私募融资

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“.

 

China Private Equity Secondaries — New York Times, Bloomberg, CNNMoney

Leave a Comment / March 12, 2014

–Dual

It is imperative for the private equity industry in China to develop an efficient, liquid market for secondaries. Our goal is both to facilitate an active dialogue, as well as help bring this about. Only by breaking the current logjam of no exits in China PE can money again start to flow in significant amounts to capital-hungry private companies. No less than the future fitness of China’s entrepreneurial private sector is at stake.

In the last several days, along with the Wall Street Journal article posted yesterday, five other financial media (New York Times, Bloomberg, AVCJ, PEI, CNN Money) published stories on this topic, referencing research results from China First Capital. I’m pleased to share them.

Private Equity in China: Which Way Out?

HONG KONG — Welcome to the private equity game in China: you can buy in anytime you like, but you can never leave. At least, that is how it is starting to seem for many of the firms that bought in big during the boom of last decade.

Starting from a base of almost nothing in 2000, global private equity funds and their start-up local counterparts rushed into the Chinese market – completing nearly 10,000 deals worth a combined $230 billion from 2001 to 2012, according to a report released this week by China First Capital, a boutique investment bank based in the southern city of Shenzhen.More…

 

Private-equity funds in China are still holding 82 percent of the companies they’ve invested in since 2007, as the frozen market for initial public offerings keeps them from exiting, a study showed.

Funds hold 6,584 companies after disposing of 1,445 and seeing 20 go bankrupt, according to a report from China First Capital, a Shenzhen-based firm that advises on private equity and mergers. Investors still hold companies valued at $94.3 billion, compared with a total of $194.7 billion, according to public data compiled by the firm and its own research. More...

 

 

At least 200 private equity portfolio companies in China are attractive targets for potential secondary buyers and the number is likely to grow 15-25% per year as funds come to the end of their lives and find that exit options are still limited.

These companies represent the cream of a much larger pool of investments that are as yet un-exited by Chinese PE investors, according to a proprietary study by specialist investment bank China First Capital. It estimates that more than 7,500 portfolio companies remain in private equity firms’ portfolios from investments made since 2000.  More…

 

As other exit avenues for private equity dry up in China, GP-to-GP secondaries could be the only option for the 7,500 unexited portfolio
companies, according to a recent study from China First Capital.

China has 7,550 unexited private equity investments totaling $100 billion that will soon have to be realised through routes other than the traditional IPO, according to a recent study from China First Capital.
As fund lives begin to expire, Peter Fuhrman, chairman and chief executive of CFC, believes the standout option will be GP-to-GP secondary transactions. This is especially true for RMB funds, which have a three-to-five year life rather than the ten years typical with US dollar funds. More…

China’s stalled market for new share listings is severely limiting the ability of private equity funds to cash out their
investments in the country, according to a new research report from China First Capital.
The Shenzhen-based investment bank analyzed more than 9,000 private equity and venture capital deals completed in
China since 2001, and found that more than $100 billion — much from the U.S. — remains invested. More…

 

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Private Equity In China – Time For A New Exit?

Leave a Comment / January 10, 2013

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Article from Wall Street Journal January 8, 2013

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China was once one of the few bright spots globally for private equity. Now it’s a quagmire – and investors are going to have to change the way they approach the market.

That’s the finding of a new report by Shenzhen-based private equity advisory China First Capital (pdf). According to the company’s own research, there have been about 9,000 private equity deals completed in China over the past decade, but in more than 7,500 of those instances – or $130 billion worth of investment – investors still haven’t managed to cash out.

“Over the last 18 months, first the U.S. capital markets, then Hong Kong’s and finally China’s Shanghai and Shenzhen domestic stock markets have dramatically lowered the number of IPOs of Chinese companies,” writes Peter Fuhrman, China First Capital chairman, in the report. “It seems more likely than not that the golden age of Chinese IPOs, when over 350 companies were listing each year across public markets in the U.S., Hong Kong and China, is now over.”

It’s not a turn of events that will be easily remedied. A wave of fraud allegations leveled by auditors and short sellers against a number of small Chinese companies listed in the U.S. has destroyed investor confidence in the sector and all but frozen new IPOs. Listings in Hong Kong dropped off in 2012 owing to that market’s poor performance, but even if it recovers many private-equity-invested companies are too small to clear the Hong Kong bourse’s listing requirements. And in mainland China, the regulator has all but stopped new listings in Shanghai and Shenzhen for fear that new offerings would divert liquidity and drive lower two of the world’s most underperforming markets.

Analysts tip China’s domestic IPO market to come back to life this year. PricewaterhouseCoopers expects a combined 200 IPOs raising between 130 billion yuan ($20.7 billion) and 150 billion yuan on the Shanghai and Shenzhen stock exchanges in 2013, it said in a report. But that’s not going to clear the private equity backlog.

About 100 companies have already been cleared by the China Securities Regulatory Commission to list their shares, but are waiting for the market to improve. A further 800 companies have already filed IPO applications and are waiting for regulator’s nod. And according to Mr. Fuhrman, an additional 600 or 700 companies could be ready to apply as soon as the regulator signals it’s fully ready to take new applications. With many funds needing to return cash to their investors in the not-so-distant future, waiting for an IPO slot to open up is looking like the financial equivalent of a Hail Mary.

Traditionally, IPOs have been the preferred way for private equity investors in China to get their money out of companies they invested in. That’s in part because during the golden years of 2006 and 2007, sky-high IPO prices would result in a killing for investors that got in early. But it’s also because finding another company willing to buy the company you’ve invested in – a popular exit for private equity investors in developed markets – is seldom an option in China. Private equity investors usually take only a minority stake in Chinese companies, often because the entrepreneur who founded the firm is unwilling to relinquish control.

“To achieve [a] trade sale exit, the [investor] would need to persuade the majority owner, usually the person running the company, to sell out,” said the report. “Even in cases where that is possible, there is not an active market for corporate control in China. Few deals have been successfully concluded where a private entrepreneur, alongside a PE minority investor, has sold the business.”

The answer to this investment exit quandary might be secondary deals, whereby one private equity fund sells its stake in a company to another private equity fund, or in some cases sells its entire stable of companies to another fund. So far there have been very few such deals in China, but Mr. Fuhrman thinks they could be the way of the future.

“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,” says the report.

Secondary deals are usually unpopular among investors that give their money to private equity funds. Large investors who have allocated money to a number of private equity shops see them as a waste of their money, particularly if one fund they’ve invested in sells to another fund they’ve invested in – all the more so if it’s at a higher price.

Secondary deals overseas often involve distressed assets – the kind a private equity fund is willing to sell at a loss just to be rid of them. But the deals Mr. Fuhrman foresees coming to the table in China would be of much higher quality, with funds forced to sell because they’re due to return cash to investors rather than because of any underlying problem with the investment.

The current quagmire is a problem that’s been building for some time, and private equity funds have so far proven reluctant to embrace secondary deals as an exit. But with the chances of getting an IPO done looking less like a bottleneck and more like the eye of a needle, major changes might be forced upon funds and the way they do business.

– Dinny McMahon

 

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Cornerstone Investing: Brilliant New Idea or Mistaken Strategy for China Private Equity Firms?

Leave a Comment / December 19, 2012

Cornerstone investing is among the latest new investment strategies favored by some in the private equity industry in China. It is still early. But, cornerstone deals may prove to be among the least successful risk-adjusted ways to make money investing in Chinese companies.  Cornerstone investing involves putting big money up to buy shares in a company at the time of its IPO. In essence, it’s no different than buying any other publicly-traded share through your stockbroker, except a little worse in one respect. The cornerstone investors usually accept restrictive covenants that prevent them from exiting until months after the IPO. The investment strategy, such as it is, amounts to hoping the stock price will go up.

This is obviously quite a departure from the way PE firms typically operate in China: discovering a great private company, putting money in while the company is still illiquid, then nurturing their growth for several years up to and beyond a public offering. Done well, this process will earn a PE investor returns of 500% or more. Generally, PE firms also can indemnify themselves against losing money by exercising a put to sell their shares back to a company that fails to IPO successfully. It’s hard to imagine any scenario where cornerstone investing can do as well, and many where it will be significantly worse. One example: the possibility that the overall stock market performs poorly,  as it has in Hong Kong for the last year or so.

Cornerstone investing is a well-established practice in Hong Kong IPOs. Previously, it was only rich Hong Kong plutocrats who did these deals, at a time when most IPOs were heavily oversubscribed and likely to record a big first day jump in price. Now, the plutocrats are gone, new IPOs have fallen steeply,  valuations are way down, and PE firms have taken their place. What is it they say about fools going where wise men dare not tread?

How popular are these cornerstone deals now in Hong Kong? Hundreds of millions of dollars of PE capital have already been deployed. According to data from Bank of America Merrill Lynch cited by the Wall Street Journal, “private-equity funds… [make] up 41% of cornerstone investors in Hong Kong IPOs in 2012, compared with just 5% last year.” The only limiting factor seems to be the big falloff in the number of Chinese companies going public in Hong Kong this year. PE firms appetite to do these deals seems, if anything, to be getting stronger.

Finding a cornerstone investor is usually a great deal for the company staging an IPO, since it means there are fewer shares that need to be sold to the general public, and the lock-in provisions provide comfort to other investors that the company should be worth more later than it is at time of IPO. So, price volatility is reduced.

And the corresponding benefits for the PE firm are? Good question. The PE firms will claim they are buying into a good company at a comparatively good price, that they’ve done extensive DD and are confident of long-term stock price appreciation, with moderate to low risk. In other words, it’s a good place to invest their LPs money. That might be more plausible if cornerstone investing was producing large returns of late. It hasn’t. The Hong Kong stock market remains at a very low level. Yes, maybe the Hong Kong stock market will rally, and so lift these shares, conveniently after the lock-in has expired, allowing the PE firms a nice trading profit.

As an investment strategy, this basically amounts to market timing. And as most financial theory teaches us, all market timing is as likely to lose money as earn it. The PE firms will argue otherwise, that they are acting like good “value investors”, buying the shares at what they deem to be a low IPO price. As the company grows, its stock price will as well. Could be. But, there is an argument that this is what hedge funds and mutual funds are designed to do. They bet on the earnings momentum and so share price direction of publicly-traded equities. Is PE investing in China so difficult, so profit-constrained that PE firms now need to appropriate someone else’s business model? And do so without having much, if any, of a track record in this sort of investing?

That’s really the challenge here. Why should PE firms do these deals if there are still many outstanding pre-IPO equity investment opportunities available in China? PE firms can acquire a meaningful ownership stake in a dynamic private Chinese company, at low valuation, enjoy all kinds of special investor rights and privileges, including that guaranteed buy-back, that aren’t available to cornerstone investors.

With cornerstone investing, a PE firm is mainly at the mercy of the stock market. Will overall share prices go up or down or stay the same? It’s passive. With typical PE investing, the potential rewards, as well as downside protections, are obviously much better. But, so is the work you need to do.

That may explain a lot of the appeal of cornerstone investing. Cornerstone investing is simple. You get the IPO prospectus from a well-known underwriter, parse the audited financials, study other quoted comps, maybe talk to management about their growth prospects and how the IPO proceeds will be spent. You then make a determination about whether the company looks to be a good medium-to-long term bet. You never need to leave the office.

Compare that to PE deals in China. Due diligence is messy, slow, expensive and hazardous. Many deals never close because the PE firm discovers, during DD, that a Chinese firm’s financials are not compliant with tax laws, or the founder’s main supplier is his cousin’s husband or the company has failed to acquire the appropriate licenses. In these cases, the PE firm has to swallow the cost of the DD, which can run to $250,000 or more per deal. Too many examples of this kind of loss-making and a PE firm will start to find its LPs are less willing to commit money in the future.

This kind of “DD risk” is largely absent from cornerstone deals. A company staging an IPO has gone through multiple rounds of vetting, approval and audits. All paid for by parties other than the PE firm. So, cornerstone investing can look, from a certain crooked perspective, like typical PE investing minus all the costs and hassle of “DIY DD”. After all, the companies going public are usually similar in scale, business model and growth to purely-private deals the PE firm will look at in China.

Cornerstone investing is suddenly popular with some PE firms because stock market valuations have fallen so far in Hong Kong. Valuations, in p/e terms, are usually lower now in a Hong Kong IPO than for a comparable company raising money in a private placement in China: 4-8X this year’s net income for the HK IPOs, and 8-10X for the private placements.

PE firms are given money by investors, and usually paid an annual management fee, to take on this risk and trouble of finding good companies, screening them, negotiating a good deal, and then remaining actively engaged, after investment, on the board, to help the company achieve its targets and an eventual exit. This is where the big money has been made in China PE, not in betting on the direction of publicly-traded share prices.

As a stock picking strategy, it’s not unreasonable to suppose that Hong Kong stock prices are now at a cyclical low, and will start to move closer to the valuations on China’s domestic stock markets. If so, then some cornerstone deals may end up making decent money.

But, PE firms are not, or should not be, stock-pickers, market-timers, valuation arbitrageurs. This is truest of all for those PE firms that raised money to invest – actively and passionately — in China’s outstanding private entrepreneurial companies.

 

 

Two New CFC Research Reports

Leave a Comment / April 7, 2013

China First Capital (中国首创）published two new research reports, one in English and one Chinese. Both are now available for download here. The contents are different, as is the focus.

To download the English report, titled “Private Equity in China 2012: The Pace of Change Quickens“, Click here

For the Chinese report, “2012-2013 中国私募股权融资与市场趋势” Click here

In fact, “No Exit” would be the more appropriate title for a report about private equity in China this year. Jean-Paul Sartre‘s famous play of that name is a conversation between three dead people stuck in hell. They are eternally damned. PE funds currently stuck inside Chinese investments with no way to exit are not in such a hopelessly miserable situation. But, some may be feeling that way.

Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all pretty much slammed the door shut on IPOs for Chinese companies. In previous years, over 300 Chinese companies would IPO. This year, that number will fall by at least 80%, maybe more. Stock markets in the US, Hong Kong and China all have slightly different explanations for the sharp drop-off in IPOs of Chinese companies. But, a common thread runs throughout: a deep distrust among investors and regulators of the accuracy of Chinese companies’ financial accounts.  The view is that a Chinese company’s IPO prospectus may be as much a work of fiction as the Sartre play. Under such circumstances, companies can’t IPO, and PE firms can’t find buyers for their illiquid shares.

China’s domestic stock markets were the last to bar the door against Chinese IPOs. Until mid-year, China’s all-powerful securities regulator the CSRC was continuing to process and approve IPO applications, and companies were going public at a rate of about five a week. Then, in July, the whole complex system of approving and placing IPO shares basically stopped functioning. A Chinese company called Xindadi (新大地） exposed a serious defect at the heart of the regulatory system in China. The CSRC’s primarily function is to stop any bad company with dodgy accounts from accessing China’s domestic capital markets. Layer upon bureaucratic layer is piled up inside the CSRC to prevent officials from conspiring together to let a bad company’s application pass through. The underwriter, the lawyers and accountants are also held legally accountable to detect and expose bad companies. Yet Xindadi managed to slip through.

Xindadi’s IPO application was approved by the CSRC and the company was waiting its turn to go public when media reports surfaced that described a rather clumsy, though, nearly-successful fraud. Xindadi’s financial accounts  turned out to be fake from top to bottom. Xindadi’s business model is aptly summarized by comments made nearly a century ago by the US Federal Trade Commission about another rogue outfit, ” fraud, deceit, misrepresentation, dishonesty, breach of trust and oppression.”

The Xindadi IPO was pulled before the underwriters could sell any shares. The CSRC went into a kind of post-traumatic shock from which it’s yet to recover. It basically stopped approving new IPOs in most cases. Meanwhile the number of Chinese companies who’ve filed for IPO continues to lengthen, and now is over 800. If and when the CSRC goes back to its previous rate of approving IPOs, which isn’t likely anytime soon,  it would take four years to clear this backlog.

Predictably, for PE firms in China,  “No Exit” has now turned into “No Entrance”. Not knowing when IPO windows will reopen, PE firms have mainly stopped doing new deals.  Chinese private sector companies, for whom PE is the main source of growth capital, are feeling the pinch. Equity capital, even for good companies,  is difficult, if not impossible, to come by. The abrupt cut-off of PE financing will certainly lead to slower growth and fewer new jobs in China.

IPOs of Chinese companies in the US, Hong Kong and China have been an important, if little recognized, part of China’s growth story over the last decade. They fueled the boom in private equity  — both the creation over the last five years of hundreds of new PE firms and the raising of tens of billions of dollars in new capital –  and with it, a huge increase in total net new investment into China’s private sector companies. Chinese investment, particularly spending by state-owned companies, and government-backed infrastructure projects, is still largely financed by bank lending. But, the equity capital provided by PE firms has played a key part in financing the growth of larger private companies in China.  PE money has underpinned increased competition, choice and economic dynamism in China.

Now that gusher of PE money has turned to a trickle.  What next for private equity and corporate finance in China? The two new CFC reports summarize some of the main developments and trends in private equity and capital markets this year, and makes some predictions about the year to come. The Chinese-language report was written, as are other CFC Chinese reports, for the specific use and reference of domestic Chinese business-owners and senior management. The key message is that it’s getting far more difficult for companies to raise money, either through private placement or IPO.

The English report focuses more heavily on what’s going on in the private equity industry in China. Unlike many, I remain overall extremely positive about the fundamentals in China, that PE investment in China’s growing private sector companies represents the best risk-adjusted investment opportunity in the world. While exits through IPO are far fewer, China’s strongest investment asset remains firmly in place:  the compounded genius of its millions of private entrepreneurs to create wealth and push forward positive social and economic change.

 

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.

 

 

Dollars No Longer Welcome

1 Comment / October 23, 2012

2012 is going to be a bad year for new dollar investment in Chinese financial assets. This reverses what was thought to be, only a few years ago, an irreversible trend as more of the world’s largest and most sophisticated investors sought to increase the asset allocation in China. It’s not that China has fallen out of favor with institutional investors. If anything, China’s comparative strengths — in terms of solid +7% economic growth, a vibrant domestic consumer market, reasonably healthy banks, prudent fiscal policy — stand in ever starker contrast with the insipid economies and improvident governments of Europe, the US, Japan.

So, how come fewer dollars are flowing into China? The main reason is that the stock markets in the US and Hong Kong have fallen out of love with Chinese IPOs. These two stock markets have been the primary source for more than a decade of new dollar funding for domestic Chinese companies. Just two years ago, Chinese companies accounted for one-third of all IPOs in the US. The IPO market for Chinese companies listing in Hong Kong was even hotter. Last year, almost $70 billion was raised by Chinese companies listing on the Hong Kong Stock Exchange.

Dollars raised in New York or Hong Kong IPOs were converted into Renminbi, then invested to fuel the growth of hundreds of Chinese private companies and SOEs. Stock markets in London, Frankfurt, Seoul, Singapore, Sydney also provided access for Chinese companies to list and raise capital there. Overall, the international capital markets have been a key source of growth capital for Chinese companies, and so an important part of China’s overall economic transformation.

This year, the US will probably host fewer than five Chinese IPOs, and the total amount raised by Chinese companies in Hong Kong will be down by at least 65% from last year. The two other sources of dollar investment in Chinese companies — private equity and institutional purchases of Chinese shares — are also trending downward. Of the two, PE money was by far the more important, particularly over the last decade. In a good year, over $5 billion of capital was invested into private Chinese companies by PE firms. But, rule changes in China began to make dollar PE investing more difficult starting five years ago. It’s harder now to get permission to convert dollars into Renminbi, and Chinese companies can no longer easily create offshore holding company structures to facilitate dollar investment and an eventual exit through offshore IPO.

Rule changes slowed, but didn’t stop, dollar PE investing in China. The bigger problem now is that stock market investors in the US, and to a slightly lesser extent those in Hong Kong, no longer want to buy Chinese shares at IPO. It’s mainly because retail and institutional investors outside China distrust the quality and truthfulness of Chinese corporate accounting. If offshore IPOs dry up, dollar PE investors have no way to cash out. M&A exit is still rare. The twin result this year: less dollar PE money entering China, and also a steep drop in offshore IPO fundraising for Chinese companies.

Consider what this means: the world’s largest pools of institutional capital are finding it more difficult to invest in the world’s fastest growing major economy. This makes no financial sense. Chinese companies have a huge appetite for growth capital, and have the potential to achieve high rates of return for investors. Investment in China’s private entrepreneurial companies remains perhaps the best risk-adjusted investment class in the world. But, all the same, this year will see a steep drop of new international investment in Chinese companies.

Perhaps partially to compensate, China this year has liberalized the rules somewhat to allow international institutions to buy shares quoted in China. But, since that money goes to buy shares held by other investors, rather than to the company itself, investing in Chinese-quoted shares has little, if any impact, in filling Chinese companies’ need for growth capital. The appeal of owning China-quoted shares is hardly overpowering, as the market has been a poor performer overall, and share prices are more propelled by rumor than fundamental value.

At any earlier time in recent history, a dramatic drop like this year’s in new dollar investment into China would be felt acutely by Chinese companies. But, as dollar investing has dried up, Renminbi investing has more than filled the gap. The Shenzhen and Shanghai stock markets are now far larger sources of fresh IPO capital for Chinese companies than New York or Hong Kong ever were. Also, Renminbi PE firms have proliferated.

For a mix of reasons, China is now, arguably, more financially self-reliant than it has been since Mao’s day. Autarky used to be state policy. Now, it is a consequence of China’s own rising affluence and capital accumulation, together with some nationalistic policy changes and the fall-off in interest among international investors to finance Chinese IPOs. Ironically, as China has been drawn more into the global trade and financial system, its need for external capital has lessened.

That is unfortunate. Dollar investment in China benefits both sides. It offers dollar investors higher potential rates of return than investing in mature developed economies. This means better-funded and more generous pensions for American and European retirees. For Chinese companies, dollar investors usually tend to be more hands-on, in a good way, than Renminbi funds. So, they help improve the overall competitiveness, professionalism, corporate governance and strategic planning of the Chinese firms they invest in. Many of China’s best entrepreneurial companies — including well-known firms like Baidu, Alibaba, Tencent, as well as hundreds of domestic Chinese brand-name companies few outside of China have heard of– were nurtured towards success by dollar investors.

Since just about everyone wins from new dollar investing in China, what can be done to reverse this year’s big slide? The answer is “not a lot”. I don’t see any strong likelihood that international investors will grow less allergic to Chinese IPOs. Renminbi PE and IPO funding for Chinese companies will continue to grow strongly. Only the removal of capital controls in China, and full Renminbi convertibility, would change the current situation, and lead, most likely, to large new flows of offshore capital into China.

But, full Renminbi convertibility is nowhere in sight. For the foreseeable future, China’s growth mainly will be financed at home.

 

 

 

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.

 

 

Private Equity Valuation: Terminal Multiple Is All That Matters

2 Comments / September 10, 2012

A lot gets written, and even more gets discussed, about how to value private companies for the purposes of PE or VC investment. There is an awful lot of “Mongolian talk” going around, a translation of the Chinese term, 胡说 , meaning senseless drivel. PEs often use irrelevant or misleading comps to justify a lowball valuation. Companies are no less guilty, setting their valuation expectations unrealistically high, based on hear-say about other deals being done or a misreading of current stock market p/e multiples.

So, how do you work out a fair valuation? The only way I know is if both sides agree on the same set of facts to advance from. That is already challenge enough. How big a challenge?

Below, I share part of an email memo I sent to a large Chinese industrial equipment manufacturer. Their controlling shareholder hopes to sell down some of its shares, while also raising some new capital for the business. They are a sophisticated group, with strong management. They approached several investment banks, including ours, to represent them in the capital raising. We made the final cut, and they then insisted that the advisor they choose must achieve a valuation for them of at least 10X this year’s net income.

In more than just the two words “that’s unreasonable”,  I set out why they need to be more accommodating with reality.

“Your goal, which I thoroughly share, is to bring in a first-rate PE and get the best price for a valuable asset. I would work with all my diligence to achieve that.  But, let’s look frankly and factually at current market conditions. At the moment, domestically-listed Chinese companies in [your]  industry are trading at a trailing p/e of 28X and forward (this year’s) p/e of 22x. Both have fallen by approx. one-third in the last year. (The 22X is the basis we should use, to compare like-with-like. You have set your valuation target of +10X based on this year’s net income.) 

Your valuation target of +10X is a discount to quoted comps of 50% or narrower. That is a smaller discount, and so higher entry valuation for PE firms, than deals being done now. 

As you know, all PE deals, since they involve illiquid companies often years away from IPO exit, are always done at discount to quoted comps. The discount is not fixed, but the only time PE deals were closed routinely at prices over 10X (rarely if ever above 15X) was two years ago or more when comparable stock market p/e valuations (generally on the CHINEXT)  were 70X-100X previous year’s net.   A rich price indeed, and for a while, it had a levitating effect on PE valuations.

Current market conditions are that there are no investments from first-line PEs with terminal multiples at +10X. I emphasize the word “terminal multiple” because quite often — too often in our experience — a PE will offer a higher multiple at term sheet stage, to win the competitive right to pursue exclusive due diligence. These deals are almost always “repriced” at closing to a level below 10X, when PE firm has most of the leverage. PE will claim they turned up “new facts” in DD, as they always do, that justify the repricing.  They promise you +10x in a term sheet knowing they will only close the deal at a lower price, when all other interested investors have vanished from the scene. Unfair? Duplicitous? Get used to it. It’s the way the game is played.

The other common occurrence in China PE is that there is a headline multiple of +10X but it is linked to an aggressive next year + this year (sometime even three year) profit guarantee. The level is set by PE firm in full expectation that company will not meet the profit targets, so triggering the ratchet, often quite punitive. This process will bring the terminal multiple down significantly. We’ve seen and heard of deals where this terminal multiple is half the headline number at signing of term sheet or Share Purchase Agreement. In other words, the SPA has a headline multiple of 12X, but terminal multiple, after ratchet is triggered,  works out to 6X-7X.

From my experience, the ratchet is triggered in over half PE deals done in China. In the case of some leading China PEs, [names omitted to shield the guilty], the ratchet is triggered in over 80% of the deals they do. The ratchet trigger is very unfortunate for the company, and reflects the fact they are badly advised, by advisory firms paid a fee based on “headline valuation at closing” not terminal valuation.  

The other condition attached to deals with headline p/e of +10X is a high IRR (usually +20% p.a. simple interest) for buybacks triggered by “no qualifying IPO”. The buyback is a feature of almost all PE deals done in China. As you would be financially liable for such a payment, if I work as your investment banker, I’d want to negotiate this mechanism very carefully with PE, to assure your best interests are fully protected. It’ll mean a fight with the PE firms, but it will be gentlemanly. You want an IRR of no more than 10%. Why? One way to think of it is that for every 100 basis points the buyout IRR is fixed above LIBOR, you can argue the terminal multiple falls by 0.3X to 0.5X, because of the contingent liability.  

Yours is a highly cyclical industry. We are now in the downward loop, heading for the bottom of cycle. This negatively impacts valuation. Your cap table, particularly the fact the company is controlled by a CEO who has no capital directly invested in the business, also negatively impacts valuation. For last three years (2009, 2010, 2011) your net income has been flat, and net margins have fallen by almost half. This too negatively impacts valuation.  That’s three strikes already. You’re not “out”, as in baseball. But, it’s a three-ton weight pushing down your terminal multiple. 

I can promise you that if we work together, you will get the best outcome available in current marketplace, and be working with a firm that shares your commitment to integrity, professionalism and accountability.  

But, if you do decide to move forward with the other advisor, I’d urge you to ask them to address the specific points raised here, and structure their compensation on an “all or nothing” basis: they only earn a fee if the terminal multiple is above 10X, as they are now promising.  

A seller’s focus on valuation is understandable. But, too often in our experience, it can play into the hands of both the PE investor and your investment banker. Both will encourage your expectations knowing that the final bill on valuation will only be presented to you in two to three year’s time.  More often than not, only they will be feeling victorious at that point.

Cordially,
Peter”

This company decided to retain the other investment bank.

 

 

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

1 Comment / September 6, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

Teaching the Elephant to Dance – China’s SOEs Transform

1 Comment / April 7, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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

Leave a Comment / May 23, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Leave a Comment / April 26, 2012

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

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

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

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

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

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

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Chinese Private Equity Moves from IPO to IRR

1 Comment / April 10, 2012

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

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

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

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

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

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

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

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

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

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

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

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

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