傅成

The Easiest Company in the World to Run

Leave a Comment / March 28, 2011

sancai19

If you could be the boss of any company in the world, with your pay package completely tied to performance, which would you choose? If you answered Kweichow Moutai Ltd., congratulations. You couldn’t have made a better choice.

For those who don’t know this company, it is the largest and by far most successful distiller of China’s favored prestige alcoholic drink. There is no faster-growing, large spirits company anywhere in the world. Better still, if you do become boss, there’s just about nothing you could do short of outright criminality that would in any way slow its stupefying growth rate.  In 2010, sales rose by about 20% to over $2.2 billion. So strong and constant is the demand for the company’s product that their major headache is preventing designated retailers from raising the price above the already sky-high levels fixed by the company.

During 2010, the street price of a bottle of Moutai’s highest-end brew, called Feitian, doubled from Rmb 700 ($105) to over Rmb1,300 ($200). The raw material cost? Probably under Rmb10 per bottle.  Getting a fix on its real level of profitability is hard to do. But, in my estimation, there is no more profitable liquid mass-produced anywhere in the world. Make no mistake. Moutai is not 25-year-old Courvoisier. Chinese love the stuff. But, it is a species of what Americans would call “rockgut”, distilled from a low-end grain called sorghum and then diluted with water drawn from springs surrounding the distillery in Guizhou province.

When I first came to China 30 years ago, a bottle of Moutai cost no more than a few dollars. It’s the same stuff today, brewed according to a Qing Dynasty formula. The main difference is that over 30 years, the price has gone up 30-fold. And no, that’s not because sorghum prices have skyrocketed.

So, what explains Moutai’s astounding success? Simple math. More and more Chinese chasing an insufficient supply of the country’s highest-end liquor brand. Consumption of bottled liquor has grown by 20% over the last five years, and shows no sign of slowing. Moutai plans to double its output over the next four years, then double it again by 2020. Overall, the plan is to increase output by 2.5 times in next nine years.

At the start of the year,  Moutai put in a price cap, to try to stop its retailers selling Feitian for over Rmb959 a bottle.  The price immediately shot up over Rmb1,200. Seeing the Moutai fly off the shelves, retailers then imposed limits on the number of bottles a customer could buy at one time. Supply restricted, the price just kept climbing.

Packaging and marketing are pretty much unchanged over the last 30 years. Along withTsingtao beer, it’s one of the few branded products in China to stick to the old and clumsy pre-revolution spelling of its name. The company is called Kweichow Moutai but no one knows it under that name. In China, it is pronounced “Gway-Joe Mao-Tai”.

Good, bad or indifferent, whoever is the CEO of this company (the current incumbent is Yuan Renguo) will certainly succeed in keeping things buoyant. As long as Chinese keep making money, they are going to spend a percentage on Moutai. The company has even achieved some success in export markets lately, with sales rising 55% to $50mn in 2010.

If Mr. Yuan chooses early retirement and wants to bring in some foreign blood at the top, I’m available to take over. I’ve been to Guizhou, most recently just two weeks ago,  and like the scenery and the food. I also know how (thanks to a Guizhou client)  to evaluate the quality of Moutai: you rub a bit between your palms. If it smells like soy sauce, it’s the real thing.

The only snag: I’m not much of a fan of the company’s product. Since moving to China, I’ve had enough of it to pickle a goodly portion of my liver. But, it’s still an unacquired taste. Drinking good cognac or Armagnac familiarizes you with the aromas of peat and oak. Drinking Moutai familiarizes you with how instantaneously alcohol can go from gullet to bloodstream. Most frequently, I can remember drinking Moutai but not how I get home afterward. Maybe that’s the secret to the brand’s success?

 

 

 

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Taxed At Source: Renminbi Private Equity Firms Confront the Taxman

Leave a Comment / March 15, 2011

snuff1

The formula for success in private equity is simple the world over: make lots of money investing other people’s money, keep 20% of the profits and pay little or no taxes on your share of the take. This tax avoidance is perfectly legal. PE firms are usually incorporated as offshore holding companies in tax-free domains like the Cayman Islands.

Depending on their nationality, partners at PE firms may need to pay some tax on the profits distributed to them individually. But, some quick footwork can also keep the taxman at bay. For example, I know PE partners who are Chinese nationals, living in Hong Kong. They plan their lives to be sure not to be in either Hong Kong or China for more than 182 days a year, and so escape most individual taxes as well. Even when they pay, it’s usually at the capital gains rate, which is generally far lower than income tax.

The tax efficiency is fundamental to private equity, and most other forms of fiduciary investing. If the PE firm’s profits were assessed with income tax ahead of distributions to Limited Partners (“LPs”), it would significantly reduce the overall rate of return, to say nothing about potentially incurring double taxation when those LPs share of profits got dinged again by the tax man.

China, as everyone in the PE world knows, is very keen to foster growth of its own homegrown private equity firms. It has introduced a raft of new rules to allow PE firms to incorporate, invest Renminbi and exit via IPO in China. So far so good. The Chinese government is also pouring huge sums of its own cash into private equity, either directly through state-owned companies and agencies, or indirectly through the country’s pay-as-you-go social security fund. (See my recent blog post here.)

Exact figures are hard to come by. But, it’s a safe bet that at least Rmb100 billion (USD$15 billion) in capital was committed to domestic private equity firms last year. This year should see even larger number of new domestic PE firms established, and even larger quadrants of capital poured in.

It’s going to be a few years yet before the successful Chinese domestic PE firms start returning significant investment profits to their investors. When they do, their investors will likely be in for something of an unpleasant surprise: the PE firms’ profits, almost certainly, will be reduced by as much as 25% because of income tax.

In other words, along with building a large homegrown PE industry that can rival those of the US and Europe, China is also determined to assess those domestic PE firms with sizable income taxes. These two policy priorities may turn out to be wholly incompatible. PE firms, more than most, have a deep, structural aversion to paying income tax on their profits. For one thing, doing so will cut dramatically into the personal profits earned by PE partners, lowering significantly the after-tax returns for these professionals. If so, the good ones will be tempted to move to Hong Kong to keep more of their share of the profits they earn investing others’ money. If so, then China could get deprived of some experienced and talented PE partners its young industry can ill afford to lose.

It’s still early days for the PE industry in China. Renminbi PE firms really only got started two years ago. I’ve yet to hear any partners of domestic PE firms complain. But, my guess is that the complaining will begin just as soon as these PE firms begin to have successful exits and begin to write very large checks to the Chinese tax bureau. What then?

China’s tax code is nothing if not fluid. New tax rules are announced and implemented on a weekly basis. Sometimes taxes go down. Most often lately, they go up.  Compared to developed countries, changing the tax code in China is simpler, speedier. So, if the Chinese government discovers that taxing PE firms is causing problems, it can reverse the policy rather quickly.

The PE firms will likely argue that taxing their profits will end up hurting hundreds of millions of ordinary Chinese whose pensions will be smaller because the PE firms’ gains are subject to tax. In industry, this is known as the “widows and orphans defense”. Chinese contribute a share of their paycheck to the state pension system, which then invests this amount on their behalf, including about 10% going to PE investment.

PE firms outside China are structured as offshore companies, with offices in places like London, New York and Hong Kong, but a tax presence in low- and no-tax domains. But, there’s currently no real way to do this in China, to raise, invest and earn Renminbi in an offshore entity. Changing that opens up an even larger can of worms, the current restrictions preventing most companies or individuals outside China from holding or investing Renminbi. This restriction plays a key part in China’s all-important Renminbi exchange rate policy, and management of the country’s nearly $2.8 trillion of foreign reserves.

The world’s major PE firms are excitedly now raising Renminbi funds. Several have already succeeded, including Carlyle and TPG. They want access to domestic investment opportunities as well as the high exit multiples on China’s stock market. When and if the income tax rules start to bite and the firm’s partners get a look at their diminished take, they may find the appeal of working and investing in China far less alluring.

 

 

 

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CFC’s Latest Research Report Addresses Most Treacherous Issue for Chinese Companies Seeking Domestic IPO

Leave a Comment / March 6, 2011

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For Chinese private companies, one obstacle looms largest along the path to an IPO in China: the need to become fully compliant with China’s tax and accounting rules.  This process of becoming “规范” (or “guifan” in Pinyin)  is not only essential for any Chinese company seeking private equity and an eventual IPO, it is also often the most difficult, expensive, and tedious task a Chinese entrepreneur will ever undertake.

More good Chinese companies are shut out from capital markets or from raising private equity because of this “guifan” problem than any other reason. It is also the most persistent challenge for all of us active in the PE industry and in assisting SME to become publicly-traded businesses.

My firm has just published a Chinese-language research report on the topic, titled “民营企业上市规范问题”. You can download a copy by clicking here or from Research Reports page of the CFC website.

The report was written specifically for an audience of Chinese SME bosses, to provide them both with analysis and recommendations on how to manage this process successfully.  Our goal here (as with all of our research reports) is to provide tools for Chinese entrepreneurs to become leaders in their industry, and eventually leaders on the stock market. That means more PE capital gets deployed, more private Chinese companies stage successful exits and most important, China’s private sector economy continues its robust growth.

For English-only speakers, here’s a summary of some of the key points in the report:

  1. The process of becoming “guifan” will almost always mean that a Chinese company must begin to invoice all sales and purchases, and so pay much higher rates of tax, two to three years before any IPO can take place
  2. The higher tax rate will mean less cash for the business to invest in its own expansion. This, in turn, can lead to an erosion in market share, since “non-guifan” competitors will suddenly enjoy significant cost advantages
  3. Another likely consequence of becoming “guifan” – significantly lower net margins. This, in turn, impacts valuation at IPO
  4. The best way to lower the impact of “guifan” is to get more cash into the business as the process begins, either new bank lending or private equity. This can replenish the money that must now will go to pay the taxman, and so pump up the capital available to expansion and re-investment
  5. As a general rule, most  Chinese private companies with profits of at least Rmb30mn can raise at least five times more PE capital than they will pay in increased annual taxes from becoming “guifan”. A good trade-off, but not a free lunch
  6. For a PE fund, it’s necessary to accept that some of the money they invest in a private Chinese company will go, in effect, to pay Chinese taxes. But, since only “guifan” companies will get approved for a domestic Chinese IPO, the higher tax payments are like a toll payment to achieve exit at China’s high IPO valuations
  7. After IPO, the company will have plenty of money to expand its scale and so, in the best cases, claw back any cost disadvantage or net margin decline during the run-up to IPO

We spend more time dealing with “guifan” issues than just about anything else in our client work. Often that means working to develop valuation methodologies that allow our clients to raise PE capital without being excessively penalized for any short-term decrease in net income caused by “guifan” process.

Along with the meaty content, the report also features fifteen images of Tang Dynasty “Sancai“ ceramics, perhaps my favorite among all of China’s many sublime styles of pottery.



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Chinese New Year Is Upon Us — Rabbits in Red Underwear

Leave a Comment / February 6, 2011

Newyear

It is certainly the largest annual mass underwear change in the world. This week, as many as 100 million Chinese will take off their red underwear for the first time in a year and change into other colors. Meanwhile, 100 million other Chinese this week will pull on red underwear and wear no other color for the next twelve months.

It’s not fashion that rules this process, but supersition. This week is Chinese New Year. Wearing red underwear is meant to provide protection against misfortunes likely to target the one-in-twelve Chinese who this year will celebrate their 本命年 (“benming nian”), or birth year . This is a Rabbit Year. Everone born during a previous Rabbit year is likely going to take some precautions this year, including the red underwear. A red string bracelet or belt are also commonly worn by people during their birth year.

One’s birth year isn’t automatically going to be unlucky. But, there’s thousands of years of folk tradition that says people should extra mindful. This extends across most aspects of daily life. Many Chinese will try to avoid making larger life changes, or consequential business decisions, during their birth year.  I have one client, for example, whose founder was born 72 years ago, in a Tiger Year. The company is booming. The founder had numerous offers during 2010 to sell his business for a significant sum, or start work on an IPO. He chose to do nothing but wait things out. Now that Rabbit Year is dawning, he is ready to start considering his exit options. And, of course, changing back to a more neutral color of underwear.

As a Westerner, it takes some getting used-to, this notion that one’s birth year may come freighted with potential misfortune. After all, in all belief systems except possibly the Nihilists, one’s birth is considered a blessing.  But, in Chinese tradition, the anniversary of one’s birth year is a time when things can go especially awry. Or worse. The red underwear is meant to act as a kind of lightning rod, attracting an added flow of good luck during the year.

Red, of course, is associated with happiness, prosperity and good fortune in Chinese culture. Two of the more common sights in stores and on streets in China this time of year are crimson-colored envelopes and similarly-colored underwear. The envelopes, of course, are used to hold the cash handed out as New Year gifts to family and coworkers. The new underwear for men, women and children, in all sizes and styles,  is the flight suit for those about to traverse their birth year.

There’s also quite a lot of red underwear on sale this time of year in the US and Europe. But, it’s generally of the skimpy and sexy Victoria’s Secret variety, given by husbands and boyfriends as a Valentine’s Day gift. That custom is catching on rather quickly also in China, where Valentine’s Day is celebrated twice a year, on February 14 and also usually sometime in August (the date changes every year according to the lunar calendar), when the traditional Chinese version known as 亲人节  (“Qinren Jie”) falls.

Underwear is less commonly given as a Valentine’s gift in China. However,  fathers, brothers, husbands and boyfriends are supposed to buy red underwear for the women in their lives about to enter their birth year. Love in China is often expressed as a protective impulse.

I tended to view the mass changeover of one-twelfth of China to red underwear as a quaint superstition, one of the evermore scarce expressions of an antique and thoroughly unscientific traditional culture. But, over the last year, I saw at first hand the kind of mischief and harm that can target people during their birth year.

Last summer, I got word that another client of mine, one of my favorite people in China, was arrested while trying to cross into Hong Kong. He was accused of paying a bribe to a senior government official in one of China’s less developed inland provinces. He was taken from the Hong Kong border to a prison in the province’s capital, then held in detention for over three months while his friends and family raised the money to free him.

Under Chinese law, paying a bribe is treated more leninently than accepting one. But, it also signals rather emphatically the person has money.

I saw him soon after he got out. He was a shambles, gaunt, with a prison buzzcut and clothes that no longer properly fit him. I offered to help out his new venture, unrelated to the one that landed him in jail.

I invited him for lunch again a few weeks ago. He was his old self again, brimming with vigor and good cheer. As soon as the tea was poured, he proposed a toast, “To a happy Year of the Rabbit, and a quick end to the Tiger Year, my birth year.” We never discussed directly his time in prison, or even that I knew about his ordeal. He’s elated to be out of jail – and, by all appearances, almost as happy to be out of his birth year.

I glanced down at his feet.  He was wearing red sox.

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In Full Agreement

Leave a Comment / January 27, 2011

pyramid

I commend unreservedly the following article from today’s Wall Street Journal editorial page. It discusses US reverse mergers and OTCBB IPOs for Chinese companies, identifying reasons these deals happen and the harm that’s often done.


What’s Behind China’s Reverse IPOs?


A dysfunctional financial system pushes companies toward awkward deals in America.
By JOSEPH STERNBERG

As if China Inc. didn’t already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators, and not a few reporters, worry that American investors may have been victims of frauds perpetrated by shady foreign firms.

Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.

In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company’s management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget’s management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America.

It’s an odd deal. The goal of a traditional IPO is to extract cash from the global capital market. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.

Despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?

One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China’s still-new economy with immature domestic financial markets, it’s entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital-raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)

More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.

The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it’s not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.

So although the SEC investigation is likely to attract ample attention to the U.S. investor- protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge-fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.

Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism’s most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can’t solve that problem quickly, a controversy over some penny stocks will be the least of anyone’s problems.

Mr. Sternberg is an editorial page writer for The Wall Street Journal Asia.

China’s Economy: From Red Light to Highlights

1 Comment / October 21, 2010

Cinnabar Enamel snuff bottle from China First Capital blog post

After 30 years of economic progress unparalleled in human history, China can rewrite the rules on which leading economic indicators are most important to track.  I want to nominate a new one: the rate at which brothels are converted to beauty parlors.

At least in my Shenzhen neighborhood, this indicator is certainly at an all-time high. In the last four months, two rather seedy massage and KTV parlors have undergone very lavish renovation and reopened as large, expensive, multi-floored hair-dressing salons.

The clear implication: you can make more money in China these days selling perms and dye jobs than selling sex. This is an economic change in China of historic, if under-appreciated, importance.

Shenzhen has long had a reputation as one of the red light capitals of China. Some of the reasons: proximity to Hong Kong, a transient population made up largely of economic migrants, a local government with more of a laissez-faire attitude than elsewhere in China.

I can’t imagine anyone but the local police are keeping count, but I’d guess there must be thousands of places in the city offering sex for cash. These range from tiny storefronts with five to ten girls in folding chairs, to all manner of sauna, massage and KTV joints, most, but not all of which, augment their more legitimate offerings with the paid option to take one of the hostesses home with you, or do a little groping on the premises.

Or so I’m told. I know it may sound either prudish or disingenuous, but I’ve never been a customer of one of these places. I do, however, marvel at the variety and number of places selling sex here. The five-minute walk from my house to the local supermarket takes me past two big neon-lit places, called 会所, or “clubs” with touts out front and some heavily made-up ladies within. Down two smaller alleys are small storefront brothels.

In the building where I live, one of the fancier ones in my neighborhood, business cards are slipped under my door most every night offering “home delivery services”. They stress the a variety of women available, including  nurses, college students, migrants, mistresses, foreigners.

This is the part of Shenzhen’s sex trade I most deeply object to. The cards are put under every door. The photos on the card are of naked women.  My next-door neighbors include Chinese families with young kids. It’s unseemly, and I’ve complained numerous times to the doormen, but they claim not to know who is responsible for distributing the cards. My guess is they are paid to look the other way.

The economics of hair-dressing are certainly more favorable than the economics of prostitution. It’s not unusual for a woman to spend Rmb200-300 or more on a haircut and shampoo. Get your hair colored and the price can double. Though there are already dozens of hair salons in my neighborhood, they all seem to be jam-packed at all hours of the day. That never looks to be the case of the places selling sex. They always seem empty, over-staffed and under-patronized.

One thing hairdressers and brothels have in common,  the busiest time is 9pm-1am. Hairdressers, most of whom are men, earn a pretty good living, making around USD$1,000 a month. But, they work long hours, usually 12 hours a day. Most of the customers are women, but these places also cater to men. I pay Rmb 50 for a haircut and no shampoo. That’s a little less than the cost of a haircut at the joint I used to go to in LA’s Koreatown.

Every new beauty parlor that opens is confirmation of some larger economic trends in China.  Women have more disposable income, and more of an inclination to spend it on fashion, cosmetics, or a new hairstyle.  Prices are quickly reaching levels similar to those in the US. In Shenzhen, a young woman can now easily earn as much every month sitting at a desk in an office as sitting in a storefront brothel. That is probably a change from a few years ago.

China’s economy is changing quickly from export-dependence to a reliance on the domestic market, from dominance of manufacturing to the rise of the service sector. In my part of Shenzhen, what’s changing most quickly: who is serving what to whom for how much.