私募资金

Chengdu — Great City, but Where Are the Great Food Companies?

Leave a Comment / October 4, 2011

Ge dish from China First Capital blog post

Among major cities in China, Chengdu takes the prize as most pleasant, livable,  comfortably affluent, relaxed and charming. I arrived back here today. I’m reminded immediately there’s much to like about Chengdu, and one thing to love: the food.

Chengdu is famed for its “小吃”, (“xiaochi”) literally “small eats”. To translate 小吃 as “snack”, as most dictionaries do, doesn’t even remotely begin to do it justice. A 小吃  is a often one-bowl wonder of intense, jarring flavors. They not only take the place of a full meal with rice, they make the Chinese staple seem almost superfluous, a waste of precious space in the stomach.

There are about a dozen小吃 that can stop me in mid-stride, any time of day. These include several varieties of cold noodles, including the bean jelly ones called 凉粉, literally “cold powder”，as well as dandan noodles served dazzlingly hot, in both senses of the word.

My favorite 小吃 , by a wide margin, is 抄手 , literally, “to fold one’s arms”. It’s an odd name, since the last thing I’d ever do when I see a bowl of抄手 in Chengdu is fold my arms. They are always thrust outward, in anticipation.  抄手 is a bowl of wontons steeped in a fire-engine red soupy sauce, optimally with enough Sichuan pepper corn to numb the tongue all the way down the gullet. This frees up the nose to do the real work of decoding all the subtle flavors.

Offiically, Chengdu has a per capital income of around $5,200, about half Shanghai’s. But, I’d prefer living and working in Chengdu any day. So would many Chinese I know. The economy is doing well, despite some geographic disadvantages. Chengdu is the most westerly of China’s large cities, and so isolated from the most developed regions of China. It’s over 1,000 miles to Shanghai, Beijing, and almost as far to Shenzhen.

Chengdu is doing well economically – though you don’t always have a sense this ranks as high on the list of civic priorities as drinking tea and playing mahjong. The electronics and telecom industries are both doing well. Quite a few companies have received PE investment.

The one industry, however, that is still relatively undeveloped is the food business. This is odd. By logic, Chengdu should be a center of China’s food processing and restaurant industry. Not only is it a great food town, situated in a very region valley producing some of China’s best fruits and vegetables, but it is also capital of Sichuan Province.

Sichuan food is almost certainly the most popular “non native” cuisine across China. Within a mile of where I live in Shenzhen, there are probably over 50 Sichuan restaurants. It’s the same in Beijing, Shanghai and most other major cities.

There’s an innate association in Chinese minds between Sichuan and good food. In this, Sichuan reminds me a lot like Italy. Italian food is prized across all of the Western world, and as a result, some of the Western world’s biggest and most successful food companies are based in Italy. Among the larger ones are Barilla, Bertolli, Buitoni, Parmalat, Ferrero. These, and thousands of smaller ones making wine, cheese, salami, all benefit from the widespread popularity of Italian food, and the high market value of associating a food brand with Italy.

Chengdu and Sichuan should be no different. It should be the capital of China’s food processing industry. But, as far as I can tell, there are as of yet no great food companies or food brands based there.  If you shop around in Chengdu, the food products being marketed as “authentic Sichuan food ” are mainly an assortment of beef jerky, along with sweet and savory biscuits made from beans and peanuts.

There’s nothing wrong with any of these products, but there isn’t a big brand national brand among them. The mass market is going unserved.

Let’s look at two of the biggest food product categories where Sichuan brands should predominate: chili sauce and instant noodles. Each of these product areas have sales of billions of dollars a year in China. Yet, the leading brands come from outside Sichuan. In the case of instant noodles, the leaders are mainly Taiwanese and Japanese.

In chili sauce, the biggest brands all seem to come from Guizhou province. This, particularly, should cause a collective loss of face across Sichuan. Their spicy food  “owns” the palettes of hundreds of millions of people and yet the main brands of chili sauce in supermarkets come from the poorer province to its south.

The companies selling bottled pre-made Sichuan sauces (for popular dishes like Gongbao Jiding, Mapo Toufu and Yuxing Rousi) mainly come from Taiwan, Shanghai, even Hong Kong. It’s as if the most popular brands of spaghetti sauce were made in Brazil. Chinese food companies all over are eating Sichuan’s lunch.

This situation is unnatural and, I’d hope, unsustainable. Sichuan companies should by rights eventually dominate the market for many food products in China, much as Italian food companies are among the largest in Europe.

Some lucky PE investors should someday make a lot of money backing Sichuan food companies. Me and my company would love to play our part in this. Ambitious food entrepreneurs in Chengdu, call us anytime — 0755 33222093. If ever there were a billion-dollar unfilled market opportunity in China, this would be it.

 

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China: The World’s Best Risk Adjusted Investment Opportunity

1 Comment / August 21, 2011

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Seoul, Korea. At the Harvard Project for Asia and International Relations’ annual conference, I gave a talk today titled “China, The World’s Best Risk-Adjusted Investment Opportunity”. A copy of the PPT can be downloaded by clicking here. 

The slides are mainly just talking points, rather than fully fleshed-out contents. The idea was to work backwards from the conclusion, as propounded in the title, to the reasons why. My argument is that a confluence of factors are at work here, to create this agreeable situation where investing in Chinese private companies offers the highest returns relative to risk.

Those factors are:

  1. China’s current stage of six-pronged development (Slide 2)  
  2. A large group of talented entrepreneurs tested and tempered by the difficulties of starting and managing a private business in China (Slide 5)
  3. Plentiful equity capital (from private equity and venture capital firms) with clearly-articulated investment criteria (Slide 6)
  4. An investment strategy that offers multiple ways for capital to impact positively the performance of a private company,  lowering the already-minimal risk an investment will tank (Slide 7)
  5. The returns calculus (Slide 8 ) – the formula here is profits (in USD millions) multiplied by a p/e multiple, producing enterprise valuation. The first equation is an example of investor entry price, pre-IPO, and the second is investor exit price, after a round PE investment and an IPO. The gain is twenty-fold.  Thus do nickels turn into dollars
  6. Downsides – best risk-adjusted returns does not mean risk-free returns. Here are some of the ways that a pre-IPO investment can go bad (Slide 9) 

Since the audience in Seoul was largely non-Chinese, I also included two slides with the same map of China, illustrating the progression of economic development in China, from a few favored areas on China’s eastern seaboard during the early phases, to the current situation where economic growth, and entrepreneurial talent, is far more broadly-spread across the country.

As a proxy to illustrate this diffusion of economic dynamism across China, slide 4 shows, in gold, the areas of China where CFC has added clients and projects in the last 18 months. Slide 3 shows the original nucleus of economic success in China – Guangdong, Fujian, Zhejiang, Shanghai, Jiangsu and Beijing. We also have clients in these places. 

On seeing Slide 4, I realized it also displays my travel patterns over the last year.  I’ve been everywhere in red or gold, except Gansu, but adding in Yunnan, during that time. That’s a big bite out of a big country. This trip to Korea is my first flight outside China in two years, excepting a couple of short trips back to the US to see family. 

In the next two weeks, after returning from Korea, I’ll make three separate trips, to Henan, Jiangsu and Beijing, to visit existing clients and meet several potential new ones. While Chinese private SME provide the best risk-adjusted investment returns anywhere, you can’t do much from behind a desk. Opportunity is both widespread and widely-spread.

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Private Equity in China, CFC’s New Research Report

Leave a Comment / August 14, 2011

 

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The private equity industry in China continues on its remarkable trajectory: faster, bigger, stronger, richer. CFC’s latest research report has just been published, titled “Private Equity in China 2011-2012: Positive Trends & Growing Challenges”. You can download a copy by clicking here.

The report looks at some of the larger forces shaping the industry, including the swift rise of Renminbi PE funds, the surging importance of M&A, and the emergence of a privileged group of PE firms with inordinate access to capital and IPO markets. The report includes some material already published here.

It’s the first English-language research report CFC has done in two years. For Chinese readers, some similar information has run in the two columns I write, for China’s leading business newspaper, the 21st Century Herald (click here “21世纪经济报道”) as well as Forbes China (click here“福布斯中文”) 

Despite all the success and the new money that is pouring in as a consequence, Chinese private equity retains its attractive fundamentals: great entrepreneurs, with large and well-established companies, short of expansion capital and a knowledgeable partner to help steer towards an IPO. Investing in Chinese private companies remains the best large-scale risk-adjusted investment opportunity in the world, bar none.

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Crawling Blindfold & Naked Through A Minefield

1 Comment / June 27, 2011

 

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

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

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

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

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

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

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

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

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

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

Leave a Comment / June 22, 2011

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Leave a Comment / May 25, 2011

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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CFC’s Annual Report on Private Equity in China

Leave a Comment / May 2, 2011

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

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

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

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

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

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

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

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

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

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

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

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

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


 

 

 

How Big Can PE Industry in China Grow?

Leave a Comment / April 12, 2011

Ivory carved vase

By one conventional measure, China’s private equity industry is still a fraction of the size of larger developed economies. The PE penetration rate calculates the total annual flow of private equity finance as a percentage of total GPD. In China, the PE penetration rate is currently 0.1% of GDP. In the US, it’s eight times larger. In the UK, the flow of PE funding 2% of GDP, or twenty times the size of China.

While this calculation of PE penetration rate correctly suggests China’s PE industry still has significant room for growth, it is also somewhat misleading. It’s an apples-and-oranges comparison. Private equity in the US and Europe is mainly used to take over large underperforming businesses or subsidiaries of big public companies. These are control investments, usually financed with heavy amounts of borrowed money and a relative sliver of equity. These deals routinely exceed $1 billion. Indeed, during the first half of this year, the ten largest PE deals, all involving US companies, had total transaction value of over $20 billion.

In China, these sort of leveraged buyout deals, for the most part,  are impossible. PE capital in China flows almost entirely into minority investments in profitable fast-growing private companies. Typical deal size is $10mn for 15%-20% of a company’s shares. Deals of this kind are far more rare in the US and UK.

The more accurate term for Private Equity investing in China is “growth capital investment.” The goal is to add fuel to a fire, providing a fast-growing company with additional capital to build new factories or expand its sales and distribution channels. This kind of investing has a far higher success rate than PE investing in the US and Europe. In China, PE firms support winners. In the rest of the world, PE firms generally try to heal the wounded.

If you measured the penetration rate of growth capital investment, I have no doubt China would now be number one in the world. Nowhere else in the world can match China in the number of great private companies that are growing by over 30% a year, have the scale, experience, management and market leadership to continue to double in size every two to three years. The only real limiting factor is a shortage of capital. That’s where PE firms come in. They invest, monitor, then exit a few years later through an IPO.

That’s another big difference between PE in China and the rest of the world. PE investors in China don’t work nearly as hard as they do elsewhere. In China, the hardest part is finding good companies and then agreeing on the size and valuation of an investment. After that, it’s usually smooth sailing. In the US and Europe, it’s not only difficult to find good investment opportunities. The big challenge begins after an investment is made, in designing and then implementing often complex, risky restructuring plans, including a lot of hiring and firing.

With so much bank borrowing involved, short-term cash-flow problems can prove fatal for the PE firm’s investment. Miss an interest payment and banks can seize the business, wiping out the PE firm’s equity investment. A notable example: Cerberus’s leveraged takeover of US automaker Chrysler. Within six months of the deal’s closing, Cerberus’s $7.4 billion investment was mainly wiped out when Chrysler’s sales plummeted.

In China, PE deals also occasionally turn sour. But, the most common reason is fraud or simple theft. PE money goes into a company and disappears, usually into personal bank account of the company’s boss. This isn’t very common. But, it does happen. The PE firm will usually have a legal right to take control of a company if its money is lost or misused. But, the legal process can be slow and the outcome uncertain. By the time a PE gains control, just about everything of value can be drained out of the company. The PE firm ends up owning 100% of a business worth far less than what they put into it.

In China, PE firms often play the role of a disciplinarian, setting up rules and doling out cash as a reward for good behavior. In the US and Europe, the PE is more like a doctor in a trauma ward.

McKinsey & Company, the global consulting firm, has estimated that China’s private equity fund penetration rate could more than quadruple in the next five years, to reach 0.5% of GDP.  If so, the annual amount of PE capital flowing into private companies could reach Rmb200 billion (US$30 billion.)  There are certainly enough good investment opportunities.

At this point, the main thing holding the industry back is a lack of strong, talented people inside PE firms. Great entrepreneurs vastly outnumber great investors in China.

 

 

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Taxed At Source: Renminbi Private Equity Firms Confront the Taxman

Leave a Comment / March 15, 2011

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

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

Leave a Comment / March 6, 2011

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

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

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

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

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

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

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

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



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Is US Right to Fear China’s Industrial Policy?

1 Comment / February 21, 2011

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A particularly – and atypically – alarmist article ran recently in the Wall St. Journal titled “U.S. Firms, China in Tech War” . You can read it here ( WSJ Article) and decide for yourself. The thrust is that Chinese national policy has shifted in recent years, making it more difficult for Western government companies to win government contracts and protect their most valuable intellectual property. According to the Journal, it’s part of a new “Chinese industrial policy” to transform China into a hothouse of homegrown leading edge technologies, with companies able to challenge American supremacy.

It makes good copy. According to the article, the issues are of such portent that President Obama discussed them directly with China’s leader, Hu Jintao, during the latter’s visit to the US last month. The article cites a fretful report from the US Chamber of Commerce in China, titled “China’s Drive for ‘Indigenous Innovation’: A Web of Industrial Policies”.  The report claims China is building an “intricate web of new rules considered by many international technology companies to be a blueprint for technology theft on a scale the world has never seen before.”

To me, it seems that the Journal may be guilty of mistaking cause for effect. Is China pursuing a nationalist domestic procurement policy? Most likely, just as the US and virtually every other developed country does. Will this make it harder for non-Chinese companies to sell gear to China’s government agencies?  Quite probably. Are Chinese rules crafted in such a way to make it obligatory for Western companies to transfer their technology to Chinese partners? Seems to be the case.

But, will any of this actually achieve the stated goal? Here, I’m a lot less agitated than the Americans quoted in the Journal article. The reason is also found in the same article, which makes a passing reference to similar rules in place in Japan, Korea, Germany and elsewhere. Fat lot of good they’ve done those countries.  Their aggressive “buy local” rules, and other protectionist measures to “nurture” domestic innovation have done little to nothing to achieve their stated aim. In fact, the opposite is the case. If you want to draw up a list of the countries that have lost significant ground to the US in new technologies over the last twenty years, you can start with those that pursued similar regimes to China.

Twenty years ago, France, Germany and Japan all had large, well-known computer companies. Today, Bull, Nixdorf and NEC are either bankrupt or laughing stocks. Their governments’ passionate embrace turned out to be a kiss of death.

The same is true in the industries that the US government has chosen to support and nourish with subsidies and protection. Think about the billions wasted (or as our current US administration tabs it “invested” ) on “alternative energy” and “clean transport” in the US.

Industrial policy, in almost all cases, has a track record untainted by success. There are a lot of good reasons for this, but the most fundamental of all is that government officials, however well-schooled and well-meaning, have no competence to choose winning technologies, and certainly do so with far diminished effectiveness than an open, vibrant market of billions of customers.

Governments all love command and control. The problem is they can only do one of the two. Commanding your citizens to produce advanced products, and lavishing subsidies and protection on those who pay attention to you, is not the same as controlling which technologies will prove most useful, as well as most time- and money-saving.

Yes, this system can produce bullet trains in Japan and China, and maglev trains in Germany. Problem is, no one else wants to buy them, and your citizens are mainly too busy and happy futzing around on Facebook or Google to much care about any of this.

If China does favor domestic technology companies, the risk is these companies produce just enough innovation to please their government customers. But,  like Bull, Nixdorf and NEC, they will produce nothing that anyone else with free choice will care to buy.

Sure, I’d like US companies to have a better crack at the Chinese market. But, then again, I’d like some of my Chinese clients to have a better crack also at the Japanese, Korean and European markets they are often shut out of. Governments by their nature, sadly, are usually protectionist and nationalist. China is no different. The US has often tried to keep these malign instincts at bay. But, my homeland has all kinds of “buy American” favoritism in place for government contracts.

Innovation is important. But, often enough, it’s good marketing, pricing and efficient global distribution that wins customers, and generates the profits to reinvest in more new ideas and products. I don’t know of a single great technology company that relies on its national government as a main customer. Those that do so, like SAIC in the US or EADS in Europe, often end up falling behind the technology curve.

US companies have every right to complain about unfair procurement policies in China. There’s no solid ground, however, for believing that these same policies will result in China producing world-beating technology companies in the future. One of the surest way to find the failed technology companies of the future is to search for those whose main customers are their own nation’s bureaucrats.

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CFC’s New Research Report, Assessing Some Key Differences in IPO Markets for Chinese Companies

Leave a Comment / December 7, 2010

China First Capital research report cover

For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

  1. Valuation, p/e multiples
  2. IPO approval process – cost and timing of planning an IPO
  3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.


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