傅成

A Bond Market for Private Companies in China

Leave a Comment / December 13, 2012

Capital allocation in China was built on a wobbly pedestal. One of its three legs was missing. Equity investment and bank lending were available. But, there was no legal way for private companies to issue bonds.  That has now changed. In May this year, the Chinese government approved the establishment of a market for private company bonds in China. This is an important breakthrough, the most significant since the launch three years ago by the Shenzhen Stock Exchange of the Chinext board (创业板） for high-growth private companies. The new bond market has the potential to dramatically increase the scale of funding for private business in China.

Companies can issue bonds through a group of approved underwriters in China, who place the bonds with Chinese institutions. The bonds then trade on secondary markets established by both the Shenzhen or Shanghai stock exchanges. Bonds should lower the cost of capital for Chinese companies, and provide attractive returns for fixed-income investors. Another positive effect: the bonds disintermediate Chinese banks, which for too long have overcharged and under-served private company borrowers.

Up to now, though, China’s private company bond market is off to a bumpy start. Regulators are over-cautious, investors are inexperienced, companies are confused, the secondary markets are lacking in liquidity. We have no direct involvement in the private company bond market. We don’t issue or trade these instruments. But, we are eager to see private company bonds succeed in China. It will increase the capital available for good companies, and allow companies to achieve a more well-balanced capital structure. Capital remains in very short supply. Many PE firms in China have recently cut back rather dramatically in their funding to private companies, because of a decline in China’s stock market and a marked slowdown in the number of IPOs approved in China.

We recently prepared for the Chinese entrepreneurs we work with a short briefing memo on private company bonds. It’s in Chinese. The title is  “中国中小企业私募债”. You can download a copy by clicking here.

We explain some of the practical steps, as well as the potential benefits, for companies interested to float bonds. At the moment, only companies based in a handful of China’s more economically-advanced provinces (including Shanghai, Guangdong, Zhejiang, Jiangsu) may issue the bonds. Most underwriters expect the geographical limitations to ease, over the next year, allowing companies in all parts of the country to participate. There is no clear threshold on how big a company must be to issue bonds. But, there is a clear preference for larger businesses, with profits of at least Rmb20mn (USD$3mn). In several cases, underwriters have pooled together several smaller companies into a single bond issue. Real estate developers, currently hurting because of the cut-off in bank lending to this industry, are not eligible to issue bonds.

In theory, a company can issue bonds without offering collateral or third-party loan guarantees, both of which are required by banks to secure a typical short-term corporate loan. In practice, however, the market is signaling strongly it prefers these kinds of risk protections. Interest rates on some of the private company bonds already issued have been below the levels typically charged by banks for secured lending. But, the rate is starting to move up, to over 10%. My guess is that interest rates for good borrowers should move back below 10%. That level offers bondholders a very solid real rate of return, and prices in the risk. In the US and Europe, decent companies can borrow at LIBOR+4-6%, or around 5%-7% a year.

Overall, as the new bond market expands and matures, we expect these bonds to offer the lowest cost of capital for growth companies in China. Bond maturities can be as long as three years;  interest and principal payments can be structured to accommodate future cash flows. This is generally far more suitable than the rigid short-term lending facilities available from Chinese banks.

Underwriters are promising companies they can complete the process of issuing a bond, including regulatory approvals, in three months or less. That’s remarkably quick for any capital markets transaction in China, and reflects the fact China’s finicky securities regulator, the CSRC, has no role in approving private company bonds. The Shanghai and Shenzhen stock markets regulate and approve bond issuance.

PE firms are starting to notice that access to bond market gives private companies more leverage and a little more pricing power when negotiating equity financing. The Chinese companies that can successfully issue bonds are generally the ones that PE firms also target.  Over time, though, PE firms should welcome the emergence of a functioning private company bond market in China.  The new bond market gives companies, including those with PE investment, an opportunity ahead of a domestic IPO to operate in the capital market, build a reputation for transparency and good performance. This should mean a higher IPO valuation if and when the company does decide to go public.

 

 

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

1 Comment / September 6, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

SOEs That Are SOL – China’s Forgotten and Unprivileged State-Owned Enterprises

3 Comments / December 15, 2013

Perhaps the most commonly-heard criticism these days of the Chinese government’s economic policy is that secret policies favoring State-Owned Enterprises (so-called “SOEs”) are becoming more numerous, heavy-handed and harmful to the prospects of private business in China. This criticism, like others of China,  gains strength and credence because it is basically unfalsifiable. Since the policies are secret and the impact hidden from direct view, the only evidence offered is the continued growth and profits of SOE giants like China Mobile, ICBC, Sinopec and others.

While it’s undeniable that SOEs do enjoy a lot of advantages private companies can only dream of, often including easier access to bank loans and markets rigged to prevent free competition, I’m dubious that a real shift really is taking place, and that the Chinese government is wholesale turning its back on private business in order to make life easier for SOEs.

Not all SOEs are living a life of wine and roses. For them, government support is limited, haphazard, often counterproductive. There are hundreds of such SOEs in China. They aren’t the giant companies many foreigners have heard of. These SOEs are surviving, but not really prospering, with clapped-out equipment, low profits, bloated workforces and balance sheets larded with debt. It’s by no means clear that having a government owner is more of a benefit than a liability.

These SOEs have no real pressure to optimize profits and increase efficiency.  Their government owners, to the extent they even notice these smaller industrial SOEs,  are mainly concerned that they should continue to provide jobs, hand over a bit of money each year in taxes and dividends, and continue to increase output. In many ways, for all the epochal changes over the last 30 years in China, many SOEs are still run much as they were during the days of complete central planning:  growing bigger is still more important than growing more profitable, innovative, dynamic.

Thirty years ago, all of Chinese industry was state-owned and most urban Chinese were employed by the state. Then came the private sector reforms and liberalization under Deng Xiaoping, the rise of private business (which officially now contribute more than 70% of China’s gdp) and the bankruptcy of thousands of large SOEs, when many of the largest loss-making SOEs were forced to close. This process of culling the loss-making SOEs is often called “淘汰” (“taotai”) in Chinese, a term I quite like. It literally means to “wash clean” or “wipe out”.

But, many thousands of smaller, barely-profitable SOEs survived “taotai”. They are the ones now often living in a state more akin to Dickensian squalor than the plush recipients of government favor. Visit, as I did recently,  one of the “un-taotai’ed”  SOEs, and you will soon be disabused of the idea that all SOEs are prospering and that the Chinese government is running an economy to benefit SOEs at the expense of private business.

The SOE I visited is in Shaanxi province, about an hour’s drive from the capital, Xi’an. The factory was established in 1966, at the start of the Cultural Revolution, by a team of thousands of workers forcibly relocated from Tianjin. It manufactures certain special types of fiberglass, including some used by China’s military and space program. The SOE still produces many of the same products, on 45 year-old equipment, in a sprawling and broken-down facility the likes of which I’d never seen before in China. Most of the buildings are dilapidated, the roads inside potholed. Polluted waste water belches from pipes into overflowing holding pens.

This company, in one sense, is lucky. It has no competitors inside China, and only two elsewhere, Soviet-era factories in Byelorussia and Latvia. Saddled with unnecesarily large payroll and other ancillary costs not related to producing fiberglass, profit margins are low. But, the company earns money most years, including about $1 million in profits in 2011.

The problem, though, is that the company can’t get the capital to modernize, expand or rationalize its workforce of almost 2,500. It’s still responsible for the running costs of a local hospital, school and kindergarten. When the company’s boss goes to the government for help, he’s mainly told to fend for himself. The company is too small to get any attention from its government owners. So, it floats along in a kind of sad limbo.

With money and profit-seeking owners, the company could probably grow into a quite successful industrial business. The market for its products is actually growing. If they could let go excess payroll and obligations, margins would likely rise above 15%, generating sufficient surplus to finance the large expansion plans and upgrade the company’s boss has been trying, unsuccessfully, to implement for six years. The government says it has no cash to inject. State-owned banks, for all their supposed leniency towards SOEs, won’t increase lending. Instead, the government is urging the factory boss to find a private investor, to put together some kind of privatization plan.

But, in this case and many like it, whenever the Chinese government won’t invest, few if any sane private investors will. Any new investor would have to fund the cost of layoffs of up to 1,800 people. Most are entitled to one month severance for every month of employment.  Average salary is around $500 a month.

The new investor would also, according to Chinese law, probably need to buy its shares from the provincial arm of SASAC at a price tied to the company’s net assets, not its rather dismal operating performance. The entire business may be worth only $10 million. But, using the net asset formula, which includes a big chunk of valuable land, the price almost triples. After all this money goes out the door, the new investor would need to pump another $12mn-$15 mn into the company to finance improvements and expansion.

For any investor seeking to buy control of the company, the likely rate of return after all these outlays, even under the most optimistic scenarios, would be under 10% a year.  That’s a deal that few investors would consider. Along with the need to shell out all the money, a new owner would also acquire lots of contingent liabilities of unpredictable size and severity, including the cost of an environmental clean-up, repairs to company-owned housing where most of the current 2,300 workers, as well as retirees, live.

After spending the day with him, I sympathize with the company boss’s plight. He wants to run an efficient operation, turn it into a leading producer of certain high-technology fiberglass materials, and maybe earn his way into owning a small piece of the company. But, the current mix of policies in China will make that hard, if not impossible, to achieve.

While big SOEs do enjoy a lot of political clout, with sparkling new headquarters, and a low cost of capital that other companies envy, these smaller SOEs inhabit an altogether different and inhospitable world. Government ownership is far more of a hindrance than a help. And yet, they have no real way to free themselves.  These SOEs are, as Americans would say, SOL.

 

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Teaching the Elephant to Dance – China’s SOEs Transform

1 Comment / April 7, 2013

Over the last thirty years, China has gone from a country where just about all companies were state-owned enterprises (so-called “SOEs”) to one where now fewer than 30% are. Much of the dynamism in China’s domestic economy comes from these newer private companies. There are some very strong SOEs dominating key sectors of China’s economy, including China Mobile, Sinopec, ICBC and other large banks, as well as airlines and utilities. These companies have also been partially privatized by selling minority stakes on global stock markets. This has provided huge amounts of new capital and brought with it improved performance and corporate governance at these top SOEs.

But, many SOEs have failed, while others languish with inefficient production, overstaffing and outmoded products. For many of these, the prognosis is not good. But, at the same time, there is a entrepreneurial transformation getting underway at some of these SOEs. Managers are beginning to act more like owners and less like civil servants. We are seeing this now in our work. Some of the most interesting companies we’re talking to are SOEs eager to bring in outside capital as a first step towards privatization, and subsidiaries of larger SOEs looking for ways to split themselves off from their parent and go public independently.

I expect to see more and more private capital, particularly from private equity firms, going into SOEs. In some cases, the investors will find ways to take majority control. In others, they will link their minority investment to a corporate restructuring that gives the SOEs management equity, warrants, or other incentives to improve performance and profitability.

The likely result: some of China’s more tired SOEs are going to get a big dose of free market adrenalin. At the moment, there are lots of legal hurdles for private capital to enter into an SOE. The process is opaque. We’re spending a fair bit of time on behalf of several SOEs trying to figure out workable legal mechanisms. To succeed, any deal will take time and need champions in higher levels of government. But, practical economic policies tend to triumph in China. Private capital is, without question, the best option to improve the profitability and future prospects of many SOEs. This is good for employment, good for economic growth, good for worker incomes, good for accelerating development in inland China. These are all core policy goals in China.

I’m not able to discuss details or provide company names, but I can give an outline of several of the most interesting SOE transactions we are now working on. This should give a sense of the kind of changes that may be on the way for SOEs.

In one case, a subsidiary of one of China’s largest publicly-traded SOE construction holding companies is looking for ways, with the parent company’s encouragement, to spin itself off, raise private equity capital, and then try for an IPO. Though it contributes only about 5% of the parent company’s total revenues and operates in different markets than the parent, this subsidiary is one of the largest, most successful companies in its industry in China. Its profits this year should exceed Rmb 650mn (USD$100mn).

Because the parent company is already public, this subsidiary needs to fight for capital with other larger sister companies inside the conglomerate. It usually comes up short. With access to new capital, the subsidiary’s current managers are confident they could double the size of the business (both profits and revenues) within two to three years.  Outside of China, spinning off a subsidiary or selling a minority stake in an IPO is a fairly straight-forward process. Not so in China.

Under current rules, the CSRC, China’s stock market regulator, will not allow the parent simply to spin off the subsidiary through an IPO. There are related party transactions and deconsolidation issues.  So, we are looking at ways for a large strategic investor to buy a controlling stake in the subsidiary, then pour in as much as $250mn in new capital. The subsidiary will then build up its business to where it could either qualify for an IPO three to five years later, or the PE firm would exit by selling its stake back to the parent.

The management of this subsidiary are quite keen to put in their own money and become shareholders if their business can be separated and put on a path to IPO. They have done a very solid job building the business to its current scale, and would likely do markedly better if they had a real stake in the performance of the company.

In another deal we are working on, a chemical company now majority owned by Sinopec is bringing in new capital to buy the Sinopec shares and recapitalize the business. The company was started seven years ago by a private entrepreneur, who raised the original capital from Sinopec. The entrepreneur now controls about 40% of the company’s equity. Through the deal we’re working on, he will become the majority owner and the private equity investor will own the rest.

We’re also in discussions with the international division of one of China’s giant SOE electricity companies. This group already has sizable projects and revenues in Southeast Asia and Russia, where it built and operates large hydro and gas-fueled power plants. The international division, however, is being held back by high debt levels at the SOE parent. This means the international division has trouble borrowing enough to finance its continued growth. Since the international division is already structured legally as a Hong Kong company, it should be possible for it to raise private equity then IPO in Hong Kong. We think this division can raise as much as USD$500mn in the next three years, both in private equity and IPO.

These three (the construction subsidiary, the chemical company and international power plant business) are all very solid businesses that outside investors will likely flock to. We’re also trying to find a way to help a more troubled smaller SOE based in central China. They make certain types of special fiberglass. The core business is fundamentally sound, but is stuck also doing some other things that lose money.  It is too small now to qualify for an IPO, and is having a hard time in the current environment increasing its bank borrowing. The existing managers are eager to have an outside private equity investor come in and not only provide the capital, but also help improve manufacturing efficiency and marketing, and chop away the loss-making parts. They think an investment of Rmb 50mn could increase profits by a similar amount within two years.

As anyone with experience will tell you, working with SOEs can be a complicated and time-consuming process, particularly compared to dealing with a company founded and run by a private entrepreneur. While we’re fortunate to have strong entrepreneur-led companies as clients, I also quite enjoy working on these SOE transactions. It affords an up-close view of the way SOEs operate and problem-solve. I’m also getting to participate, in a small way, in perhaps the most significant transformation now taking place in China’s economy. With new capital and perhaps new ownership structures, SOEs are going to thrive as never before. Their greater efficiency and greater profits will be a challenge for the private sector, but overall will be a plus for China.

 

 

The CSRC Disciplines the IPO Process in China

Leave a Comment / June 11, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Renminbi Funds: Can They Rewrite the Rules of Profitable Investing?

Leave a Comment / May 23, 2012

Renminbi private equity funds are the world’s fastest-growing major pool of discretionary investment funds, with over $20 billion raised in 2011. These Renminbi funds also play an increasingly vital role in allocating capital to China’s best entrepreneurial companies. Despite their size and importance, these Renminbi funds often have a structural defect that may limit their future success.

Most Renminbi funds are managed by people whose pay is only loosely linked, if at all, to their performance. They are structured, typically, much like a Chinese state-owned enterprise (“SOE”),  with multiple managerial levels, slow and diffuse decision-making, rigid hierarchies and little individual responsibility or accountability. The resemblance to SOEs is not accidental. Renminbi funds raise a lot of their money from state-owned companies, and many fund managers come from SOE background.

Maximizing profits is generally not the prime goal of SOEs. They provide employment, steer resources to industries favored by government plans and policies. A similar mindset informs the way many Renminbi funds operate. Individual greed along with individual initiative are discouraged. There are no big pay-outs to partners. In fact, in most cases, there are no partners whatsoever.

This represents a significant departure from the ownership structure of private equity and venture capital firms elsewhere. Partnership matters because it efficiently harnesses the greed of the people doing the investing.  The General Partners (“GPs”) usually put a significant percentage of their own money into deals alongside that of the Limited Partners who capital they invest. GPs are also highly incentivized to earn profits for these LPs. The usual split is 1:4, meaning the GP keeps 20% of net profits earned investing LPs’ money.

Of course, partnership structure doesn’t guarantee GPs are going to do smart things with LPs’ money. There’s lot of examples to the contrary. But, the partnership structure does seem to work better for both sides than any other form of business combination. GPs and LPs both know that the more the GP makes for himself, the more he makes for investors.

Renminbi funds, in most all cases, are structured like ordinary companies, or as subsidiaries of larger state-owned financial holding companies. Instead of partners, they have large management teams with layer upon cumbersome layer. The top people at Renminbi funds are picked as much for their political connections, and ability to source investment capital from government bureaus and SOEs, as their investing acumen. They are wage slaves, albeit well-paid ones by Chinese standards. But, their compensation might not even be 5% of what a partner at a dollar-based private equity firm can earn in a good year. A Renminbi fund manager will rarely have his own capital locked up alongside investors, and even more rarely be awarded that handsome share of net profits.

Renminbi funds differ in other key ways from PE and VC partnerships. The Renminbi funds usually have relatively flat pay scales, modest bonuses and a consensus approach with often as many as 20 or more staff members deciding on which deals to do.  A typical dollar-based PE fund in China might have a total of 15 people, including secretaries. A Renminbi fund? Teams of over 100 are not all that uncommon. The investment committee of a dollar PE firm might have as few as five people. Partners decide which deals to do. A Renminbi firm often have ICs with dozens of members, and even then, their decisions are often not final. Often Renminbi funds need to get investors’ approval for each individual deal they seek to do. They don’t have discretionary power, as PE partnerships do, over their investors’ money.

Renminbi funds have abundant manpower to scout for deals across all of China, and can throw a lot of people into the deal-screening and due diligence process. This bulk approach has its advantages. It can sometimes take a few months of on-the-spot paper-pushing, coaching and reorganizing to get a Chinese private company into compliance with the legal and accounting rules required for outside investment. Dollar funds don’t have that capacity, in most cases.

Also, Renminbi fund managers often have similar backgrounds to the middle management teams at private companies. They are comfortable with all the dining, wining, smoking and karaoke-ing that play such a core part of Chinese business life. The dollar funds? From partners on down, they are staffed by Chinese with elite educations, often including stints in the US working or studying.  Usually they don’t drink or smoke, and prefer to get back to the hotel early at night to churn through the target company’s profit forecast.

Kill-joys though they may be, the PE dollar funds still have, in my experience, some large – and most likely decisive — advantages over the Renminbi funds. Decision-making is nimble, transparent and centralized in the hands of the firm’s few partners. If they like a deal, they can issue a term sheet the same day. At a Renminbi fund, it can take months of internal meetings, report-writing and committee assessments before any kind of term sheet is prepared. Internal back-stabbing, politicking and turf battles are also common.

We’ve also seen deals where the Renminbi fund’s staff demand kickbacks from companies in return for persuading their firms to invest. An executive at one of China’s largest, oldest Renminbi fund estimates 60% of all deals his firm does probably include such under-the-table payoffs.

It’s often futile to try to figure out who really calls the shots at a Renminbi fund. Private company bosses, including several of our clients, are often loath to work with organizations structured in this way. The boss at one of our clients recently chose to take money from two dollar PE firms because he couldn’t get a meeting with the boss of the well-known Renminbi fund that was courting him hard. That firm compounded things by explaining the fund’s boss was anyway not really involved in investment decision-making and would certainly not join our client’s board.

The message this sent: “nobody is really in charge, so if we invest, you are on your own”. For a lot of China’s self-made entrepreneurs, this isn’t the sort of message they want to hear from an investor. They like dealing with partners who have decision-making power, their own money at stake alongside the entrepreneurs. PE partners almost always take a personal role in an investment by joining the board. In short, the PE partner acts like a shareholder because he is one, directly and indirectly.

At a Renminbi fund, the managers do not have skin in the game, nor a clear financial reward from making a successful investment. A Renminbi fund manager can be fired or marginalized by his bosses at any time during the long period (generally at least 3-5 years) from investment to exit. Private equity investing has long time horizon, and the partnership structure is probably the best way to keep everyone (GP, LP, entrepreneur) engaged, aligned and committed to the long-term success of a company.

It is possible for Renminbi funds to organize themselves as partnerships. But, few have done so, and it’s unlikely many will. The GP/LP structure is supremely hard to implement in China. Those with the money generally don’t accept the principle of giving managers discretionary power to invest, and also don’t like the idea of those managers making a significant sum from deals they do.

All signs are that Renminbi funds will continue to grow strongly in number and capital raised. This is, overall, highly positive for entrepreneurship in China. Hundreds of billions of Renminbi equity capital is now available to private companies. As recently as three years ago, there was hardly any. Less clear, however, is how efficiently that money will be invested. I know from experience that Renminbi funds find and invest in great companies. But, they also are prone to a range of inefficiencies, from bureaucratic decision-making to a lack of real accountability among those investing the money,  that can adversely impact their overall performance.

One way or the other, Renminbi funds will rewrite the rules for private equity investing, and eventually provide a huge amount of data on how well these managers can do compared to PE partners. My supposition is that Renminbi firms will not achieve as high a return as dollar-based PE firms investing in China. The reason is simple: investing absent of greed is often investing absent of profit.

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Private Equity in China, 2012: CFC’s New Research Report

Leave a Comment / April 26, 2012

Around the time of Confucius 2,500 years ago, the Greek philosopher Heraclitus wrote, “Nothing is permanent except change.” It’s a perfect quick summary of the private equity industry in China. In its short 20 year history, PE in China has undergone continuous transformation: from dollars to Renminbi; from a focus on technology companies to a preference for traditional industries; from overseas IPO exits to domestic listings;  from a minor financing channel to a main artery of capital to profitable private companies competing in the most dynamic and fast-growing major market in the world.

Where is private equity in China headed? Can future performance match the phenomenal returns of recent years? Where in China are great entrepreneurial opportunities and companies emerging? These are some of the questions we’ve sought to answer in China First Capital’s latest English-language research report, titled “Private Equity in China, Positive Trends and Growing Challenges”.

You can download a copy by clicking:  Download “Private Equity in China, 2012 – 2013“.

Our view is that 2012 will be a year of increasingly fast realignment in the PE industry. With the US capital markets effectively closed to most Chinese companies, and Hong Kong Stock Exchange ever less welcoming and attractive, the primary exit paths for China PE deals are domestic IPO and M&A. Both routes are challenging. At the same time, there are too many dollar-based investors chasing too few quality larger deals in China.

“Adapt or die” describes both the Darwinian process of natural selection as well as the most effective business strategy for PE investing in China.

I’ve been working with entrepreneurs for most of my 30 year business career. It’s the joy and purpose of my life. Good entrepreneurs profit from change and uncertainty. Investors less so, if at all. This may be the biggest misalignment of all in Chinese PE. The entrepreneurial mindset is comfortable with constant change, with the destruction and opportunity created by market innovation. In my view, the PE firms most likely to succeed in China are those led by professionals with this same entrepreneurial mindset.

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Chinese Private Equity Moves from IPO to IRR

1 Comment / April 10, 2012

Most investors, including me,  would be delighted to make 15% to 20% per year, year after year. But, for many private equity firms active in China, that kind of return would be cause for shame. The reason is that recent past returns from Chinese PE , and so the expectations of LPs, is much higher, often overall annual increases of 40%-60% a year, with successful individual deals increasing by 100% a year in value during a typical three to five year holding period.

But, it is quickly becoming much more challenging to earn those +40% annual rates of return. My prediction is that profits from PE investing in China will soon begin a rather steep downward slide. This isn’t because there are fewer good Chinese companies to invest, or that valuations are rising sharply. Neither is true. It’s simply that a declining percentage of PE deals done in China will achieve those exceptionally high profits of 500%-800% or more over the life of an investment.

The reason is that fewer and fewer PE deals in China will achieve exit through IPO. Those are the deals where the big money is made. There are no precise numbers. But, my estimate would be that in recent years, one in four PE investments made by the top 50 firms active in China managed to have an IPO. Those are the deals with the outsized rates of return that do so much to lift a PE firm’s overall IRR.

In the future, the rate of successful IPO exit may fall by 30% or more for the good firms. For lesser PE firms, including many of the hundreds of Renminbi firms set up over the last three years, the percentage of deals achieving a domestic IPO in China may not reach 10%. If so, overall returns for each PE firm, as well as the industry as a whole, will fall rather dramatically from the high levels of recent years.

The returns for most PE and VC firms across the world tend toward bell curve distribution, with a small number of highly successful deals more than covering losses at the deals gone sour, and the majority of deals achieving modest increases or declines. In China, however, the successful deals have tended to be both more numerous and more profitable.  This has provided most of the propulsive thrust for the high rates of return.

The higher the rate of return, the easier it is to raise new money. PE firms each year keep 1% to 2% of the money they raise every year as a management fee. It’s a kind of tithe paid by LPs. PE firms also usually keep 20% of the net investment profits. But, this management fee is risk-free, and usually is enough to fully pay for the PE and VC firms salaries, offices, travel and other operating expenses, with anything left over split among the partners.

So, high rates of investment return in the past ends up translating into lots of new money unlinked to actual investment performance in the future. It’s a neat trick, and explains why the PE partners currently most actively out raising capital are mainly those investing in China. The more you raise now, the longer your guaranteed years of the good life. In other words, even if overall investment results deteriorate in coming years, the guaranteed income of PE firms will remain strong. Most funds have a planned lifespan of seven to ten years. So, if you raise $1 billion in 2012, you will have perhaps $20mn a year in guaranteed management fee income all the way through 2022.

The more new capital that’s raised for PE deals in China, the more investment deals can get done. The problem is, IPOs in China are basically a fixed commodity, with about 250 private companies going public a year. These domestic Chinese IPOs are the common thread linking most of the highest return PE deals. The Chinese IPOs will continue, and most likely continue to provide some of the highest profits available to PE firms anywhere. But, with the number of IPOs static and overall PE investment surging, the odds of a PE-backed company in China getting the green light for IPO will drop — rather precipitously if the current gusher of new money for PE deals in China persists.

Meantime, the number of Chinese companies going public outside China is dropping and will likely continue to. The US has all but barred the door to Chinese companies, following a spate of stories in 2011 about fraudulent accounting and false disclosure by Chinese companies quoted there. In Hong Kong, the only Chinese companies generating investor enthusiasm at IPO are ones with both significant size (profits of at least USD$25mn) and an offshore legal corporate structure. It used to be both simple and common for Chinese companies to set up holding companies outside China. The Chinese government has moved aggressively to shut down that practice, beginning in 2006. So, the number of private Chinese companies with the legal structure permitting a Hong Kong (or US, Singapore, Korean, Australian) IPO will continue to shrink.

Add it up and the return numbers for PE firms active in China begin to look much less rosy going forward than they have in the past. More deals will end in mandatory buybacks, rather than IPOs. This is the escape mechanism written into just about every PE investment contract. It allows the PE firm to sell their shares back to the company if an IPO doesn’t take place within a specified period of time, typically three to five years. The PE gets its original investment back, plus an annual rate of return (“IRR”), usually 10% to 20%.

This way PE firms can’t get stuck in an illiquid investment. The buybacks should become an increasingly common exit route for PE deals in China. But, they only work when the company can come up with the cash to buy the PE shares back. That will not always be certain, since pooling large sums of money to pay off an old investor is hardly the best use of corporate capital. Fighting it out in court will likely be a fraught process for both sides.

The direction of Chinese PE is moving from IPO to IRR.  As this process unfolds, and PE returns in China begin to trend downward, the PE investment process and valuations are likely to change, most likely for the worse. IRR deals seldom make anyone happy—not the PE firms, their LPs or the entrepreneur.

Chinese PE still offers some of the best risk-adjusted returns of any investment class. But, as often happens, the outsized returns of recent years attracts a glut of new money, leading to an eventual decline in overall profits. In investing, big success today often breeds mediocrity tomorrow.


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

Leave a Comment / March 6, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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CFC’s New Research Report on Capital Allocation and Private Equity Trends in China

Leave a Comment / February 28, 2012

 

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Capital allocation, not the amount of capital,  is the largest financial challenge confronting the private equity industry in China. Capital continues to flood into the PE sector in China. 2011 was a record year, with over $30billion in new capital raised by PE firms, including both funds investing in dollars and those investing in Renminbi. China’s private equity industry seems destined now to outstrip in size that of every other country, with exception of the US. Ten years ago, the industry hardly existed in China.

Yes, it is a time of plenty. Yet, plenty of problems remain. Many of the best private companies remain starved of capital, as China’s domestic banks continue to choke back on their lending. As a result, PE firms will play an increasingly vital role in providing growth capital to these companies. 

These are some of the key themes addressed in CFC’s latest research report, titled “2012-2013: 中国私募股权融资与市场趋势”. It can be downloaded from the CFC website or by clicking here.

The report is available in Chinese only.

Like many of CFC’s research reports, this latest one is intended primarily for reference by China’s entrepreneurs and company bosses. Private equity, particularly funds able to invest Renminbi into domestic companies,  is still a comparatively new phenomenon in China. Entrepreneurs remain, for the most part, unfamiliar with all but the basics of growth capital investment. The report assesses both costs and benefits of raising PE.

This calculus has some unique components in China. Private equity is often not just the only source for growth capital, it is also, in many cases, a pre-condition to gaining approval from the CSRC for a domestic IPO. It’s a somewhat odd concept for someone with a background only in US or European private equity. But, from an entrepreneur’s perspective, raising private equity in China is a kind of toll booth on the road to IPO. The entrepreneurs sells the PE firm a chunk of his company (usually 15%-20%) for a price significantly below comparable quoted companies’ valuation. The PE firm then manages the IPO approval process.

Most Chinese companies that apply for domestic IPO are turned down by the CSRC. Bringing in a PE firm can often greatly improve the odds of success. If a company is approved for domestic IPO, its valuation will likely be at least three to four times higher (on price/earnings basis) than the level at which the PE firm invested. Thus, both PE firm and entrepreneur stand to benefit.

The CSRC relies on PE firms’ pre-investment due diligence when assessing the quality and reliability of a company’s accounting and growth strategy. If a PE firm (particularly one of the leading firms, with significant experience and successful IPO exits in China) is willing to commit its own money, it provides that extra level of confidence the CSRC is looking for before it allows a Chinese company to take money from Chinese retail investors.

From a Chinese entrepreneur’s perspective, the stark reality is “No PE, No IPO”.

CFC’s Jessie Wu did most of the heavy lifting in preparing this latest report, which also digests some material previously published in columns I write for “21 Century Business Herald” (“21世纪经济报道) and “Forbes China”  (“福布斯中文”). The cover photo is a Ming Dynasty Xuande vase.

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

2 Comments / February 21, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

Is Huawei a Paper Tiger?

1 Comment / January 3, 2012

No large Chinese company is more scrutinized, criticized, ostracized and demonized than Huawei, the Shenzhen-based manufacturer of telecommunications equipment. With revenues of $28 billion in 2010, and 110,000 employees, Huawei is the second-largest telecom equipment company in the world, along with being the largest and most prominent private technology company in China. It is also said to enjoy significant behind-the-curtain support from senior figures in the Chinese government and military.

Not much is known about the secretive company. But for all its size and prominence in the telecommunications industry, Huawei’s corporate finances and balance sheet may be a good deal weaker than commonly assumed. The problem comes from Huawei’s unbalanced balance sheet, and an over-reliance on loans from Chinese state-owned banks, rather than payments from customers, to finance its business. In 2011, instead of too much help from the Chinese government, Huawei seems to have suffered from a lack of it.

The bigger Huawei has grown, the more criticism it has attracted. Competitors outside China have loudly claimed the company was a front for the Chinese military, and that it owes its size in large part to an efficient process of stealing others’ technology and then selling its cut-price knock-off equipment within China and to telecom monopolies in the world’s poorer, most despotic countries.

Huawei has had a particularly hard time of it in the US, where it was sued in 2003 by Cisco for patent infringement. More recently, its plans to buy several US tech companies were blocked by the US government or obstruction by US politicians. Some of the same politicians also blocked Huawei’s sale of some larger telecom equipment in the US by asserting, without producing any real evidence,  Huawei equipment was used by the Chinese military for eavesdropping.

In part to counter all the criticism and alter its reputation as a technological lightweight, Huawei has been spending heavily in recent years to build large R&D centers around the world, hiring lots of PhDs, both Chinese and Western. The company is filing patents by the truckload, a total of over 50,000 at last count. In 2010, the company is said to have invested over $2 billion in R&D. According to the company, profits in 2010 were Rmb24 billion (US$3.7 billion) up from RMB18.27 billion in 2009.

But, the question still remains: is Huawei a solid high-tech company that is misunderstood and unfairly attacked by jealous competitors or attention-seeking politicians? Or, is it more of a bloated, backward and barely profitable machine-maker kept in business through hidden subsidies and support from various arms of the Chinese government?

I have no way to accurately judge, nor any particular interest in the company. I meet with Huawei people occasionally. Huawei is, after all, the largest and most prominent company in Shenzhen, where I now live. As a private company, Huawei releases limited financial information.

My sense is that Huawei’s main problem, at least at the moment, isn’t technical competence, but poor cash flow. This has been brought on by fast-declining profit margins, slow market growth, erratic payments from customers in less-advanced countries where Huawei derives a significant percentage of its sales. To top it off, once compliant Chinese banks have turned stingy in extending loans. Add it up, and Huawei may currently be in much less robust financial condition than previously. A paper tiger? Probabaly not. But, it does look like a very large company with a similarly large imbalance in its financial structure.

To sell its products, Huawei must usually be the cheapest supplier. But, its costs are rising fast and some of its largest markets of late, like equipment for 3G and other high-bandwidth mobile phone systems, are no longer growing quickly. Other product areas are basically stagnant, especially for traditional fixed-line telecom switches.

Though the company has made no public announcement about its financial condition, my conversations with Huawei people suggest the company had a relatively poor year in 2011, and has run into some serious cash-flow challenges. One example: Huawei’s private equity arm, which until recently was trumpeted by Huawei as a key source of future profits and access to new leading-edge technologies, has all but shriveled up and died. Funding has been basically cut off. The cash is needed apparently to keep other parts of the business above water.

In the past, Huawei could sustain its cash flow by tapping China’s state-owned banks for loans. This year, the flow of loans seems to have been curtailed. One reason:  the Chinese government has clamped down hard on all bank lending to stem rising inflation. That’s impacted most heavy borrowers in China, including, it seems, Huawei.

Chinese banks have cut back lending to Huawei, so Huawei apparently has cut back elsewhere in its business. If so, it suggests Huawei’s own cash reserves are scarce, particularly for a company its size. This is caused not only by low margins, but also because Huawei, as a private company, cannot raise money from the capital markets. Its only cushion is taking loans from Chinese banks. These loans, in turn, are dialed up or dialed down not based purely on Huawei’s creditworthiness, but also the overall credit stance of the Chinese government.

The simplest solution, a Huawei IPO, seems as a remote a possibility today as it ever was. The company does not seem ready to endure that level of public disclosure — of its murky financials, ownership, profit margins, management structure, reliance on orders and loans from Chinese government-backed entities.

Over the years, most of Huawei’s erstwhile competitors – including Northern Telecom, Alcatel, Fujitsu, Siemens, AT&T – have either gone out of business, or been dramatically slimmed down. Only Sweden’s Ericsson has sales larger than Huawei.

In the absence of reasonable profit margins and reliable cash flow from customer purchases, Huawei has used a ready flow of Chinese bank loans to finance its operations and investment. But, those low margins also make it a challenge to repay the ever larger bank debts. Ultimately, positive cash flow needs to come from customers, not bank loans.

Whatever the situation with Huawei’s books at the moment, I’m rather sure we will not be reading financial headlines anytime soon about a cash crisis at Huawei. It is a large business,  and well-connected politically. It is also reportedly a large supplier of equipment to the Chinese military.

The large banks in China are state-owned and are routinely used to advance economic, political and social goals.  These banks may have cut back on funding to Huawei this year, but if the company needs money to stave off more serious – and public — financial problems, it’s all but certain the flow of bank cash will be increased. If need be, Huawei could be put on heavy state loan intravenous support.

As Huawei has grown larger, the reliance on bank lending becomes ever more of a risk. It is, above all, a very stilted, unbalanced way for the company to manage its capital needs. A diet of too much debt and too little equity often leads to corporate malnourishment.

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Song Dynasty Deal-Sourcing

1 Comment / December 5, 2011

I get asked occasionally by private equity firm guys how CFC gets such stellar clients. At least in one case, the answer is carved fish, or more accurately my ability quickly to identify the two murky objects (similar to the ones above) carved into the bottom of a ceramic dish. It also helped that I could identify where the dish was made and when.

From that flowed a contract to represent as exclusive investment bankers China’s largest and most valuable private GPS equipment company in a USD$30mn fund-raising. It’s in every sense a dream client. They are the most technologically adept in the domestic industry, with a deep strategic partnership with Microsoft, along with highly-efficient and high-quality manufacturing base in South China, high growth and very strong prospects as GPS sales begin to boom in China.

Since we started our work about two months ago, several big-time PE firms have practically fallen over themselves to invest in the company. It looks likely to be one of the fastest, smoothest and most enjoyable deals I’ve worked on.

No fish, no deal. I’m convinced of this. If I hadn’t correctly identified the carved fish, as well as the fact the dish was made in a kiln in the town of Longquan in Zhejiang Province during the Song Dynasty, this company would not have become our client. The first time I met the company’s founder and owner, he got up in the middle of our meeting, left the room and came back a few minutes later with a fine looking pale wooden box. He untied the cord, opened the cover and allowed me to lift out the dish.

I’d never seen it before, but still it was about as familiar as the face of an old teacher. Double fish carved into a blue-tinted celadon dish. The dish’s heavy coated clear glaze reflected the office lights back into my eyes. The fish are as sketchily carved as the pair in the picture here (from a similar dish sold at Sothebys in New York earlier this year), more an expressionist rendering than a precisely incised sculpture.

It’s something of a wonder the fish can be discerned at all. The potter needed to carve fast, in wet slippery clay that was far from an ideal medium to sink a knife into. Next came all that transparent glaze and then the dish had to get quickly into a kiln rich in carbon gas. The amount of carbon, the thickness and composition of the glaze, the minerals dissolved in the clay – all or any of these could have contributed to the slightly blue-ish tint, a slight chromatic shift from the more familiar green celadons of the Song Dynasty.

All that I knew and shared with the company’s boss, along with remarking the dish was “真了不起”, or truly exceptional. It’s the finest celadon piece I’ve seen in China. Few remain. The best surviving examples of Song celadon are in museums and private collection outside China. I’m not lucky enough to own any. But, I’ve handled dozens of Song celadons over the years, at auction previews of Chinese ceramic sales at Sotheby’s and Christie’s in London and New York. The GPS company boss had bought this one from an esteemed collector and dealer in Japan.

The boss and I are kindred spirits.  He and I both adore and collect Chinese antiques. His collection is of a quality and breadth that I never imagined existed still in China. Most antiques of any quality or value in China sadly were destroyed or lost during the turbulent 20th century, particularly during the Cultural Revolution.

The GPS company boss began doing business in Japan ten years ago, and built his collection slowly by buying beautiful objects there, and bringing them home to China. Of course, the reason Chinese antiques ended up in Japan is also often sad to consider. They were often part of the plunder taken by Japanese soldiers during the fourteen brutal years from 1931 to 1945 when they invaded, occupied and ravaged parts of China.

Along with the celadon dish, the GPS boss has beautiful Liao, Song, Ming and Qing Dynasty porcelains, wood and stone carvings and a set of Song Dynasty paintings of Buddhist Luohan. In the last few months, I’ve spent about 20 hours at the GPS company’s headquarters. At least three-quarters of that time, including a visit this past week, was spent with the boss, in his private office, handling and admiring his antiques, and drinking fine green tea grown on a small personal plantation he owns on Huangshan.

I’ve barely talked business with him. When I tried this past week to discuss which PE firms have offered him money, he showed scant interest. If I have questions about the company, I talk to the CFO. Early on, the boss gifted me a pretty Chinese calligraphy scroll. I reciprocated with an old piece of British Wedgwood, decorated in an ersatz Chinese style.

Deal-sourcing is both the most crucial, as well as the most haphazard aspect of investment banking work. Each of CFC’s clients has come via a different route, a different process – some are introduced, others we go out and find or come to us by word-of-mouth.  Unlike other investment banking guys, I don’t play golf. I don’t belong to any clubs. I don’t advertise.

Chinese antiques, particularly Song ceramics,  are among the few strong interests I have outside of my work.  The same goes for the GPS company boss. His 800-year old dish and my appreciation of it forged a common language and purpose between us, pairing us like the two carved fish. The likely result: his high-tech manufacturing company will now get the capital to double in size and likely IPO within four years, while my company will earn a fee and build its expertise in China’s fast-growing automobile industry.  

 

Xinjiang Is Changing the Way China Uses and Profits From Energy

Leave a Comment / December 6, 2011

 

Two truisms about China should carry the disclaimer “except in Xinjiang”. China is a densely-populated country, except in Xinjiang. China is short on natural resources, except in Xinjiang. Representing over 15% of the China’s land mass, but with a population of just 30 million, or 0.2% of the total, Xinjiang stretches 1,000 miles across northwestern China, engulfing not only much of the Gobi Desert, but some of China’s most arable farmland as well. Mainly an arid plateau, Xinjiang is in places as green and fertile as Southern England.

Underneath much of that land, we are beginning to learn, lies some of the world’s largest and richest natural resource deposits, including huge quantities of minerals China is otherwise desperately short of, including high-calorie and clean-burning coal, copper, iron ore, petroleum.  How, when and at what cost China exploits Xinjiang’s natural resources will be among the deciding issues for China’s economy over the next thirty years. Already, some remarkable progress is being made, based on two past visits. I return to Xinjiang tomorrow for five days of client meetings.

Because of its vast size and small population, Xinjiang hasn’t yet had its mineral resources fully probed and mapped. But, every year, the size of its proven resource base expands. Knowing there’s wealth under the ground, and finding a cost-effective way to dig out the minerals and get them to market are, of course,  very different things. Until recently, Xinjiang’s transport infrastructure – roads and railways – was far from adequate to provide a cost-efficient route to market for all the mineral wealth.

That bottleneck is being tackled, with new expressways opening every year, and plans underway to expand dramatically the rail network. But, transport can’t alter the fact Xinjiang is still very remote from the populated core of China’s fast-growing industrial and consumer economy. Example:  it can still be cheaper to ship a ton of iron ore from Australia to Shanghai than from areas in Xinjiang.

Xinjiang’s key resource, and the one with the largest potential market, is high-grade clean-burning coal. Xinjiang is loaded with the stuff, with over 2 trillion tons of proven reserves. Let that figure sink in. It’s the equivalent of over 650 years of current coal consumption in coal-dependent China . The Chinese planners’ goal is for Xinjiang to supply about 25% of China’s coal demand within ten years.

Xinjiang’s coal is generally both cleaner (low sulphur content) and cheaper to mine than the coal China now mainly relies on, much of which comes from a belt of deep coal running through Inner Mongolia, Shanxi and Shandong Provinces. Large coal seams in Xinjiang can be surface mined. Production costs of under Rmb150 a ton are common. The current coal price in China is over four times higher for the dirtier, lower-energy stuff.

For all its advantages, Xinjiang coal is not going to become a primary source of energy in China. The Chinese government, rightly, understands that the cost, complexity and long distances involved make shipping vast quantities of Xinjiang coal to Eastern China unworkable. Moving coal east would monopolize Xinjiang’s rail and road network, causing serious distortions in the overall economy.

Instead, the Xinjiang government is doing something both smart and innovative. It is encouraging companies to use Xinjiang’s abundant coal as a feedstock to produce lower cost supplies of industrial products and chemicals now produced using petroleum. All kinds of things become cost-efficient to manufacture when you have access to large supplies of low-cost energy from coal. Shipping finished or intermediate goods is obviously a better use of Xinjiang’s limited transport infrastructure.

I’ve seen and met the bosses of several of these large coal-based private sector projects in Xinjiang. The scale and projected profitability of these projects is awesome. In one case, a private company is using a coal mine it developed to power its $500mn factory to produce the plastic PVC. The coal reserve was provided for free, in return for the company’s agreement to invest and build the large chemical factory next to it. The cost of producing PVC at this plant should be less than one-third that of PVC made using petroleum. China’s PVC market, as well as imports, are both staggeringly large. The new plant will not only lower the cost of PVC in China but reduce China’s demand for petroleum and its byproducts.

Another company, one of the largest private companies in China,  is using its Xinjiang coal reserve, again supplied for free in return for investment in new factories, to power a large chemical plant to produce glycerine and other chemical intermediates. This company is already a large producer of these chemicals at its factories in Shandong. There, they run on petroleum. In the new Xinjiang facility, coal will be used instead, lowering overall manufacturing costs by at least 20% – 30% based on an oil price of around $50. At current oil prices, the cost savings, and margins, become far richer.

The key, of course, is that the companies get the coal reserve for free, or close to it. True, they need to build the coal mine first, but generally, that isn’t a large expense, since it can all be surface-mined.  This means that the cost of energy in these very energy-intensive projects is much lower than it would be for plants using petroleum or, to be fair, any operator elsewhere who would need to purchase the coal reserve as well as build the capital-intensive downstream facilities.

The Xinjiang projects should lock-in a significant cost advantage over a significant period of time. As investments, they also should provide consistently high returns over the long-term. While the capital investment is large, I’m confident the projects are attractive on risk/return basis, and that in a few years time, these private sector “coal-for-petroleum” projects will begin to go public, and become large and successful public companies.

The Xinjiang government keeps close tabs on this process of providing free coal reserves for use as a feedstock.  Since in most cases, these projects are looking to enter large markets now dominated by petroleum and its byproducts, there is ample room for more such deals to be done in Xinjiang.

Deals are getting larger. This summer, China’s largest coal producer, Shenhua Group, announced it would invest Rmb 52 billion ($8 billion) on a coal-to-oil project in Xinjiang. The company plans to mine 70 million tons of coal a year and turn it into three million tons of fuel oil.

Remote and sparsely-populated as it now is, Xinjiang is going to play a decisive role in China’s industrial and energy future, just as the development of America’s West has helped drive economic growth for over 100 years, and created some of America’s largest fortunes.  My prediction:  China’s West will produce more coal and mineral billionaires over the next 100 years than America’s has over the past hundred.

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Investment Banking in China — What I’ve Learned & Unlearned

4 Comments / November 2, 2011

Anyone seeking to succeed in investment banking in China should live by one rule alone: it’s not who you know, but how well you know them. In China, more than any other country where I’ve worked, the professional is also the personal. Comradeship, if not friendship, is always a necessary precondition to doing business together. If you haven’t shared a meal – and more importantly, shared a few hundred laughs – you will never share a business deal. Competence, experience, education and reputation all matter, of course. But, they all play supporting roles.

The stereotypical hard-charging pompous Wall Street investment banker wouldn’t stand much of a chance here. A “Master of the Universe” would need to master a set of different, unfamiliar skills. Personal warmth, ready humor and a relaxed and somewhat deferential attitude will go a lot farther than spreadsheet modeling, an Ivy League MBA and financial dodges to increase earnings-per-share.

I’ve been around a fair bit in my +25 year business career, doing business is over 40 countries and managing companies in the US, Europe and Asia. Everywhere, it helps to be likeable, attentive, courteous. We all prefer working with people we like.  But, since moving to China and opening a business, I’ve learned things work differently here. Making money and making friends are interchangeable in China. You can’t do the first without doing the second.

Investment banking is so personal in China because most private Chinese companies, from the biggest on down, are effectively one-man-shows, with a boss whose authority and wisdom are seldom challenged. Usually, there is  no “management team” in the sense this term is applied in the US and Europe. A Chinese boss is the master of all he (or often she, as women entrepreneurs are common here) surveys.

A substantial percentage of my time is spent getting to know, and winning the friendship, of Chinese bosses. This alone makes me a lucky guy. Without fail, the bosses I meet are smart, gifted, able, hospitable, warm. We don’t select for these qualities. They are prerequisites for success as a private business in China.

Bosses are also usually guarded about meeting new people. It comes with the territory. Anyone with a successful business in China is going to be in very large demand from a very large “catchment pool”, including just about everyone in the extended circle of the boss’s friends, relatives, employees, suppliers, political contacts. Everyone is selling or seeking something. Precious few will succeed. Being a boss in China requires enormous stamina, to deal with all those making a claim on your time, and a gift for saying “No” in ways that don’t offend.

For investment bankers, successful deal generation in China will usually follow an elliptical path. The biggest mistake is to start pitching your company, or a transaction, the moment you meet a prospective client. You need first to win the boss’s trust and friendship, then you can discuss how to work together. In my working life in China, it’s axiomatic that in a first meeting with a company boss, one or the other of us will say, “我们先做朋友”,  or “let’s become friends be first”. It’s not some throwaway line. It’s an operating manual.

The Chinese use a specific word to define the engagement between an investment banker and client. It speaks volumes about the way new business is won here. It’s “合作” or cooperation. You don’t work for a Chinese company, you cooperate with it. There’s got to be a real personal bond in place, a tangible sense of shared purpose and shared destiny.

I could probably teach a class in the cross-cultural differences of investment banking in China and the US. I’ve not only been active in both places, I’ve been on both sides of the table. Before starting CFC, I was CEO of an American company that retained one of the most renowned investment banks in the US to handle an M&A deal for us. At that company, we had a deep senior management team, including two supremely capable founders. We dealt individually and collectively with the investment bank, which had a similarly-sized team assigned to the project.

The relationships were professional, cordial. But, the investment bankers never made any real effort to become my friend, nor did I want them to. Rarely, if ever, did discussions veer away from how to create the conditions to get the best price. The bankers were explicitly pursuing their fee, and we were pursuing our strategic goal.

The deal went pretty smoothly, following a tightly-scripted and typical M&A process. The investment bank’s materials and research were first-rate, and they had no difficulty getting directly to decision-makers at some of the largest software companies in the world. They performed with the intricate precision and harmony of the Julliard Quartet.

I can count the number of times I sat down with the bankers for a nice meal where business was not discussed. Or the number of times when the meeting room rang with peals of friendly laughter. Zero. Both would be unthinkable in China.

Here, a deal is more than just a deal. Price is not the only, or even the main objective. Instead, as an investment banker, you must knit souls together, their lives, fortunes, careers, goals and temperaments. There is no spreadsheet, no due diligence list, no B-school case study, no insider jargon to consult.

Be likeable and be righteous. But. above all, do not be transparently or subliminally motivated mainly by personal greed. A successful Chinese boss will smell that coming from miles away, and recoil. You’ll rarely get past “ 您好” , the polite form of “hello”.

 

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