创业板

ZTO Spurns Huge China Valuations For Benefits of U.S. Listing — Reuters

Leave a Comment / August 12, 2020

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By Elzio Barreto and Julie Zhu | HONG KONG

Chinese logistics company ZTO Express is turning up the chance of a much more lucrative share listing at home in favor of an overseas IPO that lets its founder retain control and its investors cash out more easily.

To steal a march on its rivals in the world’s largest express delivery market, it is taking the quicker U.S. route to raise $1.3 billion for new warehouses and long-haul trucks to ride breakneck growth fueled by China’s e-commerce boom.

Its competitors SF Express, YTO Express, STO Express and Yunda Express all unveiled plans several months ago for backdoor listings in Shenzhen and Shanghai, but ZTO’s head start could prove crucial, analysts and investors said.

“ZTO will have a clear, certain route to raise additional capital via U.S. markets, which their competitors, assuming they all end up quoted in China, will not,” said Peter Fuhrman, CEO of China-focused investment bank China First Capital.

With a backlog of about 800 companies waiting for approval to go public in China and frequent changes to the listing rules by regulators, a New York listing is generally a quicker and more predictable way of raising funds and taps a broader mix of investors, bankers and investors said.

“ZTO will have a built-in long-term competitive advantage – more reliable access to equity capital,” Fuhrman added.

U.S. rules that allow founder Meisong Lai to retain control over the company and make it easier for ZTO’s private equity investors to sell their shares were some of the main reasons to go for an overseas listing, according to four people close to the company. U.S. markets allow a dual-class share structure that will give Lai 80 percent voting power in the company, even though he will only hold 28 percent of the stock after the IPO.

Most of Lai’s shares are Class B ordinary shares carrying 10 votes, while Class A shares, including the new U.S. shares, have one vote. China’s markets do not allow shares with different voting power.

ZTO’s existing shareholders, including private equity firms Warburg Pincus, Hillhouse Capital and venture capital firm Sequoia Capital will also get much more leeway and flexibility to exit their investment under U.S. market rules. In China, they would be locked in for one to three years after the IPO.

As concerns grow about a weakening Chinese currency, the New York IPO also gives it more stable dollar-denominated shares it can use for international acquisitions, the people close to the company said.

IN DEMAND

Demand for the IPO, the biggest by a Chinese company in the United States since e-commerce giant Alibaba Group’s $25 billion record in 2014, already exceeds the shares on offer multiple times, two of the people said.

That underscores the appeal of the fast-growing company to global investors, despite a valuation that places it above household names United Parcel Service Inc and FedEx Corp.

The shares will be priced on Oct. 26 and start trading the following day.

ZTO is selling 72.1 million new American Depositary Shares (ADS), equivalent to about 10 percent of its outstanding stock, in the range $16.50 to $18.50 each. The range is equal to 23.4-26.3 times its expected 2017 earnings per share, according to people familiar with the matter.

By comparison, Chinese rivals SF Express, YTO Express, STO Express and Yunda shares trade between 43 and 106 times earnings, according to Haitong Securities estimates.

UPS and FedEx, which are growing at a much slower pace, trade at multiples of 17.8 and 13.4 times.

“The A-share market (in China) does give you a higher valuation, but the U.S. market can help improve your transparency and corporate governance,” said one of the people close to ZTO. “Becoming a New York-listed company will also benefit the company in the long-term if it plans to conduct M&A overseas and seek more capital from the international market.”

China’s express delivery firms handled 20.7 billion parcels in 2015, shifting 1.5 times the volume in the United States, according to consulting firm iResearch data cited in the ZTO prospectus.

The market will grow an average 23.7 percent a year through 2020 and reach 60 billion parcels, iResearch forecasts.

Domestic rivals STO Express and YTO Express have unveiled plans to go public with reverse takeovers worth $2.5 billion and $2.6 billion, while the country’s biggest player, SF Express, is working on a $6.4 billion deal and Yunda Express on a $2.7 billion listing.

ZTO plans to use $720 million of the IPO proceeds to purchase land and invest in new facilities to expand its packaged sorting capacity, according to the listing prospectus.

The rest will be used to expand its truck fleet, invest in new technology and for potential acquisitions.

“It’s a competitive industry and you do need fresh capital for your expansion, in particular when all your rivals are doing so or plan to do so,” said one of the people close to the company.

http://www.reuters.com/article/us-zto-express-ipo-idUSKCN12L0QH

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China’s Capital Markets Go From Feast to Famine and Now Back Again, China First Capital New Research Report

Leave a Comment / January 19, 2014

China First Capital 2014 research report cover

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The long dark eclipse is over. The sun is shining again on China’s capital markets and private equity industry. That’s good news in itself, but is also especially important to the overall Chinese economy. For the last two years, investment flows into private sector companies have dropped precipitously, as IPOs disappeared and private equity firms went into hibernation. Rebalancing China’s economy away from exports and government investment will take cash. Lots of it. Expect significant progress this year as China’s private sector raises record capital and China’s state-owned enterprises (SOEs) gradually transform into more competitive, profit-maximizing businesses.

These are some of the conclusions of the most recent Chinese-language research report published by China First Capital. It is titled, “2014民企国企的转型与机遇“, which I’d translate as “2014: A Year of Transformation and Opportunities for China’s Public and Private Sectors”. You can download a copy by clicking here or visiting the Research Reports section of the China First Capital website, (http://www.chinafirstcapital.com/en/research-reports).

We’re not planning an English translation. One reason:  the report is tailored mainly to the 8,000 domestic company bosses as well as Chinese government policy-makers and officials we work with or have met. They have already received a copy. The report has also gotten a fair bit of media coverage over the last week here in China.

Our key message is we expect this year overall business conditions, as well as capital-raising environment,  to be significantly improved compared to the last two years.  We expect the IPO market to stage a significant recovery. Our prediction, over 500 Chinese companies will IPO worldwide during this year, with the majority of these IPOs here in China.

We also investigate the direction of economic and reform policy in China following the Third Plenum, and how it will open new opportunities for SOEs to finance their growth and improve their overall profitability, including through carve-out IPOs and strategic investment. SOEs will become an important new area of investment for PE firms and global strategics.

The SOEs we work with are all convinced of the need to diversify their ownership, and bring in profit-driven experienced institutional investors. For investors, SOE deals offer several clear advantages: scale is larger and valuations are usually lower than in SME deals; SOEs are fully compliant with China’s tax rules, with a single set of books; the time to IPO or other exit should be quicker than in many SME deals.

As financial markets mature in China, we think one unintended consequence will be a drop in activity on China’s recently-established over-the-counter exchange, known as the “New Third Board” (新三板）.  The report offers our reasons why we think this OTC market is a poor, inefficient choice for Chinese businesses looking to raise capital. While the aims of the Third Board are commendable, to open a new fund-raising channel for private sector companies, the reality is that it offers too little liquidity, low valuations and an uncertain path to a full listing on China’s main stock exchanges.

Over the last three years, China has had the highest growth rate and the worst performing stock market among all major economies. In part, the long stock market slide is both necessary and desirable, to bring China’s stock market valuations more in line with those of the US and Hong Kong. But, it also points to a more uncomfortable reality, that China’s listed companies too often become listless ones. Once public, many companies’ profit growth and rates of return go into long-term decline. IPO proceeds are hoarded or misspent. Rarely do managers make it a priority to increase shareholder value.

A small tweak in the IPO listing rules offers some promise of improvement. Beginning this year, a company’s control shareholder, usually the owner or a PE firm, will be locked-in and prevented from selling shares for five years if the share price stays below the original IPO level.

Spare a moment to consider the life of a successful Chinese entrepreneur, both SOE and private sector. In two years, access to capital went from feast to famine. And now maybe back again. An IPO exit went from a reachable goal to an impossibility. And now maybe back again. Meanwhile, markets at home surged while those abroad sputtered. Government reform went from minimal to now ambitious.

2014 is going to be quite a year.

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Private Equity in China 2014: A Dialogue

1 Comment / January 19, 2014

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PE in China is changing. But, from what and into what?

Over the last week, I had an email discussion with a managing director in China of one of the world’s five largest private equity firms. He wrote to tell me about the fund’s recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China.

I’ll share an edited version here. I’ve taken out the firm’s name and any references that might make it identifiable.

Think it’s easy to be a private equity boss in China, to keep your job and keep your LPs happy? It’s anything but.– – –

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn’t just reply, “sounds fine to me”.

Here’s my view of it, after a day’s thought. If I didn’t know it was from [your firm], or didn’t focus on the larger check size, I’d say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys — you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that’s your opportunity, to be the ” thoroughly professional, experienced, global, proper fiduciary” version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group,  can gain an IPO in next two years. The English idiom here is “making yourself a hostage to fortune”. In other words, the only way a PE could consistently achieve the goal of “IPO exits within 24 months” is based more on luck than planning and deal execution.

If you asked me, I’d think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It’s kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can “free ride”, to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn’t change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don’t cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can’t be faulted. In a nutshell, it’s “Get in, get out, get carry and get new capital allocations from one’s LPs.”

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don’t see them. I’m just one guy feeling the elephant’s tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically,  to raise outside PE money from a dollar fund at a discount to public markets.  Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That’s the part I’ll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you’re someone who looks at deals through a special, somewhat contrarian prism. Your firm’s new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We’re finishing up now a “What’s ahead in 2014″ Chinese-language report that we’ll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database.  I’ll send a copy when it’s done. You’ll see we’re basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors.  Your role: supply the fuel, supply the ammo.

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The China IPO Embargo: How and When IPOs May Resume

Leave a Comment / September 26, 2013

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China IPO

China first slowed its IPO machinery beginning July 2012 and then shut it down altogether almost a year ago. Since then, about the only thing stirring in China’s IPO markets have been the false hopes of various analysts, outside policy experts, stockbrokers, PE bosses, even the world’s most powerful investment bank.  All began predicting as early as January 2013 the imminent resumption of IPOs.

So here we are approaching the end of September 2013 with still no sign of when IPOs will resume in China. What exactly is going on here? Those claiming to know the full answer are mainly “talking through their hat“. Indeed, the most commonly voiced explanation for why IPOs were stopped — that IPOs would resume when China’s stock markets perked up again, after two years of steady decline — looks to be discredited. The ChiNext board, where most of China’s private companies are hoping to IPO, has not only recovered from a slump but hit new all-time highs this summer.

Let me share where I think the IPO process in China is headed, what this sudden, unexplained prolonged stoppage in IPOs has taught us, and when IPOs will resume.

First, the prime causal agent for the block in IPOs was the discovery in late June last year of a massive fraud inside a Chinese company called Guangdong Xindadi Biotechnology.  (Read about it here and here.)

This one bad apple did likely poison the whole IPO process in China, along with the hopes of the then-800 companies on the CSRC waiting list. They all had underwriters in place, audits and other regulatory filings completed and were waiting for the paperwork to be approved and then sell shares on the Shenzhen or Shanghai stock exchanges. That was a prize well worth queuing up for. China’s stock markets were then offering companies some of the world’s highest IPO valuations.

After Xindadi’s phony financials were revealed and its IPO pulled, the IPO approval process was rather swiftly shut down. Since then, the CSRC has gone into internal fix-it mode. This is China, so there are no leaks and no press statements about what exactly is taking place inside the CSRC and what substantive changes are being considered. We do know heads rolled. Xindadi’s accountants and lawyers have been sanctioned and are probably on their way to jail, if they aren’t there already A new CSRC boss was brought in, new procedures to detect and new penalties to discourage false accounting were introduced.  The waiting list was purged of about one-third of the 800 applicants. No new IPO applications have been accepted for over a year.

IPOs will only resume when there is more confidence, not only within the CSRC but among officials higher up, that the next Xindadi will be detected, and China’s capital markets can keep out the likes of Longtop Financial and China MediaExpress, two Chinese companies once quoted on NASDAQ exchange. They, along with others, pumped up their results through false accounting, then failed spectacularly.  Overall, according to McKinsey, investors in U.S.-listed Chinese companies lost 72% of their investment in the last two years.

China’s leadership urgently does not want anything similar to occur in China. That much is certain. How to achieve this goal is less obvious, and also the reason China’s capital market remains, for now, IPO-less.

If there were a foolproof bureaucratic or regulatory way for the CSRC to detect all fraudulent accounting inside Chinese companies waiting to IPO in China,  the CSRC would have found it by now. They haven’t because there isn’t. So, when IPOs resume, we can expect the companies chosen to have undergone the most forensic examination practiced anywhere. The method will probably most approximate the double-blind testing used by the FDA to confirm the efficacy of new medicines.

Different teams, both inside the CSRC and outside, will separately pour over the financials. Warnings will be issued very loudly. Anyone found to be book-cooking, or lets phony numbers get past him,  is going to be dealt with harshly. China, unlike the US, does not have “country club prisons” for white collar felons.

The CSRC process will turn several large industries in China into IPO dead zones, with few if any companies being allowed to go public. The suspect industries will include retail chains, restaurants and catering, logistics, agricultural products and food processing. Any company that uses franchisees to sell or distribute its products will also find it difficult, if not impossible, to IPO in China. In all these cases, transactions are done using cash or informal credit, without proper receipts. That fact alone will be enough to disqualify a company from going public in China.

Pity the many PE firms that earlier invested in companies like this and have yet to exit. They may as well write down to zero the value of these investments.

Which companies will be able to IPO when the markets re-open? First preference will be for SOEs, or businesses that are part-owned by or do most of their business with SOEs. This isn’t really because of some broader policy preference to favor the state sector over private enterprise. It’s simply because SOEs, unlike private companies, are audited annually, and are long accustomed to paper-trailing everything they do. In the CSRC’s new “belt and suspenders” world, it’s mainly only SOEs that look adequately buckled up.

Among private companies, likely favorites will include high-technology companies (software, computer services, biotech), since they tend to have fewer customers (and so are easier to audit) and higher margins than businesses in more traditional industries. High margins matter not only, or even mainly, because they demonstrate competitive advantage. Instead, high margins create more of a profit cushion in case something goes wrong at a business, or some accounting issue is later uncovered.

The CSRC previously played a big part in fixing the IPO share price for each company going public. My guess is, the CSRC is going to pull back and let market forces do most of the work. This isn’t because there’s a new-found faith in the invisible hand. Simply, the problem is the CSRC’s workload is already too burdensome. Another old CSRC policy likely to be scrapped: tight control on the timing of all IPOs, so that on average, one company was allowed to IPO each working day. The IPO backlog is just too long.

The spigot likely will be opened a bit. If so, IPO valuations will likely continue to fall. From a peak in 2009, valuations on a p/e basis had already more than halved to around 35 when the CSRC shut down all IPOs.  IPO valuations in China will stay higher than, for example, those in Hong Kong. But, the gap will likely go on narrowing.

What else can we expect to see once IPOs resume? Less securitized local government borrowing. Over the last 16 months, with lucrative IPO underwriting in hibernation,  China’s investment banks, brokerage houses and securities lawyers all kept busy by helping local government issue bonds. It’s a low margin business, and one not universally approved-of by China’s central government.

How about things that will not change from the way things were until 16 months ago? The CSRC will continue to forbid companies, and their brokers, from doing pre-IPO publicity or otherwise trying to hype the shares before they trade. If first day prices go up or down by what CSRC determines is “too much”, say by over 15%, expect the CSRC to signal its displeasure by punishing the brokerage houses managing the deals.  The CSRC is the lord and master of China’s IPO markets, but a nervous one, stricken by self-doubt.

China needs IPOs because its companies need low-cost sources of growth capital. When IPOs stopped, so too did most private equity investment in China. It’s clear to me this collapse in equity funding has had a negative impact on overall GDP, and Chinese policy-makers’ plans to rebalance its economy away from the state-owned sector. It’s a credit to China’s overall economic dynamism, and the resourcefulness of its entrepreneurs,  that economic growth has held up so well this past 18 months.

IPOs in China are a creature of China’s administrative state. Companies, investors, bankers, are all mainly just bystanders. Right now, the heaviest chop to lift in China’s bureaucracy may be the one to stamp the resumption of IPOs. So, when exactly will IPOs resume? Sometime around Thanksgiving (November 24, 2013) would be my guess.

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Jiuding Capital: China’s “PE Factory” Breaks Down

Leave a Comment / June 12, 2013

Less than 18 months ago, Harvard Business School published one of its famed “cases” on Kunwu Jiuding Capital (昆吾九鼎投资管理有限公), praising the Chinese domestic private equity firm for its ” outstanding performance ” and “dazzling investment results”. (Click here to read abridged copy.) Today,  the situation has changed utterly. Jiuding’s “dazzling results”, along with that HBS case, look more like relics from a bygone era.

Jiuding developed a style of PE investing that was, for awhile, as perfectly adapted to Chinese conditions as the panda is to predator-free bamboo jungles in Sichuan. Jiuding kept it simple. Don’t worry too much about the company’s industry, its strategic advantage, R&D or management skills. Instead,  look only for deals where you could make a quick killing. In China, that meant looking for companies that best met the requirements for an immediate domestic IPO. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations.

Jiuding’s pre-investment work consisted mainly of simulating the IPO approval process of China’s securities regulator, the CSRC. If these simulations suggested a high likelihood of speedy CSRC IPO approval, a company got Jiuding’s money. The objective was to invest and then get out in as short a period as possible, preferably less than two years. A more typical PE deal in China might wait four years or more for an opportunity to IPO.

Jiuding did dozens of deals based on this investment method. When things worked according to plan, meaning one of Jiuding’s deals got quickly through its IPO, the firm made returns of 600% or more. After a few such successes, Jiuding’s fundraising went into overdrive. Once a small domestic Renminbi PE firm, Jiuding pretty soon became one of the most famous and largest, with the RMB equivalent of over $1 billion in capital.

Then, last year, a capital markets asteroid wiped out Jiuding’s habitat.  The CSRC abruptly, and without providing any clear explanation, first slowed dramatically the number of IPO approvals, then in October 2012, halted IPOs altogether. This has precipitated a crisis in China’s private equity industry. Few other PE firms are as badly impacted as Jiuding. The CSRC’s sudden block on IPOs revealed the fact that Jiuding’s system for simulating the IPO approval process had a fatal flaw. It could not predict, anticipate or hedge against the fact that IPOs in China remain not a function of market dynamics, but political and institutional policies that can change both completely and suddenly.

If Jiuding made one key mistake, it was assuming that the IPO approval system that prevailed from 2009 through mid-2012 was both replicable and likely to last well into the future. In other words, it was driving ahead at full speed while looking back over its shoulder.

Jiuding’s deals are now stranded, with no high probability way for many to achieve IPO exit before the expiry of fund life. That was another critical weakness in the Jiuding approach: it raised money in many cases by promising its RMB investors to return all capital within four to six years, about half the life cycle of a typical global PE firm like Carlyle or Blackstone.

Jiuding’s deals, like thousands of others in China PE,  are part of a backlog that could take a decade or more to clear. The numbers are stupefying: at its height the CSRC never approved more than 125 IPOs a year for PE-backed companies in China. There are already 100 companies approved and waiting to IPO, 400 more with applications submitted and in the middle of CSRC investigation, and at least another 2,000-3,000 waiting for a time when the CSRC again allows companies to freely submit applications.

Jiuding’s assets and liabilities are fundamentally mismatched. That’s as big a mistake in private equity as it is in the banking and insurance industries. Jiuding’s assets –  its shareholdings in well over a hundred domestic companies — are and will likely remain illiquid for years into the future. Meantime, the people whose capital it invests,  mainly rich Chinese businesspeople, will likely demand their money back as originally promised, sometime in the next few years. There’s a word for a situation where a company’s near-term liabilities are larger than the liquidatable value of its assets.

In the Harvard Business School case, Jiuding’s leadership is credited with perfecting a “PE factory”,  which according to the HBS document “subverted the traditional private equity business model.”  They might as well have claimed Jiuding also subverted the law of gravity. There are no real shortcuts, no assembly line procedure, for making and exiting successfully from PE investments in China.

In an earlier analysis, written as things turned out just as the CSRC’s unannounced block on IPOs was coming into effect, I suggested Jiuding would need to adjust its investment methods, and more closely follow the same process used by bigger, more famous global PE firms. In other words, they would need to get their hands dirty, and invest for a longer time horizon, based more on a company’s medium term business prospects, not its likelihood of achieving an instant IPO.

Jiuding, in short, will need to focus its investing more on adding value and less on extracting it. Can it? Will it? Or has its time, like the boom years of CSRC IPO approval and +80X p/e IPO valuations in China,  come and gone?

 

 

Goldman Sachs Predicts 349 IPOs in China in 2013 — Brilliant Analysis? Or Wishful Thinking?

Leave a Comment / April 5, 2013

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We’re one-quarter of the way through 2013 and so far no IPOs in China. Capital flows to private companies remain paralyzed. Never fear, says Goldman Sachs. In a 24-page research report published January 23rd of this year (click here to read an excerpt), Goldman projects there will be 349 IPOs in China this year, a record number. Its prediction is based on Goldman’s calculation that 2013 IPO proceeds will reach a fixed percentage (in this case 0.7%) of 2012 year-end total Chinese stock market capitalization.

This formula provides Goldman Sachs with a precise amount of cash to be raised this year in China from IPOs: Rmb 180bn ($29 billion), an 80% increase over total IPO proceeds raised in China last year. It then divvies up that Rmb 180 billion into its projected 349 IPOs,  with 93 to be listed in China’s main Shanghai stock exchange, 171 on the SME board in Shenzhen, and 85 on the “Chinext“ (创业板）exchange. To get to Goldman’s numbers will require levels of daily IPO activity that China has never seen.

The report features 35 exhibits, graphs, charts and tables, including scatter plots, cross-country comparisons, time series data on what is dubbed “IPO ratios (IPO value as % of last year-end’s total market cap)”. It’s quite a statistical tour de force, with the main objective seeming to be to allay concerns that too many new IPOs in China will hurt overall China share price levels. In other words, Goldman is convinced a key issue that is now blocking IPOs in China is one of supply and demand. The Goldman calculation, therefore, shows that even the 349 new IPOs, taking Rmb180 billion in new money from investors, shouldn’t have a particularly adverse impact on overall share price levels in China.

I’ve heard versions of this analysis (generally not as comprehensive or data-driven as Goldman’s) multiple times over the last year, as China IPO activity first slowed dramatically, then was shut down completely six months ago. The CSRC itself has never said emphatically why all IPOs have stopped. So, everyone, including Goldman,  is to some extent guessing. Goldman’s guess, however, comes accessorized with this complex formula that uses December 31, 2012 share prices as a predictor for the scale of IPOs in 2013.

I’m grateful to a friend at China PE firm CDH for sending me the Goldman report a few days ago. I otherwise wouldn’t have seen it. I’m not sure if Goldman Sachs released any follow-up reports or notes since on China IPOs. Goldman was the first Wall Street firm to win an underwriting license in China. It’s impossible to say how much Goldman’s business has been hurt by the near-year-long drought in China IPOs.

Goldman shows courage, it seems to me, in making a precise projection on the number of IPOs in China this year, and relying on their own mathematical equation to derive that number. Here’s how all IPO activity in China since 1994 looks when the Goldman formula is plotted:

 

 

 

 

 

 

 

 

 

 

 

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I’m not a gambling man, and personally hope to see as many IPOs as possible this year of Chinese companies. Even a fool knows the easiest way to lose money in financial markets is to be on the other side of a bet with Goldman Sachs. That said, I’m prepared to take a shot.  I’d be delighted to make a bet with the Goldman team that wrote the report. A spread bet, with “over/under” on the 349 number. I take the “under”. We settle up on January 1, 2014. Any takers?

My own guess – and that’s all it is -  is that there will be around 120 IPOs in China this year. But, this prediction admittedly does not rely on any formula like Goldman Sachs and so lacks exactitude. In fact, I approach things from a very different direction. I don’t think the only, or even main,  reason there are no IPOs in China is because of concerns about how new IPOs might impact overall share prices.

I put as much, or more, importance on rebuilding the CSRC’s capacity to keep fraudulent companies from going public in China. The CSRC seems to have had quite stellar record in this regard until last summer, when a company called Guangdong Xindadi Biotechnology got through the CSRC approval process and was in the final stages of preparing for its IPO. Reports in the Chinese media began to cast doubt on the company and its finances. Within weeks, the Xindadi IPO was pulled by the CSRC. The company and its accountants are now under criminal investigation.

The truth is still murky. But, if press reports are to be believed, even in part, Xindadi’s financial accounts were as fraudulent as some of the more notorious offshore Chinese listed companies like Sino-Forest and Longtop Financial targeted by short sellers and specialist research houses in the US.  The CSRC process — with its multiple levels of “double-blind” control, audit, verification —   was designed to eliminate any potential for this sort of thing to happen in China’s capital markets.

But, it seems to have happened. So, in my mind, getting the CSRC IPO approval process back on track is a key variable determining when, and how many, new IPOs will occur this year in China. This cannot be rendered statistically. The head of the CSRC was just moved to another job, which complicates things perhaps even more and may lead to longer delays before IPOs are resumed and get back to the old levels.

How far is the CSRC going now to try to make its IPO approval process more able to detect fraud? It has instructed accountants and lawyers to redo, at their own expense, the audits and legal diligence on companies they represent now on the CSRC waiting list.  Over 100 companies just dropped off the CSRC IPO approval waiting list, leaving another 650 or so stranded in the approval process, along with the 100 companies that have already gotten the CSRC green light but have been unable to complete their IPO.

A friend at one Chinese underwriter also told us recently that meetings between CSRC officials, companies waiting for IPO approval and their advisers are now video-taped. A team of facial analysis experts on the CSRC payroll then reviews the tapes to decide if anyone is telling a lie. If true, it opens a new chapter in the history of securities regulation.

If, as I believe,  restoring the institutional credibility of the CSRC approval process is a prerequisite for the resumption of major IPO activity in China, a statistical exhibit-heavy analysis like Goldman’s is only going to capture some, not all, of the key variables. Human behavior, fear of punishment, organizational function and dysfunction, as well as darker psychological motives also play a large role. An expert in behavioral finance might be more well-equipped to predict accurately when and how many IPOs China will have this year than Goldman’s crack team of portfolio strategists.

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Five Minutes with Peter Fuhrman — Private Equity International Magazine

Leave a Comment / May 1, 2014

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The chairman of research firm China First Capital discusses China’s growing exit problem, and its possible impact on private equity in 2013.

A growing concern for private equity in China is the lack of IPO exits. How do you see that playing out in 2013?

“I don’t expect any substantial improvement or change in the problems that are blocking IPO exits domestically and internationally. And because the China private equity industry is significantly over-allocated to IPO exits, along with diminishing fund life, [this] will be a time of increasing difficulty for GPs. At the same time, the inability to exit will also continue to prevent [GPs] from doing new deals, and that is where the greatest economic harm will be done. Of course I don’t trivialise the importance of the $100 billion that’s locked away in unexited PE investments, but the real victims of this are going to be the private entrepreneurs of China. At this point, over half of all [China’s] GDP activity is generated from the private sector. The private equity money and the IPO money is what [businesses] need to grow, because private companies in China basically can’t borrow. They need private equity money and IPO proceeds to continue to thrive. “  More…

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Paid to Gamble But Reluctant To Do So

Leave a Comment / January 24, 2013

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Venture Capital Financing in the US

(Source; The Wall Street Journal)

 

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They are the best-paid gamblers in the world, the General Partners at private equity and venture capital firms. They are paid to take risks, to make bets, with other people’s money. And for this, they usually get a guaranteed high annual retainer, a salary that generally puts them in the top 1% of all wage-earners in their country, and also a share of profits earned from putting others’ money at risk. In other words, their life is on the order of “heads I win, tails I win” compensation. They make a handsome salary, have all their expenses covered, are unlikely ever to get fired, and also usually get to claim 20%-25% of the profits from successful deals.

Given those incentives, and the fact the guys with the money (your fund’s LPs) are paying you to find great opportunities and bet on them rather than sit on your hands, you would assume that GPs would want to keep the flow of new deals moving along at a reasonable pace. In fact, inactivity is, next to losing all the LPs money on bad investments, the surest way for a PE fund to put itself out of business. And yet this do-nothing strategy is now common across China’s private equity industry. For the better part of a year, deal-making has all but dried up.

From a recent high of around 1,200 PE deals closed in a single year in China,  in 2012 the total tumbled. My surmise is that the number of new PE deals closed in China last year was down at least 75% from 2011. The activity that took place did so almost entirely during the first half of the year. An industry now holding over $100 billion in capital and employing well over 10,000 people, including some of the most well-educated and well-paid in China, ground to a halt during 2012.

Let me offer up one example. I won’t name them, since I know and like the people running this shop: a fund that is among the biggest of all China-focused PEs, with over $4 billion in capital, made a total of three investments in all of 2012. Two of them were in “club deals” where they threw money into a pot along with a bunch of other funds. Though they keep a full-time staff of 100, funded by the management fee drawn from LPs money, this firm closed only one deal that they actually initiated. At a guess, these guys have an annual management fee in excess of $50mn, and during 2012, their headcount more than doubled.

In any other line of work, a company that decreased its output to about zero, while significantly increasing its expenses, would be on the fast-track to insolvency. But, not in the PE industry in China. It’s currently the norm. Now, of course, those same PE firms will say they are keeping themselves busy monitoring their previous investments, rather than closing new ones. Yes, that’s necessary work. But, still, the radical slow-down in PE activity in PE is without precedent elsewhere in the PE and VC world.

Look, for example, to the VC industry in the US. In good years and bad, with IPOs plentiful and nonexistent, VC firms keep up their dealmaking.  These two charts at the top of the page show this quite clearly. Across a six-year cycle of capital markets boom and bust, the number of new VC investments closed stayed relatively constant at between 600-800 per quarter. In other words, VC workloads in the US stayed relatively stable. They kept channeling LP money into new opportunities. The dollar amounts fluctuated, peaking recently during the run-up to the highly-anticipated IPOs of Linkedin, Facebook, Groupon and Zynga.  Valuations rose and so did check size. But, deal flow stayed steady, even after Linkedin, Facebook, Groupon and Zynga’s share prices nosedived following IPOs.

This is the picture of a mature industry, managed by experienced professionals who’ve seen their share of stock market up and down cycles, heard thousands of pitches for “sure things” that raised some money only to later crash and burn. Some VC firms crashed and burned with them. But, overall, the industry has kept its wits, its focus and its discipline to invest through bad times as well as stellar ones.

The contrast with China’s PE industry is rather stark. There are perhaps as many as 5,000 PE and VC firms in China. No one knows for sure. New ones keep getting formed every week. The more seasoned of the China PE and VC firms have a history of about 10 years. But, the overwhelming majority have been in this game for less than five years. In other words, today there is a large industry, well-financed and with control over a significant amount of the growth capital available in the world’s second largest economy, that was basically created out of nothing, over just the last few years.

Obviously, these thousands of new PE firms couldn’t point to their long history of identifying and investing in private companies. But, LPs poured money in all the same. They were investing more in China — in the remarkable talents of its entrepreneurs and the continued dynamism of its economy — than in the track record of those doing the investing. That seems a wise idea to me. As I’ve mentioned more than once, putting money into China’s better entrepreneur-led companies is certainly among the better risk-adjusted investment opportunities in the world.

If anything, the opportunities are riper and cheaper than a year ago, as valuations have come down and good companies with significant scale (revenues above $25mn) have kept up a rate of profit growth above 30%. In the US VC industry, this would be a strong buy signal. Not so in China. Not now.

PE firms are collecting tens of millions of dollars from LPs in management fees, but not putting much new LP money to productive use by investing in companies that can generate a return. Nor are they actively exiting from previously-made investments and returning capital to LPs. This situation can’t last indefinitely.  For people handed chips and paid to gamble, it’s unwise to spend too much of the time away from the casino snoozing in your high roller suite.

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Buyout Firms Lack Exit Ramp in China — Wall Street Journal

Leave a Comment / June 25, 2016

 

WSJ

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

Download PDF version.

 

China Private Equity Secondaries — the new China First Capital research report

Leave a Comment / April 7, 2013

 

In the current difficult market environment for private equity in China, secondary transactions provide a valuable way forward.  Staging successful IPOs or M&A will remain severely challenging. This is the conclusion of a proprietary research report recently completed and published by China First Capital. An abridged version is available by clicking here.  You can also visit the Research Reports section of the China First Capital website.

Secondaries potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments. And yet these secondary deals still remain rare. As a result, General Partners, Limited Partners and investee companies, as well as China’s now-large private equity industry,  are all at risk from serious adverse outcomes.

This new CFC research report is a data-driven examination of the potential market for secondary transactions in China, the significant scope for profit on all sides of the transaction, as well as the no less significant obstacles to the development of an efficient, liquid, stable long-term market in these secondary positions in China.

The report’s conclusion is that secondaries have the potential to benefit all three core constituencies in the China PE industry — GPs, LPs and investee companies. The universe of deals potentially available for secondary exit is large, over 7,500 unexited investments made in China by PE firms since 2000.

However, the greatest potential for both PE sellers and buyers across the short to medium term is in a group of select companies CFC terms “Quality Secondaries“. These are PE investments that fulfill four criteria:

  1. unexited and not in IPO approval process, domestically or internationally
  2. investee companies have grown well (+25% a year) since the original round of PE investment, and have continuing scope to expand enterprise value and achieve eventual capital markets or trade sale exit in 3-6 year time frame
  3. businesses are sound from legal and regulatory perspective, have effective corporate governance, and a majority owner  that will support secondary sale to another PE institution
  4. current PE investor seeks secondary exit because of fund life or portfolio management reasons

CFC’s  analysis reveals that the potential universe of “Quality Secondaries” is at least 200 companies. This number will likely grow by approx. 15%-25% a year, as funds reach latter stage of their lives and if other exit options remain limited.

At the current juncture, in this market environment, and assuming “Quality Secondary” deals are done at market valuations, these investment represent some of the better values to be found in growth capital investing in China.  DD risk is significantly lower than in primary deals, and contingent risks (opportunity costs, and legal risks of pursuing other non-IPO exits) are lower.

Despite the current lack of significant deal-making activity in this area, secondaries will likely go from current low levels to gain a meaningful share of all PE exits in China.

The secondaries market in China will have unique factors compared to the US, Europe and elsewhere. There will likely be limited investor interest in any secondary deal involving a Chinese company or a portfolio that has underperformed since PE investment, or could otherwise be characterized as a  “distress” situation.

Quality Secondaries transactions in China will involve PE investors “cherry-picking” good companies at fair valuations.  The primary motivation for selling PEs is misalignment between its remaining fund life and the time required and risk inherent in achieving  domestic or offshore IPO or trade sale exit during that shortened time frame.

In contrast with secondary deals done outside China, we do not expect to see much activity involving the sale of all or most of a PE firm’s portfolio of investments. Specialist secondary firms operating elsewhere (e.g. Coller Capital, Harbourvest) do not currently have the experience or manpower in China to take on the complexities of managing and liquidating all or most of an existing portfolio of minority investments.

Rather, we expect those PEs with strong operating performance in growth capital investing in China to exploit favorable market conditions by becoming active buyers of Quality Secondaries.   GPs that prefer larger deals, (+USD25mn/Rmb200mn), should be particularly interested in Quality Secondaries, since company scale and investment amount will likely be larger, on average, than primary deals in China.

Selling PEs can pursue exit strategies based on option of selling either part or all of a successful unexited deal. A part liquidation in Quality Secondary transaction can mitigate risk and return capital to LPs while still retaining future upside. A full exit through secondary can increase fund’s realized IRR and so assist future fundraising. Importantly, a selling PE needs to act before pricing leverage is transferred mainly to buyers — generally this means secondary deals should be evaluated and priced in market when fund still has minimum of two years left of active period.

While clearly the most acute need for exit will be investments made before 2008, more recent investments need also to be assessed based on current market conditions. Many GPs are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve.

In particular, much of this “wait and see” approach is based on the hope that Hong Kong’s once-vibrant, now-moribund IPO market for Chinese companies returns to its earlier state. The US stock market will certainly remain off limits to most Chinese companies for a long time to come. Exit through China’s domestic stock market is now seriously blocked by bureaucratic slowdowns and an approval backlog that even under optimistic scenarios could take three to five years to clear.

The need for diversification is no less paramount for exits than entries. Many of the same PEs that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on  a single path to exit: the Hong Kong IPO.  By itself, such dependence on a single exit path is risky. In the current environment, it looks even more so.

The flood of Chinese IPOs in Hong Kong basically came to a halt a year ago.  When they do resume, it may prove challenging for all but the best and biggest Chinese companies to successfully issue shares there. What will become of the other deals? How will GPs and LPs profit from investments already made? That’s the focus on this new report, titled, “China Secondaries:  The Necessary & Attractive Exit For Private Equity Deals in China“.

 

Jiuding Capital: Local Boy Makes Good Atop China’s PE Industry

1 Comment / June 17, 2013

In China’s PE jungle, a mouse is king. Started just five years ago, Kunwu Jiuding Capital (昆吾九鼎投资管理有限公) has probably achieved the best results and best returns for investors in China’s private equity industry over the last three years. Indeed, few if any PE investors anywhere have out-performed Jiuding in recent years. (For a more recent analysis on challenges facing Jiuding, please click here. )

With only around $1 billion in assets, Jiuding is around 1%-2% the size of the leading global PE firms like Blackstone, KKR, Bain Capital and Carlyle. Yet, none of these firms matches Jiuding’s recent record at investing, exiting, and pocketing big returns in China. The firm is about as different from the likes of TPG, KKR and Carlyle as firms in the same industry can get. Jiuding isn’t staffed with Ivy League MBAs, operates out of modest offices, makes no claim to particular expertise in business operations, nor does it reward its partners with hundreds of millions in profits from carried interest.

Jiuding has mastered a form of PE investing devoid of glamour, prestige or deal-making genius. Rather than “Barbarians at the Gate“, think more “Accountants at the Cash Till“. Jiuding may want to savor its current status as “king of the China PE jungle”. The money-making formula Jiuding has used so effectively is getting tougher all the time.

The Jiuding investment method is blunt: it invests only in Chinese companies it believes will very soon thereafter get approved for domestic IPO. It’s not trying to guess which industries will flourish, or how Chinese consumers will spend their money in the future. It makes no bets on unproved technologies, or companies that may be growing fast, but are still years away from an IPO. Its investment technique is based on reproducing internally, as much as possible, the lengthy, opaque approval IPO process of China’s all-powerful securities regulator the CSRC.

Jiuding focuses more on guessing what the CSRC will do, rather than how a particular company will fare. This way, it hopes to capture a big valuation differential between its entry price and exit price after IPO. At its high point two years ago, there was a ten-fold gap between Jiuding’s entry and exit multiples. Jiuding bought in at a p/e of less than 10X, and could exit at over 80X. Though share prices and p/e multiples have fallen, the gap remains ample, still under 10X going in, and a likely 25X-30X going out.

Here’s the way it works: the CSRC IPO approval process can take anywhere from two to five years. Jiuding times its investment as close as legally permissible to the time when the company will file for IPO. It then gets to work doing everything it can to improve the likelihood of CSRC approval, attending meetings at the CSRC, lobbying backstage. When things go smoothly, Jiuding can enter and exit an investment in three years, including the mandatory one-year lockup after IPO.

The average hold time for other PE firms investing in China can be as long as six to eight years. These other firms are willing to invest earlier and then help the company transition, often over a two to three year period, to full tax and regulatory compliance. This is a prerequisite before filing for IPO. Change in China is perpetual, sudden, frenetic. The longer a PE firm holds an investment, the greater the risk some change in the rules, or the domestic market, or the exchange rate, or the competitive landscape will ruin a once-strong company.

These uncertainties, as well as the significant risk a Chinese company will not pass CSRC’s IPO approval process, are the two largest China PE investment risks that Jiuding tries to eliminate. For Jiuding, this means a hyper-technical focus on whether a company is paying all its taxes and whether its main customer is actually the founder’s brother-in-law. In other words, are there serious related party transactions? This is often the main reason the CSRC turns down an IPO application.

Other PEs, particularly the global giants,  take a different approach. They expend huge energy on the process of analyzing and predicting the future course of a company’s products, markets, competitive position. This involves a lot of brain power and also some guesswork. The results are mixed. A lot of deals never close, because the PE firm, after spending hundreds of thousands of dollars and lots of man-hours, can’t complete due diligence. Others will never reach the stage of even applying for IPO, let alone getting approval.

Jiuding seems perfectly-adapted to the Chinese investment terrain. When its process works, its bets pay off handsomely, often delivering returns of at least three times capital invested. Jiuding calls this a “PE factory method”. It tries to systematize as much of the investment process as possible. Jiuding has a huge staff of at least 250 people, ten times the size of other PEs in China. They are kept busy doing this work of collecting company data and then simulating the CSRC’s approval process. It invites its LPs, mainly wealthy Chinese bosses, to participate in deal screening and approval. If the majority of LPs doesn’t approve of a deal, it doesn’t get done. In the PE industry, this is often known as “letting the lunatics run the asylum”.

To be sure, Jiuding doesn’t always get it right. It does more deals each year than just about every other PE firm in China. Quite a few will flame out before IPO. But, Jiuding will usually get its original investment back, by forcing companies to buy back the shares. Meantime, its IPO hit rate is high, as far as I can tell. The company discloses information only sporadically, and its website lists only fourteen IPOs. Its actual tally is certainly far higher. Jiuding regards everything about its business — its portfolio of investments, its total capital, its staff size — as commercial secrets.

Jiuding differs in another important way from larger, better-known PE firms: it helps itself to less of its LPs’ money . Jiuding takes a lower management fee, usually a one-time 3% charge, rather than annual 1%-3%, and awards itself with a smaller carry on successful deals. Jiuding’s almost as efficient at raising money as it is investing it. It’s already raised at least ten different funds, including, recently, a dollar one.

With everything going so well, Jiuding, and its stripped-down approach to PE investing, looks unstoppable. But, there are some signs of serious problems ahead for Jiuding. Its main problems now aren’t raising money or even finding good companies. Partly, it’s a challenge familiar to most successful Chinese companies, including many Jiuding has invested in: copycats start springing up everywhere. In the last two years, hundreds of new Renminbi PE firms were founded. Many are trying to duplicate Jiuding’s formula. They also focus on companies ready to apply for IPO, and also try to anticipate the way the CSRC will rule on the application. Jiuding needs to fight harder now to win deals, and often does this by agreeing to invest at higher price than others. That will inevitably lower potential returns.

The second, larger problem is the CSRC’s IPO approval process itself. It is becoming slower, and also even more impenetrable and unpredictable, even to the savants at Jiuding. It’s harder now for Jiuding to get in and out of deals quickly, a key to its success. The backlog of Chinese companies with CSRC approval and waiting to IPO is now at around 500. In most cases, that means a wait of at least two years after the laborious CSRC process is complete. A lot can go wrong during that time. So, an investor like Jiuding will need to understand, before going in, more about a company and its longer-term prospects.

In China’s PE market, where good companies are plentiful and IPO exits are limited, Jiuding has prospered by focusing more on understanding the regulator than on understanding a company’s business model and industry. It never needed to bother much with monitoring the day-to-day dramas of running a company, or offering sage advice as a board member, or helping a company expand its partnerships and improve marketing. Yet, all this is becoming more and more necessary. These aren’t skills Jiuding has mastered. Who has? The same big global PE firms (including Carlyle, TPG, Blackstone, KKR, Bain Capital) that Jiuding has lately run circles around. Jiuding’s “PE factory” must adapt or die.

 

 

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.

 

 

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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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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