doubts can be raised about the quality, credibility and soundness of the judgments the accountants provide in assessing China’s private equity industry. Even as the PE market began to slide into serious trouble last year, the accountants kept talking up the industry. In particular, it’s worth reading the two big and well-publicized reports on China private equity produced by Ernst & Young  and PWC. Both can be downloaded by clicking here. E&Y Report. PWC Report.

Both of these documents were published in late December 2012. All IPO activity for Chinese companies had come to an abrupt halt months earlier, and along with this, China’s PE firms basically went into hibernation, closing off almost all new investment in China. The situation has, if anything, worsened so far in 2013. And yet, to read these reports, my opinion would be that that everything was overall pretty rosy.

Nowhere is it mentioned that a main factor contributing to the collapse of Chinese IPOs is the widespread loss of confidence in the work of accountants. While the PWC report does note the challenge posed by limited exits, it echoes the generally bullish sentiment of the E&Y report. PWC confidently predicts, “We think new deal and exit activity will accelerate strongly from 2Q13 as pricing expectations adjust.” In other words, according to PWC, we’re weeks away now from not just the revival of the comatose China PE industry, it’s going to leap out of bed and begin doing wind-sprints.

Let’s see how things play out.  But, the greater likelihood in my opinion is that 2013 will be the worst year in recent history for China PE. Further out, things look even more dire, as hundreds of PE funds reach the end of their lives still holding tens of billions of dollars in illiquid investments made with LP money.

Why then all the optimism, the boosterism, the cheerleading from the accountants? I have a lot of respect for their professionalism. To me, it seems that their enthusiasm may be more a matter of  wishing, hoping and urging that the PE industry, and the fees that come from it, continue to grow. To crib a line from Warren Buffett’s latest Letter to Shareholders, “wishing makes dreams come true only in Disney movies; it’s poison in business.”

China PE has been good — no, make that, very good — to the Big Four accounting firms. It’s anybody’s guess, but I’d estimate the total fees earned as recently as 2011 by the Big Four for work done for PE firms in China is well above $75mn. This is for audits of existing and potential investments, for other due diligence services and for portfolio valuation.

PE firms are certainly one of the key sources of revenue for the Big Four in China. The Big Four also do work for Chinese corporations, but that market is much more crowded in China, with thousands of local accounting firms also getting their share of corporate audits and tax. The local firms charge about half what the Big Four do. The global PE firms rely almost exclusively on the Big Four to do all their work in China. The PE firms pay top dollar.

The Big Four get paid big money to do audits and projections on many of the deals the bigger PE firms are considering in China.  Very often during due diligence the PE firm opts to abandon a deal. Even when they do, the accounting firms get paid in full. At around $250,000 a pop, the financial DD package on PE deals that never close has become a very lucrative line of business. I’ve also known of cases where the PE firm paid for the audit and projections but then tossed them away after deciding the conclusions were flawed.

Reading the E&Y and PWC reports, it seems to me a primary purpose was marketing, to let the PE industry in China feel good about itself, to reassure distant LPs, and even to encourage China GPs to be a little more bold and active. Nowhere does one read any kind of more sober analysis pointing to the systemic problems in the industry caused by the enormous overhang of unexited deals, expiring fund life, the damage done to IPO markets by false accounting, the billions of dollars in LP money at risk. The reports seem more like propaganda than a prudent assessment.

It’s also puzzling that the accounting companies shared no serious research on the scale of the problem of unexited deals in China. Self-interest, as well as professional credibility,  would seem to dictate it.  Instead, it was my company, which earns fees of precisely zero from PE firms, that made the effort over six months to research and contextualize the problem of unexited deals in China. We had no financial incentive to do this work, but did so because we thought it’s the best way to put the China PE industry on a sounder long-term footing and get PEs to start again making new investments.

It’s not only the accountants that have been gorging on PE firm fees. The big US and UK law firms, management consultants like McKinsey, market research firms and placement agents have also been earning very fat fees and retainers from China’s PE business. My guess is the total amount of LP wealth transferred by China PE firms to professional services firms is above $250mn a year. None of these firms issued serious public warnings to their PE clients about problems bedeviling the industry. McKinsey, which interviews GPs, offered this in the 2012 report I saw on private equity in China, ” As one large GP in China told us, “We’re busier than we have been in the last eight or nine years.”

I can’t help but feel that all these professional services firms have perhaps gotten a little drunk and maybe a little lazy from all the easy money they’ve been earning from China-focused PE funds. No one wants to say anything that might close down the tap on the billions of new LP money coming into China each year, a meaningful slice of which always gets divided among these professional service firms. And so the rather utopian portrayals of China PE keep getting printed and circulated.

It’s similar to the way equity analysts at brokerage houses never seem to have a bad word to say about the companies their firms do business with. Even when an analyst decides the company is a loser, the published research will merely advise to “Hold” or “Accumulate”. In the head-to-head combat between a revenue stream and forthright assessment, the revenue stream always seems to win.

 

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Secondaries offer solution for US capital locked in China — AltAssets

Leave a Comment / May 24, 2013

The future of private equity and venture capital in China is threatened by a huge overhang of illiquid investments. US institutional investors and pension funds are at risk in a market that until recently was a source of significant investment profits. Private equity secondaries offer a potential way out, according to China First Capital.

China’s private equity industry, having grown in less than a decade from nothing into a giant rivaling the private equity industry in the US, is in the early stages of a unique crisis that could undermine the remarkable gains of recent years, according to a newly-published research report by China First Capital, an international investment bank. Over $100bn in private equity and venture capital investments is now blocked inside deals with no easy exit. A significant percentage of that capital is from limited partners, family offices, university endowments in the USA.

Private equity firms in China are running out of time and options. Exit through trade sale or M&A, a common practice elsewhere, is almost nonexistent in China. One viable solution, the creation of an efficient and liquid market in private equity secondaries in China where private equity firms could sell out to one another, has yet to develop. As a result, private equity general partners, their limited partner investors and investee companies in China risk serious adverse outcomes.

Secondary deals will likely go from current low levels to gain a meaningful share of all private equity exits in China, China First Capital said.

In all, over $130bn is now invested in un-exited private equity deals in China. The un-exited private equity and venture capital deals are screened and analysed across multiple variables, including date, investment size, tier of private equity firm, industry, price-earnings ratio.

Secondary deals potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments and return money to their limited partners, the report finds. The most acute need for exit will be investments made before 2008, since private equity firms generally need to return money to their limited partners within five to seven years. But, more recent private equity and venture deals will also need to be assessed based on current market conditions.

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 slammed the door shut on IPOs for most Chinese companies. As a result, private equity firms can’t find buyers for illiquid shares, and so can’t return money to their Limited Partners.

“Many private equity firms are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve,” according to China First Capital’s chairman and founder, Peter Fuhrman. “The need for diversification is no less paramount for exits than entries,” he continues. “Many of the same private equity firms that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on a single path to exit: an IPO in Hong Kong or China. By itself, such dependence on a single exit path is risky. In the current environment, with most IPO activity at a halt, it looks even more so. ”

Secondary activity in China will differ significantly from secondaries done in the US and Europe, he added. Buyers will cherry-pick good deals, rather than buying entire portfolios, and escape much of the due diligence risk that plagues primary private equity deals in China. Sellers, in many cases, will be able to achieve a significant rate of return in a secondary sale and so return strong profits to their limited partners. Private equity-invested companies stand to benefit as well, since a secondary transaction can be linked to a new round of financing to provide additional growth capital to the business. In short, secondary deals in China should be three-sided transactions where all sides come out ahead.

But, significant obstacles remain. The private equity and venture capital industry in China has grown large, but has not yet fully matured. The industry is fragmented, with several hundred older dollar funds, and several thousand Renminbi firms launched more recently, some fully private and some state-owned with most falling somewhere in between.

Absent a significant and sustained surge in IPO activity in 2013, the pressure on private equity firms to exit through secondaries will intensify. According to the report, no private equity firm is now raising money for a fund dedicated to buying secondaries in China. There is a market need. As a fund strategy, private equity secondaries offer Limited Partners greater diversification across asset types and maturities in China.

Private equity has been a powerful force for good in China, the report concludes. Entrepreneurs, consumers, investors have all benefited enormously. Profit opportunities for private equity firms and Limited Partner investors remain large. Exit opportunities are the weak link. A well-functioning secondary market is an urgent and fundamental requirement for the future health and success of China’s private equity industry.

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