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Real Estate Prices in China – For Many, Higher Means Happier

Leave a Comment / July 18, 2011

China’s government is engaged in mortal combat to control rapidly-rising real estate prices. Or so you would believe from reading the newspapers and listening to all the economic commentary. But, it’s not entirely true. The reality is, China’s government is trying to navigate a tricky path between the interests of current homeowners, and those who’ve yet to join the housing ladder. Current homeowners, of course, are perfectly happy for prices to keep rising. In today’s China, homeowners are one-and-the-same with the country’s most important political constituency.

When I first came to China in 1981, this country was, both in its rhetoric and policy, still a nation of and for “workers and peasants”. These “have-not” groups enjoyed preferential access to housing, jobs and higher education.

Today, most power belongs to society’s “haves”, the urban and educated population that creates and captures the benefits of China’s remarkable economic growth. The government must seek to keep this group content. The easiest way to do this, of course, is to create policies and conditions where personal incomes continue to rise. Since most personal savings is tied up in housing and the stock market, the government must focus heavily, in ways perhaps no other government in the world does,  on measures that produce favorable outcomes for people with money tied up in property or shares.

Overall, China’s government has been consistently successful doing this. With housing prices, they’ve perhaps been a little too successful, since the policy mix has created a situation where prices continue to rise by over 50% on an annualized basis, and are now often higher, per square meter, than they are in most of the US and Europe. For the tens of millions who have owned property for more than six months, this translates into very significant increases in personal wealth.

In short, for every person currently priced out of the housing market, there maybe three or four who are feeling flusher than they ever have. That means, if you could measure such things, greater net happiness in China when property prices are rising.

China’s government, if it wanted to,  has the power to drive down housing prices in a hurry. It owns all the land in China. By releasing more of it for residential development, the certain outcome would be to lower or even roll back the growth of housing prices. Yet doing so will also have wealth effects on those who already own.

The other policy levers at the government’s disposal – introducing property taxes, restricting people from buying more than one residential property, raising minimum down-payments,  – can have some impact. These are the main tools the government is now using to moderate housing price inflation. But, all evidence is, these steps aren’t having a major impact. Property prices continue to rise, if less explosively than they did in 2009 and 2010.

Most of the talk from government is about increasing affordable housing, especially in cities. But, the policy mix is still designed in such a way that prices should continue to move upward.

Hong Kong is a constructive example. There too, property prices are high and moving higher, and the government is tinkering with policy changes to slow rapid increases. But, high property prices have been a fixture of Hong Kong life for a generation.

The Hong Kong government owns most of the undeveloped land. It tightly controls the amount of new land auctioned each year. This maximizes the government’s profits from land sales, while sustaining upward pressure on property prices overall. This makes all current owners, from large developers like Li Ka-shing’s Hutchinson Whampoa and Cheung Kong Holdings, happy as well as the two-thirds of Hong Kong citizens who own their own homes.

Home ownership in China is not quite as high overall. But, it is likely just as high, if not higher, among the huge part of China’s population whose political and economic clout is greatest. China is wise to want to extend to more people the benefits of home ownership. But, the next time you hear that China’s property prices are rapidly rising, the meaning is: the country’s very many haves now have very much more.

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China’s Most Profitable Industry Becomes One of the Toughest

4 Comments / July 7, 2011

Chinese real estate is no longer the easiest legal risk-adjusted money-making business in the world. It’s been a swift reversal. For the better part of twenty years, there’s been no simpler way to amass a great fortune than developing property in China.

The business model was as simple as it was profitable: acquire a piece of property from friends in government at a fraction of its market value, mortgage the property heavily with obliging state-owned banks, sell out most of the units (either offices or apartments) within weeks of construction beginning, and then pocket returns of 500% or more before the building was even occupied.

Continuously rising property prices, often increasing by 10% or more per month,  provided incentive to hold onto some units for later sale. A final wrinkle was to demand a cash advance from the construction company when awarding the building contract, so limiting even more the amount of capital needed, and improving return-on-equity even more.

There was just about zero risk in deals like this. Then, the Chinese government began clamping down, starting gingerly about a year ago and then with added ferocity in recent months,  in an effort to restrain property prices and overall inflation. At this point, what was once the easiest business in China has become one of the hardest. Sweetheart land deals are far more rare, as the central government in Beijing is no longer turning a blind eye.

More importantly, banks have all but stopped lending to property developers. This has dried up liquidity in an industry that was for many years awash in it. The projects getting built now, for the most part, are those where little or no bank debt is required. That means heavy upfront equity investment, or taking money from loan sharks who charge interest rates of 25%-30% a year. This fundamentally alters the arithmetic of a real estate deal in China. The more equity and high-interest debt that goes in, the lower the returns and, it seems,  the more likely a project is to hit problems.

And problems have become the norm. Another government change, little reported but absolutely crucial to the change in fortunes of the real estate business in China, is that it’s no longer easy and cheap to get current residents off the land, so it can be sold at a high price to a developer. New rules make it very expensive and risky for any developer to undertake this process of relocation and demolition.

Any delay, and delays are rampant, can quickly drain away a developer’s cash. For example, if one old tenant refuses to take the relocation money and move out, it is no longer a simple thing in most instances to get the local government, or hired goons, to force them out. Until all old tenants are resettled, no construction can begin. This can push back by months or even years the date that developers can begin pre-sales. Meantime, you keep paying usurious interest rates to lenders who have taken the whole project, as well as many of other unrelated assets, as collateral.

A final nail: residential real estate prices are now rising far more slowly. This is the result of tighter mortgage rules, property taxes in some cities, as well as new regulations that limit the number of apartments people can buy. In Beijing, for example, you need to prove you have paid local Beijing taxes before being allowed to buy.

Of course, taking the easy money out of real estate is a prime policy objective of the Chinese government. That the government would be successful in this was never much in doubt. The speed and geographical scope of the impact, however, has caught a lot of people (including me) by surprise. Projects that six months ago looked like sure things are today struggling. The sudden evaporation of bank finance, in particular, is playing havoc. Banks in China are state-controlled. When they responded slowly, earlier this year, to government suggestions they slow the flow of funds to the real estate sector, the government took more active measures, including raising six times banks’ reserve requirements.

Rocketing property prices are a major contributor, directly and indirectly, to inflation, which is now, by official figures, at its highest level in China in over three years. So, the government’s actions had a broader purpose than altering the return formula for real estate investment in China. At the moment, though, that’s been the main impact, to make it far harder to do both residential and commercial real estate projects in China. When and by how much inflation will be curbed is unclear.

The bigger question is: has the game changed permanently in Chinese real estate, or will things revert as soon as inflation is down to where the government wants it to be. The rising real estate prices of the last 20 years have not only helped the country’s real estate barons. They have also been a main source of rising middle class wealth in China. That’s where the government policy becomes more an art than science: how to strip away real estate developers’ easy profits, while keeping the middle class feeling flush and contented. I’ll write about that in a following blog post.

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Crawling Blindfold & Naked Through A Minefield

1 Comment / June 27, 2011

 

Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The PE firms now considering the “delist-relist” transactions I wrote about last time (click here to read)  are jeopardizing not only their investors’ money, but the firm’s own survival.  The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to ever raise money from LPs again. In other words, PE firms that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE firms considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors. There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms active in China.

This investment approach, of looking for mispriced or distressed assets on the stock market,  is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US.  But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made.  How will LPs respond if a PE firm does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE firm is taking.

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China PE Firms Do PF (Perfectly Foolhardy) “Delist-Relist” Deals

Leave a Comment / June 22, 2011

Hands down, it is the worst investment idea in the private equity industry today: to buy all shares of a Chinese company trading in the US stock market, take it private, and then try to re-list the company in China. Several such deals have already been hatched, including one by Bain Capital that’s now in the early stages, the planned buyout of NASDAQ-quoted Harbin Electric (with PE financing provided by Abax Capital) and a takeover completed by Chinese conglomerate Fosun.

From what I can gather, quite a few other PE firms are now actively looking at similar transactions. While the superficial appeal of such deals is clear, the risks are enormous, unmanageable and have the potential to mortally would any PE firm reckless enough to try.

A bad investment idea often starts from some simple math. In this case, it’s the fact there are several hundred Chinese companies quoted in the US on the OTCBB or AMEX with stunningly low valuations, often just three to four times their earnings.  That means an investor can buy all the traded shares at a low overall price, and then, in partnership with the controlling shareholders,  move the company to a more friendly stock market, where valuations of companies of a similar size trade at 20-30 times profits.

Sounds easy, doesn’t it? It’s anything but. Start with the fact that those low valuations in the US may not only be the result of unappreciative or uncomprehending American investors. Any Chinese company foolish enough to list on the OTCBB, or do any other sort of reverse merger, is probably suffering other less obvious afflictions. One certainty:  that the boss had little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing which, among its other curses, likely cost the Chinese company at least one million dollars to complete, including subsequent listing and compliance costs.

Why would any PE firm, investing as a fiduciary, want to go in business with a boss like this? An “undervalued asset” in the control of a guy misguided enough to go public on the OTCBB may not be in any way undervalued.

Next, the complexities of taking a company private in the US. There’s no fixed price. But, it’s not a simple matter of tendering for the shares at a price high enough to induce shareholders to sell. The legal burden, and so legal costs, are fearsome. Worse, lots can – and often will – go wrong, in ways that no PE firm can predict or control. The most obvious one here is that the PE firm, along with the Chinese company, get targeted by a class action lawsuit.

These are common enough in any kind of M&A deal in the US. When the deal involves a cash-rich PE firm and a Chinese company with questionable management abilities, it becomes a high likelihood event. Contingency law-firms will be salivating. They know the PE firm has the cash to pay a rich settlement, even if the Chinese company is a total dog. Legal fees to defend a class action lawsuit can run into tens of millions of dollars. Settling costs less, but targets you for other opportunistic lawsuits that keep the legal bills piling up.

The PE firm itself ends up spending more time in court in the US than investing in China. I doubt this is the preferred career path for the partners of these PE firms. Bain Capital may be able to scare off or fight off the tort lawyers. But, other PE firms, without Bain’s experience, capital and in-house lawyers in the US, will not be so fortunate. Instead, think lambs to slaughter.

Also waiting to explode, the possibility of an SEC investigation，or maybe jail time. Will the PE firm really be able to control the Chinese company’s boss from tipping off friends, who then begin insider trading? The whole process of “bringing private” requires the PE firm to conspire together, in secret, with the boss of the US-quoted Chinese company to tender for shares later at a premium to current price. That boss, almost certainly a Chinese citizen, can work out pretty quickly that even if he breaks SEC insider trading rules, by talking up the deal before it’s publicly disclosed, there’s no risk of him being extradited to the US. In other words, lucrative crime without punishment.

The PE firm’s partners, on the other hand, are not likely immune. Some will likely be US passport or Green Card holders. Or, as likely, they have raised money from US institutions. In either case, they will have a much harder time evading the long arm of US justice. Even if they do, the publicity will likely render them  “persona non grata” in the US, and so unable to raise additional funds there.

Such LP risk – that the PE firm will be so disgraced by the transaction with the US-quoted Chinese company that they’ll be unable in the future to raise funds in the US – is both large and uncontrollable. The potential returns for doing these “delist-relist” deals  aren’t anywhere close to commensurate with that risk. Leaving aside the likelihood of expensive lawsuits or SEC action, there is a fundamental flaw in these plans.

It is far from certain that these Chinese companies, once taken private, will be able to relist in China. Without this “exit”, the economics of the deal are, at best, weak. Yes, the Chinese company can promise the PE firm to buy back their shares if there is no successful IPO. But, that will hardly compensate them for the risks and likely costs.

Any proposed domestic IPO in China must gain the approval  of China’s CSRC. Even for strong companies, without the legacy of a failed US listing, have a low percentage chance of getting approval. No one knows the exact numbers, but it’s likely last year and this, over 2,000 companies applied for a domestic IPO in China. About 10%-15% of these will succeed. The slightest taint is usually enough to convince the CSRC to reject an application. The taint on these “taken private” Chinese companies will be more than slight. If there’s no certain China IPO, then the whole economic rationale of these “take private” deals is very suspect.  The Chinese company will be then be delisted in the US, and un-listable in China. This will give new meaning to the term “financial purgatory”, privatized Chinese companies without a prayer of ever having tradeable shares again.

Plus, even if they did manage to get CSRC approval, will Chinese retail investors really stampede to buy, at a huge markup, shares of a company that US investors disparaged? I doubt it. How about Hong Kong? It’s not likely their investors will be much more keen on this shopworn US merchandise. Plus, these days, most Chinese company looking for a Hong Kong IPO needs net profits of $50mn and up. These OTCBB and reverse merger victims will rarely, if ever, be that large, even after a few years of spending PE money to expand.

Against all these very real risks, the PE firms can point to what? That valuations are much lower for these OTCBB and reverse merger companies in the US than comparables in China. True. For good reason. The China-quoted comps don’t have bosses foolish or reckless enough to waste a million bucks to do a backdoor listing in the US, and then end up with shares that barely trade, even at a pathetic valuation. Who would you rather trust your money to?

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China Goes Shopping: The Compelling Logic of Doing M&A Deals in the US

1 Comment / April 7, 2013

Selling a business in the US?  Chinese can pay top dollar.

We are entering a golden age of Chinese M&A deals in the US. There is certainly a sharp pick-up in activity going on – not so much of announced deals yet, though there have been several, but in more intensive discussions between potential Chinese acquirers and US companies. There is also a lot more shopping and tire-kicking by Chinese buyers. I certainly see it in our business. We’re engaged now in several M&A deals whose goal is sale of a US company to a Chinese buyer. I expect to see more.

The reasons for this upsurge are many – including the recent appreciation of the Renminbi against the dollar, the growing scale and managerial sophistication of Chinese companies (particularly private as opposed to state-owned ones), attractive prices for target US companies, the launch in 2009 by the Shenzhen Stock Exchange of the Chinextboard for fast-growing private companies.

The best reason for Chinese buyers to acquire US firms is one less-often mentioned – to profit from p/e arbitrage. The gap between stock market valuations in the US and China, on price-earnings basis, are wide. The average trailing p/e in the US now is 14. On China’s Chinext board, it’s 45. For fast-growth Chinese companies, the p/e multiples can exceed 70. This gives some Chinese acquirers leeway to pay a higher price for a US business.

In the best cases, a dollar of earnings may cost $10-$15 to acquire through purchase of a US business, but that dollar is immediately worth fifty dollars or more to the Chinese firm’s own valuation. As long as the gap remains so large, it makes enormous economic sense for Chinese acquirers to be out buying US businesses.

This is equally true for Chinese companies already quoted on the Chinese stock market as well as those with that ambition. Indeed, for reasons unique to China, the incentive is stronger for private companies to do this p/e arbitrage. In China, public companies generally are forbidden from doing secondary offerings, nor can they use their own shares to pay for an acquisition. When a Chinese public company consolidates a US acquisition’s profits, its overall market value will likely rise. But, it has no way to capitalize by selling additional shares and replenish the corporate treasury.

For a private company, the larger the profits at IPO, the higher the IPO proceeds. An extra $1 million in profits the year before an IPO can raise the market cap by $50mn – $70mn when the company goes public on Chinext. Private Chinese companies, unlike those already public in China,  can also use their shares to pay for acquisitions. The better private companies also often have a private equity investor involved. The PE firms can be an important source of cash to finance acquisitions, since it will juice their own returns. PE firms like making money from p/e arbitrage.

In M&A, the best pricing strategy is to swap some of my overvalued paper to buy all of someone else’s undervalued paper.  At the moment, some of the most overvalued paper belongs to Chinese companies on the path to IPO in China.

Most M&A deals end up benefitting the selling shareholders far more than the buyers. That’s because the buyers almost always fail to capture the hoped-for savings and efficiencies from combining two firms. Too often, such synergies turn out to be illusory.

For Chinese acquirers, p/e arbitrage greatly increases the likelihood of an M&A deal paying off – if not immediately, then when the combined company goes public.

If the target company in the US has reasonable rate of profit growth, the picture gets even rosier. The rules are, a private Chinese company will generally need to wait three years after an acquisition to go public in China. As long as the acquired business’s profits keep growing, the Chinese companies market value at IPO will as well. Chinese acquirers should do deals like that all day long.

But, as of now, they are not. One reason, of course, is that things can and often also go wrong in M&A deals. Any acquirer can easily stumble trying to manage a new business, and to maintain its rate of growth after acquisition. It’s tougher still when it’s cross-border and cross-cultural.

Another key reason: domestic M&A activity in China is still rather scant. There isn’t a lot of experience or expertise to tap, particularly for private companies. Knowing you want to buy and knowing how to do so are very different beasts. I’ve seen that in our work. Chinese companies immediately grasp the logic and pay-off from a US acquisition. They are far less sure how to proceed. They commonly will ask us, investment bankers to the seller, how to move ahead, how to work out a proper valuation.

The best deals, as well as the easiest, will be Chinese acquiring US companies with a large untapped market in China. Our clients belong in this camp, US companies that have differentiated technology and products with the potential to expand very rapidly across China.

In one case, our client already has revenues and high profit margins in China, but lacks the local management and know-how to fulfill the demand in China.  The senior management are all based in the US, and the company sends trained US workers over to China, putting them up in hotels for months at a time, rather than using Chinese locals. Simply by localizing the staff and taking over sales operation now outsourced to a Chinese “agent”, the US company could more than double net profits in China.

The US management estimates their potential market in China to be at least ten times larger than their current level of revenues, and annual profits could grow more. But, to achieve that, the current  owners have concluded their business needs Chinese ownership.

If all goes right, the returns on this deal for a Chinese acquirer could set records in M&A. Both p/e arbitrage and high organic profit growth will see to that. Our client could be worth over $2 billion in a domestic IPO in China in four years’ time, assuming moderate profit targets are hit and IPO valuations remain where they are now on China’s Chinext exchange.

Another client is US market leader in a valuable media services niche, with A-List customers, high growth and profits this year above $5mn. After testing the M&A waters in the US, the company is now convinced it will attract a higher price in China. The company currently has no operations now in China, but the market for their product is as large – if not larger – than in the US. Again, it needs a Chinese owner to unlock the market. We think this company will likely prove attractive to quoted Chinese technology companies, and fetch a higher price than it will from US buyers.

The same is true for many other US companies seeking an exit. US businesses will often command a higher price in China, because of the valuation differentials and high-growth potential of China’s domestic market.

China business has prospered over the last 20 years by selling things US consumers want to buy. In the future,  it will prosper also by buying businesses the US wants to sell.

 


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Chinese Press Interviews

Leave a Comment / June 8, 2011

Back-to-back articles over the last several days in two Chinese dailies, Shenzhen Economic Daily (深圳商报)and Tianjin Ribao (天津日报). In both, I’m rather extensively quoted. You can read them here:

Shenzhen Economic Daily

Tianjin Ribao

For those whose Chinese is wanting (as is mine, some of the time), the Shenzhen Economic Daily article discusses the difficulties Chinese companies have run into after getting listed in the US stock market. One possible solution is to “de-list” these companies, by buying out all public shareholders, then applying for an IPO in China. Could it work? Perhaps, but my guess is that a Chinese company trying the Prodigal Son technique will likely meet with much skepticism from Chinese retail investors.

The article in the Tianjin Ribao is a general survey of developments in private equity in China. It discusses the shifting locus of PE investment towards inland China. This is a development I embrace. The vast majority of China’s vast population lives in places that have no outside equity capital, and no private companies on the stock market.

Over the last six months, I put in the time to prospect in regions that have thus far received little, to no, private equity. I’ve visited companies in Guizhou, Yunnan, Guangxi, Hunan, Sichuan, Qinghai, Henan, Liaoning, Xinjiang, Hebei, Shandong. We’ve taken on clients in quite a number of these. I hope to add more. The one constant in all these prospecting trips: there are outstanding entrepreneurs running outstanding businesses in every corner of this country.

 

 

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China Needs Shale Gas as Much, If Not More, Than US

Leave a Comment / May 25, 2011

Shale gas is the most important major new source of energy on the planet, as well as the most important development in the petroleum economy since deep water drilling. Shale gas is reshaping the world’s energy market in a way that even a decade ago seemed unthinkable. This is especially true in the US, where most of the shale gas development is now taking place. Ten years ago, shale gas was just 1% of American natural-gas supplies. Today, it is about 25% and could rise to 50% within two decades. Estimates are that US has more than a 100-year supply of natural gas, thanks to the development of shale gas. Natural gas is used for everything from home heating and cooking to electric generation, industrial processes and petrochemical feedstocks.

Shale gas was first discovered over a century ago. But, it’s only become a commercially-viable source of natural gas with the invention, over the last twenty years, of new drilling technology to break layers of rock and release the gas trapped within. The technology is known as hydraulic fracturing (now widely known as “fracking” or “fracing”). The companies that have played the leading role in developing this technology are mainly all American. They are already making billions of dollars using their techniques to drill deep under the surface across the continental US and harvest the gas trapped there.  The US, which just a few years ago looked to be running out of natural gas, now may someday begin exporting, thanks to its large deposits of shale gas.

The US has long been the world’s largest user and importer of energy. Last year, it was announced that China has overtaken the US in overall energy consumption. Its energy imports are on track to overtake America’s. Although natural gas use is increasing in China, it only comprised 4 percent of the country’s total energy consumption in 2008.

Beneath China’s surface also lies shale gas, most likely quite a lot of it. According to information released by the US Energy Information Administration (EIA) in April, China has 1,275 tcf of technically recoverable shale gas resources, nearly 50% more than the US.  Those estimated recoverable reserves are more than one thousand times the amount of natural gas used in China in 2010.

For China in decades to come, as much as for America, shale gas could be the energy “game-changer”, increasing energy self-reliance and helping to shift the country away from its heavy reliance on coal for electricity generation. Domestic shale gas, if fully exploited, would have enormous impacts not only in China, but worldwide. It could moderate China’s skyrocketing demand for petroleum, one of the primary drivers of higher oil prices. It would mean less coal gets mined and burned, which would have widespread environmental benefits and also ease the strain on the nation’s transportation infrastructure, a large part of which is now devoted to moving coal from where its mined to where its burned for electricity.

China already has more cars and busses running on natural gas than the US. Quite a few cities, including some large ones like Chongqing and Urumqi in Xinjiang, have many of their taxis running on natural gas. There is already a large infrastructure of “natural gas stations” across China. In other words, China stands to benefit, proportionately, even more from the US from a large supply of cheap, domestic natural gas.

The key question is: will China be able to tap its shale gas efficiently? In fact, it may be one of the most important questions in world energy markets over the next five to ten years. The technology is new, complex and almost entirely American. The owners may not be interested to share it with Chinese companies. For one thing, most of the companies with core technology and experience in tapping shale gas are themselves producers, not just suppliers of drilling equipment. Under current rules, they might not find China a very attractive market, especially when the US has so much untapped natural gas, as does neighboring Canada.

China’s leaders clearly understand the importance of shale gas to its economy and the importance of US shale gas technology. China’s goal is to produce 30 billion cubic meters a year from shale, equivalent to almost half the country’s gas consumption in 2008.  In November 2009, US President Barack Obama agreed to share US gas-shale technology with China, and to promote US investment in Chinese shale-gas development.

That sounds more significant than it probably is. President Obama cannot do much to help China, since the US government has little shale gas technology of its own, nor can he provide any real economic incentive for US companies to share technology with China. If there is a good market reason for US companies to drill for shale gas in China, they will surely do it. That is not the case now, as far as I can tell. Energy production and pricing are both heavily controlled by the Chinese government. A US shale gas producer would probably not be able to fully-own a shale gas field in China, nor sell its output at world market prices.  So, my guess is the owners of the best shale gas technology will not likely share it with China.

PetroChina and China National Offshore Oil Corporation (CNOOC) bought stakes in North American shale drillers like Chesapeake Energy and EnCana with the intent of acquiring technology and ramping up production at home. But, it is not certain, to say the least, that this strategy will pay off — becoming a small shareholder is not the same as buying a right to that company’s technology and expertise.

That leaves China with two choices, neither of which is appetizing: first, rely on domestic technology; second, try to obtain US technology by other than legal means. It could take domestic producers a long time to master the technology, and even then, it may not be equal to the best of what the US now has. With the second route, the problem is that it’s not enough just to get hold of drilling equipment. Exploiting shale gas reserves requires a mix of special equipment and know-how, which is far harder to obtain. A lot of the most successful shale gas fields in the US, for example, use horizontal drilling, a method pioneered in US, that allows operators to “ drill down to a certain depth and then to drill at an angle or even sideways. This exposes more of the reservoir, permitting the recovery of a much greater amount of gas,” according to the noted energy researcher Daniel Yergin.

China needs its shale gas, now. It is of vital importance to China, as well as the rest of the developed world. Everyone is hurt if Chinese demand for petroleum continues to push prices higher and higher, especially when there is an attractive alternative, that China shifts more of its energy consumption to natural gas, produced at home.

It’s a troubling sign that China’s Ministry of Land and Resources continues to delay distribution of the country’s first official shale gas blocks. Its first announcements indicated that only Chinese state-owned energy companies could bid on rights to these shale gas deposits.

My preference would be for China’s government to make it as financially rewarding to exploit shale gas there as it is in the US. It can do this with a mix of tax incentives and various rebates available, for example, to US companies that develop shale gas fields in China. The US oil industry doesn’t bother much with politics. They go where there is money to be made.

China will likely spend over $180 billion this year on oil imports, enriching foreigners in places like Iran, Russia and Venezuela. Based on that uncomfortable fact, and that using more natural gas will cut the environmental damage caused by burning so much coal, the rational policy choice is to do about whatever it takes to get US shale gas producers to come to China and start drilling, fraccing and pumping.

My advice: let it be done, and let it be done soon.


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CFC’s Annual Report on Private Equity in China

Leave a Comment / May 2, 2011

2010 is the year China’s private equity industry hit the big time. The amount of new capital raised by PE firms reached an all-time high, exceeding Rmb150 billion (USD $23 billion). In particular, Renminbi PE funds witnessed explosive growth in 2010, both in number of new funds and amount of new capital. China’s National Social Security Fund accelerated the process of investing part of the country’s retirement savings in PE. At the same time, the country’s largest insurance companies received approval to begin investing directly in PE, which could add hundreds of billions of Renminbi in new capital to the pool available for pre-IPO investing in China’s private companies.

China First Capital has just published its third annual report on private equity in China. It is available in Chinese only by clicking here:  CFC 2011 Report. Or, you can download directly from the Research Reports section of the CFC website.

The report is illustrated with examples of Shang Dynasty bronze ware. I returned recently from Anyang, in Henan. Anyone with even a passing interest in these early Chinese bronze wares should visit the city’s splendid Yinxu Museum.

This strong acceleration of the PE industry in China contrasts with situation in the rest of the world. In the US and Europe, both PE and VC investments remained at levels significantly lower than in 2007. IPO activity in these areas remains subdued, while the number of Chinese companies going public, and the amount of capital raised, both reached new records in 2010. There is every sign 2011 will surpass 2010 and so widen even farther the gap separating IPO activity for Chinese companies and those elsewhere.

The new CFC report argues that China’s PE industry has three important and sustainable advantages compared to other parts of the world. They are:

  1. High economic growth – at least five times higher in 2010 than the rate of gdp growth in the US and Europe
  2. Active IPO market domestically, with high p/e multiples and strong investor demand for shares in newly-listed companies
  3. A large reservoir of strong private companies that are looking to raise equity capital before an IPO

CFC expects these three trends to continue during 2011 and beyond. Also important is the fact that the geographic scope of PE investment in China is now extending outside Eastern China into new areas, including Western China, Shandong,  Sichuan. Previously, most of China’s PE investment was concentrated in just four provinces (Guangdong, Fujian, Zhejiang, Jiangsu) and its two major cities, Beijing and Shanghai. These areas of China now generally have lower rates of economic growth, higher labor costs and more mature local markets than in regions once thought to be backwaters.

PE investment is a bet on the future, a prediction on what customers will be buying in three to five years. That is the usual time horizon from investment to exit. China’s domestic market is highly dynamic and fast-changing. A company can go from founding to market leadership in that same 3-5 year period.  At the same time, today’s market leaders can easily fall behind, fail to anticipate either competition or changing consumer tastes.

This Schumpetrian process of “creative destruction” is particularly prevalent in China. Markets in China are growing so quickly, alongside increases in consumer spending, that companies offering new products and services can grow extraordinary quickly.  At its core, PE investment seeks to identify these “creative destroyers”, then provide them with additional capital to grow more quickly and outmaneuver incumbents. When PE firms are successful doing this, they can earn enormous returns.

One excellent example: a $5 million investment made by Goldman Sachs PE in Shenzhen pharmaceutical company Hepalink in 2007.  When Hepalink had its IPO in 2010, Goldman Sachs’ investment had appreciated by over 220 times, to a market value of over $1 billion.

Risk and return are calibrated. Technology investments have higher rates of return (as in example of Goldman Sachs’s investment in Hepalink)  as well as higher rates of failure. China’s PE industry is now shifting away from investing in companies with interesting new technologies but no revenue to PE investment in traditional industries like retail, consumer products, resource extraction.  For PE firms, this lowers the risk of an investment becoming a complete loss. Rates of return in traditional industries are often still quite attractive by international standards.

For example: A client of CFC in the traditional copper wire industry got PE investment in 2008. This company expects to have its IPO in Hong Kong later this year. When it does, the PE firm’s investment will have risen by over 10-fold.  Our client went from being one of numerous smaller-scale producers to being among China’s largest and most profitable in the industry. In capital intensive industries, private companies’ access to capital is still limited. Those firms that can raise PE money and put it to work expanding output can quickly lower costs and seize large amounts of market share.

Our view: the risk-adjusted returns in Chinese private equity will continue to outpace most other classes of investing anywhere in the world. China will remain in the vanguard of the world’s alternative investment industry for many long years to come.


 

 

 

Entrepreneurship in China– The Fuel in the Economy’s Engine

1 Comment / April 26, 2011

Fish bowl from China First Capital blog

China’s only abundant and inexhaustible natural resource is the entrepreneurial talent of its people. Nowhere else in the world can match the number of talented businesspeople, both in absolute numbers and as a share of the active population. That’s what I’ve learned in a 25-year career working alongside great entrepreneurs in the US, Europe and Asia. Today’s China is the most entrepreneurially-endowed place in the world. What that means, above all, is that China’s economy, propelled by robust entrepreneurial activity,  will prosper for the next several decades at least.

Entrepreneurs everywhere seem to share a common gene, and have more in common with one another than they do with the rest of the population in their home countries. They are more tolerant of risk, more compelled to try or invent new things, more able to see opportunities for profit, especially when they are invisible to others.

But, in China, entrepreneurs have some unique characteristics compared to those in the US and Europe. For one thing, until comparatively recently, China’s economy was a near-perfect socialist vacuum in which entrepreneurship could not survive.  The economy was almost entirely in state hands. Laws giving equal treatment to private companies were only introduced in 2005. Decades of pent-up entrepreneurial energy were unleashed. More great private companies have been started in the last ten years in China than in any other place in history.

We are still in the early years of the Big Bang of Chinese entrepreneurship. Everyone in the world is feeling the effects. Within China, private entrepreneurs now supply much of what China’s vast consumer market buys. Outside China, much of what’s labeled “Made in China” is produced in factories started and run by these new entrepreneurs.

There are some other important ways in which China’s entrepreneurs are different than those in US and Europe. A very minor percentage of China’s entrepreneurs are university graduates. They build their companies with almost no capital, and no access to bank credit. They face daunting challenges unknown to entrepreneurs most everywhere else: an absence of clear commercial laws or intellectual property protection, very burdensome tax and labor rules, holdover policies that give state-owned companies significant advantages.

Despite it all, every year, more of China’s population are going into business for themselves. Not all will build billion-dollar businesses. But, more will do so in China over the next several decades than anywhere else.

Partly, it’s simple math: China has both a huge domestic market and is the world’s largest manufacturing and exporting nation. But, these factors are themselves the product of China’s earlier entrepreneurial success, not a precondition for it. Earlier entrepreneurs created the fertile environment for today’s new private companies to thrive. The process is cumulative, and very fast-moving.. I see this every day in my work. We are meeting more great entrepreneurs now, on a weekly basis, than we did three, six or twelve months ago.

Another fact stands out when I compare these Chinese entrepreneurs to others I’ve worked with in the US and Europe. Chinese entrepreneurs do most everything single-handedly. They build companies without relying on a big management team or a circle of advisors. Decision-making is mainly based on hunch and experience, not on market research or focus groups. Even large private companies in China are managed like sole proprietorships. Nothing of importance is delegated. One person controls all the decision-making levers, casting the one and deciding vote on any issue of importance to do with operations, marketing, finance, strategy, sales. They are lone navigators, steering their businesses through very tricky waters, dealing with government officials, suppliers, customers, as well as their own employees.

Since starting China First Capital three years ago, I’ve been fortunate enough to meet several hundred outstanding Chinese entrepreneurs from dozens of different industries. Most are cut from the same cloth — crisp, confident, charismatic. With few exceptions, most do not have college degrees or much experience working for anyone else. They are born entrepreneurs.

Take one boss I met recently. He began his working life 30 years ago, after high school, as a trader. He was good at it, and saved enough, eventually, to go into manufacturing one of the products he was selling as a wholesaler to others. He moved up quickly, from producing basic low-margin commodity products to investing in his own R&D. He kept plowing profits back into the R&D work, and then to build new factory lines to produce a range of unique, patent-protected products he invented. These products deliver higher margins and target a larger, richer market than anything he previously manufactured.

The business is now growing very swiftly. Also typical, his son has joined the business, after getting a college degree abroad.  This boss, like most others I have met, knows how to work the system to his maximum advantage. His new products let him qualify as a high-tech enterprise, and so pay a much lower corporate income tax rate. The local government has shown its further support by selling him a large tract of land to build a new factory on, at a fraction of its market price.

This boss, somewhat uncommonly, has a very strong management team around him to manage finances, factory production and marketing. He is the force of gravity holding whole business together. It’s hard to imagine anyone else, except perhaps one day his son, could run this business as well. That’s another characteristic shared by most good entrepreneurial companies in China – they are never quite as successful once the founder steps down.

Another distinguishing trait of entrepreneurship in China – there are far more women bosses here than I ever saw in the US or Europe.  The ones I’ve met, along with being successful entrepreneurs, are also all quite elegant, attractive, even seductive. Those aren’t words usually associated with entrepreneurs anywhere else in the world.

According to the magazine China Entrepreneur, there are currently more than 29 million female entrepreneurs in China,  or about 20% of the total number of entrepreneurs in the country. Overall, China has more entrepreneurs, male and female, than most countries have citizens.

China’s economy continues to perform at a level never achieved by a major economy. Can this continue? I believe it can. The most emphatic reason is the entrepreneurial genius of so many of its citizens.

 

 

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